![Reading 17 ■ Understanding Income Statements
6
INTRODUCTION
The income statement presents information on the financial results of a company’s
business activities over a period of time. The income statement communicates how
much revenue the company generated during a period and what costs it incurred in
connection with generating that revenue. The basic equation underlying the income
statement, ignoring gains and losses, is Revenue minus Expenses equals Net income.
The income statement is also sometimes referred to as the “statement of operations,”
“statement of earnings,” or “profit and loss (P&L) statement.” Under both International
Financial Reporting Standards (IFRS) and US generally accepted accounting principles
(US GAAP), the income statement may be presented as a separate statement followed
by a statement of comprehensive income that begins with the profit or loss from the
income statement or as a section of a single statement of comprehensive income.1 This
reading focuses on the income statement, and the term income statement will be used
to describe either the separate statement that reports profit or loss used for earnings
per share calculations or that section of a statement of comprehensive income that
reports the same profit or loss. The reading also includes a discussion of comprehensive
income (profit or loss from the income statement plus other comprehensive income).
Investment analysts intensely scrutinize companies’ income statements. Equity
analysts are interested in them because equity markets often reward relatively high-
or low-
earnings growth companies with above-
average or below-
average valuations,
respectively, and because inputs into valuation models often include estimates of
earnings. Fixed-
income analysts examine the components of income statements, past
and projected, for information on companies’ abilities to make promised payments on
their debt over the course of the business cycle. Corporate financial announcements
frequently emphasize information reported in income statements, particularly earn-
ings, more than information reported in the other financial statements.
This reading is organized as follows: Section 2 describes the components of the
income statement and its format. Section 3 describes basic principles and selected
applications related to the recognition of revenue, and Sections 4–7 describe basic
principles and selected applications related to the recognition of expenses. Sections
8–10 cover non-
recurring items and non-
operating items. Sections 11–14 explain
the calculation of earnings per share. Sections 15–16 introduce income statement
analysis, and Section 17 explains comprehensive income and its reporting. A summary
of the key points and practice problems in the CFA Institute multiple choice format
complete the reading.
COMPONENTS AND FORMAT OF THE INCOME
STATEMENT
a describe the components of the income statement and alternative presentation
formats of that statement;
1
2
1 International Accounting Standard (IAS) 1, Presentation of Financial Statements, establishes the pre-
sentation and minimum content requirements of financial statements and guidelines for the structure of
financial statements under IFRS. Under US GAAP, the Financial Accounting Standards Board Accounting
Standards Codification ASC Section 220-
10-
45 [Comprehensive Income–Overall–Other Presentation
Matters] discusses acceptable formats in which to present income, other comprehensive income, and
comprehensive income.
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![Components and Format of the Income Statement 7
Exhibits 1, 2, and 3 show the income statements for Anheuser-
Busch InBev SA/NV (AB
InBev), a multinational beverage company based in Belgium, Molson Coors Brewing
Company (Molson Coors), a US-
based multinational brewing company, and Groupe
Danone (Danone), a French food manufacturer.2 AB InBev and Danone report under
IFRS, and Molson Coors reports under US GAAP. Note that both AB InBev and Molson
Coors show three years’ income statements and list the years in chronological order
with the most recent year listed in the left-
most column. In contrast, Danone shows
two years of income statements and lists the years in chronological order from left
to right with the most recent year in the right-
most column. Different orderings of
chronological information are common.
On the top line of the income statement, companies typically report revenue.
Revenue generally refers to the amount charged for the delivery of goods or services
in the ordinary activities of a business. Revenue may also be called sales or turnover.3
For the year ended 31 December 2017, AB InBev reports $56.44 billion of revenue,
Molson Coors reports $13.47 billion of revenue (labeled “sales”), and Danone reports
€24.68 billion of revenue (labeled “sales”).
Revenue is reported after adjustments (e.g., for cash or volume discounts, or for
other reductions), and the term net revenue is sometimes used to specifically indicate
that the revenue has been adjusted (e.g., for estimated returns). For all three compa-
nies in Exhibits 1 through 3, footnotes to their financial statements (not shown here)
state that revenues are stated net of such items as returns, customer rebates, trade
discounts, or volume-
based incentive programs for customers.
In a comparative analysis, an analyst may need to reference information disclosed
elsewhere in companies’ annual reports—typically the notes to the financial statements
and the Management Discussion and Analysis (MD&A)—to identify the appropri-
ately comparable revenue amounts. For example, excise taxes represent a significant
expenditure for brewing companies. On its income statement, Molson Coors reports
$13.47 billion of revenue (labeled “sales”) and $11.00 billion of net revenue (labeled “net
sales”), which equals sales minus $2.47 billion of excise taxes. Unlike Molson Coors, AB
InBev does not show the amount of excise taxes on its income statement. However, in
its disclosures, AB InBev notes that excise taxes (amounting to $15.4 billion in 2017)
have been deducted from the revenue amount shown on its income statement. Thus,
the amount on AB InBev’s income statement labeled “revenue” is more comparable
to the amount on Molson Coors’ income statement labeled “net sales.”
Exhibit 1
Anheuser-
Busch InBev SA/NV Consolidated Income Statement (in Millions of US Dollars)
[Excerpt]
12 Months Ended December 31
2017 2016 2015
Revenue $56,444 $45,517 $43,604
Cost of sales (21,386) (17,803) (17,137)
Gross profit 35,058 27,715 26,467
Distribution expenses (5,876) (4,543) (4,259)
Sales and marketing expenses (8,382) (7,745) (6,913)
(continued)
2 Following net income, the income statement also presents earnings per share, the amount of earnings
per common share of the company. Earnings per share will be discussed in detail later in this reading,
and the per-
share display has been omitted from these exhibits to focus on the core income statement.
3 Sales is sometimes understood to refer to the sale of goods, whereas revenue can include the sale of
goods or services; however, the terms are often used interchangeably. In some countries, the term “turn-
over” may be used in place of revenue.
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![Reading 17 ■ Understanding Income Statements
8
12 Months Ended December 31
2017 2016 2015
Administrative expenses (3,841) (2,883) (2,560)
Other operating income/(expenses) 854 732 1,032
Restructuring (468) (323) (171)
Business and asset disposal (39) 377 524
Acquisition costs business combinations (155) (448) (55)
Impairment of assets — — (82)
Judicial settlement — — (80)
Profit from operations 17,152 12,882 13,904
Finance cost (6,885) (9,216) (3,142)
Finance income 378 652 1,689
Net finance income/(cost) (6,507) (8,564) (1,453)
Share of result of associates and joint ventures 430 16 10
Profit before tax 11,076 4,334 12,461
Income tax expense (1,920) (1,613) (2,594)
Profit from continuing operations 9,155 2,721 9,867
Profit from discontinued operations 28 48
Profit of the year 9,183 2,769 9,867
Profit from continuing operations attributable to:
Equity holders of AB InBev 7,968 1,193 8,273
Non-controlling interest 1,187 1,528 1,594
Profit of the year attributable to:
Equity holders of AB InBev 7,996 1,241 8,273
Non-controlling interest $1,187 $1,528 $1,594
Note: reported total amounts may have slight discrepancies due to rounding
Exhibit 2
Molson Coors Brewing Company Consolidated Statement of Operations (in Millions of US
Dollars) [Excerpt]
12 Months Ended
Dec. 31, 2017 Dec. 31, 2016 Dec. 31, 2015
Sales $13,471.5 $6,597.4 $5,127.4
Excise taxes (2,468.7) (1,712.4) (1,559.9)
Net sales 11,002.8 4,885.0 3,567.5
Cost of goods sold (6,217.2) (2,987.5) (2,131.6)
Gross profit 4,785.6 1,897.5 1,435.9
Marketing, general and administrative expenses (3,032.4) (1,589.8) (1,038.3)
Special items, net (28.1) 2,522.4 (346.7)
Equity Income in MillerCoors 0 500.9 516.3
Operating income (loss) 1,725.1 3,331.0 567.2
Exhibit 1 (Continued)
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![Components and Format of the Income Statement 9
12 Months Ended
Dec. 31, 2017 Dec. 31, 2016 Dec. 31, 2015
Other income (expense), net
Interest expense (349.3) (271.6) (120.3)
Interest income 6.0 27.2 8.3
Other income (expense), net (0.1) (29.7) 0.9
Total other income (expense), net (343.4) (274.1) (111.1)
Income (loss) from continuing operations before income taxes 1,381.7 3,056.9 456.1
Income tax benefit (expense) 53.2 (1,055.2) (61.5)
Net income (loss) from continuing operations 1,434.9 2,001.7 394.6
Income (loss) from discontinued operations, net of tax 1.5 (2.8) 3.9
Net income (loss) including noncontrolling interests 1,436.4 1,998.9 398.5
Net (income) loss attributable to noncontrolling interests (22.2) (5.9) (3.3)
Net income (loss) attributable to Molson Coors Brewing
Company
$1,414.2 $1,993.0 $395.2
Exhibit 3
Groupe Danone Consolidated Income Statement (in Millions of
Euros) [Excerpt]
Year Ended 31 December
2016 2017
Sales 21,944 24,677
Cost of goods sold (10,744) (12,459)
Selling expense (5,562) (5,890)
General and administrative expense (2,004) (2,225)
Research and development expense (333) (342)
Other income (expense) (278) (219)
Recurring operating income 3,022 3,543
Other operating income (expense) (99) 192
Operating income 2,923 3,734
Interest income on cash equivalents and short-
term investments
130 151
Interest expense (276) (414)
Cost of net debt (146) (263)
Other financial income 67 137
Other financial expense (214) (312)
Income before tax 2,630 3,296
Income tax expense (804) (842)
Net income from fully consolidated
companies
1,826 2,454
Share of profit of associates 1 109
Net income 1,827 2,563
(continued)
Exhibit 2 (Continued)
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![Issues in Expense Recognition: Depreciation and Amortization 23
warranties. One possible approach would be for a company to wait until actual expenses
are incurred under the warranty and to reflect the expense at that time. However, this
would not result in a matching of the expense with the associated revenue.
Under the matching principle, a company is required to estimate the amount of
future expenses resulting from its warranties, to recognize an estimated warranty
expense in the period of the sale, and to update the expense as indicated by experience
over the life of the warranty.
ISSUES IN EXPENSE RECOGNITION: DEPRECIATION
AND AMORTIZATION
d describe general principles of expense recognition, specific expense recogni-
tion applications, and implications of expense recognition choices for financial
analysis;
Companies commonly incur costs to obtain long-
lived assets. Long-lived assets are
assets expected to provide economic benefits over a future period of time greater than
one year. Examples are land (property), plant, equipment, and intangible assets (assets
lacking physical substance) such as trademarks. The costs of most long-
lived assets
are allocated over the period of time during which they provide economic benefits.
The two main types of long-
lived assets whose costs are not allocated over time are
land and those intangible assets with indefinite useful lives.
Depreciation is the process of systematically allocating costs of long-
lived assets
over the period during which the assets are expected to provide economic benefits.
“Depreciation” is the term commonly applied to this process for physical long-
lived
assets such as plant and equipment (land is not depreciated), and amortisation is
the term commonly applied to this process for intangible long-
lived assets with a
finite useful life.18 Examples of intangible long-
lived assets with a finite useful life
include an acquired mailing list, an acquired patent with a set expiration date, and
an acquired copyright with a set legal life. The term “amortisation” is also commonly
applied to the systematic allocation of a premium or discount relative to the face value
of a fixed-
income security over the life of the security.
IFRS allow two alternative models for valuing property, plant, and equipment:
the cost model and the revaluation model.19 Under the cost model, the depreciable
amount of that asset (cost less residual value) is allocated on a systematic basis over
the remaining useful life of the asset. Under the cost model, the asset is reported at
its cost less any accumulated depreciation. Under the revaluation model, the asset is
reported at its fair value. The revaluation model is not permitted under US GAAP.
Although the revaluation model is permitted under IFRS, as noted earlier, it is not as
widely used and thus we focus on the cost model here. There are two other differences
between IFRS and US GAAP to note: IFRS require each component of an asset to be
depreciated separately and US GAAP do not require component depreciation; and
IFRS require an annual review of residual value and useful life, and US GAAP do not
explicitly require such a review.
6
18 Intangible assets with indefinite life are not amortised. Instead, they are reviewed each period as to
the reasonableness of continuing to assume an indefinite useful life and are tested at least annually for
impairment (i.e., if the recoverable or fair value of an intangible asset is materially lower than its value in
the company’s books, the value of the asset is considered to be impaired and its value must be decreased).
IAS 38, Intangible Assets and FASB ASC Topic 350 [Intangibles–Goodwill and Other].
19 IAS No. 16, Property, Plant, and Equipment.
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![Reading 17 ■ Understanding Income Statements
24
The method used to compute depreciation should reflect the pattern over which
the economic benefits of the asset are expected to be consumed. IFRS do not pre-
scribe a particular method for computing depreciation but note that several methods
are commonly used, such as the straight-
line method, diminishing balance method
(accelerated depreciation), and the units of production method (depreciation varies
depending upon production or usage).
The straight-line method allocates evenly the cost of long-
lived assets less esti-
mated residual value over the estimated useful life of an asset. (The term “straight line”
derives from the fact that the annual depreciation expense, if represented as a line
graph over time, would be a straight line. In addition, a plot of the cost of the asset
minus the cumulative amount of annual depreciation expense, if represented as a line
graph over time, would be a straight line with a negative downward slope.) Calculating
depreciation and amortisation requires two significant estimates: the estimated useful
life of an asset and the estimated residual value (also known as “salvage value”) of
an asset. Under IFRS, the residual value is the amount that the company expects to
receive upon sale of the asset at the end of its useful life. Example 3 assumes that an
item of equipment is depreciated using the straight-
line method and illustrates how
the annual depreciation expense varies under different estimates of the useful life and
estimated residual value of an asset. As shown, annual depreciation expense is sensitive
to both the estimated useful life and to the estimated residual value.
EXAMPLE 3
Sensitivity of Annual Depreciation Expense to Varying
Estimates of Useful Life and Residual Value
Using the straight-
line method of depreciation, annual depreciation expense is
calculated as:
Cost Residual value
Estimated useful life
−
Assume the cost of an asset is $10,000. If, for example, the residual value of
the asset is estimated to be $0 and its useful life is estimated to be 5 years, the
annual depreciation expense under the straight-
line method would be ($10,000
– $0)/5 years = $2,000. In contrast, holding the estimated useful life of the asset
constant at 5 years but increasing the estimated residual value of the asset to
$4,000 would result in annual depreciation expense of only $1,200 [calculated as
($10,000 – $4,000)/5 years]. Alternatively, holding the estimated residual value
at $0 but increasing the estimated useful life of the asset to 10 years would result
in annual depreciation expense of only $1,000 [calculated as ($10,000 – $0)/10
years]. Exhibit 7 shows annual depreciation expense for various combinations
of estimated useful life and residual value.
Exhibit 7
Annual Depreciation Expense (in Dollars)
Estimated
Useful Life
(Years) Estimated Residual Value
0 1,000 2,000 3,000 4,000 5,000
2 5,000 4,500 4,000 3,500 3,000 2,500
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![Non-Recurring Items and Non-Operating Items: Discontinued Operations and Unusual or Infrequent items 29
both IFRS and US GAAP. Financial standards provide various criteria for reporting
the effect separately, which are generally that the discontinued component must be
separable both physically and operationally.24
In Exhibit 1, AB InBev reported profit from discontinued operations of $28 million
in 2017 and $48 million in 2016. In Exhibit 2, Molson Coors reported income from
discontinued operations of $1.5 million and $3.9 million in 2017 and 2015, respectively,
and a loss from discontinued operations of $2.8 million in 2016.
Because the discontinued operation will no longer provide earnings (or cash flow)
to the company, an analyst may eliminate discontinued operations in formulating
expectations about a company’s future financial performance.
8.2 Unusual or Infrequent Items
IFRS require that items of income or expense that are material and/or relevant to the
understanding of the entity’s financial performance should be disclosed separately.
Unusual or infrequent items are likely to meet these criteria. Under US GAAP, mate-
rial items that are unusual or infrequent, and that are both as of reporting periods
beginning after December 15, 2015, are shown as part of a company’s continuing
operations but are presented separately. For example, restructuring charges, such
as costs to close plants and employee termination costs, are considered part of a
company’s ordinary activities. As another example, gains and losses arising when a
company sells an asset or part of a business, for more or less than its carrying value,
are also disclosed separately on the income statement. These sales are considered
ordinary business activities.
Highlighting the unusual or infrequent nature of these items assists an analyst in
judging the likelihood that such items will reoccur. This meets the IFRS criteria of
disclosing items that are relevant to the understanding of an entity’s financial perfor-
mance. In Exhibit 2, Molson Coors’ income statement showed a separate line item
for “Special Items, net.” The company’s footnotes provide details on the amount and
explain that this line includes revenues or expenses that either they “do not believe
to be indicative of [their] core operations, or they believe are significant to [their]
current operating results warranting separate classification”. In Exhibit 3, the income
statement of Danone shows an amount for “Recurring operating income” followed
by a separate line item for “other operating income (expense)”, which is not included
as a component of recurring income. Exhibit 8 presents an excerpt from Danone’s
additional disclosure about this non-
recurring amount.
Exhibit 8
Highlighting Infrequent Nature of Items—Excerpt from Groupe
Danone footnotes to its 2017 financial statements
NOTE 6. Events and Transactions Outside the Group’s Ordinary Activities
[Excerpt]
“Other operating income (expense) is defined under Recommendation
2013-
03 of the French CNC relating to the format of consolidated
financial statements prepared under international accounting stan-
dards, and comprises significant items that, because of their excep-
tional nature, cannot be viewed as inherent to Danone’s current
activities. These mainly include capital gains and losses on disposals
of fully consolidated companies, impairment charges on goodwill,
significant costs related to strategic restructuring and major external
(continued)
24 IFRS No. 5, Non-
Current Assets Held for Sale and Discontinued Operations, paragraphs 31–33.
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![Non-Recurring Items: Changes in Accounting Policy 31
are made for other reasons, such as providing a better reflection of the company’s
performance. Changes in accounting policies are reported through retrospective
application25 unless it is impractical to do so.
Retrospective application means that the financial statements for all fiscal years
shown in a company’s financial report are presented as if the newly adopted accounting
principle had been used throughout the entire period. Notes to the financial statements
describe the change and explain the justification for the change. Because changes in
accounting principles are retrospectively applied, the financial statements that appear
within a financial report are comparable.
Example 5 presents an excerpt from Microsoft Corporation’s Form 10-
K for the
fiscal year ended 30 June 2018 describing a change in accounting principle resulting
from the new revenue recognition standard. Microsoft elected to adopt the new
standard 1 July 2017, earlier than the required adoption date. Microsoft also elected
to use the “full retrospective method,” which requires companies to restate prior
periods’ results. On its income statement, both 2016 and 2017 are presented as if the
new standard had been used throughout both years. In the footnotes to its financial
statements, Microsoft discloses the impact of the new standard.
EXAMPLE 5
Microsoft Corporation Excerpt from Footnotes to the
Financial Statements
The most significant impact of the [new revenue recognition] standard
relates to our accounting for software license revenue. Specifically, for
Windows 10, we recognize revenue predominantly at the time of billing
and delivery rather than ratably over the life of the related device. For
certain multi-
year commercial software subscriptions that include
both distinct software licenses and SA, we recognize license revenue
at the time of contract execution rather than over the subscription
period. Due to the complexity of certain of our commercial license
subscription contracts, the actual revenue recognition treatment
required under the standard depends on contract-
specific terms and
in some instances may vary from recognition at the time of billing.
Revenue recognition related to our hardware, cloud offerings (such
as Office 365), LinkedIn, and professional services remains substan-
tially unchanged. Refer to Impacts to Previously Reported Results
below for the impact of adoption of the standard in our consolidated
financial statements.
(In $ millions, except per share
amounts)
As
Previously
Reported
New
Revenue
Standard
Adjustment
As
Restated
Income Statements
Year Ended June 30, 2017
Revenue 89,950 6,621 96,571
Provision for income taxes 1,945 2,467 4,412
(continued)
25 IAS No. 8, Accounting Policies, Changes in Accounting Estimates and Errors, and FASB ASC Topic 250
[Accounting Changes and Error Corrections].
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![Reading 17 ■ Understanding Income Statements
32
(In $ millions, except per share
amounts)
As
Previously
Reported
New
Revenue
Standard
Adjustment
As
Restated
Net income 21,204 4,285 25,489
Diluted earnings per share 2.71 0.54 3.25
Year Ended June 30, 2016
Revenue 85,320 5,834 91,154
Provision for income taxes 2,953 2,147 5,100
Net income 16,798 3,741 20,539
Diluted earnings per share 2.1 0.46 2.56
Question: Based on the above information, describe whether Microsoft’s results
appear better or worse under the new revenue recognition standard.
Solution:
Microsoft’s results appear better under the new revenue recognition standard.
Revenues and income are higher under the new standard. The net profit margin
is higher under the new standard. For 2017, the net profit margin is 26.4% (=
25,489/96,571) under the new standard versus 23.6% (= 21,204/89,950) under
the old standard. Reported revenue grew faster under the new standard. Revenue
growth under the new standard was 5.9% [= (96,571/91,154) – 1] compared to
5.4% [= (89,950/85,320) – 1)] under the old standard.
Microsoft’s presentation of the effects of the new revenue recognition enables
an analyst to identify the impact of the change in accounting standards.
Note that the new revenue recognition standard also offered companies the option
of using a “modified retrospective” method of adoption. Under the modified retrospec-
tive approach, companies were not required to revise previously reported financial
statements. Instead, they adjusted opening balances of retained earnings (and other
applicable accounts) for the cumulative impact of the new standard.
In contrast to changes in accounting policies (such as whether to expense the cost
of employee stock options), companies sometimes make changes in accounting esti-
mates (such as the useful life of a depreciable asset). Changes in accounting estimates
are handled prospectively, with the change affecting the financial statements for the
period of change and future periods. No adjustments are made to prior statements, and
the adjustment is not shown on the face of the income statement. Significant changes
should be disclosed in the notes. Exhibit 9 provides an excerpt from the annual Form
10-
K of Catalent Inc., a US-
based biotechnology company, that illustrates a change
in accounting estimate.
Exhibit 9
Change in Accounting Estimate
Catalent Inc. discloses a change in the method it uses to calculate both annual
expenses related to its defined benefit pension plans. Rather than use a single,
weighted-
average discount rate in its calculations, the company will use the spot
rates applicable to each projected cash flow.
Post-
Retirement and Pension Plans
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![Reading 17 ■ Understanding Income Statements
34
general, for non-
financial services companies,28 non-
operating income that is dis-
closed separately on the income statement (or in the notes) includes amounts earned
through investing activities.
Among non-
operating items on the income statement (or accompanying notes),
non-
financial service companies also disclose the interest expense on their debt
securities, including amortisation of any discount or premium. The amount of inter-
est expense is related to the amount of a company’s borrowings and is generally
described in the notes to the financial statements. For financial service companies,
interest income and expense are likely components of operating activities. (Note that
the characterization of interest and dividends as non-
operating items on the income
statement is not necessarily consistent with the classification on the statement of cash
flows. Specifically, under IFRS, interest and dividends received can be shown either as
operating or as investing on the statement of cash flows, while under US GAAP interest
and dividends received are shown as operating cash flows. Under IFRS, interest and
dividends paid can be shown either as operating or as financing on the statement of
cash flows, while under US GAAP, interest paid is shown as operating and dividends
paid are shown as financing.)
In practice, companies often disclose the interest expense and income separately,
along with a net amount. For example, in Exhibit 1, ABN InBev’s 2017 income state-
ment shows finance cost of $6,885 million, finance income of $378 million, and net
finance cost of $6,507 million. Similarly, in Exhibit 3, Danone’s 2017 income statement
shows interest income of €130, interest expense of €276, and cost of net debt of €146.
For purposes of assessing a company’s future performance, the amount of financing
expense will depend on the company’s financing policy (target capital structure) and
borrowing costs. The amount of investing income will depend on the purpose and
success of investing activities. For a non-
financial company, a significant amount of
financial income would typically warrant further exploration. What are the reasons
underlying the company’s investments in the securities of other companies? Is the
company simply investing excess cash in short-
term securities to generate income
higher than cash deposits, or is the company purchasing securities issued by other
companies for strategic reasons, such as access to raw material supply or research?
EARNINGS PER SHARE AND CAPITAL STRUCTURE
AND BASIC EPS
g describe how earnings per share is calculated and calculate and interpret a com-
pany’s earnings per share (both basic and diluted earnings per share) for both
simple and complex capital structures;
One metric of particular importance to an equity investor is earnings per share (EPS).
EPS is an input into ratios such as the price/earnings ratio. Additionally, each share-
holder in a company owns a different number of shares. IFRS require the presentation
of EPS on the face of the income statement for net profit or loss (net income) and
profit or loss (income) from continuing operations.29 Similar presentation is required
under US GAAP.30 This section outlines the calculations for EPS and explains how
the calculation differs for a simple versus complex capital structure.
11
28 Examples of financial services companies are insurance companies, banks, brokers, dealers, and
investment companies.
29 IAS No. 33, Earnings Per Share.
30 FASB ASC Topic 260 [Earnings Per Share].
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![Diluted EPS: the If-Converted Method 37
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?
2 What is the company’s basic EPS?
Solution to 1:
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 × (6 months/12 months) = 600,000
1,100,000 × (3 months/12 months) = 275,000
Weighted average number of shares outstanding 1,125,000
Solution to 2:
Basic EPS = (Net income – Preferred dividends)/Weighted average number of
shares = ($2,500,000 – $200,000)/1,125,000 = $2.04
EXAMPLE 8
A Basic EPS Calculation (3)
Assume the same facts as Example 7 except that on 1 December 2018, a previ-
ously declared 2-
for-
1 stock split took effect. Each shareholder of record receives
two shares in exchange for each current share that he or she owns. What is the
company’s basic EPS?
Solution:
For EPS calculation purposes, a stock split is treated as if it occurred at the begin-
ning of the period. The weighted average number of shares would, therefore, be
2,250,000, and the basic EPS would be $1.02 [= ($2,500,000 – $200,000)/2,250,000].
DILUTED EPS: THE IF-CONVERTED METHOD
g describe how earnings per share is calculated and calculate and interpret a com-
pany’s earnings per share (both basic and diluted earnings per share) for both
simple and complex capital structures;
If a company has a simple capital structure (in other words, one that includes no
potentially dilutive financial instruments), then its basic EPS is equal to its diluted
EPS. However, if a company has potentially dilutive financial instruments, its diluted
EPS may differ from its basic EPS. Diluted EPS, by definition, is always equal to or less
than basic EPS. The sections below describe the effects of three types of potentially
12
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![Reading 17 ■ Understanding Income Statements
40
dilutive security: $50,000 of 6 percent convertible bonds, convertible into a total
of 10,000 shares. Assuming a tax rate of 30 percent, calculate Oppnox’s basic
and diluted EPS.
Solution:
If the debt securities had been converted, the debt securities would no longer be
outstanding and instead, an additional 10,000 shares of common stock would be
outstanding. Also, if the debt securities had been converted, the company would
not have paid interest of $3,000 on the convertible debt, so net income available
to common shareholders would have increased by $2,100 [= $3,000(1 – 0.30)]
on an after-
tax basis. Exhibit 12 illustrates the calculation of diluted EPS using
the if-
converted method for convertible debt.
Exhibit 12
Calculation of Diluted EPS for Oppnox Company Using the
If-
Converted Method: Case of a Convertible Bond
Basic EPS
Diluted EPS Using If-
Converted Method
Net income $750,000 $750,000
After-
tax cost of interest 2,100
Numerator $750,000 $752,100
Weighted average number of shares
outstanding
690,000 690,000
If converted 0 10,000
Denominator 690,000 700,000
EPS $1.09 $1.07
DILUTED EPS: THE TREASURY STOCK METHOD
g describe how earnings per share is calculated and calculate and interpret a com-
pany’s earnings per share (both basic and diluted earnings per share) for both
simple and complex capital structures;
When a company has stock options, warrants, or their equivalents32 outstanding,
diluted EPS is calculated as if the financial instruments had been exercised and the
company had used the proceeds from exercise to repurchase as many shares of common
stock as possible at the average market price of common stock during the period. The
weighted average number of shares outstanding for diluted EPS is thus increased by
the number of shares that would be issued upon exercise minus the number of shares
that would have been purchased with the proceeds. This method is called the treasury
stock method under US GAAP because companies typically hold repurchased shares
as treasury stock. The same method is used under IFRS but is not named.
13
32 Hereafter, options, warrants, and their equivalents will be referred to simply as “options” because the
accounting treatment for EPS calculations is interchangeable for these instruments under IFRS and US GAAP.
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![Comprehensive Income 49
by a significant increase in finance costs. The increased finance costs resulted from
the 2016 merger with SABMiller. Valued at more than $100 billion, the acquisition
was one of the largest in history. The combination of AB InBev and SABMiller also
explains the increase in revenue from around $45 billion to over $56 billion. The
profitability ratios and the common-
size income statement thus serve to highlight
areas about which an analyst might wish to gain further understanding.
COMPREHENSIVE INCOME
k describe, calculate, and interpret comprehensive income;
l describe other comprehensive income and identify major types of items
included in it.
The general expression for net income is revenue minus expenses. There are, however,
certain items of revenue and expense that, by accounting convention, are excluded
from the net income calculation. To understand how reported shareholders’ equity
of one period links with reported shareholders’ equity of the next period, we must
understand these excluded items, known as other comprehensive income. Under
IFRS, other comprehensive income includes items of income and expense that are “not
recognized in profit or loss as required or permitted by other IFRS.” Total compre-
hensive income is “the change in equity during a period resulting from transaction
and other events, other than those changes resulting from transactions with owners
in their capacity as owners.”35
Under US GAAP, comprehensive income is defined as “the change in equity
[net assets] of a business enterprise during a period from transactions and other
events and circumstances from non-
owner sources. It includes all changes in equity
during a period except those resulting from investments by owners and distributions
to owners.”36 While the wording differs, comprehensive income is conceptually the
same under IFRS and US GAAP.
Comprehensive income includes both net income and other revenue and expense
items that are excluded from the net income calculation (collectively referred to as
Other Comprehensive Income). Assume, for example, a company’s beginning share-
holders’ equity is €110 million, its net income for the year is €10 million, its cash
dividends for the year are €2 million, and there was no issuance or repurchase of
common stock. If the company’s actual ending shareholders’ equity is €123 million,
then €5 million [€123 – (€110 + €10 – €2)] has bypassed the net income calculation
by being classified as other comprehensive income. If the company had no other
comprehensive income, its ending shareholders’ equity would have been €118 million
[€110 + €10 – €2].
Four types of items are treated as other comprehensive income under both IFRS
and US GAAP. (The specific treatment of some of these items differs between the two
sets of standards, but these types of items are common to both.)
■
■ Foreign currency translation adjustments. In consolidating the financial state-
ments of foreign subsidiaries, the effects of translating the subsidiaries’ balance
sheet assets and liabilities at current exchange rates are included as other com-
prehensive income.
17
35 IAS 1, Presentation of Financial Statements.
36 FASB ASC Section 220-
10-
05 [Comprehensive Income–Overall–Overview and Background].
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![Comprehensive Income 51
and losses as part of other comprehensive income. These debt and equity investments
are referred to as being measured at fair value through other comprehensive income.
Accounting for these securities is similar to accounting for US GAAP’s available-
for-
sale debt securities.
Even where unrealized holding gains and losses are excluded from a company’s
net income (profit and loss), they are included in other comprehensive income and
thus form a part of a company’s comprehensive income.
EXAMPLE 14
Other Comprehensive Income
Assume a company’s beginning shareholders’ equity is €200 million, its net
income for the year is €20 million, its cash dividends for the year are €3 million,
and there was no issuance or repurchase of common stock. The company’s actual
ending shareholders’ equity is €227 million.
1 What amount has bypassed the net income calculation by being classified
as other comprehensive income?
A €0.
B €7 million.
C €10 million.
2 Which of the following statements best describes other comprehensive
income?
A Income earned from diverse geographic and segment activities.
B Income that increases stockholders’ equity but is not reflected as part
of net income.
C Income earned from activities that are not part of the company’s ordi-
nary business activities.
Solution to 1:
C is correct. If the company’s actual ending shareholders’ equity is €227 mil-
lion, then €10 million [€227– (€200 + €20 – €3)] has bypassed the net income
calculation by being classified as other comprehensive income.
Solution to 2:
B is correct. Answers A and C are not correct because they do not specify whether
such income is reported as part of net income and shown in the income statement.
EXAMPLE 15
Other Comprehensive Income in Analysis
An analyst is looking at two comparable companies. Company A has a lower
price/earnings (P/E) ratio than Company B, and the conclusion that has been
suggested is that Company A is undervalued. As part of examining this con-
clusion, the analyst decides to explore the question: What would the company’s
P/E look like if total comprehensive income per share—rather than net income
per share—were used as the relevant metric?
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![Solutions 61
financial results of any prior years included in the report comparable. Notes to
the financial statements describe the change and explain the justification for the
change.
16 C is correct. The weighted average number of shares outstanding for 2009 is
1,050,000. Basic earnings per share would be $1,000,000 divided by 1,050,000,
or $0.95.
17 B is correct. The formula to calculate diluted EPS is as follows:
Diluted EPS = (Net income – Preferred dividends)/[Weighted average
number of shares outstanding + (New shares that would have been issued at
option exercise – Shares that could have been purchased with cash received
upon exercise) × (Proportion of year during which the financial instruments
were outstanding)].
The underlying assumption is that outstanding options are exercised, and then
the proceeds from the issuance of new shares are used to repurchase shares
already outstanding:
Proceeds from option exercise = 100,000 × $20 = $2,000,000
Shares repurchased = $2,000,000/$25 = 80,000
The net increase in shares outstanding is thus 100,000 – 80,000 = 20,000.
Therefore, the diluted EPS for CWC = ($12,000,000 – $800,000)/2,020,000 =
$5.54.
18 A is correct. Basic and diluted EPS are equal for a company with a simple
capital structure. A company that issues only common stock, with no financial
instruments that are potentially convertible into common stock has a simple
capital structure. Basic EPS is calculated using the weighted average number of
shares outstanding.
19 B is correct. LB has warrants in its capital structure; if the exercise price is
less than the weighted average market price during the year, the effect of their
conversion is to increase the weighted average number of common shares out-
standing, 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 calcula-
tion of basic EPS. LB’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.
20 A is correct. With stock options, the treasury stock method must be used.
Under that method, the company would receive $100,000 (10,000 × $10) and
would repurchase 6,667 shares ($100,000/$15). The shares for the denominator
would be:
Shares outstanding 1,000,000
Options exercises 10,000
Treasury shares purchased (6,667)
Denominator 1,003,333
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![Reading 17 ■ Understanding Income Statements
62
21 C is correct.
Diluted EPS = (Net income)/(Weighted average number of shares out-
standing + New common shares that would have been issued
at conversion)
= $200,000,000/[50,000,000 + (2,000,000 × 2)]
= $3.70
The diluted EPS assumes that the preferred dividend is not paid and that the
shares are converted at the beginning of the period.
22 A is correct. When a company has stock options outstanding, diluted EPS is
calculated as if the financial instruments had been exercised and the company
had used the proceeds from the exercise to repurchase as many shares possible
at the weighted average market price of common stock during the period. As a
result, the conversion of stock options increases the number of common shares
outstanding but has no effect on net income available to common sharehold-
ers. The conversion of convertible debt increases the net income available to
common shareholders by the after-
tax amount of interest expense saved. The
conversion of convertible preferred shares increases the net income available to
common shareholders by the amount of preferred dividends paid; the numera-
tor becomes the net income.
23 B is correct. Common size income statements facilitate comparison across time
periods (time-
series analysis) and across companies (cross-
sectional analysis)
by stating each line item of the income statement as a percentage of revenue.
The relative performance of different companies can be more easily assessed
because scaling the numbers removes the effect of size. A 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.
24 C is correct. Comprehensive income includes both net income and other com-
prehensive income.
Other comprehensive income = Unrealized gain on available-
for-
sale
securities – Unrealized loss on derivatives
accounted for as hedges + Foreign currency
translation gain on consolidation
= $5 million – $3 million + $2 million
= $4 million
Alternatively,
Comprehensive income – Net income = Other comprehensive income
Comprehensive income = (Ending shareholders equity – Beginning share-
holders equity) + Dividends
= ($493 million – $475 million) + $1 million
= $18 million + $1 million = $19 million
Net income is $15 million so other comprehensive income is $4 million.
25 A is correct. Other comprehensive income includes items that affect sharehold-
ers’ equity but are not reflected in the company’s income statement. In consoli-
dating the financial statements of foreign subsidiaries, the effects of translating
the subsidiaries’ balance sheet assets and liabilities at current exchange rates are
included as other comprehensive income.
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![Reading 18 ■ Understanding Balance Sheets
64
INTRODUCTION AND COMPONENTS OF THE
BALANCE SHEET
a describe the elements of the balance sheet: assets, liabilities, and equity
b describe uses and limitations of the balance sheet in financial analysis;
The balance sheet provides information on a company’s resources (assets) and its
sources of capital (equity and liabilities/debt). This information helps an analyst assess
a company’s ability to pay for its near-
term operating needs, meet future debt obliga-
tions, and make distributions to owners. The basic equation underlying the balance
sheet is Assets = Liabilities + Equity.
Analysts should be aware that different types of assets and liabilities may be
measured differently. For example, some items are measured at historical cost or a
variation thereof and others at fair value.1 An understanding of the measurement
issues will facilitate analysis. The balance sheet measurement issues are, of course,
closely linked to the revenue and expense recognition issues affecting the income
statement. Throughout this reading, we describe and illustrate some of the linkages
between the measurement issues affecting the balance sheet and the revenue and
expense recognition issues affecting the income statement.
This reading is organized as follows: In Sections 1–3, we describe and give examples
of the elements and formats of balance sheets. Sections 4–6 discuss current assets and
current liabilities. Sections 7–11 focus on assets, and Section 12 focuses on liabilities.
Sections 13–14 describe the components of equity and illustrates the statement of
changes in shareholders’ equity. Sections 15–16 introduce balance sheet analysis. A
summary of the key points and practice problems in the CFA Institute multiple-
choice
format conclude the reading.
1.1 Components and Format of the Balance Sheet
The balance sheet (also called the statement of financial position or statement of
financial condition) discloses what an entity owns (or controls), what it owes, and
what the owners’ claims are at a specific point in time.2
The financial position of a company is described in terms of its basic elements
(assets, liabilities, and equity):
■
■ Assets (A) are what the company owns (or controls). More formally, assets are
resources controlled by the company as a result of past events and from which
future economic benefits are expected to flow to the entity.
■
■ Liabilities (L) are what the company owes. More formally, liabilities represent
obligations of a company arising from past events, the settlement of which is
expected to result in a future outflow of economic benefits from the entity.
■
■ Equity (E) represents the owners’ residual interest in the company’s assets after
deducting its liabilities. Commonly known as shareholders’ equity or owners’
equity, equity is determined by subtracting the liabilities from the assets of a
company, giving rise to the accounting equation: A – L = E or A = L + E.
1
1 IFRS and US GAAP define “fair value” as an exit price, i.e., the price that would be received to sell an
asset or paid to transfer a liability in an orderly transaction between market participants at the measurement
date (IFRS 13, FASB ASC Topic 820).
2 IFRS uses the term “statement of financial position” (IAS 1 Presentation of Financial Statements), and
US GAAP uses the terms “balance sheet” and “statement of financial position” interchangeably (ASC 210-
10-
05 [Balance Sheet–Overall–Overview and Background]).
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![Reading 18 ■ Understanding Balance Sheets
66
31 December
Assets 2017 2016*
Total equity 25,540 26,397
Equity and liabilities 42,497 44,277
Source: SAP Group 2017 annual report.
Notes: Numbers exactly from the annual report as prepared by the company, which reflects some
rounding.
* Numbers are the reclassified numbers from the SAP Group 2017 annual report.
Exhibit 2
Apple Inc. Consolidated Balance Sheets
(Excerpt)* (in millions of $)
Assets 30 September 2017 24 September 2016
Total current assets 128,645 106,869
[All other assets] 246,674 214,817
Total assets 375,319 321,686
Liabilities and shareholders’
equity
Total current liabilities 100,814 79,006
[Total non-
current liabilities] 140,458 114,431
Total liabilities 241,272 193,437
Total shareholders’ equity 134,047 128,249
Total liabilities and shareholders’
equity
375,319 321,686
*Note: The italicized subtotals presented in this excerpt are not explicitly shown on the face of the
financial statement as prepared by the company.
Source: Apple Inc. 2017 annual report (Form 10K).
SAP Group uses the title Statement of Financial Position and Apple uses the title
Balance Sheet. Despite their different titles, both statements report the three basic
elements: assets, liabilities, and equity. Both companies are reporting on a consolidated
basis, i.e., including all their controlled subsidiaries. The numbers in SAP Group’s
balance sheet are in millions of euro, and the numbers in Apple’s balance sheet are
in millions of dollars.
Balance sheet information is as of a specific point in time. These exhibits are from
the companies’ annual financial statements, so the balance sheet information is as of
the last day of their respective fiscal years. SAP Group’s fiscal year is the same as the
calendar year and the balance sheet information is as of 31 December. Apple’s fiscal
year ends on the last Saturday of September, so the actual date changes from year to
year. About every six years, Apple’s fiscal year will include 53 weeks rather than 52
weeks. This feature of Apple’s fiscal year should be noted, but in general, the extra
week is more relevant to evaluating statements spanning a period of time (the income
and cash flow statements) rather than the balance sheet which captures information
as of a specific point in time.
Exhibit 1 (Continued)
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![Reading 18 ■ Understanding Balance Sheets
70
Exhibit 4
SAP Group Consolidated Statements of Financial Position
(Excerpt: Current Assets Detail) (in millions of €)
As of 31 December
Assets 2017 2016
Cash and cash equivalents €4,011 €3,702
Other financial assets 990 1,124
Trade and other receivables 5,899 5,924
Other non-
financial assets 725 581
Tax assets 306 233
Total current assets 11,930 11,564
Total non-
current assets 30,567 32,713
Total assets 42,497 44,277
Total current liabilities 10,210 9,674
Total non-
current liabilities 6,747 8,205
Total liabilities 16,958 17,880
Total equity 25,540 26,397
Total equity and liabilities €42,497 €44,277
Source: SAP Group 2017 annual report.
Exhibit 5
Apple Inc. Consolidated Balance Sheet (Excerpt: Current Assets
Detail) * (in millions of $)
Assets
30
September,
2017
24
September,
2016
Cash and cash equivalents $20,289 $20,484
Short-
term marketable securities 53,892 46,671
Accounts receivable, less allowances of $58 and $53,
respectively
17,874 15,754
Inventories 4,855 2,132
Vendor non-
trade receivables 17,799 13,545
Other current assets 13,936 8,283
Total current assets 128,645 106,869
[All other assets] 246,674 214,817
Total assets 375,319 321,686
Total current liabilities 100,814 79,006
[Total non-
current liabilities] 140,458 114,431
Total liabilities 241,272 193,437
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![Current Assets: Cash and Cash Equivalents, Marketable Securities and Trade Receivables 73
2 In general, how does the amount of allowance for doubtful accounts relate
to bad debt expense?
3 In general, what are some factors that could cause a company’s allowance
for doubtful accounts to decrease?
Solution to 1:
($ millions) The percentage of 2017 accounts receivable estimated to be uncollect-
ible is 0.32 percent, calculated as $58/($17,874 + $58). Note that the $17,874 is net
of the $58 allowance, so the gross amount of accounts receivable is determined
by adding the allowance to the net amount. The percentage of 2016 accounts
receivable estimated to be uncollectible is 0.34 percent [$53/($15,754 + $53)].
Solution to 2:
Bad debt expense is an expense of the period, based on a company’s estimate
of the percentage of credit sales in the period, for which cash will ultimately
not be collected. The allowance for bad debts is a contra asset account, which
is netted against the asset accounts receivable.
To record the estimated bad debts, a company recognizes a bad debt expense
(which affects net income) and increases the balance in the allowance for doubtful
accounts by the same amount. To record the write off of a particular account
receivable, a company reduces the balance in the allowance for doubtful accounts
and reduces the balance in accounts receivable by the same amount.
Solution to 3:
In general, a decrease in a company’s allowance for doubtful accounts in absolute
terms could be caused by a decrease in the amount of credit sales.
Some factors that could cause a company’s allowance for doubtful accounts
to decrease as a percentage of accounts receivable include the following:
■
■ Improvements in the credit quality of the company’s existing customers
(whether driven by a customer-
specific improvement or by an improve-
ment in the overall economy);
■
■ Stricter credit policies (for example, refusing to allow less creditworthy
customers to make credit purchases and instead requiring them to pay
cash, to provide collateral, or to provide some additional form of financial
backing); and/or
■
■ Stricter risk management policies (for example, buying more insurance
against potential defaults).
In addition to the business factors noted above, because the allowance is based
on management’s estimates of collectability, management can potentially bias
these estimates to manipulate reported earnings. For example, a management
team aiming to increase reported income could intentionally over-
estimate
collectability and under-
estimate the bad debt expense for a period. Conversely,
in a period of good earnings, management could under-
estimate collectability
and over-
estimate the bad debt expense with the intent of reversing the bias in
a period of poorer earnings.
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![Reading 18 ■ Understanding Balance Sheets
76
Exhibit 7
Apple Inc. Consolidated Balance Sheet (Excerpt: Current
Liabilities Detail)* (in millions of $)
Assets
30
September 2017
24
September 2016
Total current assets 128,645 106,869
[All other assets] 246,674 214,817
Total assets 375,319 321,686
Liabilities and shareholders’ equity
Accounts payable 49,049 37,294
Accrued expenses 25,744 22,027
Deferred revenue 7,548 8,080
Commercial paper 11,977 8,105
Current portion of long-
term debt 6,496 3,500
Total current liabilities 100,814 79,006
[Total non-
current liabilities] 140,458 114,431
Total liabilities 241,272 193,437
Total shareholders’ equity 134,047 128,249
Total liabilities and shareholders’ equity 375,319 321,686
*Note: The italicized subtotals presented in this excerpt are not explicitly shown on the face of the
financial statement as prepared by the company.
Source: Apple Inc. 2017 annual report (Form 10K).
Trade payables, also called accounts payable, are amounts that a company owes
its vendors for purchases of goods and services. In other words, these represent the
unpaid amount as of the balance sheet date of the company’s purchases on credit.
An issue relevant to analysts is the trend in overall levels of trade payables relative to
purchases (a topic to be addressed further in ratio analysis). Significant changes in
accounts payable relative to purchases could signal potential changes in the company’s
credit relationships with its suppliers. The general term “trade credit” refers to credit
provided to a company by its vendors. Trade credit is a source of financing that allows
the company to make purchases and then pay for those purchases at a later date.
Financial liabilities that are due within one year or the operating cycle, whichever
is longer, appear in the current liability section of the balance sheet. Financial liabilities
include borrowings such as bank loans, notes payable (which refers to financial liabil-
ities owed by a company to creditors, including trade creditors and banks, through a
formal loan agreement), and commercial paper. In addition, any portions of long-
term
liabilities that are due within one year (i.e., the current portion of long-
term liabilities)
are also shown in the current liability section of the balance sheet. According to its
footnote disclosures, most of SAP’s €1,561 million of current financial liabilities is for
bonds payable due in the next year. Apple shows $11,977 million of commercial paper
borrowing (short-
term promissory notes issued by companies) and $6,496 million of
long-
term debt due within the next year.
Accrued expenses (also called accrued expenses payable, accrued liabilities, and
other non-
financial liabilities) are expenses that have been recognized on a company’s
income statement but not yet been paid as of the balance sheet date. For example,
SAP’s 2017 balance sheet shows €597 million of tax liabilities. In addition to income
taxes payable, other common examples of accrued expenses are accrued interest
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![Reading 18 ■ Understanding Balance Sheets
80
Assets
30
September 2017
24
September 2016
Goodwill 5,717 5,414
Acquired intangible assets, net 2,298 3,206
Other non-
current assets 10,162 8,757
[All other assets] 246,674 214,817
Total assets 375,319 321,686
Liabilities and shareholders’ equity
Total current liabilities 100,814 79,006
[Total non-
current liabilities] 140,458 114,431
Total liabilities 241,272 193,437
Total shareholders’ equity 134,047 128,249
Total liabilities and shareholders’ equity 375,319 321,686
*Note: The italicized subtotals presented in this excerpt are not explicitly shown on the face of the
financial statement as prepared by the company.
Source: Apple Inc. 2017 annual report (Form 10K).
7.1 Property, Plant, and Equipment
Property, plant, and equipment (PPE) are tangible assets that are used in company
operations and expected to be used (provide economic benefits) over more than one
fiscal period. Examples of tangible assets treated as property, plant, and equipment,
include land, buildings, equipment, machinery, furniture, and natural resources such
as mineral and petroleum resources. IFRS permits companies to report PPE using
either a cost model or a revaluation model.9 While IFRS permits companies to use
the cost model for some classes of assets and the revaluation model for others, the
company must apply the same model to all assets within a particular class of assets.
US GAAP permits only the cost model for reporting PPE.
Under the cost model, PPE is carried at amortised cost (historical cost less any
accumulated depreciation or accumulated depletion, and less any impairment losses).
Historical cost generally consists of an asset’s purchase price, plus its delivery cost,
and any other additional costs incurred to make the asset operable (such as costs to
install a machine). Depreciation and depletion refer to the process of allocating (rec-
ognizing as an expense) the cost of a long-
lived asset over its useful life. Land is not
depreciated. Because PPE is presented on the balance sheet net of depreciation and
depreciation expense is recognised in the income statement, the choice of deprecia-
tion method and the related estimates of useful life and salvage value impact both a
company’s balance sheet and income statement.
Whereas depreciation is the systematic allocation of cost over an asset’s useful life,
impairment losses reflect an unanticipated decline in value. Impairment occurs when
the asset’s recoverable amount is less than its carrying amount, with terms defined
as follows under IFRS:10
■
■ Recoverable amount: The higher of an asset’s fair value less cost to sell, and its
value in use.
Exhibit 9 (Continued)
9 IAS 16, Property, Plant and Equipment, paragraphs 29-
31.
10 IAS 36, Impairment of Assets, paragraph 6. US GAAP uses a different approach to impairment.
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![Non-Current Assets: Goodwill 85
in a company’s own financial statements (e.g., its reputation, established distribution
system, trained employees) have value. Second, a target company’s expenditures in
research and development may not have resulted in a separately identifiable asset
that meets the criteria for recognition but nonetheless may have created some value.
Third, part of the value of an acquisition may arise from strategic positioning versus a
competitor or from perceived synergies. The purchase price might not pertain solely
to the separately identifiable assets and liabilities acquired and thus may exceed the
value of those net assets due to the acquisition’s role in protecting the value of all of the
acquirer’s existing assets or to cost savings and benefits from combining the companies.
The subject of recognizing goodwill in financial statements has found both propo-
nents and opponents among professionals. The proponents of goodwill recognition
assert that goodwill is the present value of excess returns that a company is expected
to earn. This group claims that determining the present value of these excess returns
is analogous to determining the present value of future cash flows associated with
other assets and projects. Opponents of goodwill recognition claim that the prices
paid for acquisitions often turn out to be based on unrealistic expectations, thereby
leading to future write-
offs of goodwill.
Analysts should distinguish between accounting goodwill and economic goodwill.
Economic goodwill is based on the economic performance of the entity, whereas
accounting goodwill is based on accounting standards and is reported only in the case
of acquisitions. Economic goodwill is important to analysts and investors, and it is not
necessarily reflected on the balance sheet. Instead, economic goodwill is reflected in
the stock price (at least in theory). Some financial statement users believe that good-
will should not be listed on the balance sheet, because it cannot be sold separately
from the entity. These financial statement users believe that only assets that can be
separately identified and sold should be reflected on the balance sheet. Other financial
statement users analyze goodwill and any subsequent impairment charges to assess
management’s performance on prior acquisitions.
Under both IFRS and US GAAP, accounting goodwill arising from acquisitions
is capitalized. Goodwill is not amortised but is tested for impairment annually. If
goodwill is deemed to be impaired, an impairment loss is charged against income in
the current period. An impairment loss reduces current earnings. An impairment loss
also reduces total assets, so some performance measures, such as return on assets
(net income divided by average total assets), may actually increase in future periods.
An impairment loss is a non-
cash item.
Accounting standards’ requirements for recognizing goodwill can be summarized
by the following steps:
A The total cost to purchase the target company (the acquiree) is determined.
B The acquiree’s identifiable assets are measured at fair value. The acquiree’s
liabilities and contingent liabilities are measured at fair value. The difference
between the fair value of identifiable assets and the fair value of the liabilities
and contingent liabilities equals the net identifiable assets acquired.
C Goodwill arising from the purchase is the excess of a) the cost to purchase
the target company over b) the net identifiable assets acquired. Occasionally,
a transaction will involve the purchase of net identifiable assets with a value
greater than the cost to purchase. Such a transaction is called a “bargain pur-
chase.” Any gain from a bargain purchase is recognized in profit and loss in the
period in which it arises.15
15 IFRS 3 Business Combinations and FASB ASC 805 [Business Combinations].
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![Reading 18 ■ Understanding Balance Sheets
92
Exhibit 12
SAP Group Consolidated Statements of Financial Position
(Excerpt: Non-
Current Liabilities Detail) (in millions of €)
as of 31 December
2017 2016
Assets
Total current assets 11,930 11,564
Total non-
current assets 30,567 32,713
Total assets 42,497 44,277
Total current liabilities 10,210 9,674
Trade and other payables 119 127
Tax liabilities 470 365
Financial liabilities 5,034 6,481
Other non-
financial liabilities 503 461
Provisions 303 217
Deferred tax liabilities 240 411
Deferred income 79 143
Total non-
current liabilities 6,747 8,205
Total liabilities 16,958 17,880
Total equity 25,540 26,397
Total equity and liabilities €42,497 €44,277
Source: SAP Group 2017 annual report.
Exhibit 13
Apple Inc. Consolidated Balance Sheet (Excerpt: Non-
Current
Liabilities Detail)* (in millions of $)
Assets
30
September 2017
24
September 2016
Total current assets 128,645 106,869
[All other assets] 246,674 214,817
Total assets 375,319 321,686
Liabilities and shareholders’ equity
Total current liabilities 100,814 79,006
Deferred revenue, non-
current 2,836 2,930
Long-term debt 97,207 75,427
Other non-
current liabilities 40,415 36,074
[Total non-
current liabilities] 140,458 114,431
Total liabilities 241,272 193,437
Total shareholders’ equity 134,047 128,249
Total liabilities and shareholders’ equity 375,319 321,686
*Note: The italicized subtotals presented in this excerpt are not explicitly shown on the face of the
financial statement as prepared by the company.
Source: Apple Inc. 2017 annual report (Form 10K).
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![Reading 18 ■ Understanding Balance Sheets
94
COMPONENTS OF EQUITY
f describe the components of shareholders’ equity
Equity is the owners’ residual claim on a company’s assets after subtracting its lia-
bilities.21 It represents the claim of the owner against the company. Equity includes
funds directly invested in the company by the owners, as well as earnings that have
been reinvested over time. Equity can also include items of gain or loss that are not
recognized on the company’s income statement.
13.1 Components of Equity
Six main components typically comprise total owners’ equity. The first five components
listed below comprise equity attributable to owners of the parent company. The sixth
component is the equity attributable to non-
controlling interests.
1 Capital contributed by owners (or common stock, or issued capital). The
amount contributed to the company by owners. Ownership of a corporation is
evidenced through the issuance of common shares. Common shares may have a
par value (or stated value) or may be issued as no par shares (depending on reg-
ulations governing the incorporation). Where par or stated value requirements
exist, it must be disclosed in the equity section of the balance sheet. In addition,
the number of shares authorized, issued, and outstanding must be disclosed for
each class of share issued by the company. The number of authorized shares
is the number of shares that may be sold by the company under its articles of
incorporation. The number of issued shares refers to those shares that have
been sold to investors. The number of outstanding shares consists of the issued
shares less treasury shares.
2 Preferred shares. Classified as equity or financial liabilities based upon their
characteristics rather than legal form. For example, perpetual, non-
redeemable
preferred shares are classified as equity. In contrast, preferred shares with man-
datory redemption at a fixed amount at a future date are classified as financial
liabilities. Preferred shares have rights that take precedence over the rights of
common shareholders—rights that generally pertain to receipt of dividends and
receipt of assets if the company is liquidated.
3 Treasury shares (or treasury stock or own shares repurchased). Shares in the
company that have been repurchased by the company and are held as treasury
shares, rather than being cancelled. The company is able to sell (reissue) these
shares. A company may repurchase its shares when management considers the
shares undervalued, needs shares to fulfill employees’ stock options, or wants to
limit the effects of dilution from various employee stock compensation plans.
A repurchase of previously issued shares reduces shareholders’ equity by the
amount of the cost of repurchasing the shares and reduces the number of total
shares outstanding. If treasury shares are subsequently reissued, a company
does not recognize any gain or loss from the reissuance on the income state-
ment. Treasury shares are non-
voting and do not receive any dividends declared
by the company.
13
21 IASB Conceptual Framework (2018), paragraph 4.4 (c) and FASB ASC 505-
10-
05-
3 [Equity–Overview
and Background].
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![Components of Equity 95
4 Retained earnings. The cumulative amount of earnings recognized in the
company’s income statements which have not been paid to the owners of the
company as dividends.
5 Accumulated other comprehensive income (or other reserves). The cumula-
tive amount of other comprehensive income or loss. The term comprehensive
income includes both a) net income, which is recognized on the income state-
ment and is reflected in retained earnings, and b) other comprehensive income
which is not recognized as part of net income and is reflected in accumulated
other comprehensive income.22
6 Noncontrolling interest (or minority interest). The equity interests of minority
shareholders in the subsidiary companies that have been consolidated by the
parent (controlling) company but that are not wholly owned by the parent
company.
Exhibits 14 and 15 present excerpts of the balance sheets of SAP Group and Apple
Inc., respectively, with detailed line items for each company’s equity section. SAP’s
balance sheet indicates that the company has €1,229 million issued capital, and the
notes to the financial statements disclose that the company has issued 1,229 million
no-
par common stock with a nominal value of €1 per share. SAP’s balance sheet also
indicates that the company has €1,591 million of treasury shares, and the notes to the
financial statements disclose that the company holds 35 million of its shares as treasury
shares. The line item share premium of €570 million includes amounts from treasury
share transactions (and certain other transactions). The amount of retained earnings,
€24,794 million, represents the cumulative amount of earnings that the company has
recognized in its income statements, net of dividends. SAP’s €508 million of “Other
components of equity” includes the company’s accumulated other comprehensive
income. The notes disclose that this is composed of €330 million gains on exchange
differences in translation, €157 million gains on remeasuring available-for-
sale financial
assets, and €21 million gains on cash flow hedges. The balance sheet next presents a
subtotal for the amount of equity attributable to the parent company €25,509 million
followed by the amount of equity attributable to non-
controlling interests €31 mil-
lion. Total equity includes both equity attributable to the parent company and equity
attributable to non-
controlling interests.
The equity section of Apple’s balance sheet consists of only three line items: com-
mon stock, retained earnings, and accumulated other comprehensive income/(loss).
Although Apple’s balance sheet shows no treasury stock, the company does repurchase
its own shares but cancels the repurchased shares rather than holding the shares in
treasury. Apple’s balance sheet shows that 5,126,201 thousand shares were issued and
outstanding at the end of fiscal 2017 and 5,336,166 thousand shares were issued and
outstanding at the end of fiscal 2016. Details on the change in shares outstanding is
presented on the Statement of Shareholders’ Equity in Exhibit 16, which shows that
in 2017 Apple repurchased 246,496 thousand shares of its previously issued common
stock and issued 36,531 thousand shares to employees.
22 IFRS defines Total comprehensive income as “the change in equity during a period resulting from
transactions and other events, other than those changes resulting from transactions with owners in
their capacity as owners. (IAS 1, Presentation of Financial Statements, paragraph 7. Similarly, US GAAP
defines comprehensive income as “the change in equity [net assets] of a business entity during a period
from transactions and other events and circumstances from nonowner sources. It includes all changes in
equity during a period except those resulting from investments by owners and distributions to owners.”
(FASB ASC Master Glossary.)
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![Reading 18 ■ Understanding Balance Sheets
96
Exhibit 14
SAP Group Consolidated Statements of Financial Position
(Excerpt: Equity Detail) (in millions of €)
as of 31 December
Assets 2017 2016
Total current assets 11,930 11,564
Total non-
current assets 30,567 32,713
Total assets 42,497 44,277
Total current liabilities 10,210 9,674
Total non-
current liabilities 6,747 8,205
Total liabilities 16,958 17,880
Issued capital 1,229 1,229
Share premium 570 599
Retained earnings 24,794 22,302
Other components of equity 508 3,346
Treasury shares (1,591) (1,099)
Equity attributable to owners of parent 25,509 26,376
Non-controlling interests 31 21
Total equity 25,540 26,397
Total equity and liabilities €42,497 €44,277
Source: SAP Group 2017 annual report.
Exhibit 15
Apple Inc. Consolidated Balance Sheet (Excerpt: Equity Detail)
(in millions of $) (Number of shares are reflected in thousands)
Assets
30
September 2017
24
September 2016
Total current assets 128,645 106,869
[All other assets] 246,674 214,817
Total assets 375,319 321,686
Liabilities and shareholders’ equity
Total current liabilities 100,814 79,006
[Total non-
current liabilities] 140,458 114,431
Total liabilities 241,272 193,437
Common stock and additional paid-
in capital,
$0.00001 par value: 12,600,000 shares autho-
rized; 5,126,201 and 5,336,166 shares issued
and outstanding, respectively
35,867 31,251
Retained earnings 98,330 96,364
Accumulated other comprehensive income/
(loss)
(150) 634
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![Statement of Changes in Equity 97
Assets
30
September 2017
24
September 2016
Total shareholders’ equity 134,047 128,249
Total liabilities and shareholders’ equity 375,319 321,686
Source: Apple Inc. 2017 annual report (10K).
STATEMENT OF CHANGES IN EQUITY
f describe the components of shareholders’ equity
The statement of changes in equity (or statement of shareholders’ equity) presents
information about the increases or decreases in a company’s equity over a period. IFRS
requires the following information in the statement of changes in equity:
■
■ total comprehensive income for the period;
■
■ the effects of any accounting changes that have been retrospectively applied to
previous periods;
■
■ capital transactions with owners and distributions to owners; and
■
■ reconciliation of the carrying amounts of each component of equity at the
beginning and end of the year.23
Under US GAAP, the requirement as specified by the SEC is for companies to provide
an analysis of changes in each component of stockholders’ equity that is shown in
the balance sheet.24
Exhibit 16 presents an excerpt from Apple’s Consolidated Statements of Changes in
Shareholders’ Equity. The excerpt shows only one of the years presented on the actual
statement. It begins with the balance as of 24 September 2016 (i.e., the beginning of
fiscal 2017) and presents the analysis of changes to 30 September 2017 in each com-
ponent of equity that is shown on Apple’s balance sheet. As noted above, the number
of shares outstanding decreased from 5,336,166 thousand to 5,126,201 thousand as
the company repurchased 246,496 thousand shares of its common stock and issued
36,531 thousand new shares which reduced the dollar balance of Paid-
in Capital and
Retained earnings by $913 million and $581 million, respectively. The dollar balance
in common stock also increased by $ 4,909 million in connection with share-
based
compensation. Retained earnings increased by $48,351 million net income, minus
$12,803 million dividends, $33,001 million for the share repurchase and $581 million
adjustment in connection with the stock issuance. For companies that pay dividends,
the amount of dividends are shown separately as a deduction from retained earnings.
The statement also provides details on the $784 million change in Apple’s Accumulated
other comprehensive income. Note that the statement provides a subtotal for total
comprehensive income that includes net income and each of the components of other
comprehensive income.
14
Exhibit 15 (Continued)
23 IAS 1, Presentation of Financial Statements, paragraph 106.
24 FASB ASC 505-
10-
S99 [Equity–Overall–SEC materials] indicates that a company can present the
analysis of changes in stockholders’ equity either in the notes or in a separate statement.
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![Reading 18 ■ Understanding Balance Sheets
118
28 C is correct. The debt-
to-
equity ratio, a solvency ratio, is an indicator of finan-
cial risk.
29 B is correct. The quick ratio ([Cash + Marketable securities + Receivables] ÷
Current liabilities) is 1.07 ([= €4,011 + €990 + €5,899] ÷ €10,210). As noted in
the text, the largest component of the current financial assets are loans and
other financial receivables. Thus, financial assets are included in the quick ratio
but not the cash ratio.
30 B is correct. The financial leverage ratio (Total assets ÷ Total equity) is 1.66 (=
€42,497 ÷ €25,540).
31 C is correct. The presence of goodwill on Company A’s balance sheet signi-
fies that it has made one or more acquisitions in the past. The current, cash,
and quick ratios are lower for Company A than for the sector average. These
lower liquidity ratios imply above-
average liquidity risk. The total debt, long-
term debt-
to-
equity, debt-
to-
equity, and financial leverage ratios are lower
for Company B than for the sector average. These lower solvency ratios imply
below-
average solvency risk.
Current ratio is (35/35) = 1.00 for Company A, versus (48/28) = 1.71 for the
sector average.
Cash ratio is (5 + 5)/35 = 0.29 for Company A, versus (7 + 2)/28 = 0.32 for the
sector average.
Quick ratio is (5 + 5 + 5)/35 = 0.43 for Company A, versus (7 + 2 + 12)/28 =
0.75 for the sector average.
Total debt ratio is (55/100) = 0.55 for Company B, versus (63/100) = 0.63 for the
sector average.
Long-
term debt-
to-
equity ratio is (20/45) = 0.44 for Company B, versus (28/37)
= 0.76 for the sector average.
Debt-
to-
equity ratio is (55/45) = 1.22 for Company B, versus (63/37) = 1.70 for
the sector average.
Financial leverage ratio is (100/45) = 2.22 for Company B, versus (100/37) =
2.70 for the sector average.
32 A is correct. The quick ratio is defined as (Cash and cash equivalents +
Marketable securities + receivables) ÷ Current liabilities. For Company A, this
calculation is (5 + 5 + 5)/35 = 0.43.
33 C is correct. The financial leverage ratio is defined as Total assets ÷ Total equity.
For Company B, total assets are 100 and total equity is 45; hence, the financial
leverage ratio is 100/45 = 2.22.
34 A is correct. The cash ratio is defined as (Cash + Marketable securities)/Current
liabilities. Company A’s cash ratio, (5 + 5)/35 = 0.29, is higher than (5 + 0)/25 =
0.20 for Company B.
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![Cash Flow Statement: Differences Between IFRS and US GAAP 123
as either an operating activity or a financing activity. Companies must use a consistent
classification from year to year and disclose separately the amounts of interest and
dividends received and paid and where the amounts are reported.
Under US GAAP, discretion is not permitted in classifying interest and dividends.
Interest received and interest paid are reported as operating activities for all compa-
nies.3 Under US GAAP, dividends received are always reported as operating activities
and dividends paid are always reported as financing activities.
EXAMPLE 2
Operating versus Financing Cash Flows
On 31 December 2018, a company issued a £30,000 180-
day note at 8 percent
and used the cash received to pay for inventory and issued £110,000 long-
term
debt at 11 percent annually and used the cash received to pay for new equipment.
Which of the following most accurately reflects the combined effect of both
transactions on the company’s cash flows for the year ended 31 December 2018
under IFRS? Cash flows from:
A operations are unchanged.
B financing increase £110,000.
C operations decrease £30,000.
Solution:
C is correct. The payment for inventory would decrease cash flows from oper-
ations. The issuance of debt (both short-
term and long-
term debt) is part of
financing activities and would increase cash flows from financing activities by
£140,000. The purchase of equipment is an investing activity. Note that the
treatment under US GAAP would be the same for these transactions.
Companies may also engage in non-
cash investing and financing transactions. A
non-
cash transaction is any transaction that does not involve an inflow or outflow
of cash. For example, if a company exchanges one non-
monetary asset for another
non-
monetary asset, no cash is involved. Similarly, no cash is involved when a com-
pany issues common stock either for dividends or in connection with conversion of a
convertible bond or convertible preferred stock. Because no cash is involved in non-
cash transactions (by definition), these transactions are not incorporated in the cash
flow statement. However, because such transactions may affect a company’s capital
or asset structures, any significant non-
cash transaction is required to be disclosed,
either in a separate note or a supplementary schedule to the cash flow statement.
CASH FLOW STATEMENT: DIFFERENCES BETWEEN
IFRS AND US GAAP
c contrast cash flow statements prepared under International Financial Reporting
Standards (IFRS) and US generally accepted accounting principles (US GAAP)
3
3 FASB ASC Topic 230 [Statement of Cash Flows].
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![Cash Flow Statement: Direct and Indirect Methods for Reporting Cash Flow from Operating Activities 125
CASH FLOW STATEMENT: DIRECT AND INDIRECT
METHODS FOR REPORTING CASH FLOW FROM
OPERATING ACTIVITIES
d compare and contrast the direct and indirect methods of presenting cash from
operating activities and describe arguments in favor of each method
There are two acceptable formats for reporting cash flow from operating activities
(also known as cash flow from operations or operating cash flow), defined as the
net amount of cash provided from operating activities: the direct and the indirect
methods. The amount of operating cash flow is identical under both methods; only
the presentation format of the operating cash flow section differs. The presentation
format of the cash flows from investing and financing is exactly the same, regardless
of which method is used to present operating cash flows.
The direct method shows the specific cash inflows and outflows that result in
reported cash flow from operating activities. It shows each cash inflow and outflow
related to a company’s cash receipts and disbursements. In other words, the direct
method eliminates any impact of accruals and shows only cash receipts and cash
payments. The primary argument in favor of the direct method is that it provides
information on the specific sources of operating cash receipts and payments. This is
in contrast to the indirect method, which shows only the net result of these receipts
and payments. Just as information on the specific sources of revenues and expenses is
more useful than knowing only the net result—net income—the analyst gets additional
information from a direct-
format cash flow statement. The additional information is
useful in understanding historical performance and in predicting future operating
cash flows.
The indirect method shows how cash flow from operations can be obtained from
reported net income as the result of a series of adjustments. The indirect format begins
with net income. To reconcile net income with operating cash flow, adjustments are
made for non-
cash items, for non-
operating items, and for the net changes in operating
accruals. The main argument for the indirect approach is that it shows the reasons for
differences between net income and operating cash flows. (However, the differences
between net income and operating cash flows are equally visible on an indirect-
format
cash flow statement and in the supplementary reconciliation required under US GAAP
if the company uses the direct method.) Another argument for the indirect method
is that it mirrors a forecasting approach that begins by forecasting future income and
then derives cash flows by adjusting for changes in balance sheet accounts that occur
because of the timing differences between accrual and cash accounting.
IFRS and US GAAP both encourage the use of the direct method but permit either
method. US GAAP encourage the use of the direct method but also require companies
to present a reconciliation between net income and cash flow (which is equivalent to
the indirect method).4 If the indirect method is chosen, no direct-
format disclosures
are required. The majority of companies, reporting under IFRS or US GAAP, present
using the indirect method for operating cash flows.
Many users of financial statements prefer the direct format, particularly analysts
and commercial lenders, because of the importance of information about operating
receipts and payments in assessing a company’s financing needs and capacity to repay
existing obligations. Preparers argue that adjusting net income to operating cash flow,
as in the indirect format, is easier and less costly than reporting gross operating cash
receipts and payments, as in the direct format. With advances in accounting systems
4
4 FASB ASC Section 230-
10-
45 [Statement of Cash Flows–Overall–Other Presentation Matters].
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![Cash Flow Statement Analysis: Common Size Analysis 155
Exchange rate effects on cash (151) 272
Increase in cash 38 81
The primary source of cash for Groupe Danone in 2016 is operating activities.
In both 2016 and 2017, there was sufficient operating cash flow to cover usual
capital expenditures, and operating cash flow exceeded net income. Evaluating
the five prior years [not shown in this Example], you confirm that Danone typ-
ically derives most of its cash from operating activities, reports operating cash
flow greater than net income, and generates sufficient operating cash flow to
cover capital expenditures.
The fact that the primary source of cash is from operations is positive and
desirable for a mature company. Additionally, the fact that operating cash flow
exceeds net income in both years is a positive sign. Finally, operating cash flows
exceed normal capital expenditures, indicating that the company can fund capital
expenditures from operations.
In 2017, however, the primary source of cash was financing activities, and
the investing section shows significant use of cash for purchase of subsidiar-
ies within investing activities. Footnotes disclose a major acquisition with an
aggregate value of €12.5 billion, some of which was funded through proceeds
from an earlier bond issuance, which appears as a financing cash flow in the
financing section for 2016.
For purposes of Yee’s cash flow forecast, the company’s targets for free cash
flow and debt reduction—as well as disclosures concerning the acquisition’s
impact on 2017 operating results—are potentially helpful.
CASH FLOW STATEMENT ANALYSIS: COMMON SIZE
ANALYSIS
h analyze and interpret both reported and common-
size cash flow statements
In common-
size analysis of a company’s income statement, each income and expense
line item is expressed as a percentage of net revenues (net sales). For the common-
size
balance sheet, each asset, liability, and equity line item is expressed as a percentage
of total assets. For the common-
size cash flow statement, there are two alternative
approaches. The first approach is to express each line item of cash inflow (outflow) as
a percentage of total inflows (outflows) of cash, and the second approach is to express
each line item as a percentage of net revenue.
Exhibit 14 demonstrates the total cash inflows/total cash outflows method for
Acme Corporation. Under this approach, each of the cash inflows is expressed as a
percentage of the total cash inflows, whereas each of the cash outflows is expressed as
a percentage of the total cash outflows. In Panel A, Acme’s common-
size statement is
based on a cash flow statement using the direct method of presenting operating cash
flows. Operating cash inflows and outflows are separately presented on the cash flow
statement, and therefore, the common-
size cash flow statement shows each of these
operating inflows (outflows) as a percentage of total inflows (outflows). In Panel B,
Acme’s common-
size statement is based on a cash flow statement using the indirect
method of presenting operating cash flows. When a cash flow statement has been
presented using the indirect method, operating cash inflows and outflows are not
separately presented; therefore, the common-
size cash flow statement shows only
the net operating cash flow (net cash provided by or used in operating activities) as a
17
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![Reading 19 ■ Understanding Cash Flow Statements
158
Percentage of
Net Revenue
Cash paid to retire long-
term debt $(500) (2.12)%
Cash paid to retire common stock (600) (2.54)
Cash paid for dividends (1,120) (4.75)
Net cash used for financing activities $(2,220) (9.41)%
Net decrease in cash $(152) (0.64)%
EXAMPLE 9
Analysis of a Common-
Size Cash Flow Statement
Andrew Potter is examining an abbreviated common-
size cash flow statement
for Apple Inc., a multinational technology company. The common-
size cash
flow statement was prepared by dividing each line item by total net sales for
the same year.
Apple Inc. Common Size Statements OF Cash Flows as Percentage of
Total Net Sales
12 Months Ended
30 Sep.
2017
24 Sep.
2016
26 Sep.
2015
Statement of Cash Flows [Abstract]
Operating activities:
Net income 21.1% 21.2% 22.8%
Adjustments to reconcile net
income to cash generated by oper-
ating activities:
Depreciation and amortization 4.4% 4.9% 4.8%
Share-
based compensation expense 2.1% 2.0% 1.5%
Deferred income tax expense 2.6% 2.3% 0.6%
Other –0.1% 0.2% 0.2%
Changes in operating assets and
liabilities:
Accounts receivable, net –0.9% 0.2% 0.2%
Inventories –1.2% 0.1% –0.1%
Vendor non-
trade receivables –1.9% 0.0% –1.6%
Other current and non-
current assets –2.3% 0.5% –0.1%
Accounts payable 4.2% 0.9% 2.1%
Deferred revenue –0.3% –0.7% 0.4%
Exhibit 15 (Continued)
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![Cash Flow Statement Analysis: Free Cash Flow to Firm and Free Cash Flow to Equity 161
FCFF is the cash flow available to the company’s suppliers of debt and equity capital
after all operating expenses (including income taxes) have been paid and necessary
investments in working capital and fixed capital have been made. FCFF can be com-
puted starting with net income as
FCFF = NI + NCC + Int(1 – Tax rate) – FCInv – WCInv
where
NI = Net income
NCC = Non-
cash charges (such as depreciation and amortisation)
Int = Interest expense
FCInv = Capital expenditures (fixed capital, such as equipment)
WCInv = Working capital expenditures
The reason for adding back interest is that FCFF is the cash flow available to the
suppliers of debt capital as well as equity capital. Conveniently, FCFF can also be
computed from cash flow from operating activities as
FCFF = CFO + Int(1 – Tax rate) – FCInv
CFO represents cash flow from operating activities under US GAAP or under
IFRS where the company has included interest paid in operating activities. If interest
paid was included in financing activities, then CFO does not have to be adjusted
for Int(1 – Tax rate). Under IFRS, if the company has placed interest and dividends
received in investing activities, these should be added back to CFO to determine FCFF.
Additionally, if dividends paid were subtracted in the operating section, these should
be added back in to compute FCFF.
The computation of FCFF for Acme Corporation (based on the data from Exhibits
6, 7, and 8) is as follows:
CFO $2,606
Plus: Interest paid times (1 – income tax rate)
{$258 [1 – 0.34a]} 170
Less: Net investments in fixed capital
($1,300 – $762) (538)
FCFF $2,238
a Income tax rate of 0.34 = (Tax expense ÷ Pretax income) = ($1,139 ÷ $3,349).
FCFE is the cash flow available to the company’s common stockholders after all
operating expenses and borrowing costs (principal and interest) have been paid and
necessary investments in working capital and fixed capital have been made. FCFE
can be computed as
FCFE = CFO – FCInv + Net borrowing
When net borrowing is negative, debt repayments exceed receipts of borrowed
funds. In this case, FCFE can be expressed as
FCFE = CFO – FCInv – Net debt repayment
The computation of FCFE for Acme Corporation (based on the data from Exhibits
6, 7, and 8) is as follows:
CFO $2,606
Less: Net investments in fixed capital ($1,300 – $762) (538)
Less: Debt repayment (500)
FCFE $1,568
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![Activity Ratios 201
slight differences due to rounding (90/3.18 = 28.30 and 365/12.91 = 28.27). Another
time-
related computational detail is that for companies using a 52/53-
week annual
period and for leap years, the actual days in the year should be used rather than 365.
In some cases, an analyst may want to know how many days of inventory are on
hand at the end of the year rather than the average for the year. In this case, it would
be appropriate to use the year-
end inventory balance in the computation rather
than the average. If the company is growing rapidly or if costs are increasing rapidly,
analysts should consider using cost of goods sold just for the fourth quarter in this
computation because the cost of goods sold of earlier quarters may not be relevant.
Example 6 further demonstrates computation of activity ratios using Hong Kong Stock
Exchange(HKEX)-listed Lenovo Group Limited.
EXAMPLE 6
Computation of Activity Ratios
An analyst would like to evaluate Lenovo Group’s efficiency in collecting its
trade accounts receivable during the fiscal year ended 31 March 2018 (FY2017).
The analyst gathers the following information from Lenovo’s annual and interim
reports:
US$ in Thousands
Trade receivables as of 31 March 2017 4,468,392
Trade receivables as of 31 March 2018 4,972,722
Revenue for year ended 31 March 2018 45,349,943
Calculate Lenovo’s receivables turnover and number of days of sales out-
standing (DSO) for the fiscal year ended 31 March 2018.
Solution:
Receivables turnover = Revenue/Average receivables
= 45,349,943/[(4,468,392 + 4,972,722)/2]
= 45,349,943/4,720,557
= 9.6069 times, or 9.6 rounded
DSO = Number of days in period/Receivables
turnover
= 365/9.6
= 38.0 days
On average, it took Lenovo 38 days to collect receivables during the fiscal year
ended 31 March 2018.
8.2 Interpretation of Activity Ratios
In the following section, we further discuss the activity ratios that were defined in
Exhibit 10.
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![Reading 20 ■ Financial Analysis Techniques
228
effect of different levels of fixed asset investment across companies. It facilitates com-
parison between companies in the same sector but at different stages of infrastructure
maturity. Price to sales is calculated in a similar manner and is sometimes used as a
comparative price metric when a company does not have positive net income.
Another price-
based ratio that facilitates useful comparisons of companies’ stock
prices is price to book value, or P/B, which is the ratio of price to book value per
share. This ratio is often interpreted as an indicator of market judgment about the
relationship between a company’s required rate of return and its actual rate of return.
Assuming that book values reflect the fair values of the assets, a price to book ratio of
one can be interpreted as an indicator that the company’s future returns are expected
to be exactly equal to the returns required by the market. A ratio greater than one
would indicate that the future profitability of the company is expected to exceed the
required rate of return, and values of this ratio less than one indicate that the company
is not expected to earn excess returns.14
14.1.2 Interpretation of Earnings per Share
Exhibit 18 presented a number of per-
share quantities that can be used in valuation
ratios. In this section, we discuss the interpretation of one such critical quantity,
earnings per share or EPS.15
EPS is simply the amount of earnings attributable to each share of common stock.
In isolation, EPS does not provide adequate information for comparison of one com-
pany with another. For example, assume that two companies have only common stock
outstanding and no dilutive securities outstanding. In addition, assume the two com-
panies have identical net income of $10 million, identical book equity of $100 million
and, therefore, identical profitability (10 percent, using ending equity in this case for
simplicity). Furthermore, assume that Company A has 100 million weighted average
common shares outstanding, whereas Company B has 10 million weighted average
common shares outstanding. So, Company A will report EPS of $0.10 per share, and
Company B will report EPS of $1 per share. The difference in EPS does not reflect a
difference in profitability—the companies have identical profits and profitability. The
difference reflects only a different number of common shares outstanding. Analysts
should understand in detail the types of EPS information that companies report:
Basic EPS provides information regarding the earnings attributable to each share
of common stock.16 To calculate basic EPS, the weighted average number of shares
outstanding during the period is first calculated. The weighted average number of
shares consists of the number of ordinary shares outstanding at the beginning of the
period, adjusted by those bought back or issued during the period, multiplied by a
time-weighting factor.
Accounting standards generally require the disclosure of basic as well as diluted
EPS (diluted EPS includes the effect of all the company’s securities whose conversion
or exercise would result in a reduction of basic EPS; dilutive securities include con-
vertible debt, convertible preferred, warrants, and options). Basic EPS and diluted
EPS must be shown with equal prominence on the face of the income statement for
each class of ordinary share. Disclosure includes the amounts used as the numera-
tors in calculating basic and diluted EPS, and a reconciliation of those amounts to
the company’s profit or loss for the period. Because both basic and diluted EPS are
presented in a company’s financial statements, an analyst does not need to calculate
these measures for reported financial statements. Understanding the calculations is,
however, helpful for situations requiring an analyst to calculate expected future EPS.
14 For more detail on valuation ratios as used in equity analysis, see the curriculum reading “Equity
Valuation: Concepts and Basic Tools.”
15 For more detail on EPS calculation, see the reading “Understanding Income Statements.”
16 IAS 33, Earnings per Share and FASB ASC Topic 260 [Earnings per Share].
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![Reading 20 ■ Financial Analysis Techniques
234
17.2 Historical Research on Ratios in Credit Analysis
A great deal of academic and practitioner research has focused on determining
which ratios are useful in assessing the credit risk of a company, including the risk
of bankruptcy.
One of the earliest studies examined individual ratios to assess their ability to
predict failure of a company up to five years in advance. Beaver (1967) found that six
ratios could correctly predict company failure one year in advance 90 percent of the
time and five years in advance at least 65 percent of the time. The ratios found effective
by Beaver were cash flow to total debt, ROA, total debt to total assets, working capital
to total assets, the current ratio, and the no-
credit interval ratio (the length of time a
company could go without borrowing). Altman (1968) and Altman, Haldeman, and
Narayanan (1977) found that financial ratios could be combined in an effective model
for predicting bankruptcy. Altman’s initial work involved creation of a Z-score that
was able to correctly predict financial distress. The Z-score was computed as
Z = 1.2 × (Current assets – Current liabilities)/Total assets
+ 1.4 × (Retained earnings/Total assets)
+ 3.3 × (EBIT/Total assets)
+ 0.6 × (Market value of stock/Book value of liabilities)
+ 1.0 × (Sales/Total assets)
In his initial study, a Z-score of lower than 1.81 predicted failure and the model was
able to accurately classify 95 percent of companies studied into a failure group and
a non-
failure group. The original model was designed for manufacturing companies.
Subsequent refinements to the models allow for other company types and time peri-
ods. Generally, the variables found to be useful in prediction include profitability
ratios, coverage ratios, liquidity ratios, capitalization ratios, and earnings variability
(Altman 2000).
Similar research has been performed on the ability of ratios to predict bond ratings
and bond yields. For example, Ederington, Yawtiz, and Roberts (1987) found that a
small number of variables (total assets, interest coverage, leverage, variability of cov-
erage, and subordination status) were effective in explaining bond yields. Similarly,
Ederington (1986) found that nine variables in combination could correctly classify
more than 70 percent of bond ratings. These variables included ROA, long-
term
debt to assets, interest coverage, cash flow to debt, variability of coverage and cash
flow, total assets, and subordination status. These studies have shown that ratios are
effective in evaluating credit risk, bond yields, and bond ratings.
BUSINESS AND GEOGRAPHIC SEGMENTS
f explain the requirements for segment reporting and calculate and interpret
segment ratios
Analysts often need to evaluate the performance underlying business segments
(subsidiary companies, operating units, or simply operations in different geographic
areas) to understand in detail the company as a whole. Although companies are not
required to provide full financial statements for segments, they are required to provide
segment information under both IFRS and US GAAP.20
18
20 IFRS 8, Operating Segments and FASB ASC Topic 280 [Segment Reporting].
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![Reading 20 ■ Financial Analysis Techniques
248
the period would both likely decrease the average inventory for the period (the
denominator of the inventory turnover ratio), thus increasing the ratio rather
than decreasing it.
9 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 receiv-
ables turnover. Longer payment terms would likely increase the average amount
of accounts receivable and thus decrease receivables turnover.
10 A is correct. The average accounts receivable balances (actual and desired) must
be calculated to determine the desired change. The average accounts receivable
balance can be calculated as an average day’s credit sales times the DSO. For the
most recent fiscal year, the average accounts receivable balance is $15.62 million
[= ($300,000,000/365) × 19]. The desired average accounts receivable balance
for the next fiscal year is $16.03 million (= ($390,000,000/365) × 15). This is
an increase of $0.41 million (= 16.03 million – 15.62 million). An alternative
approach is to calculate the turnover and divide sales by turnover to determine
the average accounts receivable balance. Turnover equals 365 divided by DSO.
Turnover is 19.21 (= 365/19) for the most recent fiscal year and is targeted to
be 24.33 (= 365/15) for the next fiscal year. The average accounts receivable
balances are $15.62 million (= $300,000,000/19.21), and $16.03 million (=
$390,000,000/24.33). The change is an increase in receivables of $0.41 million
11 A is correct. Company A’s current ratio of 4.0 (= $40,000/$10,000) indi-
cates it is more liquid than Company B, whose current ratio is only 1.2 (=
$60,000/$50,000). Company B is more solvent, as indicated by its lower debt-
to-
equity ratio of 30 percent (= $150,000/$500,000) compared with Company A’s
debt-
to-
equity ratio of 200 percent (= $60,000/$30,000).
12 C is correct. The company’s efficiency deteriorated, as indicated by the decline
in its total asset turnover ratio from 1.11 {= 4,390/[(4,384 + 3,500)/2]} for
FY10 to 0.87 {= 11,366/[(12,250 + 13,799)/2]} for FY14. The decline in the
total asset turnover ratio resulted from an increase in average total assets from
GBP3,942 [= (4,384 + 3,500)/2] for FY10 to GBP13,024.5 for FY14, an increase
of 230 percent, compared with an increase in revenue from GBP4,390 in FY10
to GBP11,366 in FY14, an increase of only 159 percent. The current ratio is not
an indicator of efficiency.
13 B is correct. Comparing FY14 with FY10, the company’s solvency deteriorated,
as indicated by a decrease in interest coverage from 10.6 (= 844/80) in FY10
to 8.4 (= 1,579/188) in FY14. The debt-
to-
asset ratio increased from 0.14 (=
602/4,384) in FY10 to 0.27 (= 3,707/13,799) in FY14. This is also indicative of
deteriorating solvency. In isolation, the amount of profits does not provide
enough information to assess solvency.
14 C is correct. Comparing FY14 with FY10, the company’s liquidity improved,
as indicated by an increase in its current ratio from 0.71 [= (316 + 558)/1,223]
in FY10 to 0.75 [= (682 + 1,634)/3,108] in FY14. Note, however, comparing
only current investments with the level of current liabilities shows a decline in
liquidity from 0.26 (= 316/1,223) in FY10 to 0.22 (= 682/3,108) in FY14. Debt-
to-
assets ratio and interest coverage are measures of solvency not liquidity.
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![Reading 21 ■ Inventories
254
INTRODUCTION
Merchandising and manufacturing companies generate revenues and profits through
the sale of inventory. Further, inventory may represent a significant asset on these
companies’ balance sheets. Merchandisers (wholesalers and retailers) purchase inven-
tory, ready for sale, from manufacturers and thus account for only one type of inven-
tory—finished goods inventory. Manufacturers, however, purchase raw materials
from suppliers and then add value by transforming the raw materials into finished
goods. They typically classify inventory into three different categories:1 raw materials,
work in progress,2 and finished goods. Work-
in-
progress inventories have started the
conversion process from raw materials but are not yet finished goods ready for sale.
Manufacturers may report either the separate carrying amounts of their raw materi-
als, work-
in-
progress, and finished goods inventories on the balance sheet or simply
the total inventory amount. If the latter approach is used, the company must then
disclose the carrying amounts of its raw materials, work-
in-
progress, and finished
goods inventories in a footnote to the financial statements.
Inventories and cost of sales (cost of goods sold)3 are significant items in the finan-
cial statements of many companies. Comparing the performance of these companies
is challenging because of the allowable choices for valuing inventories: Differences in
the choice of inventory valuation method can result in significantly different amounts
being assigned to inventory and cost of sales. Financial statement analysis would be
much easier if all companies used the same inventory valuation method or if inventory
price levels remained constant over time. If there was no inflation or deflation with
respect to inventory costs and thus unit costs were unchanged, the choice of inventory
valuation method would be irrelevant. However, inventory price levels typically do
change over time.
International Financial Reporting Standards (IFRS) permit the assignment of inven-
tory costs (costs of goods available for sale) to inventories and cost of sales by three
cost formulas: specific identification, first-
in, first-
out (FIFO), and weighted average
cost.4 US generally accepted accounting principles (US GAAP) allow the same three
inventory valuation methods, referred to as cost flow assumptions in US GAAP, but
also include a fourth method called last-
in, first-
out (LIFO).5 The choice of inventory
valuation method affects the allocation of the cost of goods available for sale to ending
inventory and cost of sales. Analysts must understand the various inventory valuation
methods and the related impact on financial statements and financial ratios in order
to evaluate a company’s performance over time and relative to industry peers. The
company’s financial statements and related notes provide important information that
the analyst can use in assessing the impact of the choice of inventory valuation method
on financial statements and financial ratios.
This reading is organized as follows: Section 2 discusses the costs that are included
in inventory and the costs that are recognised as expenses in the period in which they
are incurred. Sections 3–6 describe inventory valuation methods and compare the
measurement of ending inventory, cost of sales and gross profit under each method,
and when using periodic versus perpetual inventory systems. Sections 7 and 8 describe
the LIFO method, LIFO reserve, and effects of LIFO liquidations, and demonstrate
the adjustments required to compare a company that uses LIFO with one that uses
1
1 Other classifications are possible. Inventory classifications should be appropriate to the entity.
2 This category is commonly referred to as work in process under US GAAP.
3 Typically, cost of sales is IFRS terminology and cost of goods sold is US GAAP terminology.
4 International Accounting Standard (IAS) 2 [Inventories].
5 Financial Accounting Standards Board Accounting Standards Codification (FASB ASC) Topic 330
[Inventory].
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![Cost of inventories 255
FIFO. Section 9 describes the financial statement effects of a change in inventory
valuation method. Section 10 discusses the measurement and reporting of inventory
when its value changes. Sections 11–13 describe the presentation of inventories on
the financial statements and related disclosures, discuss inventory ratios and their
interpretation, and show examples of financial analysis with respect to inventories.
A summary and practice problems conclude the reading.
COST OF INVENTORIES
a contrast costs included in inventories and costs recognised as expenses in the
period in which they are incurred
Under IFRS, the costs to include in inventories are “all costs of purchase, costs of
conversion, and other costs incurred in bringing the inventories to their present loca-
tion and condition.”6 The costs of purchase include the purchase price, import and
tax-
related duties, transport, insurance during transport, handling, and other costs
directly attributable to the acquisition of finished goods, materials, and services. Trade
discounts, rebates, and similar items reduce the price paid and the costs of purchase.
The costs of conversion include costs directly related to the units produced, such as
direct labour, and fixed and variable overhead costs.7 Including these product-
related
costs in inventory (i.e., as an asset) means that they will not be recognised as an expense
(i.e., as cost of sales) on the income statement until the inventory is sold. US GAAP
provide a similar description of the costs to be included in inventory.8
Both IFRS and US GAAP exclude the following costs from inventory: abnormal
costs incurred as a result of waste of materials, labour or other production conver-
sion inputs, any storage costs (unless required as part of the production process),
and all administrative overhead and selling costs. These excluded costs are treated
as expenses and recognised on the income statement in the period in which they are
incurred. Including costs in inventory defers their recognition as an expense on the
income statement until the inventory is sold. Therefore, including costs in inventory
that should be expensed will overstate profitability on the income statement (because
of the inappropriate deferral of cost recognition) and create an overstated inventory
value on the balance sheet.
EXAMPLE 1
Treatment of Inventory-
Related Costs
Acme Enterprises, a hypothetical company that prepares its financial statements
in accordance with IFRS, manufactures tables. In 2018, the factory produced
900,000 finished tables and scrapped 1,000 tables. For the finished tables, raw
material costs were €9 million, direct labour conversion costs were €18 million,
and production overhead costs were €1.8 million. The 1,000 scrapped tables
(attributable to abnormal waste) had a total production cost of €30,000 (€10,000
raw material costs and €20,000 conversion costs; these costs are not included in
2
6 International Accounting Standard (IAS) 2 [Inventories].
7 Fixed production overhead costs (depreciation, factory maintenance, and factory management and
administration) represent indirect costs of production that remain relatively constant regardless of the
volume of production. Variable production overhead costs are indirect production costs (indirect labour
and materials) that vary with the volume of production.
8 FASB Accounting Standards Codification™ (ASC) Topic 330 [Inventory].
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![Calculations of cost of sales, gross profit, and ending inventory 259
shipment received, 180,000 kg of the second shipment received, and 240,000 kg
of the final shipment received was sent to customers. Answers to the following
questions should be rounded to the nearest 1,000 AED.
1 What are the reported cost of sales, gross profit, and ending inventory
balances for 2018 under the specific identification method?
2 What are the reported cost of sales, gross profit, and ending inventory
balances for 2018 under the weighted average cost method?
3 What are the reported cost of sales, gross profit, and ending inventory
balances for 2018 under the FIFO method?
4 What are the reported cost of sales, gross profit, and ending inventory
balances for 2018 under the LIFO method?
Solution to 1:
Under the specific identification method, the physical flow of the specific inven-
tory items sold is matched to their actual cost.
Sales = 520,000 × 240 = 124,800,000 AED
Cost of sales = (100,000 × 110) + (180,000 × 100) + (240,000 × 90) =
50,600,000 AED
Gross profit = 124,800,000 – 50,600,000 = 74,200,000 AED
Ending inventory = (20,000 × 100) + (60,000 × 90) = 7,400,000 AED
Note that in spite of the segregation of inventory within the warehouse, it would
be inappropriate to use specific identification for this inventory of interchange-
able items. The use of specific identification could potentially result in earnings
manipulation through the shipment decision.
Solution to 2:
Under the weighted average cost method, costs are allocated to cost of sales and
ending inventory by using a weighted average mix of the actual costs incurred for
all inventory items. The weighted average cost per unit is determined by dividing
the total cost of goods available for sale by the number of units available for sale.
Weighted average cost = [(100,000 × 110) + (200,000 × 100) + (300,000 ×
90)]/600,000 = 96.667 AED/kg
Sales = 520,000 × 240 = 124,800,000 AED
Cost of sales = 520,000 × 96.667 = 50,267,000 AED
Gross profit = 124,800,000 – 50,267,000 = 74,533,000 AED
Ending inventory = 80,000 × 96.667 = 7,733,360 AED
Solution to 3:
Under the FIFO method, the oldest inventory units acquired are assumed to be
the first units sold. Ending inventory, therefore, is assumed to consist of those
inventory units most recently acquired.
Sales = 520,000 × 240 = 124,800,000 AED
Cost of sales = (100,000 × 110) + (200,000 × 100) + (220,000 × 90) =
50,800,000 AED
Gross profit = 124,800,000 – 50,800,000 = 74,000,000 AED
Ending inventory = 80,000 × 90 = 7,200,000 AED
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![Reading 21 ■ Inventories
264
Solution to 1:
Company L using
LIFO Year 1 Year 2 Year 3 Year 4 Year 5
Ending inventorya $16,000 $16,000 $16,000 $16,000 $16,000
Salesb $300,000 $343,200 $392,621 $449,158 $513,837
Cost of salesc 160,000 183,040 209,398 239,551 274,046
Gross profit $140,000 $160,160 $183,223 $209,607 $239,791
a Inventory is unchanged at $16,000 each year (2,000 units × $8). 2,000 of the
units acquired in the first year are assumed to remain in inventory.
b Sales Year X = (20,000 × $15)(1.10)X–1(1.04)X–1. The quantity sold increases
by 10 percent each year and the selling price increases by 4 percent each year.
c Cost of sales Year X = (20,000 × $8)(1.10)X–1(1.04)X–1. In Year 1, 20,000
units are sold with a cost of $8. In subsequent years, the number of units pur-
chased equals the number of units sold and the units sold are assumed to be
those purchased in the year. The quantity purchased increases by 10 percent
each year and the purchase price increases by 4 percent each year.
Note that if the company sold more units than it purchased in a year, inventory
would decrease. This is referred to as LIFO liquidation. The cost of sales of the
units sold in excess of those purchased would reflect the inventory carrying
amount. In this example, each unit sold in excess of those purchased would
have a cost of sales of $8 and a higher gross profit.
Company F using
FIFO Year 1 Year 2 Year 3 Year 4 Year 5
Ending inventorya $16,000 $16,640 $17,306 $17,998 $18,718
Salesb $300,000 $343,200 $392,621 $449,158 $513,837
Cost of salesc 160,000 182,400 208,732 238,859 273,326
Gross profit $140,000 $160,800 $183,889 $210,299 $240,511
a Ending Inventory Year X = 2,000 units × Cost in Year X = 2,000 units [$8 ×
(1.04)X–1]. 2,000 units of the units acquired in Year X are assumed to remain
in inventory.
b Sales Year X = (20,000 × $15)(1.10)X–1(1.04)X–1
c Cost of sales Year 1 = $160,000 (= 20,000 units × $8). There was no begin-
ning inventory.
Cost of sales Year X (where X ≠ 1) = Beginning inventory plus purchases
less ending inventory
= (Inventory at Year X–1) + [(20,000 × $8)(1.10)X–1(1.04)X–1] − (Inventory
at Year X)
= 2,000($8)(1.04)X–2 + [(20,000 × $8)(1.10)X–1(1.04)X–1] – [2,000 ($8)(1.04)
X–1]
For example, cost of sales Year 2 = 2,000($8) + [(20,000 × $8)(1.10)(1.04)] –
[2,000 ($8)(1.04)] = $16,000 + 183,040 – 16,640 = $182,400
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![LIFO liquidations 271
the LIFO reserve of $215 million in 2017. Therefore, under the FIFO method,
cumulative gross profits would have been $2,139 million higher as of the end of
2016 and $1,924 million higher as of the end of 2017. The estimated tax savings
would be higher (lower) if income tax rates were assumed to be higher (lower).
Solution to 6:
The amount that would be added to CAT’s retained earnings is $1,214 million
(1,924 – 710) or (–215 × 72% + 2,139 × 64%). This represents the cumulative
increase in operating profit due to the decrease in cost of goods sold (LIFO
reserve of $1,924 million) less the assumed taxes on that profit ($710 million, see
solution to 5 above). Some analysts advocate ignoring the tax consequences and
suggest simply adjusting inventory and equity by the same amount. They argue
that the reported equity of the firm is understated by the difference between
the current value of its inventory (approximated by the value under FIFO) and
its carrying value (value under LIFO).
Solution to 7:
Under the FIFO method, an additional $710 million is assumed to have been
incurred for tax expenses. If CAT switched to FIFO, it would have an additional
tax liability of $710 million as a consequence of the restatement of financial
statements to the FIFO method. This illustrates the significant immediate income
tax liabilities that may arise in the year of transition from the LIFO method
to the FIFO method. If CAT switched to FIFO for tax purposes, there would
be a cash outflow of $710 million for the additional taxes. However, because
the company is not actually converting at this point for either tax or reporting
purposes, it is appropriate to reflect a deferred tax liability rather than a reduc-
tion in cash. In this case for analysis purposes, under FIFO, inventory would
increase by $1,924 million, equity by $1,214 million, and non-
current liabilities
by $710 million.
Solution to 8:
CAT’s ratios for 2017 under the LIFO and FIFO methods are as follows:
LIFO FIFO
Inventory turnover 3.33 2.76
Days of inventory on hand 109.6 days 132.2 days
Gross profit margin 27.24% 26.74%
Net profit margin 1.66% 1.32%
Return on assets 0.99% 0.77%
Current ratio 1.35 1.42
Total liabilities-to-equity ratio 4.59 4.27
Inventory turnover ratio = Cost of goods sold ÷ Average inventory
LIFO = 3.33 = 31,049 ÷ [(10,018 + 8,614) ÷ 2]
FIFO = 2.76 = 31,264 ÷ [(11,942 + 10,753) ÷ 2]
The ratio is higher under LIFO because, given rising inventory costs, cost of
goods sold will be higher and inventory carrying amounts will be lower under
LIFO. If an analyst made no adjustment for the difference in inventory methods,
it might appear that a company using the LIFO method manages its inventory
more effectively.
Days of inventory on hand = Number of days in period ÷ Inventory turnover ratio
LIFO = 109.6 days = (365 days ÷ 3.33)
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![Reading 21 ■ Inventories
272
FIFO = 132.2 days = (365 days ÷ 2.76)
Without adjustment, a company using the LIFO method might appear to manage
its inventory more effectively. This is primarily the result of the lower inventory
carrying amounts under LIFO.
Gross profit margin = Gross profit ÷ Total revenue
LIFO = 27.24 percent = [(42,676 – 31,049) ÷ 42,676]
FIFO = 26.74 percent = [(42,676 – 31,264) ÷ 42,676]
Revenue of financial products is excluded from the calculation of gross profit.
Gross profit is sales of machinery and engines less cost of goods sold. The gross
profit margin is lower under FIFO because the cost of goods sold is higher from
the LIFO reserve reduction.
Net profit margin = Net income ÷ Total revenue
LIFO = 1.66 percent = (754 ÷ 45,462)
FIFO = 1.32 percent = (599 ÷ 45,462]
The net profit margin is higher under LIFO because the cost of goods sold is
lower due to the LIFO liquidation. The absolute percentage difference is less than
that of the gross profit margin because of lower income taxes on the decreased
income reported under FIFO and because net income is divided by total revenue
including sales of machinery and engines and revenue of financial products. The
company appears to be more profitable under LIFO.
Return on assets = Net income ÷ Average total assets
LIFO = 0.99 percent = 754 ÷ [(76,962 + 74,704) ÷ 2]
FIFO = 0.77 percent = 599 ÷ [(76,962 + 1,924) + (74,704 + 2,139) ÷ 2]
The total assets under FIFO are the LIFO total assets increased by the LIFO
reserve. The return on assets is lower under FIFO because the of the lower net
income due to the higher cost of goods sold as well as higher total assets due to
the LIFO reserve adjustment. The company appears to be less profitable under
FIFO.
Current ratio = Current assets ÷ Current liabilities
LIFO = 1.35 = (36,244 ÷ 26,931)
FIFO = 1.42 = [(36,244 + 1,924) ÷ 26,931]
The current ratio is lower under LIFO primarily because of lower inventory
carrying amount. The company appears to be less liquid under LIFO.
Total liabilities-to-equity ratio = Total liabilities ÷ Total shareholders’ equity
LIFO = 4.59 = (63,196 ÷ 13,766)
FIFO = 4.27 = [(63,196 + 710) ÷ (13,766 + 1,214)]
The ratio is higher under LIFO because the addition to retained earnings under
FIFO reduces the ratio. The company appears to be more highly leveraged under
LIFO.
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![Reading 21 ■ Inventories
274
liquidation). The gross profit due to LIFO liquidation may also be determined
by multiplying the number of units liquidated times the difference between the
replacement cost of the units liquidated and their historical purchase cost. For
RF, 1,000 units times $15 ($115 replacement cost per fan less the $100 historical
cost per fan) equals the $15,000 gross profit due to LIFO liquidation.
INVENTORY METHOD CHANGES
b describe different inventory valuation methods (cost formulas)
f demonstrate the conversion of a company’s reported financial statements from
LIFO to FIFO for purposes of comparison
Companies on rare occasion change inventory valuation methods. Under IFRS, a
change in method is acceptable only if the change “results in the financial statements
providing reliable and more relevant information about the effects of transactions,
other events, or conditions on the business entity’s financial position, financial perfor-
mance, or cash flows.”11 If the change is justifiable, then it is applied retrospectively.
This means that the change is applied to comparative information for prior peri-
ods as far back as is practicable. The cumulative amount of the adjustments relating
to periods prior to those presented in the current financial statements is made to
the opening balance of each affected component of equity (i.e., retained earnings or
comprehensive income) of the earliest period presented. For example, if a company
changes its inventory method in 2018 and it presents three years of comparative
financial statements (2016, 2017, and 2018) in its annual report, it would retrospec-
tively reflect this change as far back as possible. The change would be reflected in the
three years of financial statements presented; the financial statements for 2016 and
2017 would be restated as if the new method had been used in these periods, and
the cumulative effect of the change on periods prior to 2016 would be reflected in
the 2016 opening balance of each affected component of equity. An exemption to the
restatement applies when it is impracticable to determine either the period-
specific
effects or the cumulative effect of the change.
Under US GAAP, the conditions to make a change in accounting policy and the
accounting for a change in inventory policy are similar to IFRS.12 US GAAP, however,
requires companies to thoroughly explain why the newly adopted inventory account-
ing method is superior and preferable to the old method. If a company decides to
change from LIFO to another inventory method, US GAAP requires a retrospective
restatement as described above. However, if a company decides to change to the LIFO
method, it must do so on a prospective basis and retrospective adjustments are not
made to the financial statements. The carrying amount of inventory under the old
method becomes the initial LIFO layer in the year of LIFO adoption.
Analysts should carefully evaluate changes in inventory valuation methods.
Although the stated reason for the inventory change may be to better match inven-
tory costs with sales revenue (or some other plausible business explanation), the real
underlying (and unstated) purpose may be to reduce income tax expense (if changing
to LIFO from FIFO or average cost), or to increase reported profits (if changing from
LIFO to FIFO or average cost). As always, the choice of inventory valuation method
can have a significant impact on financial statements and the financial ratios that are
9
11 IAS 8 [Accounting Policies, Changes in Accounting Estimates and Errors].
12 FASB ASC Topic 250 [Accounting Changes and Error Corrections].
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![Inventory adjustments 275
derived from them. As a consequence, analysts must carefully consider the impact of
the change in inventory valuation methods and the differences in inventory valuation
methods when comparing a company’s performance with that of its industry or its
competitors.
INVENTORY ADJUSTMENTS
g describe the measurement of inventory at the lower of cost and net realisable
value
h describe implications of valuing inventory at net realisable value for financial
statements and ratios
Significant financial risk can result from the holding of inventory. The cost of inventory
may not be recoverable due to spoilage, obsolescence, or declines in selling prices.
IFRS state that inventories shall be measured (and carried on the balance sheet) at the
lower of cost and net realisable value.13 Net realisable value is the estimated selling
price in the ordinary course of business less the estimated costs necessary to make
the sale and estimated costs to get the inventory in condition for sale. The assessment
of net realisable value is typically done item by item or by groups of similar or related
items. In the event that the value of inventory declines below the carrying amount
on the balance sheet, the inventory carrying amount must be written down to its net
realisable value14 and the loss (reduction in value) recognised as an expense on the
income statement. This expense may be included as part of cost of sales or reported
separately.
In each subsequent period, a new assessment of net realisable value is made.
Reversal (limited to the amount of the original write-
down) is required for a sub-
sequent increase in value of inventory previously written down. The reversal of any
write-
down of inventories is recognised as a reduction in cost of sales (reduction in
the amount of inventories recognised as an expense).
US GAAP used to specify the lower of cost or market to value inventories.15 For
fiscal years beginning after December 15, 2016, inventories measured using other
than LIFO and retail inventory methods are measured at the lower of cost or net
realisable value. This is broadly consistent with IFRS with one major difference: US
GAAP prohibit the reversal of write-
downs. For inventories measured using LIFO and
retail inventory methods, market value is defined as current replacement cost subject
to upper and lower limits. Market value cannot exceed net realisable value (selling
price less reasonably estimated costs of completion and disposal). The lower limit of
market value is net realisable value less a normal profit margin. Any write-
down to
market value or net realisable value reduces the value of the inventory, and the loss in
value (expense) is generally reflected in the income statement in cost of goods sold.
An inventory write-
down reduces both profit and the carrying amount of inven-
tory on the balance sheet and thus has a negative effect on profitability, liquidity,
and solvency ratios. However, activity ratios (for example, inventory turnover and
total asset turnover) will be positively affected by a write-
down because the asset
base (denominator) is reduced. The negative impact on some key ratios, due to the
decrease in profit, may result in the reluctance by some companies to record inventory
10
13 IAS 2 paragraphs 28–33 [Inventories – Net realisable value].
14 Frequently, rather than writing inventory down directly, an inventory valuation allowance account is
used. The allowance account is netted with the inventory accounts to arrive at the carrying amount that
appears on the balance sheet.
15 FASB ASC Section 330-
10-
35 [Inventory – Overall – Subsequent Measurement].
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![Reading 21 ■ Inventories
276
write-
downs unless there is strong evidence that the decline in the value of inventory
is permanent. This is especially true under US GAAP where reversal of a write-
down
is prohibited.
IAS 2 [Inventories] does not apply to the inventories of producers of agricultural
and forest products and minerals and mineral products, nor to commodity broker–
traders. These inventories may be measured at net realisable value (fair value less
costs to sell and complete) according to well-
established industry practices. If an
active market exists for these products, the quoted market price in that market is the
appropriate basis for determining the fair value of that asset. If an active market does
not exist, a company may use market determined prices or values (such as the most
recent market transaction price) when available for determining fair value. Changes
in the value of inventory (increase or decrease) are recognised in profit or loss in the
period of the change. US GAAP is similar to IFRS in its treatment of inventories of
agricultural and forest products and mineral ores. Mark-
to-
market inventory account-
ing is allowed for bullion.
EXAMPLE 7
Accounting for Declines and Recoveries of Inventory
Value
Hatsumei Enterprises, a hypothetical company, manufactures computers and
prepares its financial statements in accordance with IFRS. In 2017, the cost of
ending inventory was €5.2 million but its net realisable value was €4.9 million.
The current replacement cost of the inventory is €4.7 million. This figure exceeds
the net realisable value less a normal profit margin. In 2018, the net realisable
value of Hatsumei’s inventory was €0.5 million greater than the carrying amount.
1 What was the effect of the write-
down on Hatsumei’s 2017 financial state-
ments? What was the effect of the recovery on Hatsumei’s 2018 financial
statements?
2 Under US GAAP, if Hatsumei used the LIFO method, what would be the
effects of the write-
down on Hatsumei’s 2017 financial statements and of
the recovery on Hatsumei’s 2018 financial statements?
3 What would be the effect of the recovery on Hatsumei’s 2018 financial
statements if Hatsumei’s inventory were agricultural products instead of
computers?
Solution to 1:
For 2017, Hatsumei would write its inventory down to €4.9 million and record
the change in value of €0.3 million as an expense on the income statement. For
2018, Hatsumei would increase the carrying amount of its inventory and reduce
the cost of sales by €0.3 million (the recovery is limited to the amount of the
original write-down).
Solution to 2:
Under US GAAP, for 2017, Hatsumei would write its inventory down to €4.7 mil-
lion and typically include the change in value of €0.5 million in cost of goods sold
on the income statement. For 2018, Hatsumei would not reverse the write-down.
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![Inventory adjustments 281
31 December (Swedish krona in millions) 2017
Taxes on increased operating profit* −872
Profit (after recovery of previous write-
downs) 23,900
* Taxes on the increased operating profit are assumed to be 872 (3,489 × 25%) for 2017.
Solution to 5:
The Volvo Group’s financial ratios for 2017 with the allowance for inventory
obsolescence and without the allowance for inventory obsolescence are as follows:
With Allowance
(As Reported)
Without Allowance
(Adjusted)
Inventory turnover ratio 5.04 4.71
Days of inventory on hand 72.4 77.5
Gross profit margin 23.95% 23.89%
Net profit margin 6.36% 6.31%
Inventory turnover ratio = Cost of sales ÷ Average inventory
With allowance (as reported) = 5.04 = 254,581 ÷ [(52,701 + 48,287) ÷ 2]
Without allowance (adjusted) = 4.71 = 254,775 ÷ [(56,190 + 51,970) ÷ 2]
Inventory turnover is higher based on the numbers as reported because inventory
carrying amounts will be lower with an allowance for inventory obsolescence.
The company might appear to manage its inventory more efficiently when it
has inventory write-
downs.
Days of inventory on hand = Number of days in period ÷ Inventory turnover ratio
With allowance (as reported) = 72.4 days = (365 days ÷ 5.04)
Without allowance (adjusted) = 77.5 days = (365 days ÷ 4.71)
Days of inventory on hand are lower based on the numbers as reported because
the inventory turnover is higher. A company with inventory write-
downs might
appear to manage its inventory more effectively. This is primarily the result of
the lower inventory carrying amounts.
Gross profit margin = Gross income ÷ Net sales
With allowance (as reported) = 23.95 percent = (80,167 ÷ 334,748)
Without allowance (adjusted) = 23.89 percent = [(80,167 − 194) ÷ 334,748]
In this instance, the gross profit margin is slightly higher with inventory write-
downs because the cost of sales is lower (due to the reduction in the allowance
for inventory obsolescence). This assumes that inventory write-
downs (and
inventory write-
down recoveries) are reported as part of cost of sales.
Net profit margin = Profit ÷ Net sales
With allowance (as reported) = 6.36 percent = (21,283 ÷ 334,748)
Without allowance (adjusted) = 6.31 percent = (21,138 ÷ 334,748)
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![Reading 21 ■ Inventories
286
CAT (LIFO) CAT (FIFO) Volvo
Total liabilities-to-equity ratioc 4.59 4.27 2.78
Return on equityd 5.59% 4.05% 20.59%
Calculations for ratios previously calculated (see Examples 5 and 8) are not shown again.
a Return on assets = Net income ÷ Average total assets
Volvo = 5.25 percent = 21,283 ÷ [(412,494 + 398,916) ÷ 2]
b Current ratio = Current assets ÷ Current liabilities
Volvo = 1.12 = [199,039 ÷ (10,806 + 167,317)]
The question indicates to include current provisions in current liabilities.
c Total liabilities-
to-
equity ratio = Total liabilities ÷ Total shareholders’ equity
Volvo = 2.78 = [(29,147 + 96,213 + 10,806 + 167,317) ÷ 109,011]
The question indicates to include provisions in total liabilities.
d Return on equity = Net income ÷ Average shareholders’ equity
CAT (LIFO) = 5.59 percent = 754 ÷ [(13,766 + 13,213) ÷ 2]
CAT (FIFO) = 4.05 percent = 599 ÷ {[(13,766 + 1,924 – 710) + (13,213 + 2,139
– 770)] ÷ 2}
Volvo = 20.59 percent = 21,283 ÷ [(109,011 + 97,764) ÷ 2]
Comparing CAT (FIFO) and Volvo, it appears that Volvo manages its inven-
tory more effectively. It has higher inventory turnover and fewer days of inventory
on hand. Volvo appears to have superior profitability based on net profit margin.
A primary reason for CAT’s low profitability in 2017 was due to a substantial
increase in the provision for income taxes. An analyst would likely further inves-
tigate CAT’s increase in provision for income taxes, as well as other reported
numbers, rather than reaching a conclusion based on ratios alone (in other
words, try to identify the underlying causes of changes or differences in ratios).
Solution to 2:
The 2017 and 2016 inventory to total assets ratios for CAT using LIFO and
adjusted to FIFO and for Volvo as reported, are as follows:
CAT (LIFO) CAT (FIFO) Volvo
2017 13.02% 15.28% 12.78%
2016 11.53% 14.14% 12.10%
Inventory to total assets
CAT (LIFO) 2017 =13.02 percent = 10,018 ÷ 76,962
CAT (LIFO) 2016 = 11.53 percent = 8,614 ÷ 74,704
CAT (FIFO) 2017 = 15.28 percent = 11,942 ÷ (76,962 + 1,924
– 710)
CAT (FIFO) 2016 = 14.14 percent = 10,753 ÷ (74,704 + 2,139
– 770)
Volvo 2017 = 12.78 percent = 52,701 ÷ 412,494
Volvo 2016 = 12.10 percent = 48,287 ÷ 398,916
Based on the numbers as reported, CAT appears to have a similar percentage
of assets tied up in inventory as Volvo. However, when CAT’s inventory is adjusted
to FIFO, it has a higher percentage of its assets tied up in inventory than Volvo.
The increase in inventory as a percentage of total assets is cause for some
concern. Higher inventory typically results in higher maintenance costs (for
example, storage and financing costs). A build-
up of slow moving or obsolete
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![Illustrations of inventory analysis: Adjusting LIFO to FIFO 287
inventories may result in future inventory write-
downs. In Volvo’s Note 17, the
breakdown by inventory classification shows a significant increase in the inven-
tory of production materials. Volvo may be planning on increasing production
of more finished goods inventory (which has also increased). Looking at CAT’s
Note 7, all classifications of inventory seem to be increasing and because these
are valued using the LIFO method, there is some cause for concern. The company
must be increasing inventory quantities and adding new LIFO layers.
Solution to 3:
CAT’s and Volvo’s 2017 and 2016 growth rates for sales (“Sales of machinery
and engines” for CAT and “Net sales” for Volvo), finished goods, and inventories
other than finished goods” are as follows:
2017 CAT Volvo
Sales 19.3% 10.9%
Finished goods 4.0% 4.2%
Inventories other than finished goods 30.2% 18.1%
2016 CAT Volvo
Sales –19.0% –3.4%
Finished goods –10.7% 12.8%
Inventories other than finished goods –11.8% 2.3%
Growth rate = (Value for year – Value for previous year)/Value for previous year
2017 CAT
Sales = 19.3 percent = (42,676 – 35,773) ÷ 35,773
Finished goods = 4.0 percent = (4,761 – 4,576) ÷ 4,576
Inventories other than finished goods = 30.2 percent = [(2,802 + 2,254 +
201) – (2,102 + 1,719 + 217)] ÷ (2,102 + 1,719 + 217)
2017 Volvo
Sales = 10.9 percent = (334,748 – 301,914) ÷ 301,914
Finished products = 4.2 percent = (32,304 – 31,012) ÷ 31,012
Inventories other than finished products =18.1 percent = (20,397 – 17,275)
÷ 17,275
2016 CAT
Sales = –19.0 percent = (35,773 – 44,147) ÷ 44,147
Finished goods = –10.7 percent = (4,576 – 5,122) ÷ 5,122
Inventories other than finished goods = –11.8 percent = [(2,102+ 1,719 +
217) – (2,467 + 1,857 + 254)] ÷ (2,467 + 1,857 + 254)
2016 Volvo
Sales = – 3.4 percent = (301,914 – 312,515) ÷ 312,515
Finished products = 12.8 percent = (31,012 – 27,496) ÷ 27,496
Inventories other than finished products = 2.3 percent = (17,275 – 16,894)
÷ 16,894
For both companies, the growth rates in finished goods inventory exceeds the
growth rate in sales; this could be indicative of accumulating excess inventory.
Volvo’s growth rate in finished goods compared to its growth rate in sales is
significantly higher but the lower growth rates in finished goods inventory for
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![Reading 21 ■ Inventories
292
(€ millions) 2017 2016 2015
Net effect of exchange rate changes
and other changes
63 10 12
At 31 December (549) (432) (318)
Rounding differences may result in totals that are slightly different from the sum and
from corresponding numbers in the note.
1 Calculate Jollof’s inventory turnover, number of days of inventory on
hand, gross profit margin, current ratio, debt-
to-
equity ratio, and return
on total assets for 2017 and 2016 based on the numbers reported. Use an
average for inventory and total asset amounts and year-
end numbers for
other ratio items. For debt, include only bonds and notes issued, long-
term; other long-
term debt; and current portion of long-
term debt.
2 Based on the answer to Question 1, comment on the changes from 2016
to 2017.
3 If Jollof had used the weighted average cost method instead of the FIFO
method during 2017, 2016, and 2015, what would be the effect on Jollof’s
reported cost of sales and inventory carrying amounts? What would be
the directional impact on the financial ratios that were calculated for Jollof
in Question 1?
Solution to 1:
The financial ratios are as follows:
2017 2016
Inventory turnover ratio 5.05 5.38
Number of days of inventory on hand 72.3 days 67.8 days
Gross profit margin 34.1% 32.1%
Current ratio 1.25 1.26
Debt-to-equity ratio 0.98 0.43
Return on total assets –16.9% –9.2%
Inventory turnover ratio = Cost of sales ÷ Average inventory
2017 inventory turnover ratio = 5.05 = 9,400 ÷ [(1,845 + 1,877) ÷ 2]
2016 inventory turnover ratio = 5.38 = 10,150 ÷ [(1,877 + 1,898) ÷ 2]
Number of days of inventory = 365 days ÷ Inventory turnover ratio
2017 number of days of inventory = 72.3 days = 365 days ÷ 5.05
2016 number of days of inventory = 67.8 days = 365 days ÷ 5.38
Gross profit margin = Gross profit ÷ Total revenue
2017 gross profit margin = 34.1% = 4,867 ÷ 14,267
2016 gross profit margin = 32.1% = 4,795 ÷ 14,945
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![Illustrations of inventory analysis: Impacts of writedowns 293
Current ratio = Current assets ÷ Current liabilities
2017 current ratio = 1.25 = 12,238 ÷ 9,817
2016 current ratio = 1.26 = 11,504 ÷ 9,117
Debt-
to-
equity ratio = Total debt ÷ Total shareholders’ equity
2017 debt-
to-
equity ratio = 0.98 = (3,302 + 56 + 921) ÷ 4,388
2016 debt-
to-
equity ratio = 0.43 = (3,794 + 40 + 406) ÷ 9,830
Return on assets = Net income ÷ Average total assets
2017 return on assets = –16.9% = –4,345 ÷ [(22,941 + 28,417) ÷ 2]
2016 return on assets = –9.2% = –2,921 ÷ [(28,417 + 35,188) ÷ 2]
Solution to 2:
From 2016 to 2017, the inventory turnover ratio declined and the number of days
of inventory increased by 4.5 days. Jollof appears to be managing inventory less
efficiently. The gross profit margin improved by 2.0 percent, from 32.1 percent
in 2016 to 34.1 percent in 2017. The current ratio is relatively unchanged from
2016 to 2017. The debt-
to-
equity ratio has risen significantly in 2017 compared
to 2016. Although Jollofn’s total debt has been relatively stable during this time
period, the company’s equity has been declining rapidly because of the cumu-
lative effect of its net losses on retained earnings.
The return on assets is negative and deteriorated in 2017 compared to 2016.
A larger net loss and lower total assets in 2017 resulted in a higher negative
return on assets. The analyst should investigate the underlying reasons for the
sharp decline in Jollof’s return on assets. From Exhibit 8, it is apparent that
Jollof’s gross profit margins were insufficient to cover the administrative and
selling expenses and research and development costs in 2016 and 2017. Large
restructuring costs and asset impairment losses contributed to the loss from
operating activities in both 2016 and 2017.
Solution to 3:
If inventory replacement costs were increasing during 2015, 2016, and 2017 (and
inventory quantity levels were stable or increasing), Jollof’s cost of sales would
have been higher and its gross profit margin would have been lower under the
weighted average cost inventory method than what was reported under the FIFO
method (assuming no inventory write-
downs that would otherwise neutralize
the differences between the inventory valuation methods). FIFO allocates the
oldest inventory costs to cost of sales; the reported cost of sales would be lower
under FIFO given increasing inventory costs. Inventory carrying amounts would
be higher under the FIFO method than under the weighted average cost method
because the more recently purchased inventory items would be included in
inventory at their higher costs (again assuming no inventory write-
downs that
would otherwise neutralize the differences between the inventory valuation
methods). Consequently, Jollof’s reported gross profit, net income, and retained
earnings would also be higher for those years under the FIFO method.
The effects on ratios are as follows:
■
■ The inventory turnover ratios would all be higher under the weighted
average cost method because the numerator (cost of sales) would be
higher and the denominator (inventory) would be lower than what was
reported by Jollof under the FIFO method.
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![Solutions 313
SOLUTIONS
1 C is correct. Transportation costs incurred to ship inventory to customers
are an expense and may not be capitalized in inventory. (Transportation costs
incurred to bring inventory to the business location can be capitalized in inven-
tory.) Storage costs required as part of production, as well as costs incurred as
a result of normal waste of materials, can be capitalized in inventory. (Costs
incurred as a result of abnormal waste must be expensed.)
2 B is correct. Inventory expense includes costs of purchase, costs of conversion,
and other costs incurred in bringing the inventories to their present loca-
tion and condition. It does not include storage costs not required as part of
production.
3 A is correct. IFRS allow the inventories of producers and dealers of agricultural
and forest products, agricultural produce after harvest, and minerals and min-
eral products to be carried at net realisable value even if above historical cost.
(US GAAP treatment is similar.)
4 A is correct. A perpetual inventory system updates inventory values and quan-
tities and cost of goods sold continuously to reflect purchases and sales. The
ending inventory of 800 units consists of 300 units at $20 and 500 units at $17.
(300 × $20) + (500 × $17) = $14,500
5 A is correct. In an environment with falling inventory costs and declining
inventory levels, periodic LIFO will result in a higher ending inventory value
and lower cost of goods sold versus perpetual LIFO and perpetual FIFO meth-
ods. This results in a lower inventory turnover ratio, which is calculated as
follows:
Inventory turnover ratio = Cost of goods sold/Ending inventory
The inventory turnover ratio using periodic LIFO is $39,000/$16,000 = 244% or
2.44 times.
The inventory turnover ratio using perpetual LIFO is 279% or 2.79 times, which
is provided in Table 2 (= 40,500/14,500 from previous question).
The inventory turnover for perpetual FIFO is $41,400/$13,600 = 304% or 3.04
times.
6 B is correct. During a period of rising inventory costs, a company using the
FIFO method will allocate a lower amount to cost of goods sold and a higher
amount to ending inventory as compared with the LIFO method. The inventory
turnover ratio is the ratio of cost of sales to ending inventory. A company using
the FIFO method will produce a lower inventory turnover ratio as compared
with the LIFO method. The current ratio (current assets/current liabilities) and
the gross profit margin [gross profit/sales = (sales less cost of goods sold)/sales]
will be higher under the FIFO method than under the LIFO method in periods
of rising inventory unit costs.
7 A is correct. LIFO reserve is the FIFO inventory value less the LIFO inventory
value. In periods of rising inventory unit costs, the carrying amount of inven-
tory under FIFO will always exceed the carrying amount of inventory under
LIFO. The LIFO reserve may increase over time as a result of the increasing
difference between the older costs used to value inventory under LIFO and the
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![Reading 21 ■ Inventories
316
29 C is correct. The storage costs for inventory awaiting shipment to customers are
not costs of purchase, costs of conversion, or other costs incurred in bringing
the inventories to their present location and condition and are not included in
inventory. The storage costs for the chocolate liquor occur during the produc-
tion process and are thus part of the conversion costs. Excise taxes are part of
the purchase cost.
30 C is correct. The carrying amount of inventories under FIFO will more closely
reflect current replacement values because inventories are assumed to consist
of the most recently purchased items. FIFO is an acceptable, but not preferred,
method under IFRS. Weighted average cost, not FIFO, is the cost formula that
allocates the same per unit cost to both cost of sales and inventory.
31 B is correct. Inventory turnover = Cost of sales/Average inventory =
41,043/7,569.5 = 5.42. Average inventory is (8,100 + 7,039)/2 = 7,569.5.
32 B is correct. For comparative purposes, the choice of a competitor that reports
under IFRS is requested because LIFO is permitted under US GAAP.
33 A is correct. The carrying amount of the ending inventory may differ because
the perpetual system will apply LIFO continuously throughout the year, liqui-
dating layers as sales are made. Under the periodic system, the sales will start
from the last layer in the year. Under FIFO, the sales will occur from the same
layers regardless of whether a perpetual or periodic system is used. Specific
identification identifies the actual products sold and remaining in inventory,
and there will be no difference under a perpetual or periodic system.
34 B is correct. The cost of sales is closest to CHF 4,550. Under FIFO, the inven-
tory acquired first is sold first. Using Exhibit 4, a total of 310 cartons were
available for sale (100 + 40 + 70 + 100) and 185 cartons were sold (50 + 100 +
35), leaving 125 in ending inventory. The FIFO cost would be as follows:
100 (beginning inventory) × 22 = 2,200
40 (4 February 2009) × 25 = 1,000
45 (23 July 2009) × 30 = 1,350
Cost of sales = 2,200 + 1,000 + 1,350 = CHF 4,550
35 A is correct. Gross profit will most likely increase by CHF 7,775. The net realis-
able value has increased and now exceeds the cost. The write-
down from 2017
can be reversed. The write-
down in 2017 was 9,256 [92,560 × (4.05 – 3.95)].
IFRS require the reversal of any write-
downs for a subsequent increase in value
of inventory previously written down. The reversal is limited to the lower of
the subsequent increase or the original write-
down. Only 77,750 kilograms
remain in inventory; the reversal is 77,750 × (4.05 – 3.95) = 7,775. The amount
of any reversal of a write-
down is recognised as a reduction in cost of sales. This
reduction results in an increase in gross profit.
36 C is correct. Using the FIFO method to value inventories when prices are rising
will allocate more of the cost of goods available for sale to ending inventories
(the most recent purchases, which are at higher costs, are assumed to remain
in inventory) and less to cost of sales (the oldest purchases, which are at lower
costs, are assumed to be sold first).
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![Solutions 319
48 A is correct. An inventory write-
down increases cost of sales and reduces
profit and reduces the carrying value of inventory and assets. This has a nega-
tive effect on profitability and solvency ratios. However, activity ratios appear
positively affected by a write-
down because the asset base, whether total assets
or inventory (denominator), is reduced. The numerator, sales, in total asset
turnover is unchanged, and the numerator, cost of sales, in inventory turnover
is increased. Thus, turnover ratios are higher and appear more favorable as the
result of the write-
down.
49 B is correct. Finished goods least accurately reflect current prices because some
of the finished goods are valued under the “last-
in, first-
out” (“LIFO”) basis. The
costs of the newest units available for sale are allocated to cost of goods sold,
leaving the oldest units (at lower costs) in inventory. ZP values raw materials
and work in process using the weighted average cost method. While not fully
reflecting current prices, some inflationary effect will be included in the inven-
tory values.
50 C is correct. FIFO inventory = Reported inventory + LIFO reserve = ¥608,572 +
10,120 = ¥618,692. The LIFO reserve is disclosed in Note 2 of the notes to con-
solidated financial statements.
51 A is correct. The inventory turnover ratio would be lower. The average inven-
tory would be higher under FIFO and cost of products sold would be lower by
the increase in LIFO reserve. LIFO is not permitted under IFRS.
Inventory turnover ratio = Cost of products sold ÷ Average inventory
2018 inventory turnover ratio as reported = 10.63 = ¥5,822,805/[(608,572 +
486,465)/2].
2018 inventory turnover ratio adjusted to FIFO as necessary = 10.34 =
[¥5,822,805 – (19,660 – 10,120)]/[(608,572 + 10,120 + 486,465 + 19,660)/2].
52 A is correct. No LIFO liquidation occurred during 2018; the LIFO reserve
increased from ¥10,120 million in 2008 to ¥19,660 million in 2018. Management
stated in the MDA that the decrease in inventories reflected the impacts of
decreased sales volumes and fluctuations in foreign currency translation rates.
53 C is correct. Finished goods and raw materials inventories are lower in 2018
when compared to 2017. Reduced levels of inventory typically indicate an antic-
ipated business contraction.
54 B is correct. The decrease in LIFO inventory in 2018 would typically indicate
that more inventory units were sold than produced or purchased. Accordingly,
one would expect a liquidation of some of the older LIFO layers and the LIFO
reserve to decrease. In actuality, the LIFO reserve increased from ¥10,120 mil-
lion in 2017 to ¥19,660 million in 2018. This is not to be expected and is likely
caused by the increase in prices of raw materials, other production materials,
and parts of foreign currencies as noted in the MDA. An analyst should seek
to confirm this explanation.
55 B is correct. If prices have been decreasing, write-
downs under FIFO are least
likely to have a significant effect because the inventory is valued at closer to
the new, lower prices. Typically, inventories valued using LIFO are less likely to
incur inventory write-
downs than inventories valued using weighted average
cost or FIFO. Under LIFO, the oldest costs are reflected in the inventory carry-
ing value on the balance sheet. Given increasing inventory costs, the inventory
carrying values under the LIFO method are already conservatively presented at
the oldest and lowest costs. Thus, it is far less likely that inventory write-
downs
will occur under LIFO; and if a write-
down does occur, it is likely to be of a
lesser magnitude.
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![Introduction Acquisition of Property, Plant and Equipment 323
financial statement presentation, disclosures, and analysis of long-
lived assets. Section
13 discusses differences in financial reporting of investment property compared with
property, plant, and equipment. A summary is followed by practice problems.
1.2 Acquisition of Long-
Lived Assets
Upon acquisition, property, plant, and equipment (tangible assets with an economic
life of longer than one year and intended to be held for the company’s own use) are
recorded on the balance sheet at cost, which is typically the same as their fair value.2
Accounting for an intangible asset depends on how the asset is acquired. If several
assets are acquired as part of a group, the purchase price is allocated to each asset on
the basis of its fair value. An asset’s cost potentially includes expenditures additional
to the purchase price.
A key concept in accounting for expenditures related to long-
lived assets is whether
and when such expenditures are capitalised (i.e., included in the asset shown on the
balance sheet) versus expensed (i.e., treated as an expense of the period on the income
statement). After examining the specific treatment of certain expenditures, we will
consider the general financial statement impact of capitalising versus expensing and
two analytical issues related to the decision—namely, the effects on an individual
company’s trend analysis and on comparability across companies.
1.3 Property, Plant, and Equipment
This section primarily discusses the accounting treatment for the acquisition of
long-
lived tangible assets (property, plant, and equipment) through purchase. Assets
can be acquired by methods other than purchase.3 When an asset is exchanged for
another asset, the asset acquired is recorded at fair value if reliable measures of fair
value exist. Fair value is the fair value of the asset given up unless the fair value of
the asset acquired is more clearly evident. If there is no reliable measure of fair value,
the acquired asset is measured at the carrying amount of the asset given up. In this
case, the carrying amount of the assets is unchanged, and no gain or loss is reported.
Typically, accounting for the exchange involves removing the carrying amount
of the asset given up, adding a fair value for the asset acquired, and reporting any
difference between the carrying amount and the fair value as a gain or loss. A gain
would be reported when the fair value used for the newly acquired asset exceeds the
carrying amount of the asset given up. A loss would be reported when the fair value
used for the newly acquired asset is less than the carrying amount of the asset given up.
When property, plant, or equipment is purchased, the buyer records the asset at
cost. In addition to the purchase price, the buyer also includes, as part of the cost of
an asset, all the expenditures necessary to get the asset ready for its intended use.
For example, freight costs borne by the purchaser to get the asset to the purchaser’s
place of business and special installation and testing costs required to make the asset
usable are included in the total cost of the asset.
2 Fair value is defined in International Financial Reporting Standards (IFRS) and under US generally
accepted accounting principles (US GAAP) in the Financial Accounting Standards Board (FASB) Accounting
Standards Codification (ASC) as “the price that would be received to sell an asset or paid to transfer a
liability in an orderly transaction between market participants at the measurement date.” [IFRS 13 and
FASB ASC Topic 820]
3 IAS 16 Property, Plant and Equipment, paragraphs 24–26 [Measurement of Cost]; IAS 38 Intangible Assets,
paragraphs 45–47 [Exchange of Assets]; and FASB ASC Section 845-
10-
30 [Nonmonetary Transactions
– Overall – Initial Measurement].
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![Acquisition of Intangible Assets 327
purchase price a company allocated to each asset. Understanding the types of assets a
company acquires can offer insights into the company’s strategic direction and future
operating potential.
2.2 Intangible Assets Developed Internally
In contrast with the treatment of construction costs of tangible assets, the costs to
internally develop intangible assets are generally expensed when incurred. There
are some situations, however, in which the costs incurred to internally develop an
intangible asset are capitalised. The general analytical issues related to the capitalising-
versus-
expensing decision apply here—namely, comparability across companies and
the effect on an individual company’s trend analysis.
The general requirement that costs to internally develop intangible assets be
expensed should be compared with capitalising the cost of acquiring intangible assets
in situations other than business combinations. Because costs associated with internally
developing intangible assets are usually expensed, a company that has internally devel-
oped such intangible assets as patents, copyrights, or brands through expenditures on
RD or advertising will recognise a lower amount of assets than a company that has
obtained intangible assets through external purchase. In addition, on the statement of
cash flows, costs of internally developing intangible assets are classified as operating
cash outflows whereas costs of acquiring intangible assets are classified as investing
cash outflows. Differences in strategy (developing versus acquiring intangible assets)
can thus impact financial ratios.
IFRS require that expenditures on research (or during the research phase of an
internal project) be expensed rather than capitalised as an intangible asset.5 Research is
defined as “original and planned investigation undertaken with the prospect of gaining
new scientific or technical knowledge and understanding.”6 The “research phase of an
internal project” refers to the period during which a company cannot demonstrate that
an intangible asset is being created—for example, the search for alternative materials
or systems to use in a production process. In contrast with the treatment of research-
phase expenditures, IFRS allow companies to recognise an intangible asset arising from
development expenditures (or the development phase of an internal project) if certain
criteria are met, including a demonstration of the technical feasibility of completing
the intangible asset and the intent to use or sell the asset. Development is defined as
“the application of research findings or other knowledge to a plan or design for the
production of new or substantially improved materials, devices, products, processes,
systems or services before the start of commercial production or use.”7
Generally, US GAAP require that both research and development costs be expensed
as incurred but require capitalisation of certain costs related to software development.8
Costs incurred to develop a software product for sale are expensed until the prod-
uct’s technological feasibility is established and are capitalised thereafter. Similarly,
companies expense costs related to the development of software for internal use until
it is probable that the project will be completed and that the software will be used
as intended. Thereafter, development costs are capitalised. The probability that the
project will be completed is easier to demonstrate than is technological feasibility.
The capitalised costs, related directly to developing software for sale or internal use,
5 IAS 38 Intangible Assets.
6 IAS 38 Intangible Assets, paragraph 8 [Definitions].
7 IAS 38 Intangible Assets, paragraph 8 [Definitions].
8 FASB ASC Section 350-
40-
25 [Intangibles—Goodwill and Other – Internal-
Use Software – Recognition]
and FASB ASC Section 985-
20-
25 [Software – Costs of Software to be Sold, Leased, or Marketed –
Recognition] specify US GAAP accounting for software development costs for software for internal use
and for software to be sold, respectively.
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![Reading 22 ■ Long-Lived Assets
330
“The intangibles with an indefinite life mainly include the Castle
and Carling brand families in Africa, the Aguila and Poker brand fam-
ilies in Colombia, the Cristal and Pilsner brand families in Ecuador,
and the Carlton brand family in Australia.
“Assets held for sale were recognized in relation to the divestiture
of SABMiller’s interests in the MillerCoors LLC joint venture and
certain of SABMiller’s portfolio of Miller brands outside of the U.S.
to Molson Coors Brewing company; the divestiture of SABMiller’s
European premium brands to Asahi Group Holdings, Ltd and the
divestiture of SABMiller’s interest in China Resources Snow Breweries
Ltd. to China Resources Beer (Holdings) Co. Ltd. ….” [Excerpt]
The following is a summary of the provisional allocation of AB InBev’s purchase
price of SABMiller:
Assets $ million
Property, plant and equipment 9,060
Intangible assets 20,040
Investment in associates 4,386
Inventories 977
Trade and other receivables 1,257
Cash and cash equivalents 1,410
Assets held for sale 24,805
All other assets 1,087
Total assets 63,022
Total liabilities –27,769
Net identified assets and liabilities 35,253
Non-controlling interests –6,200
Goodwill on acquisition 74,083
Purchase consideration 103,136
Table is excerpted from the company’s 2016 Annual Report. Portions of
detail are omitted, and subtotals are shown in italics.
Source: AB InBev 2016 Annual Report, pp. 82-
85.
CAPITALIZATION VERSUS EXPENSING: IMPACT ON
FINANCIAL STATEMENTS AND RATIOS
c explain and evaluate how capitalising versus expensing costs in the period in
which they are incurred affects financial statements and ratios;
This section discusses the implications for financial statements and ratios of capitalising
versus expensing costs in the period in which they are incurred. We first summarize
the general financial statement impact of capitalising versus expensing and two ana-
lytical issues related to the decision—namely the effect on an individual company’s
trend analysis and on comparability across companies.
3
Exhibit 1 (Continued)
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![Capitalization versus Expensing: Impact on Financial Statements and Ratios 333
Note: Because the companies use the same accounting method for both
financial and taxable income, absent the assumption of zero interest on cash
balances, expensing the €900 would have resulted in higher income and cash
flow for NOW because the lower taxes paid in the first year (€30 versus €210)
would have allowed NOW to earn interest income on the tax savings.
Solution to 2:
In general, Ending shareholders’ equity = Beginning shareholders’ equity + Net
income + Other comprehensive income – Dividends + Net capital contribu-
tions from shareholders. Because the companies in this example do not have
other comprehensive income, did not pay dividends, and reported no capital
contributions from shareholders, Ending retained earnings = Beginning retained
earnings + Net income, and Ending shareholders’ equity = Beginning sharehold-
ers’ equity + Net income.
ROE is calculated as Net income divided by Average shareholders’ equity,
and Net profit margin is calculated as Net income divided by Total revenue. For
example, CAP had Year 1 ROE of 39 percent (€490/[(€1,000 + €1,490)/2]), and
Year 1 net profit margin of 33 percent (€490/€1,500).
CAP Inc. NOW Inc.
Capitalise €900 as asset and
depreciate Expense €900 immediately
For year 1 2 3 For year 1 2 3
ROE 39% 28% 22% ROE 7% 49% 33%
Net profit
margin
33% 33% 33% Net profit
margin
5% 47% 47%
As shown, compared to expensing, capitalising results in higher profitabil-
ity ratios (ROE and net profit margin) in the first year, and lower profitability
ratios in subsequent years. For example, CAP’s Year 1 ROE of 39 percent was
higher than NOW’s Year 1 ROE of 7 percent, but in Years 2 and 3, NOW reports
superior profitability.
Note also that NOW’s superior growth in net income between Year 1 and
Year 2 is not attributable to superior performance compared to CAP but rather
to the accounting decision to recognise the expense sooner than CAP. In general,
all else equal, accounting decisions that result in recognising expenses sooner will
give the appearance of greater subsequent growth. Comparison of the growth
of the two companies’ net incomes without an awareness of the difference in
accounting methods would be misleading. As a corollary, NOW’s income and
profitability exhibit greater volatility across the three years, not because of more
volatile performance but rather because of the different accounting decision.
Solution to 3:
NOW reports an increase in cash of €70 in Year 1, while CAP reports a decrease
in cash of €110 because NOW’s taxes were €180 lower than CAP’s taxes (€30
versus €210).
Note that this problem assumes the accounting method used by each com-
pany for its tax purposes is identical to the accounting method used by the
company for its financial reporting. In many countries, companies are allowed
to use different depreciation methods for financial reporting and taxes, which
may give rise to deferred taxes.
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![Capitalisation of Interest Costs 335
will be exactly equal to the capital expenditure in Year 4. Pre-
tax profits would
be reduced by £300, regardless of whether the company capitalised or expensed
the annual computer purchases.
Compared to expensing an expenditure, capitalising the expenditure typically
results in greater amounts reported as cash from operations. Capitalised expenditures
are typically treated as an investment cash outflow whereas expenses reduce operating
cash flows. Because cash flow from operating activities is an important consideration
in some valuation models, companies may try to maximise reported cash flow from
operations by capitalising expenditures that should be expensed. Valuation models
that use free cash flow will consider not only operating cash flows but also investing
cash flows. Analysts should be alert to evidence of companies manipulating reported
cash flow from operations by capitalising expenditures that should be expensed.
In summary, holding all else constant, capitalising an expenditure enhances cur-
rent profitability and increases reported cash flow from operations. The profitability-
enhancing effect of capitalising continues so long as capital expenditures exceed the
depreciation expense. Profitability-
enhancing motivations for decisions to capitalise
should be considered when analyzing performance. For example, a company may
choose to capitalise more expenditures (within the allowable bounds of accounting
standards) to achieve earnings targets for a given period. Expensing a cost in the period
reduces current period profits but enhances future profitability and thus enhances
the profit trend. Profit trend-
enhancing motivations should also be considered when
analyzing performance. If the company is in a reporting environment which requires
identical accounting methods for financial reporting and taxes (unlike the United
States, which permits companies to use depreciation methods for reporting purposes
that differ from the depreciation method required by tax purposes), then expensing
will have a more favorable cash flow impact because paying lower taxes in an earlier
period creates an opportunity to earn interest income on the cash saved.
In contrast with the relatively simple examples above, it is generally neither pos-
sible nor desirable to identify individual instances involving discretion about whether
to capitalise or expense expenditures. An analyst can, however, typically identify
significant items of expenditure treated differently across companies. The items of
expenditure giving rise to the most relevant differences across companies will vary
by industry. This cross-
industry variation is apparent in the following discussion of
the capitalisation of expenditures.
CAPITALISATION OF INTEREST COSTS
c explain and evaluate how capitalising versus expensing costs in the period in
which they are incurred affects financial statements and ratios;
As noted above, companies generally must capitalise interest costs associated with
acquiring or constructing an asset that requires a long period of time to get ready for
its intended use.11
As a consequence of this accounting treatment, a company’s interest costs for a
period can appear either on the balance sheet (to the extent they are capitalised) or
on the income statement (to the extent they are expensed).
4
11 IAS 23 [Borrowing Costs] and FASB ASC Subtopic 835-
20 [Interest – Capitalization of Interest] specify
respectively IFRS and US GAAP for capitalisation of interest costs. Although the standards are not com-
pletely converged, the standards are in general agreement.
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![Capitalisation of Interest Costs 337
2017 2016 2015
Net cash provided by operating activities 1,162,500 1,158,128 522,026
Net cash from (used) in investing
activities
(410,226) 280,604 (469,656)
Net cash from (used) in financing
activities
(1,046,041) (1,339,717) (29,688)
Notes: EBIT represents “Income (Loss) Before Income Tax” plus “Interest expenses, net of
capitalized interest” from the income statement.
1 Calculate and interpret Melco’s interest coverage ratio with and without
capitalised interest.
2 Calculate Melco’s percentage change in operating cash flow from 2016
to 2017. Assuming the financial reporting does not affect reporting for
income taxes, what were the effects of capitalised interest on operating
and investing cash flows?
Solution to 1:
Interest coverage ratios with and without capitalised interest were as follows:
For 2017
2.37 ($544,865 ÷ $229,582) without adjusting for capitalised interest; and
2.14 [($544,865 + $26,182) ÷ ($229,582 + $37,483)] including an adjustment
to EBIT for depreciation of previously capitalised interest and an adjustment
to interest expense for the amount of interest capitalised in 2017.
For 2016
1.34 ($298,663÷ $223,567) without adjusting for capitalised interest; and
1.37 [($298,663 + $48,345) ÷ ($223,567 + $29,033)] including an adjustment
to EBIT for depreciation of previously capitalised interest and an adjustment
to interest expense for the amount of interest capitalised in 2016.
For 2015
0.49 ($58,533÷ $118,330) without adjusting for capitalised interest; and
0.38 [($58,533 + $38,511) ÷ ($118,330+ $134,838)] including an adjustment
to EBIT for depreciation of previously capitalised interest and an adjustment
to interest expense for the amount of interest capitalised in 2015.
The above calculations indicate that Melco’s interest coverage improved in
2017 compared to the previous two years. In both 2017 and 2015, the coverage
ratio is lower when adjusted for capitalised interest.
Solution to 2:
If the interest had been expensed rather than capitalised, operating cash flows
would have been lower in all three years. On an adjusted basis, but not an unad-
justed basis, the company’s operating cash flow declined in 2017 compared to
2016. On an unadjusted basis, for 2017 compared with 2016, Melco’s operating
cash flow increased by 0.4 percent in 2017 [($1,162,500 ÷ $1,158,128) – 1].
Including adjustments to expense all interest costs, Melco’s operating cash flow
also decreased by 0.4 percent in 2017 {[$1,162,500 – $37,483) ÷ ($1,158,128 –
$29,033)] – 1}.
Exhibit 3 (Continued)
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![Capitalisation of Interest and Internal Development Costs 341
C EV/EBITDA: Enterprise value/EBITDA, where enterprise value is
defined as the total market value of all sources of a company’s financ-
ing, including equity and debt, and EBITDA is earnings before inter-
est, taxes, depreciation, and amortisation.
2 Interpret the changes in the ratios.
Solution to 1:
(Dollars are in thousands, except per-
share amounts.) JHH’s 2019 ratios are
presented in the following table:
Ratios As reported As adjusted
A P/E ratio 30.0 42.9
B P/CFO 19.0 31.6
C EV/EBITDA 16.3 24.7
A Based on the information as reported, the P/E ratio was 30.0 ($42 ÷
$1.40). Based on EPS adjusted to expense software development costs, the
P/E ratio was 42.9 ($42 ÷ $0.98).
●
● Price: Assuming that the market value of the company’s equity is
based on its fundamentals, the price per share is $42, regardless of a
difference in accounting.
●
● EPS: As reported, EPS was $1.40. Adjusted EPS was $0.98. Expensing
software development costs would have reduced JHH’s 2018 operating
income by $6,000, but the company would have reported no amortisa-
tion of prior years’ software costs, which would have increased oper-
ating income by $2,000. The net change of $4,000 would have reduced
operating income from the reported $13,317 to $9,317. The effective
tax rate for 2018 ($3,825 ÷ $13,317) is 28.72%, and using this effective
tax rate would give an adjusted net income of $6,641 [$9,317 × (1 –
0.2872)], compared to $9,492 before the adjustment. The EPS would
therefore be reduced from the reported $1.40 to $0.98 (adjusted net
income of $6,641 divided by 6,780 shares).
B Based on information as reported, the P/CFO was 19.0 ($42 ÷ $2.21).
Based on CFO adjusted to expense software development costs, the P/
CFO was 31.6 ($42 ÷ $1.33).
●
● Price: Assuming that the market value of the company’s equity is
based on its fundamentals, the price per share is $42, regardless of a
difference in accounting.
●
● CFO per share, as reported, was $2.21 (total operating cash flows
$15,007 ÷ 6,780 shares).
●
● CFO per share, as adjusted, was $1.33. The company’s $6,000 expen-
diture on software development costs was reported as a cash outflow
from investing activities, so expensing those costs would reduce cash
from operating activities by $6,000, from the reported $15,007 to
$9,007. Dividing adjusted total operating cash flow of $9,007 by 6,780
shares results in cash flow per share of $1.33.
C Based on information as reported, the EV/EBITDA was 16.3 ($284,760 ÷
$17,517). Based on EBITDA adjusted to expense software development
costs, the EV/EBITDA was 24.7 ($284,760 ÷ $11,517).
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![Reading 22 ■ Long-Lived Assets
346
estimated residual value, however, the depreciation expense in the final year
of depreciation decreases the ending net book value (carrying amount) to the
estimated residual value.
SOONER Inc.
Beginning
Net Book
Value
Depreciation
Expense
Accumulated
Year-End
Depreciation
Ending Net
Book Value
Year 1 $2,300 $1,150 $1,150 $1,150
Year 2 1,150 575 1,725 575
Year 3 575 288 2,013 287
Year 4 287 187 2,200 100
Another common approach (not required in this question) is to use an
accelerated method, such as the double-
declining method, for some period (a
year or more) and then to change to the straight-
line method for the remaining
life of the asset. If SOONER had used the double-
declining method for the
first year and then switched to the straight-
line method for Years 2, 3, and 4,
the depreciation expense would be $350 [($1,150 – $100 estimated residual
value)/3 years] a year for Years 2, 3, and 4. The results for SOONER under this
alternative approach are shown below.
SOONER Inc.
Beginning
Net Book
Value
Depreciation
Expense
Accumulated
Year-End
Depreciation
Ending Net
Book Value
Year 1 $2,300 $1,150 $1,150 $1,150
Year 2 1,150 350 1,500 800
Year 3 800 350 1,850 450
Year 4 450 350 2,200 100
AZUSED Co. uses the units-
of-
production method. Dividing the equipment’s
total depreciable cost by its total productive capacity gives a cost per unit of $2.75,
calculated as ($2,300 original cost – $100 residual value)/800. The depreciation
expense recognised each year is the number of units produced times $2.75. For
Year 1, the amount of depreciation expense is $550 (200 units times $2.75). For
Year 2, the amount is $825 (300 units times $2.75). For Year 3, the amount is
$550. For Year 4, the amount is $275.
AZUSED Co.
Beginning
Net Book
Value
Depreciation
Expense
Accumulated
Year-End
Depreciation
Ending Net
Book Value
Year 1 $2,300 $550 $550 $1,750
Year 2 1,750 825 1,375 925
Year 3 925 550 1,925 375
Year 4 375 275 2,200 100
Solution to 2:
All three methods result in the same total amount of accumulated depreciation
over the life of the equipment. The significant differences are simply in the
timing of the recognition of the depreciation expense. The straight-
line method
recognises the expense evenly, the accelerated method recognises most of the
expense in the first year, and the units-
of-
production method recognises the
expense on the basis of production (or use of the asset). Under all three methods,
the ending net book value is $100.
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![Depreciation of Long-Lived Assets: Methods and Calculation 347
Solution to 3:
Total asset turnover ratio = Total revenue ÷ Average total assets
Operating profit margin = Earnings before interest and taxes ÷ Total revenue
Operating return on assets = Earnings before interest and taxes ÷ Average
total assets
Ratios are shown in the table below, and details of the calculations for Years 1
and 2 are described after discussion of the ratios.
EVEN-LI Co. SOONER Inc. AZUSED Co.
Ratio* AT PM (%) ROA (%) AT PM (%) ROA (%) AT PM (%) ROA (%)
Year 1 9.67 11.48 111.04 9.76 11.28 110.17 9.67 11.48 111.04
Year 2 9.85 11.52 113.47 10.04 11.51 115.57 9.90 11.43 113.10
Year 3 10.02 11.54 115.70 10.17 11.62 118.21 10.10 11.54 116.64
Year 4 10.18 11.57 117.74 10.23 11.67 119.42 10.22 11.65 118.98
* AT = Total asset turnover ratio. PM = Operating profit margin. ROA = Operating return on assets.
For all companies, the asset turnover ratio increased over time because sales
grew at a faster rate than that of the assets. SOONER had consistently higher
asset turnover ratios than the other two companies, however, because higher
depreciation expense in the earlier periods decreased its average total assets. In
addition, the higher depreciation in earlier periods resulted in SOONER having
lower operating profit margin and operating ROA in the first year and higher
operating profit margin and operating ROA in the later periods. SOONER appears
to be more efficiently run, on the basis of its higher asset turnover and greater
increases in profit margin and ROA over time; however, these comparisons
reflect differences in the companies’ choice of depreciation method. In addition,
an analyst might question the sustainability of the extremely high ROAs for all
three companies because such high profitability levels would probably attract
new competitors, which would likely put downward pressure on the ratios.
EVEN-LI Co.
Year 1:
Total asset turnover ratio = 300,000/[(30,300 + 30,000 + 1,750)/2]
= 300,000/31,025 = 9.67
Operating profit margin = (36,000 – 1,000 – 550)/300,000
= 34,450/300,000 = 11.48%
Operating ROA = 34,450/31,025 = 111.04%
Year 2:
Total asset turnover ratio = 320,000/[(30,000 + 1,750 + 32,000 + 1,200)/2]
= 320,000/32,475 = 9.85
Operating profit margin = (38,400 – 1,000 – 550)/320,000
= 36,850/320,000 = 11.52%
Operating ROA = 36,850/32,475 = 113.47%
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![Reading 22 ■ Long-Lived Assets
348
SOONER Inc.
Year 1:
Total asset turnover ratio = 300,000/[(30,300 + 30,000 + 1,150)/2]
= 300,000/30,725 = 9.76
Operating profit margin = (36,000 – 1,000 – 1,150)/300,000
= 33,850/300,000 = 11.28%
Operating ROA = 33,850/30,725 = 110.17%
Year 2:
Total asset turnover ratio = 320,000/[(30,000 + 1,150 + 32,000 + 575)/2]
= 320,000/31,862.50 = 10.04
Operating profit margin = (38,400 – 1,000 – 575)/320,000
= 36,825/320,000 = 11.51%
Operating ROA = 36,825/31,862.50 = 115.57%
AZUSED Co.
Year 1:
Total asset turnover ratio = 300,000/[(30,300 + 30,000 + 1,750)/2]
= 300,000/31,025 = 9.67
Operating profit margin = (36,000 – 1,000 – 550)/300,000
= 34,450/300,000 = 11.48%
Operating ROA = 34,450/31,025 = 111.04%
Year 2:
Total asset turnover ratio = 320,000/[(30,000 + 1,750 + 32,000 + 925)/2]
= 320,000/32,337.50 = 9.90
Operating profit margin = (38,400 – 1,000 – 825)/320,000
= 36,575/320,000 = 11.43%
Operating ROA = 36,575/32,337.50 = 113.10%
In many countries, a company must use the same depreciation methods for both
financial and tax reporting. In other countries, including the United States, a company
need not use the same depreciation method for financial reporting and taxes. As a
result of using different depreciation methods for financial and tax reporting, pre-
tax
income on the income statement and taxable income on the tax return may differ.
Thus, the amount of tax expense computed on the basis of pre-
tax income and the
amount of taxes actually owed on the basis of taxable income may differ. Although
these differences eventually reverse because the total depreciation is the same regardless
of the timing of its recognition in financial statements versus on tax returns, during
the period of the difference, the balance sheet will show what is known as deferred
taxes. For instance, if a company uses straight-
line depreciation for financial reporting
and an accelerated depreciation method for tax purposes, the company’s financial
statements will report lower depreciation expense and higher pre-
tax income in the
first year, compared with the amount of depreciation expense and taxable income in
its tax reporting. (Compare the depreciation expense in Year 1 for EVEN-
LI Co. and
SOONER Inc. in the previous example.) Tax expense calculated on the basis of the
financial statements’ pre-
tax income will be higher than taxes payable on the basis
of taxable income; the difference between the two amounts represents a deferred tax
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![Depreciation of Long-Lived Assets: Methods and Calculation 349
liability. The deferred tax liability will be reduced as the difference reverses (i.e., when
depreciation for financial reporting is higher than the depreciation for tax purposes)
and the income tax is paid.
Significant estimates required for calculating depreciation include the useful life
of the asset (or its total lifetime productive capacity) and its expected residual value
at the end of that useful life. A longer useful life and higher expected residual value
decrease the amount of annual depreciation expense relative to a shorter useful life and
lower expected residual value. Companies should review their estimates periodically to
ensure they remain reasonable. IFRS require companies to review estimates annually.
Although no significant differences exist between IFRS and US GAAP with respect
to the definition of depreciation and the acceptable depreciation methods, IFRS require
companies to use a component method of depreciation.14 Companies are required to
separately depreciate the significant components of an asset (parts of an item with a
cost that is significant in relation to the total cost and/or with different useful lives)
and thus require additional estimates for the various components. For instance, it may
be appropriate to depreciate separately the engine, frame, and interior furnishings of
an aircraft. Under US GAAP, the component method of depreciation is allowed but
is seldom used in practice.15 The following example illustrates depreciating compo-
nents of an asset.
EXAMPLE 9
Illustration of Depreciating Components of an Asset
CUTITUP Co., a hypothetical company, purchases a milling machine, a type
of machine used for shaping metal, at a total cost of $10,000. $2,000 was esti-
mated to represent the cost of the rotating cutter, a significant component of
the machine. The company expects the machine to have a useful life of eight
years and a residual value of $3,000 and that the rotating cutter will need to be
replaced every two years. Assume the entire residual value is attributable to the
milling machine itself, and assume the company uses straight-
line depreciation
for all assets.
1 How much depreciation expense would the company report in Year 1 if it
uses the component method of depreciation, and how much depreciation
expense would the company report in Year 1 if it does not use the compo-
nent method?
2 Assuming a new cutter with an estimated two-
year useful life is purchased
at the end of Year 2 for $2,000, what depreciation expenses would the
company report in Year 3 if it uses the component method and if it does
not use the component method?
3 Assuming replacement of the cutter every two years at a price of $2,000,
what is the total depreciation expense over the eight years if the com-
pany uses the component method compared with the total depreciation
expense if the company does not use the component method?
4 How many different items must the company estimate in the first year to
compute depreciation expense for the milling machine if it uses the com-
ponent method, and how does this compare with what would be required
if it does not use the component method?
14 IAS 16 Property, Plant and Equipment, paragraphs 43–47 [Depreciation].
15 According to KPMG’s IFRS Compared to US GAAP, December 2017, kpmg.com.
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![Reading 22 ■ Long-Lived Assets
350
Solution to 1:
Depreciation expense in Year 1 under the component method would be $1,625.
For the portion of the machine excluding the cutter, the depreciable base is total
cost minus the cost attributable to the cutter minus the estimated residual value
= $10,000 – $2,000 – $3,000 = $5,000. Depreciation expense for the machine
excluding the cutter in the first year equals $625 (depreciable cost divided by
the useful life of the machine = $5,000/8 years). For the cutter, the depreciation
expense equals $1,000 (depreciable cost divided by the useful life of the cutter
= $2,000/2 years). Thus, the total depreciation expense for Year 1 under the
component method is $1,625 (the sum of the depreciation expenses of the two
components = $625 + $1,000). Depreciation expense in Year 2 would also be
$1,625.
If the company does not use the component method, depreciation expense
in Year 1 is $875 (the depreciable cost of the total milling machine divided by
its useful life = [$10,000 – $3,000]/8 years). Depreciation expense in Year 2
would also be $875.
Solution to 2:
Assuming that at the end of Year 2, the company purchases a new cutter for
$2,000 with an estimated two-
year life, under the component method, the
depreciation expense in Year 3 will remain at $1,625. If the company does not
use the component method and purchases a new cutter with an estimated two-
year life for $2,000 at the end of Year 2, the depreciation expense in Year 3 will
be $1,875 [$875 + ($2,000/2) = $875 + $1,000].
Solution to 3:
Over the eight years, assuming replacement of the cutters every two years at a
price of $2,000, the total depreciation expense will be $13,000 [$1,625 × 8 years]
when the component method is used. When the component method is not used,
the total depreciation expense will also be $13,000 [$875 × 2 years + $1,875 × 6
years]. This amount equals the total expenditures of $16,000 [$10,000 + 3 cutters
× $2,000] less the residual value of $3,000.
Solution to 4:
The following table summarizes the estimates required in the first year to compute
depreciation expense if the company does or does not use the component method:
Estimate
Required using
component
method?
Required if not
using component
method?
Useful life of milling machine Yes Yes
Residual value of milling machine Yes Yes
Portion of machine cost attributable to
cutter
Yes No
Portion of residual value attributable
to cutter
Yes No
Useful life of cutter Yes No
Total depreciation expense may be allocated between the cost of sales and other
expenses. Within the income statement, depreciation expense of assets used in
production is usually allocated to the cost of sales, and the depreciation expense of
assets not used in production may be allocated to some other expense category. For
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![Reading 22 ■ Long-Lived Assets
360
9.5 Reversals of Impairments of Long-
Lived Assets
After an asset has been deemed impaired and an impairment loss has been reported,
the asset’s recoverable amount could potentially increase. For instance, a lawsuit
appeal may successfully challenge a patent infringement by another company, with
the result that a patent previously written down has a higher recoverable amount.
IFRS permit impairment losses to be reversed if the recoverable amount of an asset
increases regardless of whether the asset is classified as held for use or held for sale.
Note that IFRS permit the reversal of impairment losses only. IFRS do not permit the
revaluation to the recoverable amount if the recoverable amount exceeds the previ-
ous carrying amount. Under US GAAP, the accounting for reversals of impairments
depends on whether the asset is classified as held for use or held for sale.19 Under US
GAAP, once an impairment loss has been recognised for assets held for use, it cannot
be reversed. In other words, once the value of an asset held for use has been decreased
by an impairment charge, it cannot be increased. For assets held for sale, if the fair
value increases after an impairment loss, the loss can be reversed.
DERECOGNITION
j explain the derecognition of property, plant, and equipment and intangible
assets;
k explain and evaluate how impairment, revaluation, and derecognition of prop-
erty, plant, and equipment and intangible assets affect financial statements and
ratios;
A company derecognises an asset (i.e., removes it from the financial statements)
when the asset is disposed of or is expected to provide no future benefits from either
use or disposal. A company may dispose of a long-
lived operating asset by selling it,
exchanging it, abandoning it, or distributing it to existing shareholders. As previously
described, non-
current assets that management intends to sell or to distribute to
existing shareholders and which meet the accounting criteria (immediately available
for sale in current condition and the sale is highly probable) are reclassified as non-
current assets held for sale.
10.1 Sale of Long-
Lived Assets
The gain or loss on the sale of long-
lived assets is computed as the sales proceeds minus
the carrying amount of the asset at the time of sale. An asset’s carrying amount is
typically the net book value (i.e., the historical cost minus accumulated depreciation),
unless the asset’s carrying amount has been changed to reflect impairment and/or
revaluation, as previously discussed.
10
19 FASB ASC Section 360-
10-
35 [Property, Plant, and Equipment – Overall – Subsequent Measurement].
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- 1. CFA® Program Curriculum 2022 • LEVEL I • VOLUME 3 FINANCIAL STATEMENT ANALYSIS AND CORPORATE ISSUERS © CFA Institute. For candidate use only. Not for distribution.
- 2. © 2021, 2020, 2019, 2018, 2017, 2016, 2015, 2014, 2013, 2012, 2011, 2010, 2009, 2008, 2007, 2006 by CFA Institute. All rights reserved. This copyright covers material written expressly for this volume by the editor/s as well as the compilation itself. It does not cover the individual selections herein that first appeared elsewhere. Permission to reprint these has been obtained by CFA Institute for this edition only. Further reproductions by any means, electronic or mechanical, including photocopying and recording, or by any information storage or retrieval systems, must be arranged with the individual copyright holders noted. CFA®, Chartered Financial Analyst®, AIMR-PPS®, and GIPS® are just a few of the trade- marks owned by CFA Institute. To view a list of CFA Institute trademarks and the Guide for Use of CFA Institute Marks, please visit our website at www.cfainstitute.org. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. All trademarks, service marks, registered trademarks, and registered service marks are the property of their respective owners and are used herein for identification purposes only. ISBN 978-1-950157-44-0 (paper) ISBN 978-1-950157-68-6 (ebk) 10 9 8 7 6 5 4 3 2 1 © CFA Institute. For candidate use only. Not for distribution.
- 3. indicates an optional segment CONTENTS How to Use the CFA Program Curriculum xi Background on the CBOK xi Organization of the Curriculum xii Features of the Curriculum xii Designing Your Personal Study Program xiii CFA Institute Learning Ecosystem (LES) xiv Prep Providers xv Feedback xvi Financial Statement Analysis Study Session 6 Financial Statement Analysis (2) 3 Reading 17 Understanding Income Statements 5 Introduction 6 Components and Format of the Income Statement 6 Revenue Recognition 12 General Principles 13 Accounting Standards for Revenue Recognition 14 Expense Recognition: General Principles 18 General Principles 18 Issues in Expense Recognition: Doubtful Accounts, Warranties 22 Doubtful Accounts 22 Warranties 22 Issues in Expense Recognition: Depreciation and Amortization 23 Implications for Financial Analysts: Expense Recognition 27 Non- Recurring Items and Non- Operating Items: Discontinued Operations and Unusual or Infrequent items 28 Discontinued Operations 28 Unusual or Infrequent Items 29 Non- Recurring Items: Changes in Accounting Policy 30 Non- Operating Items 33 Earnings Per Share and Capital Structure and Basic EPS 34 Simple versus Complex Capital Structure 35 Basic EPS 36 Diluted EPS: the If- Converted Method 37 Diluted EPS When a Company Has Convertible Preferred Stock Outstanding 38 Diluted EPS When a Company Has Convertible Debt Outstanding 39 Diluted EPS: the Treasury Stock Method 40 Other Issues with Diluted EPS and Changes in EPS 43 Changes in EPS 44 Common- Size Analysis of the Income Statement 44 Common- Size Analysis of the Income Statement 45 Income Statement Ratios 47 © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 4. ii Contents indicates an optional segment Comprehensive Income 49 Summary 52 Practice Problems 55 Solutions 60 Reading 18 Understanding Balance Sheets 63 Introduction and Components of the Balance Sheet 64 Components and Format of the Balance Sheet 64 Balance Sheet Components 65 Current and Non- Current Classification 67 Liquidity- Based Presentation 68 Current Assets: Cash and Cash Equivalents, Marketable Securities and Trade Receivables 69 Current Assets 69 Current Assets: Inventories and Other Current Assets 74 Other Current Assets 74 Current liabilities 75 Non- Current Assets: Property, Plant and Equipment and Investment Property 79 Property, Plant, and Equipment 80 Investment Property 81 Non- Current Assets: Intangible Assets 81 Identifiable Intangibles 82 Non- Current Assets: Goodwill 84 Non- Current Assets: Financial Assets 87 Non- Current Assets: Deferred Tax Assets 91 Non- Current Liabilities 91 Long- term Financial Liabilities 93 Deferred Tax Liabilities 93 Components of Equity 94 Components of Equity 94 Statement of Changes in Equity 97 Common Size Analysis of Balance Sheet 98 Common- Size Analysis of the Balance Sheet 98 Balance Sheet Ratios 106 Summary 108 Practice Problems 111 Solutions 116 Reading 19 Understanding Cash Flow Statements 119 Introduction 120 Classification Of Cash Flows and Non- Cash Activities 121 Classification of Cash Flows and Non- Cash Activities 121 © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 5. indicates an optional segment iii Contents Cash Flow Statement: Differences Between IFRS and US GAAP 123 Cash Flow Statement: Direct and Indirect Methods for Reporting Cash Flow from Operating Activities 125 Cash Flow Statement: Indirect Method Under IFRS 126 Cash Flow Statement: Direct Method Under IFRS 129 Cash Flow Statement: Direct Method Under US GAAP 131 Cash Flow Statement: Indirect Method Under US GAAP 133 Linkages of Cash Flow Statement with the Income Statement and Balance Sheet 135 Linkages of the Cash Flow Statement with the Income Statement and Balance Sheet 135 Preparing the Cash Flow Statement: The Direct Method for Operating Activities 137 Operating Activities: Direct Method 138 Preparing the Cash Flow Statement: Investing Activities 142 Preparing the Cash Flow Statement: Financing Activities 144 Long- Term Debt and Common Stock 144 Dividends 145 Preparing the Cash Flow Statement: Overall Statement of Cash Flows Under the Direct Method 145 Preparing the Cash Flow Statement: Overall Statement of Cash Flows Under the Indirect Method 146 Conversion of Cash Flows from the Indirect to Direct Method 149 Cash Flow Statement Analysis: Evaluation of Sources and Uses of Cash 150 Evaluation of the Sources and Uses of Cash 150 Cash Flow Statement Analysis: Common Size Analysis 155 Cash Flow Statement Analysis: Free Cash Flow to Firm and Free Cash Flow to Equity 160 Cash Flow Statement Analysis: Cash Flow Ratios 162 Summary 164 Practice Problems 165 Solutions 171 Reading 20 Financial Analysis Techniques 175 Introduction 176 The Financial Analysis Process 177 Analytical Tools and Techniques 181 Financial Ratio Analysis 183 The Universe of Ratios 184 Value, Purposes, and Limitations of Ratio Analysis 186 Sources of Ratios 187 Common Size Balance Sheets and Income Statements 188 Common- Size Analysis of the Balance Sheet 189 Common- Size Analysis of the Income Statement 189 Cross- Sectional, Trend Analysis & Relationships in Financial Statements 191 Trend Analysis 192 Relationships among Financial Statements 194 The Use of Graphs and Regression Analysis 195 Regression Analysis 197 © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 6. iv Contents indicates an optional segment Common Ratio Categories & Interpretation and Context 197 Interpretation and Context 198 Activity Ratios 199 Calculation of Activity Ratios 199 Interpretation of Activity Ratios 201 Liquidity Ratios 205 Calculation of Liquidity Ratios 206 Interpretation of Liquidity Ratios 207 Solvency Ratios 210 Calculation of Solvency Ratios 211 Interpretation of Solvency Ratios 212 Profitability Ratios 215 Calculation of Profitability Ratios 215 Interpretation of Profitability Ratios 216 Integrated Financial Ratio Analysis 218 The Overall Ratio Picture: Examples 219 DuPont Analysis: The Decomposition of ROE 221 Equity Analysis and Valuation Ratios 226 Valuation Ratios 226 Industry- Specific Financial Ratios 229 Research on Financial Ratios in Credit and Equity Analysis 231 Credit Analysis 232 The Credit Rating Process 233 Historical Research on Ratios in Credit Analysis 234 Business and Geographic Segments 234 Segment Reporting Requirements 235 Segment Ratios 236 Model Building and Forecasting 238 Summary 239 Practice Problems 241 Solutions 247 Study Session 7 Financial Statement Analysis (3) 251 Reading 21 Inventories 253 Introduction 254 Cost of inventories 255 Inventory valuation methods 256 Specific Identification 257 First-In, First-Out (FIFO) 257 Weighted Average Cost 258 Last-In, First-Out (LIFO) 258 Calculations of cost of sales, gross profit, and ending inventory 258 Periodic versus perpetual inventory systems 260 Comparison of inventory valuation methods 263 The LIFO method and LIFO reserve 265 LIFO Reserve 266 © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 7. indicates an optional segment v Contents LIFO liquidations 266 Inventory method changes 274 Inventory adjustments 275 Evaluation of inventory management: Disclosures & ratios 282 Presentation and Disclosure 282 Inventory Ratios 283 Illustrations of inventory analysis: Adjusting LIFO to FIFO 284 Illustrations of inventory analysis: Impacts of writedowns 288 Summary 294 Practice Problems 297 Solutions 313 Reading 22 Long- Lived Assets 321 Introduction & Acquisition of Property, Plant and Equipment 322 Introduction 322 Acquisition of Long- Lived Assets 323 Property, Plant, and Equipment 323 Acquisition of Intangible Assets 326 Intangible Assets Purchased in Situations Other Than Business Combinations 326 Intangible Assets Developed Internally 327 Intangible Assets Acquired in a Business Combination 328 Capitalization versus Expensing: Impact on Financial Statements and Ratios 330 Capitalisation of Interest Costs 335 Capitalisation of Interest and Internal Development Costs 338 Depreciation of Long- Lived Assets: Methods and Calculation 342 Depreciation Methods and Calculation of Depreciation Expense 343 Amortisation of Long- Lived Assets: Methods and Calculation 351 The Revaluation Model 352 Impairment of Assets 356 Impairment of Property, Plant, and Equipment 357 Impairment of Intangible Assets with a Finite Life 359 Impairment of Intangibles with Indefinite Lives 359 Impairment of Long- Lived Assets Held for Sale 359 Reversals of Impairments of Long- Lived Assets 360 Derecognition 360 Sale of Long- Lived Assets 360 Long- Lived Assets Disposed of Other Than by a Sale 361 Presentation and Disclosure Requirements 363 Using Disclosures in Analysis 370 Investment Property 374 Summary 377 Practice Problems 380 Solutions 392 © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 8. vi Contents indicates an optional segment Reading 23 Income Taxes 397 Introduction 398 Differences Between Accounting Profit and Taxable Income 398 Current and Deferred Tax Assets and Liabilities 399 Deferred Tax Assets and Liabilities 400 Determining the Tax Base of Assets and Liabilities 403 Determining the Tax Base of an Asset 404 Determining the Tax Base of a Liability 405 Changes in Income Tax Rates 407 Temporary and Permanent Differences Between Taxable and Accounting Profit 408 Taxable Temporary Differences 409 Deductible Temporary Differences 410 Examples of Taxable and Deductible Temporary Differences 410 Exceptions to the Usual Rules for Temporary Differences 412 Business Combinations and Deferred Taxes 413 Investments in Subsidiaries, Branches, Associates and Interests in Joint Ventures 413 Unused Tax Losses and Tax Credits 413 Recognition and Measurement of Current and Deferred Tax 414 Recognition of a Valuation Allowance 415 Recognition of Current and Deferred Tax Charged Directly to Equity 415 Presentation and Disclosure 418 Comparison of IFRS and US GAAP 424 Summary 426 Practice Problems 428 Solutions 433 Reading 24 Non- Current (Long- Term) Liabilities 435 Introduction 436 Bonds Payable & Accounting for Bond Issuance 436 Accounting for Bond Issuance 436 Accounting for Bond Amortisation, Interest Expense, and Interest Payments 440 Accounting for Bonds at Fair Value 445 Derecognition of Debt 448 Debt Covenants 451 Presentation and Disclosure of Long- Term Debt 453 Leases 456 Examples of Leases 457 Advantages of Leasing 457 Lease Classification as Finance or Operating 457 Financial Reporting of Leases 459 Lessee Accounting—IFRS 459 Lessee Accounting—US GAAP 461 Lessor Accounting 463 Introduction to Pensions and Other Post- Employment Benefits 465 Evaluating Solvency: Leverage and Coverage Ratios 469 © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 9. indicates an optional segment vii Contents Summary 472 Practice Problems 475 Solutions 480 Study Session 8 Financial Statement Analysis (4) 487 Reading 25 Financial Reporting Quality 489 Introduction & Conceptual Overview 490 Conceptual Overview 491 GAAP, Decision Useful Financial Reporting 492 GAAP, Decision- Useful, but Sustainable? 493 Biased Accounting Choices 494 Within GAAP, but “Earnings Management” 503 Departures from GAAP 503 Differentiate between Conservative and Aggressive Accounting 505 Conservatism in Accounting Standards 506 Bias in the Application of Accounting Standards 507 Context for Assessing Financial Reporting Quality: Motivations and Conditions Conducive to Issuing Low Quality Financial Reports 508 Motivations 509 Conditions Conducive to Issuing Low- Quality Financial Reports 509 Mechanisms That Discipline Financial Reporting Quality 510 Market Regulatory Authorities 510 Auditors 512 Private Contracting 516 Detection of Financial Reporting Quality Issues: Introduction & Presentation Choices 518 Presentation Choices 519 Accounting Choices and Estimates and How Accounting Choices and Estimates Affect Earnings and Balance Sheets 525 How Accounting Choices and Estimates Affect Earnings and Balance Sheets 526 How Choices that Affect the Cash Flow Statement 537 Choices that Affect Financial Reporting 540 Warning Signs 544 1) Pay attention to revenue. 544 2) Pay attention to signals from inventories. 545 3) Pay attention to capitalization policies and deferred costs. 546 4) Pay attention to the relationship of cash flow and net income. 546 5) Other potential warnings signs. 546 Summary 549 Practice Problems 552 Solutions 556 Reading 26 Applications of Financial Statement Analysis 561 Introduction & Evaluating Past Financial Performance 562 Application: Evaluating Past Financial Performance 563 © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 10. viii Contents indicates an optional segment Application: Projecting Future Financial Performance as an Input to Market Based Valuation 566 Projecting Performance: An Input to Market- Based Valuation 567 Projecting Multiple- Period Performance 572 Application: Assessing Credit Risk 576 Screening for Potential Equity Investments 578 Framework for Analyst Adjustments & Adjustments to Investments & Adjustments to Inventory 581 A Framework for Analyst Adjustments 582 Analyst Adjustments Related to Investments 582 Analyst Adjustments Related to Inventory 582 Adjustments Related to Property, Plant, and Equipment 586 Adjustments Related to Goodwill 588 Summary 590 Practice Problems 592 Solutions 594 Corporate Issuers Study Session 9 Corporate Issuers (1) 597 Reading 27 Introduction to Corporate Governance and Other ESG Considerations 599 Introduction and Overview of Corporate Governance 600 Corporate Governance Overview 600 Stakeholder Groups 602 Stakeholder Groups 602 Principal–Agent and Other Relationships in Corporate Governance 605 Shareholder and Manager/Director Relationships 606 Controlling and Minority Shareholder Relationships 606 Manager and Board Relationships 607 Shareholder versus Creditor Interests 607 Other Stakeholder Conflicts 608 Overview and Mechanisms of Stakeholder Management 608 Overview of Stakeholder Management 609 Mechanisms of Stakeholder Management 609 Mechanisms to Mitigate Associated Stakeholder Risks 613 Employee Laws and Contracts 614 Contractual Agreements with Customers and Suppliers 615 Laws and Regulations 615 Company Boards and Committees 615 Composition of the Board of Directors 616 Functions and Responsibilities of the Board 617 Board of Directors Committees 617 Relevant Factors in Analyzing Corporate Governance and Stakeholder Management 620 Market Factors 620 Non- Market Factors 622 Risks and Benefits of Corporate Governance and Stakeholder Management 623 Risks of Poor Governance and Stakeholder Management 623 © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 11. indicates an optional segment ix Contents Benefits of Effective Governance and Stakeholder Management 625 Factors Relevant to Corporate Governance and Stakeholder Management Analysis 626 Economic Ownership and Voting Control 627 Board of Directors Representation 627 Remuneration and Company Performance 628 Investors in the Company 629 Strength of Shareholders’ Rights 629 Managing Long- Term Risks 630 Summary of Analyst Considerations 630 ESG Considerations for Investors and Analysts 632 Introduction to Environmental, Social, and Governance issues 632 ESG Investment Strategies 633 ESG Investment Approaches 634 Catalysts for Growth in ESG Investing 636 ESG Market Overview 637 ESG Factors in Investment Analysis 638 Summary 640 Practice Problems 642 Solutions 644 Reading 28 Uses of Capital 645 Introduction 645 The Capital Allocation Process 646 Investment Decision Criteria 651 Net Present Value 651 Internal Rate of Return 652 Corporate Usage of Capital Allocation Methods 654 Real Options 656 Timing Options 657 Sizing Options 657 Flexibility Options 657 Fundamental Options 658 Common Capital Allocation Pitfalls 659 Summary 660 Practice Problems 662 Solutions 666 Reading 29 Sources of Capital 669 Introduction 669 Corporate Financing Options 670 Internal Financing 671 Financial Intermediaries 672 Capital Markets 673 Other Financing 676 Considerations Affecting Financing Choices 676 Managing and Measuring Liquidity 680 Defining Liquidity Management 681 Measuring Liquidity 684 © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 12. x Contents indicates an optional segment Evaluating Short- Term Financing Choices 688 Summary 691 Practice Problems 692 Solutions 695 Glossary G-1 © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 13. xi How to Use the CFA Program Curriculum Congratulations on your decision to enter the Chartered Financial Analyst (CFA®) Program. This exciting and rewarding program of study reflects your desire to become a serious investment professional. You are embarking on a program noted for its high ethical standards and the breadth of knowledge, skills, and abilities (competencies) it develops. Your commitment should be educationally and professionally rewarding. The credential you seek is respected around the world as a mark of accomplish- ment and dedication. Each level of the program represents a distinct achievement in professional development. Successful completion of the program is rewarded with membership in a prestigious global community of investment professionals. CFA charterholders are dedicated to life- long learning and maintaining currency with the ever- changing dynamics of a challenging profession. CFA Program enrollment represents the first step toward a career- long commitment to professional education. The CFA exam measures your mastery of the core knowledge, skills, and abilities required to succeed as an investment professional. These core competencies are the basis for the Candidate Body of Knowledge (CBOK™). The CBOK consists of four components: ■ ■ A broad outline that lists the major CFA Program topic areas (www.cfainstitute. org/programs/cfa/curriculum/cbok); ■ ■ Topic area weights that indicate the relative exam weightings of the top- level topic areas (www.cfainstitute.org/programs/cfa/curriculum); ■ ■ Learning outcome statements (LOS) that advise candidates about the specific knowledge, skills, and abilities they should acquire from readings covering a topic area (LOS are provided in candidate study sessions and at the beginning of each reading); and ■ ■ CFA Program curriculum that candidates receive upon exam registration. Therefore, the key to your success on the CFA exams is studying and understanding the CBOK. The following sections provide background on the CBOK, the organiza- tion of the curriculum, features of the curriculum, and tips for designing an effective personal study program. BACKGROUND ON THE CBOK CFA Program is grounded in the practice of the investment profession. CFA Institute performs a continuous practice analysis with investment professionals around the world to determine the competencies that are relevant to the profession, beginning with the Global Body of Investment Knowledge (GBIK®). Regional expert panels and targeted surveys are conducted annually to verify and reinforce the continuous feed- back about the GBIK. The practice analysis process ultimately defines the CBOK. The CBOK reflects the competencies that are generally accepted and applied by investment professionals. These competencies are used in practice in a generalist context and are expected to be demonstrated by a recently qualified CFA charterholder. © 2021 CFA Institute. All rights reserved. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 14. xii How to Use the CFA Program Curriculum The CFA Institute staff—in conjunction with the Education Advisory Committee and Curriculum Level Advisors, who consist of practicing CFA charterholders—designs the CFA Program curriculum in order to deliver the CBOK to candidates. The exams, also written by CFA charterholders, are designed to allow you to demonstrate your mastery of the CBOK as set forth in the CFA Program curriculum. As you structure your personal study program, you should emphasize mastery of the CBOK and the practical application of that knowledge. For more information on the practice anal- ysis, CBOK, and development of the CFA Program curriculum, please visit www. cfainstitute.org. ORGANIZATION OF THE CURRICULUM The Level I CFA Program curriculum is organized into 10 topic areas. Each topic area begins with a brief statement of the material and the depth of knowledge expected. It is then divided into one or more study sessions. These study sessions should form the basic structure of your reading and preparation. Each study session includes a statement of its structure and objective and is further divided into assigned readings. An outline illustrating the organization of these study sessions can be found at the front of each volume of the curriculum. The readings are commissioned by CFA Institute and written by content experts, including investment professionals and university professors. Each reading includes LOS and the core material to be studied, often a combination of text, exhibits, and in- text examples and questions. End of Reading Questions (EORQs) followed by solutions help you understand and master the material. The LOS indicate what you should be able to accomplish after studying the material. The LOS, the core material, and the EORQs are dependent on each other, with the core material and EORQs providing context for understanding the scope of the LOS and enabling you to apply a principle or concept in a variety of scenarios. The entire readings, including the EORQs, are the basis for all exam questions and are selected or developed specifically to teach the knowledge, skills, and abilities reflected in the CBOK. You should use the LOS to guide and focus your study because each exam question is based on one or more LOS and the core material and practice problems associated with the LOS. As a candidate, you are responsible for the entirety of the required material in a study session. We encourage you to review the information about the LOS on our website (www. cfainstitute.org/programs/cfa/curriculum/study- sessions), including the descriptions of LOS “command words” on the candidate resources page at www.cfainstitute.org. FEATURES OF THE CURRICULUM End of Reading Questions/Solutions All End of Reading Questions (EORQs) as well as their solutions are part of the curriculum and are required material for the exam. In addition to the in- text examples and questions, these EORQs help demonstrate practical applications and reinforce your understanding of the concepts presented. Some of these EORQs are adapted from past CFA exams and/or may serve as a basis for exam questions. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 15. xiii How to Use the CFA Program Curriculum Glossary For your convenience, each volume includes a comprehensive Glossary. Throughout the curriculum, a bolded word in a reading denotes a term defined in the Glossary. Note that the digital curriculum that is included in your exam registration fee is searchable for key words, including Glossary terms. LOS Self-Check We have inserted checkboxes next to each LOS that you can use to track your progress in mastering the concepts in each reading. Source Material The CFA Institute curriculum cites textbooks, journal articles, and other publications that provide additional context or information about topics covered in the readings. As a candidate, you are not responsible for familiarity with the original source materials cited in the curriculum. Note that some readings may contain a web address or URL. The referenced sites were live at the time the reading was written or updated but may have been deacti- vated since then. Some readings in the curriculum cite articles published in the Financial Analysts Journal®, which is the flagship publication of CFA Institute. Since its launch in 1945, the Financial Analysts Journal has established itself as the leading practitioner-oriented journal in the investment management community. Over the years, it has advanced the knowledge and understanding of the practice of investment management through the publication of peer-reviewed practitioner-relevant research from leading academics and practitioners. It has also featured thought-provoking opinion pieces that advance the common level of discourse within the investment management profession. Some of the most influential research in the area of investment management has appeared in the pages of the Financial Analysts Journal, and several Nobel laureates have contributed articles. Candidates are not responsible for familiarity with Financial Analysts Journal articles that are cited in the curriculum. But, as your time and studies allow, we strongly encour- age you to begin supplementing your understanding of key investment management issues by reading this, and other, CFA Institute practice- oriented publications through the Research & Analysis webpage (www.cfainstitute.org/en/research). Errata The curriculum development process is rigorous and includes multiple rounds of reviews by content experts. Despite our efforts to produce a curriculum that is free of errors, there are times when we must make corrections. Curriculum errata are peri- odically updated and posted by exam level and test date online (www.cfainstitute.org/ en/programs/submit- errata). If you believe you have found an error in the curriculum, you can submit your concerns through our curriculum errata reporting process found at the bottom of the Curriculum Errata webpage. DESIGNING YOUR PERSONAL STUDY PROGRAM Create a Schedule An orderly, systematic approach to exam preparation is critical. You should dedicate a consistent block of time every week to reading and studying. Complete all assigned readings and the associated problems and solutions in each study session. Review the LOS both before and after you study each reading to ensure that © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 16. xiv How to Use the CFA Program Curriculum you have mastered the applicable content and can demonstrate the knowledge, skills, and abilities described by the LOS and the assigned reading. Use the LOS self- check to track your progress and highlight areas of weakness for later review. Successful candidates report an average of more than 300 hours preparing for each exam. Your preparation time will vary based on your prior education and experience, and you will probably spend more time on some study sessions than on others. You should allow ample time for both in- depth study of all topic areas and addi- tional concentration on those topic areas for which you feel the least prepared. CFA INSTITUTE LEARNING ECOSYSTEM (LES) As you prepare for your exam, we will email you important exam updates, testing policies, and study tips. Be sure to read these carefully. Your exam registration fee includes access to the CFA Program Learning Ecosystem (LES). This digital learning platform provides access, even offline, to all of the readings and End of Reading Questions found in the print curriculum organized as a series of shorter online lessons with associated EORQs. This tool is your one- stop location for all study materials, including practice questions and mock exams. The LES provides the following supplemental study tools: Structured and Adaptive Study Plans The LES offers two ways to plan your study through the curriculum. The first is a structured plan that allows you to move through the material in the way that you feel best suits your learning. The second is an adaptive study plan based on the results of an assessment test that uses actual practice questions. Regardless of your chosen study path, the LES tracks your level of proficiency in each topic area and presents you with a dashboard of where you stand in terms of proficiency so that you can allocate your study time efficiently. Flashcards and Game Center The LES offers all the Glossary terms as Flashcards and tracks correct and incorrect answers. Flashcards can be filtered both by curriculum topic area and by action taken—for example, answered correctly, unanswered, and so on. These Flashcards provide a flexible way to study Glossary item definitions. The Game Center provides several engaging ways to interact with the Flashcards in a game context. Each game tests your knowledge of the Glossary terms a in different way. Your results are scored and presented, along with a summary of candidates with high scores on the game, on your Dashboard. Discussion Board The Discussion Board within the LES provides a way for you to interact with other candidates as you pursue your study plan. Discussions can happen at the level of individual lessons to raise questions about material in those lessons that you or other candidates can clarify or comment on. Discussions can also be posted at the level of topics or in the initial Welcome section to connect with other candidates in your area. Practice Question Bank The LES offers access to a question bank of hundreds of practice questions that are in addition to the End of Reading Questions. These practice questions, only available on the LES, are intended to help you assess your mastery of individual topic areas as you progress through your studies. After each practice ques- tion, you will receive immediate feedback noting the correct response and indicating the relevant assigned reading so you can identify areas of weakness for further study. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 17. xv How to Use the CFA Program Curriculum Mock Exams The LES also includes access to three- hour Mock Exams that simulate the morning and afternoon sessions of the actual CFA exam. These Mock Exams are intended to be taken after you complete your study of the full curriculum and take practice questions so you can test your understanding of the curriculum and your readiness for the exam. If you take these Mock Exams within the LES, you will receive feedback afterward that notes the correct responses and indicates the relevant assigned readings so you can assess areas of weakness for further study. We recommend that you take Mock Exams during the final stages of your preparation for the actual CFA exam. For more information on the Mock Exams, please visit www.cfainstitute.org. PREP PROVIDERS You may choose to seek study support outside CFA Institute in the form of exam prep providers. After your CFA Program enrollment, you may receive numerous solicita- tions for exam prep courses and review materials. When considering a prep course, make sure the provider is committed to following the CFA Institute guidelines and high standards in its offerings. Remember, however, that there are no shortcuts to success on the CFA exams; reading and studying the CFA Program curriculum is the key to success on the exam. The CFA Program exams reference only the CFA Institute assigned curriculum; no prep course or review course materials are consulted or referenced. SUMMARY Every question on the CFA exam is based on the content contained in the required readings and on one or more LOS. Frequently, an exam question is based on a specific example highlighted within a reading or on a specific practice problem and its solution. To make effective use of the CFA Program curriculum, please remember these key points: 1 All pages of the curriculum are required reading for the exam. 2 All questions, problems, and their solutions are part of the curriculum and are required study material for the exam. These questions are found at the end of the readings in the print versions of the curriculum. In the LES, these questions appear directly after the lesson with which they are associated. The LES provides imme- diate feedback on your answers and tracks your performance on these questions throughout your study. 3 We strongly encourage you to use the CFA Program Learning Ecosystem. In addition to providing access to all the curriculum material, including EORQs, in the form of shorter, focused lessons, the LES offers structured and adaptive study planning, a Discussion Board to communicate with other candidates, Flashcards, a Game Center for study activities, a test bank of practice questions, and online Mock Exams. Other supplemental study tools, such as eBook and PDF versions of the print curriculum, and additional candidate resources are available at www. cfainstitute.org. 4 Using the study planner, create a schedule and commit sufficient study time to cover the study sessions. You should also plan to review the materials, answer practice questions, and take Mock Exams. 5 Some of the concepts in the study sessions may be superseded by updated rulings and/or pronouncements issued after a reading was published. Candidates are expected to be familiar with the overall analytical framework contained in the assigned readings. Candidates are not responsible for changes that occur after the material was written. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 18. xvi How to Use the CFA Program Curriculum FEEDBACK At CFA Institute, we are committed to delivering a comprehensive and rigorous curric- ulum for the development of competent, ethically grounded investment professionals. We rely on candidate and investment professional comments and feedback as we work to improve the curriculum, supplemental study tools, and candidate resources. Please send any comments or feedback to info@cfainstitute.org. You can be assured that we will review your suggestions carefully. Ongoing improvements in the curric- ulum will help you prepare for success on the upcoming exams and for a lifetime of learning as a serious investment professional. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 19. Financial Statement Analysis STUDY SESSIONS Study Session 5 Financial Statement Analysis (1) Study Session 6 Financial Statement Analysis (2) Study Session 7 Financial Statement Analysis (3) Study Session 8 Financial Statement Analysis (4) TOPIC LEVEL LEARNING OUTCOME The candidate should be able to demonstrate a thorough knowledge of financial reporting procedures and the standards that govern financial reporting disclosure. Emphasis is on basic financial statements and how alternative accounting methods affect those statements and the analysis of them. Financial statement analysis is critical in assessing a company’s overall financial position and associated risks over time. Security and business valuation, credit risk assessment, and acquisition due diligence all require an understanding of the major financial statements including general principles and reporting approaches. Because no set of accounting standards has universal acceptance, companies around the world may differ in reporting treatment based on their jurisdiction. Financial statement analysis requires the ability to analyze a company’s reported results with its economic reality, normalize differences in accounting treatment to make valid cross company comparisons, identify quality issues that may exist in reported financial statements, and discern evidence of financial statement manipulation by management. © 2021 CFA Institute. All rights reserved. Note: Changes in accounting standards as well as new rulings and/or pronouncements issued after the publication of the readings on financial reporting and analysis may cause some of the information in these readings to become dated. Candidates are not responsible for anything that occurs after the readings were published. In addition, candidates are expected to be familiar with the analytical frameworks contained in the readings, as well as the implications of alternative accounting methods for financial analysis and valuation discussed in the readings. Candidates are also responsible for the content of accounting standards, but not for the actual reference numbers. Finally, candidates should be aware that certain ratios may be defined and calculated differently. When alternative ratio definitions exist and no specific definition is given, candidates should use the ratio definitions emphasized in the readings. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 20. 2 Financial Statement Analysis Candidates should be familiar with the material covered in the following pre- requisite reading available in Candidate Resources on the CFA Institute website: • Financial Reporting Mechanics © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 21. Financial Statement Analysis (2) This study session addresses the three major financial statements—the income statement, the balance sheet, and the cash flow statement—by examining each in turn. The purpose, elements of, construction, pertinent ratios, and common- size analysis are presented for each major financial statement. The session concludes with a discussion of financial analysis techniques including the use of ratios to evaluate corporate financial health. READING ASSIGNMENTS Reading 17 Understanding Income Statements by Elaine Henry, PhD, CFA, and Thomas R. Robinson, PhD, CFA Reading 18 Understanding Balance Sheets by Elaine Henry, PhD, CFA, and Thomas R. Robinson, PhD, CFA Reading 19 Understanding Cash Flow Statements by Elaine Henry, PhD, CFA, Thomas R. Robinson, PhD, CFA, J. Hennie van Greuning, DCom, CFA, and Michael A. Broihahn, CPA, CIA, CFA Reading 20 Financial Analysis Techniques by Elaine Henry, PhD, CFA, Thomas R. Robinson, PhD, CFA, and J. Hennie van Greuning, DCom, CFA F inancial S tatement A nalysis S T U D Y S E S S I O N 6 © 2021 CFA Institute. All rights reserved. Note: Changes in accounting standards as well as new rulings and/or pronouncements issued after the publication of the readings on financial reporting and analysis may cause some of the information in these readings to become dated. Candidates are not responsible for anything that occurs after the readings were published. In addition, candidates are expected to be familiar with the analytical frameworks contained in the readings, as well as the implications of alternative accounting methods for financial analysis and valuation discussed in the readings. Candidates are also responsible for the content of accounting standards, but not for the actual reference numbers. Finally, candidates should be aware that certain ratios may be defined and calculated differently. When alternative ratio definitions exist and no specific definition is given, candidates should use the ratio definitions emphasized in the readings. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 22. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 23. Understanding Income Statements by Elaine Henry, PhD, CFA, and Thomas R. Robinson, PhD, CFA Elaine Henry, PhD, CFA, is at Stevens Institute of Technology (USA). Thomas R. Robinson, PhD, CFA, is at AACSB International (USA). LEARNING OUTCOMES Mastery The candidate should be able to: a. describe the components of the income statement and alternative presentation formats of that statement; b. describe general principles of revenue recognition and accounting standards for revenue recognition; c. calculate revenue given information that might influence the choice of revenue recognition method; d. describe general principles of expense recognition, specific expense recognition applications, and implications of expense recognition choices for financial analysis; e. describe the financial reporting treatment and analysis of non- recurring items (including discontinued operations, unusual or infrequent items) and changes in accounting policies; f. contrast operating and non- operating components of the income statement; g. describe how earnings per share is calculated and calculate and interpret a company’s earnings per share (both basic and diluted earnings per share) for both simple and complex capital structures; h. contrast dilutive and antidilutive securities and describe the implications of each for the earnings per share calculation; i. formulate income statements into common- size income statements; j. evaluate a company’s financial performance using common- size income statements and financial ratios based on the income statement; k. describe, calculate, and interpret comprehensive income; l. describe other comprehensive income and identify major types of items included in it. R E A D I N G 17 © 2019 CFA Institute. All rights reserved. Note: Changes in accounting standards as well as new rulings and/or pronouncements issued after the publication of the readings on financial reporting and analysis may cause some of the information in these readings to become dated. Candidates are not responsible for anything that occurs after the readings were published. In addition, candidates are expected to be familiar with the analytical frameworks contained in the readings, as well as the implications of alternative accounting methods for financial analysis and valuation discussed in the readings. Candidates are also responsible for the content of accounting standards, but not for the actual reference numbers. Finally, candidates should be aware that certain ratios may be defined and calculated differently. When alternative ratio definitions exist and no specific definition is given, candidates should use the ratio definitions emphasized in the readings. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 24. Reading 17 ■ Understanding Income Statements 6 INTRODUCTION The income statement presents information on the financial results of a company’s business activities over a period of time. The income statement communicates how much revenue the company generated during a period and what costs it incurred in connection with generating that revenue. The basic equation underlying the income statement, ignoring gains and losses, is Revenue minus Expenses equals Net income. The income statement is also sometimes referred to as the “statement of operations,” “statement of earnings,” or “profit and loss (P&L) statement.” Under both International Financial Reporting Standards (IFRS) and US generally accepted accounting principles (US GAAP), the income statement may be presented as a separate statement followed by a statement of comprehensive income that begins with the profit or loss from the income statement or as a section of a single statement of comprehensive income.1 This reading focuses on the income statement, and the term income statement will be used to describe either the separate statement that reports profit or loss used for earnings per share calculations or that section of a statement of comprehensive income that reports the same profit or loss. The reading also includes a discussion of comprehensive income (profit or loss from the income statement plus other comprehensive income). Investment analysts intensely scrutinize companies’ income statements. Equity analysts are interested in them because equity markets often reward relatively high- or low- earnings growth companies with above- average or below- average valuations, respectively, and because inputs into valuation models often include estimates of earnings. Fixed- income analysts examine the components of income statements, past and projected, for information on companies’ abilities to make promised payments on their debt over the course of the business cycle. Corporate financial announcements frequently emphasize information reported in income statements, particularly earn- ings, more than information reported in the other financial statements. This reading is organized as follows: Section 2 describes the components of the income statement and its format. Section 3 describes basic principles and selected applications related to the recognition of revenue, and Sections 4–7 describe basic principles and selected applications related to the recognition of expenses. Sections 8–10 cover non- recurring items and non- operating items. Sections 11–14 explain the calculation of earnings per share. Sections 15–16 introduce income statement analysis, and Section 17 explains comprehensive income and its reporting. A summary of the key points and practice problems in the CFA Institute multiple choice format complete the reading. COMPONENTS AND FORMAT OF THE INCOME STATEMENT a describe the components of the income statement and alternative presentation formats of that statement; 1 2 1 International Accounting Standard (IAS) 1, Presentation of Financial Statements, establishes the pre- sentation and minimum content requirements of financial statements and guidelines for the structure of financial statements under IFRS. Under US GAAP, the Financial Accounting Standards Board Accounting Standards Codification ASC Section 220- 10- 45 [Comprehensive Income–Overall–Other Presentation Matters] discusses acceptable formats in which to present income, other comprehensive income, and comprehensive income. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 25. Components and Format of the Income Statement 7 Exhibits 1, 2, and 3 show the income statements for Anheuser- Busch InBev SA/NV (AB InBev), a multinational beverage company based in Belgium, Molson Coors Brewing Company (Molson Coors), a US- based multinational brewing company, and Groupe Danone (Danone), a French food manufacturer.2 AB InBev and Danone report under IFRS, and Molson Coors reports under US GAAP. Note that both AB InBev and Molson Coors show three years’ income statements and list the years in chronological order with the most recent year listed in the left- most column. In contrast, Danone shows two years of income statements and lists the years in chronological order from left to right with the most recent year in the right- most column. Different orderings of chronological information are common. On the top line of the income statement, companies typically report revenue. Revenue generally refers to the amount charged for the delivery of goods or services in the ordinary activities of a business. Revenue may also be called sales or turnover.3 For the year ended 31 December 2017, AB InBev reports $56.44 billion of revenue, Molson Coors reports $13.47 billion of revenue (labeled “sales”), and Danone reports €24.68 billion of revenue (labeled “sales”). Revenue is reported after adjustments (e.g., for cash or volume discounts, or for other reductions), and the term net revenue is sometimes used to specifically indicate that the revenue has been adjusted (e.g., for estimated returns). For all three compa- nies in Exhibits 1 through 3, footnotes to their financial statements (not shown here) state that revenues are stated net of such items as returns, customer rebates, trade discounts, or volume- based incentive programs for customers. In a comparative analysis, an analyst may need to reference information disclosed elsewhere in companies’ annual reports—typically the notes to the financial statements and the Management Discussion and Analysis (MD&A)—to identify the appropri- ately comparable revenue amounts. For example, excise taxes represent a significant expenditure for brewing companies. On its income statement, Molson Coors reports $13.47 billion of revenue (labeled “sales”) and $11.00 billion of net revenue (labeled “net sales”), which equals sales minus $2.47 billion of excise taxes. Unlike Molson Coors, AB InBev does not show the amount of excise taxes on its income statement. However, in its disclosures, AB InBev notes that excise taxes (amounting to $15.4 billion in 2017) have been deducted from the revenue amount shown on its income statement. Thus, the amount on AB InBev’s income statement labeled “revenue” is more comparable to the amount on Molson Coors’ income statement labeled “net sales.” Exhibit 1 Anheuser- Busch InBev SA/NV Consolidated Income Statement (in Millions of US Dollars) [Excerpt] 12 Months Ended December 31 2017 2016 2015 Revenue $56,444 $45,517 $43,604 Cost of sales (21,386) (17,803) (17,137) Gross profit 35,058 27,715 26,467 Distribution expenses (5,876) (4,543) (4,259) Sales and marketing expenses (8,382) (7,745) (6,913) (continued) 2 Following net income, the income statement also presents earnings per share, the amount of earnings per common share of the company. Earnings per share will be discussed in detail later in this reading, and the per- share display has been omitted from these exhibits to focus on the core income statement. 3 Sales is sometimes understood to refer to the sale of goods, whereas revenue can include the sale of goods or services; however, the terms are often used interchangeably. In some countries, the term “turn- over” may be used in place of revenue. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 26. Reading 17 ■ Understanding Income Statements 8 12 Months Ended December 31 2017 2016 2015 Administrative expenses (3,841) (2,883) (2,560) Other operating income/(expenses) 854 732 1,032 Restructuring (468) (323) (171) Business and asset disposal (39) 377 524 Acquisition costs business combinations (155) (448) (55) Impairment of assets — — (82) Judicial settlement — — (80) Profit from operations 17,152 12,882 13,904 Finance cost (6,885) (9,216) (3,142) Finance income 378 652 1,689 Net finance income/(cost) (6,507) (8,564) (1,453) Share of result of associates and joint ventures 430 16 10 Profit before tax 11,076 4,334 12,461 Income tax expense (1,920) (1,613) (2,594) Profit from continuing operations 9,155 2,721 9,867 Profit from discontinued operations 28 48 Profit of the year 9,183 2,769 9,867 Profit from continuing operations attributable to: Equity holders of AB InBev 7,968 1,193 8,273 Non-controlling interest 1,187 1,528 1,594 Profit of the year attributable to: Equity holders of AB InBev 7,996 1,241 8,273 Non-controlling interest $1,187 $1,528 $1,594 Note: reported total amounts may have slight discrepancies due to rounding Exhibit 2 Molson Coors Brewing Company Consolidated Statement of Operations (in Millions of US Dollars) [Excerpt] 12 Months Ended Dec. 31, 2017 Dec. 31, 2016 Dec. 31, 2015 Sales $13,471.5 $6,597.4 $5,127.4 Excise taxes (2,468.7) (1,712.4) (1,559.9) Net sales 11,002.8 4,885.0 3,567.5 Cost of goods sold (6,217.2) (2,987.5) (2,131.6) Gross profit 4,785.6 1,897.5 1,435.9 Marketing, general and administrative expenses (3,032.4) (1,589.8) (1,038.3) Special items, net (28.1) 2,522.4 (346.7) Equity Income in MillerCoors 0 500.9 516.3 Operating income (loss) 1,725.1 3,331.0 567.2 Exhibit 1 (Continued) © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 27. Components and Format of the Income Statement 9 12 Months Ended Dec. 31, 2017 Dec. 31, 2016 Dec. 31, 2015 Other income (expense), net Interest expense (349.3) (271.6) (120.3) Interest income 6.0 27.2 8.3 Other income (expense), net (0.1) (29.7) 0.9 Total other income (expense), net (343.4) (274.1) (111.1) Income (loss) from continuing operations before income taxes 1,381.7 3,056.9 456.1 Income tax benefit (expense) 53.2 (1,055.2) (61.5) Net income (loss) from continuing operations 1,434.9 2,001.7 394.6 Income (loss) from discontinued operations, net of tax 1.5 (2.8) 3.9 Net income (loss) including noncontrolling interests 1,436.4 1,998.9 398.5 Net (income) loss attributable to noncontrolling interests (22.2) (5.9) (3.3) Net income (loss) attributable to Molson Coors Brewing Company $1,414.2 $1,993.0 $395.2 Exhibit 3 Groupe Danone Consolidated Income Statement (in Millions of Euros) [Excerpt] Year Ended 31 December 2016 2017 Sales 21,944 24,677 Cost of goods sold (10,744) (12,459) Selling expense (5,562) (5,890) General and administrative expense (2,004) (2,225) Research and development expense (333) (342) Other income (expense) (278) (219) Recurring operating income 3,022 3,543 Other operating income (expense) (99) 192 Operating income 2,923 3,734 Interest income on cash equivalents and short- term investments 130 151 Interest expense (276) (414) Cost of net debt (146) (263) Other financial income 67 137 Other financial expense (214) (312) Income before tax 2,630 3,296 Income tax expense (804) (842) Net income from fully consolidated companies 1,826 2,454 Share of profit of associates 1 109 Net income 1,827 2,563 (continued) Exhibit 2 (Continued) © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 28. Reading 17 ■ Understanding Income Statements 10 Year Ended 31 December 2016 2017 Net income – Group share 1,720 2,453 Net income – Non- controlling interests 107 110 Differences in presentations of items, such as expenses, are also common. Expenses reflect outflows, depletions of assets, and incurrences of liabilities in the course of the activities of a business. Expenses may be grouped and reported in different formats, subject to some specific requirements. At the bottom of the income statement, companies report net income (companies may use other terms such as “net earnings” or “profit or loss”). For 2017, AB InBev reports $9,183 million “Profit of the year”, Molson Coors reports $1,436.4 million of net income including noncontrolling interests, and Danone reports €2,563 million of net income. Net income is often referred to as the “bottom line.” The basis for this expression is that net income is the final—or bottom—line item in an income statement. Because net income is often viewed as the single most relevant number to describe a company’s performance over a period of time, the term “bottom line” sometimes is used in business to refer to any final or most relevant result. Despite this customary terminology, note that each company presents additional items below net income: information about how much of that net income is attributable to the company itself and how much of that income is attributable to noncontrolling interests, also known as minority interests. The companies consolidate subsidiaries over which they have control. Consolidation means that they include all of the revenues and expenses of the subsidiaries even if they own less than 100 percent. Noncontrolling interest represents the portion of income that “belongs” to the minority shareholders of the consolidated subsidiaries, as opposed to the parent company itself. For AB InBev, $7,996 million of the total profit is attributable to the shareholders of AB InBev, and $1,187 million is attributable to noncontrolling interests. For Molson Coors, $1,414.2 million is attributable to the shareholders of Molson Coors, and $22.2 mil- lion is attributable to noncontrolling interests. For Danone, €2,453 million of the net income amount is attributable to shareholders of Groupe Danone and €110 million is attributable to noncontrolling interests. Net income also includes gains and losses, which are increases and decreases in economic benefits, respectively, which may or may not arise in the ordinary activities of the business. For example, when a manufacturing company sells its products, these transactions are reported as revenue, and the costs incurred to generate these revenues are expenses and are presented separately. However, if a manufacturing company sells surplus land that is not needed, the transaction is reported as a gain or a loss. The amount of the gain or loss is the difference between the carrying value of the land and the price at which the land is sold. For example, in Exhibit 1, AB InBev reports a loss (proceeds, net of carrying value) of $39 million on disposals of businesses and assets in fiscal 2017, and gains of $377 million and $524 million in 2016 and 2015, respectively. Details on these gains and losses can typically be found in the companies’ disclosures. For example, AB InBev discloses that the $377 million gain in 2016 was mainly from selling one of its breweries in Mexico. Exhibit 3 (Continued) © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 29. Components and Format of the Income Statement 11 The definition of income encompasses both revenue and gains and the definition of expenses encompasses both expenses that arise in the ordinary activities of the busi- ness and losses.4 Thus, net income (profit or loss) can be defined as: a) income minus expenses, or equivalently b) revenue plus other income plus gains minus expenses, or equivalently c) revenue plus other income plus gains minus expenses in the ordinary activities of the business minus other expenses, and minus losses. The last definition can be rearranged as follows: net income equals (i) revenue minus expenses in the ordinary activities of the business, plus (ii) other income minus other expenses, plus (iii) gains minus losses. In addition to presenting the net income, income statements also present items, including subtotals, which are significant to users of financial statements. Some of the items are specified by IFRS but other items are not specified.5 Certain items, such as revenue, finance costs, and tax expense, are required to be presented separately on the face of the income statement. IFRS additionally require that line items, headings, and subtotals relevant to understanding the entity’s financial performance should be presented even if not specified. Expenses may be grouped together either by their nature or function. Grouping together expenses such as depreciation on manufacturing equipment and depreciation on administrative facilities into a single line item called “depreciation” is an example of a grouping by nature of the expense. An example of grouping by function would be grouping together expenses into a category such as cost of goods sold, which may include labour and material costs, depreciation, some salaries (e.g., salespeople’s), and other direct sales related expenses.6 All three compa- nies in Exhibits 1 through 3 present their expenses by function, which is sometimes referred to “cost of sales” method. One subtotal often shown in an income statement is gross profit or gross margin (that is revenue less cost of sales). When an income statement shows a gross profit subtotal, it is said to use a multi-step format rather than a single-step format. The AB InBev and Molson Coors income statements are examples of the multi- step for- mat, whereas the Groupe Danone income statement is in a single- step format. For manufacturing and merchandising companies, gross profit is a relevant item and is calculated as revenue minus the cost of the goods that were sold. For service companies, gross profit is calculated as revenue minus the cost of services that were provided. In summary, gross profit is the amount of revenue available after subtracting the costs of delivering goods or services. Other expenses related to running the business are subtracted after gross profit. Another important subtotal which may be shown on the income statement is operating profit (or, synonymously, operating income). Operating profit results from deducting operating expenses such as selling, general, administrative, and research and development expenses from gross profit. Operating profit reflects a company’s profits on its business activities before deducting taxes, and for non- financial com- panies, before deducting interest expense. For financial companies, interest expense would be included in operating expenses and subtracted in arriving at operating profit because it relates to the operating activities for such companies. For some companies composed of a number of separate business segments, operating profit can be useful in evaluating the performance of the individual business segments, because interest and tax expenses may be more relevant at the level of the overall company rather than an individual segment level. The specific calculations of gross profit and operating profit may vary by company, and a reader of financial statements can consult the notes to the statements to identify significant variations across companies. 4 IASB Conceptual Framework for Financial Reporting (2010), paragraphs 4.29 to 4.32. 5 Requirements are presented in IAS 1, Presentation of Financial Statements. 6 Later readings will provide additional information about alternative methods to calculate cost of goods sold. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 30. Reading 17 ■ Understanding Income Statements 12 Operating profit is sometimes referred to as EBIT (earnings before interest and taxes). However, operating profit and EBIT are not necessarily the same. Note that in each of the Exhibits 1 through 3, interest and taxes do not represent the only differences between earnings (net income, net earnings) and operating income. For example, AB InBev separately reports its share of associates’ and joint ventures’ income and Molson Coors separately reports some income from discontinued operations. Exhibit 4 shows an excerpt from the income statement of CRA International, a company providing management consulting services. Accordingly, CRA deducts cost of services (rather than cost of goods) from revenues to derive gross profit. CRA’s fiscal year ends on the Saturday nearest December 31st. Because of this fiscal year timeframe, CRA’s fiscal year occasionally comprises 53 weeks rather than 52 weeks. Although the extra week is likely immaterial in computing year- to- year growth rates, it may have a material impact on a quarter containing the extra week. In general, an analyst should be alert to the effect of an extra week when making historical compar- isons and forecasting future performance. Exhibit 4 CRA International Inc. Consolidated Statements of Operations (Excerpt) (in Thousands of Dollars) Fiscal Year Ended Dec. 30, 2017 Dec. 31, 2016 Jan. 02, 2016 Revenues $370,075 $324,779 $303,559 Costs of services (exclusive of depreciation and amortization) 258,829 227,380 207,650 Selling, general and administrative expenses 86,537 70,584 72,439 Depreciation and amortization 8,945 7,896 6,552 GNU goodwill impairment — — 4,524 Income from operations 15,764 18,919 12,394 Note: Remaining items omitted Exhibits 1 through 4 illustrate basic points about the income statement, includ- ing variations across the statements—some of which depend on the industry and/or country, and some of which reflect differences in accounting policies and practices of a particular company. In addition, some differences within an industry are primarily differences in terminology, whereas others are more fundamental accounting differ- ences. Notes to the financial statements are helpful in identifying such differences. Having introduced the components and format of an income statement, the next objective is to understand the actual reported numbers in it. To accurately interpret reported numbers, the analyst needs to be familiar with the principles of revenue and expense recognition—that is, how revenue and expenses are measured and attributed to a given accounting reporting period. REVENUE RECOGNITION b Describe general principles of revenue recognition and accounting standards for revenue recognition; c calculate revenue given information that might influence the choice of revenue recognition method; 3 © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 31. Revenue Recognition 13 Revenue is the top line in an income statement, so we begin the discussion of line items in the income statement with revenue recognition. Accounting standards for revenue recognition (which we discuss later in this section) became effective at the beginning of 2018 and are nearly identical under IFRS and US GAAP. The revenue recognition standards for IFRS and US GAAP (IFRS 15 and ASC Topic 606, respectively) were issued in 2014 and resulted from an effort to achieve convergence, consistency, and transparency in revenue recognition globally. A first task is to explain some relevant accounting terminology. The terms revenue, sales, gains, losses, and net income (profit, net earnings) have been briefly defined. The IASB Conceptual Framework for Financial Reporting (2010),7 referred to hereafter as the Conceptual Framework, further defines and discusses these income statement items. The Conceptual Framework explains that profit is a frequently used measure of performance and is composed of income and expenses.8 It defines income as follows: Income is increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants.9 In IFRS, the term “income” includes revenue and gains. Gains are similar to reve- nue, but they typically arise from secondary or peripheral activities rather than from a company’s primary business activities. For example, for a restaurant, the sale of surplus restaurant equipment for more than its carrying value is referred to as a gain rather than as revenue. Similarly, a loss typically arises from secondary activities. Gains and losses may be considered part of operating activities (e.g., a loss due to a decline in the value of inventory) or may be considered part of non- operating activities (e.g., the sale of non- trading investments). In the following simple hypothetical scenario, revenue recognition is straightfor- ward: a company sells goods to a buyer for cash and does not allow returns, so the company recognizes revenue when the exchange of goods for cash takes place and measures revenue at the amount of cash received. In practice, however, determining when revenue should be recognized and at what amount is considerably more complex for reasons discussed in the following sections. 3.1 General Principles An important aspect concerning revenue recognition is that it can occur independently of cash movements. For example, assume a company sells goods to a buyer on credit, so does not actually receive cash until some later time. A fundamental principle of accrual accounting is that revenue is recognized (reported on the income statement) when it is earned, so the company’s financial records reflect revenue from the sale when the risk and reward of ownership is transferred; this is often when the company delivers the goods or services. If the delivery was on credit, a related asset, such as trade or accounts receivable, is created. Later, when cash changes hands, the compa- ny’s financial records simply reflect that cash has been received to settle an account receivable. Similarly, there are situations when a company receives cash in advance and actually delivers the product or service later, perhaps over a period of time. In this case, the company would record a liability for unearned revenue when the cash 7 The IASB is currently in the process of updating its Conceptual Framework for Financial Reporting. 8 Conceptual Framework, paragraph 4.24. The text on the elements of financial statements and their rec- ognition and measurement is the same in the IASB Conceptual Framework for Financial Reporting (2010) and the IASB Framework for the Preparation and Presentation of Financial Statements (1989). 9 Ibid., paragraph 4.25(a). © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 32. Reading 17 ■ Understanding Income Statements 14 is initially received, and revenue would be recognized as being earned over time as products and services are delivered. An example would be a subscription payment received for a publication that is to be delivered periodically over time. 3.2 Accounting Standards for Revenue Recognition The converged accounting standards issued by the IASB and FASB in May 2014 introduced some changes to the basic principles of revenue recognition and should enhance comparability.10 The content of the two standards is nearly identical, and this discussion pertains to both, unless specified otherwise. Issuance of this converged standard is significant because of the differences between IFRS and US GAAP on revenue recognition prior to the converged standard. The converged standard aims to provide a principles- based approach to revenue recognition that can be applied to many types of revenue- generating activities. The core principle of the converged standard is that revenue should be recognized to “depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in an exchange for those goods or services.” To achieve the core principle, the standard describes the application of five steps in 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 According to the standard, a contract is an agreement and commitment, with commercial substance, between the contacting parties. It establishes each party’s obligations and rights, including payment terms. In addition, a contract exists only if collectability is probable. Each standard uses the same wording, but the threshold for probable collectability differs. Under IFRS, probable means more likely than not, and under US GAAP it means likely to occur. As a result, economically similar contracts may be treated differently under IFRS and US GAAP. The performance obligations within a contract represent promises to transfer distinct good(s) or service(s). A good or service is distinct if the customer can benefit from it on its own or in combination with readily available resources and if the promise to transfer it can be separated from other promises in the contract. Each identified performance obligation is accounted for separately. The transaction price is what the seller estimates will be received in exchange for transferring the good(s) or service(s) identified in the contract. The transaction price is then allocated to each identified performance obligation. Revenue is recognized when a performance obligation is fulfilled. Steps three and four address amount, and step five addresses timing of recognition. The amount recognized reflects expectations about collectability and (if applicable) an allocation to multiple obligations within the same contract. Revenue is recognized when the obligation- satisfying transfer is made. Revenue should only be recognized when it is highly probable that it will not be subsequently reversed. This may result in the recording of a minimal amount of rev- enue upon sale when an estimate of total revenue is not reliable. The balance sheet 10 IFRS 15 Revenue from Contracts with Customers and FASB ASC Topic 606 (Revenue from Contracts with Customers). © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 33. Revenue Recognition 15 will be required to reflect the entire refund obligation as a liability and will include an asset for the “right to returned goods” based on the carrying amount of inventory less costs of recovery. When revenue is recognized, a contract asset is presented on the balance sheet. It is only at the point when all performance obligations have been met except for payment that a receivable appears on the seller’s balance sheet. If consideration is received in advance of transferring good(s) or service(s), the seller presents a contract liability. The entity will recognize revenue when it is able to satisfy the performance obli- gation by transferring control to the customer. Factors to consider when assessing whether the customer has obtained control of an asset at a point in time: ■ ■ Entity has a present right to payment, ■ ■ Customer has legal title, ■ ■ Customer has physical possession, ■ ■ Customer has the significant risks and rewards of ownership, and ■ ■ Customer has accepted the asset. For a simple contract with only one deliverable at a single point in time, complet- ing the five steps is straight- forward. For more complex contracts—such as when the performance obligations are satisfied over time, when the terms of the multi- period contracts change, when the performance obligation includes various components of goods and services, or when the compensation is “variable”—accounting choices can be less obvious. The steps in the standards are intended to provide guidance that can be generalized to most situations. In addition, the standard provides many specific examples. These examples are intended to provide guidance as to how to approach more complex contracts. Some of these examples are summarized in Exhibit 5. Note that the end result for many examples may not differ substantially from that under revenue recognition standards that were in effect prior to the adoption of the converged standard; instead it is the conceptual approach and, in some cases, the terminology that will differ. Exhibit 5 Applying the Converged Revenue Recognition Standard The references in this exhibit are to Examples in IFRS 15 Revenue from Contracts with Customers (and ASU 2014- 09 (FASB ASC Topic 606)), on which these summaries are based. Part 1 (ref. Example 10) Builder Co. enters into a contract with Customer Co. to construct a commer- cial building. Builder Co. identifies various goods and services to be provided, such as pre- construction engineering, construction of the building’s individual components, plumbing, electrical wiring, and interior finishes. With respect to “Identifying the Performance Obligation,” should Builder Co. treat each specific item as a separate performance obligation to which revenue should be allocated? The standard provides two criteria, which must be met, to determine if a good or service is distinct for purposes of identifying performance obligations. First, the customer can benefit from the good or service either on its own or together with other readily available resources. Second, the seller’s “promise to transfer the good or service to the customer is separately identifiable from other promises in the contract.” In this example, the second criterion is not met because it is the building for which the customer has contracted, not the separate goods and services. The seller will integrate all the goods and services into a combined output and each specific item should not be treated as a distinct good or service but accounted for together as a single performance obligation. (continued) © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 34. Reading 17 ■ Understanding Income Statements 16 Part 2 (ref. Example 8) Builder Co.’s contract with Customer Co. to construct the commercial build- ing specifies consideration of $1 million. Builder Co.’s expected total costs are $700,000. The Builder incurs $420,000 in costs in the first year. Assuming that costs incurred provide an appropriate measure of progress toward completing the contract, how much revenue should Builder Co. recognize for the first year? The standard states that for performance obligations satisfied over time (e.g., where there is a long- term contract), revenue is recognized over time by measuring progress toward satisfying the obligation. In this case, the Builder has incurred 60% of the total expected costs ($420,000/$700,000) and will thus recognize $600,000 (60% × $1 million) in revenue for the first year. This is the same amount of revenue that would be recognized using the “percentage- of- completion” method under previous accounting standards, but that term is not used in the converged standard. Instead, the standard refers to performance obligations satisfied over time and requires that progress toward complete satisfaction of the performance obligation be measured based on input method such as the one illustrated here (recognizing revenue based on the proportion of total costs that have been incurred in the period) or an output method (recognizing revenue based on units produced or milestones achieved). Part 3 (ref. Example 8) Assume that Builder Co.’s contract with Customer Co. to construct the com- mercial building specifies consideration of $1 million plus a bonus of $200,000 if the building is completed within 2 years. Builder Co. has only limited expe- rience with similar types of contracts and knows that many factors outside its control (e.g., weather, regulatory requirements) could cause delay. Builder Co.’s expected total costs are $700,000. The Builder incurs $420,000 in costs in the first year. Assuming that costs incurred provide an appropriate measure of progress toward completing the contract, how much revenue should Builder Co. recognize for the first year? The standard addresses so- called “variable consideration” as part of deter- mining the transaction price. A company is only allowed to recognize variable consideration if it can conclude that it will not have to reverse the cumulative revenue in the future. In this case, Builder Co. does not recognize any of the bonus in year one because it cannot reach the non- reversible conclusion given its limited experience with similar contracts and potential delays from factors outside its control. Part 4 (ref. Example 8) Assume all facts from Part 3. In the beginning of year two, Builder Co. and Customer Co. agree to change the building floor plan and modify the contract. As a result the consideration will increase by $150,000, and the allowable time for achieving the bonus is extended by 6 months. Builder expects its costs will increase by $120,000. Also, given the additional 6 months to earn the completion bonus, Builder concludes that it now meets the criteria for including the $200,000 bonus in revenue. How should Builder account for this change in the contract? Note that previous standards did not provide a general framework for contract modifications. The converged standard provides guidance on whether a change in a contract is a new contract or a modification of an existing contract. To be considered a new contract, the change would need to involve goods and services that are distinct from the goods and services already transferred. Exhibit 5 (Continued) © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 35. Revenue Recognition 17 In this case, the change does not meet the criteria of a new contract and is therefore considered a modification of the existing contract, which requires the company to reflect the impact on a cumulative catch- up basis. Therefore, the com- pany must update its transaction price and measure of progress. Builder’s total revenue on the transaction (transaction price) is now $1.35 million ($1 million original plus the $150,000 new consideration plus $200,000 for the completion bonus). Builder Co.’s progress toward completion is now 51.2% ($420,000 costs incurred divided by total expected costs of $820,000). Based on the changes in the contract, the amount of additional revenue to be recognized is $91,200, calculated as (51.2% × $1.35 million) minus the $600,000 already recognized. The additional $91,200 of revenue would be recognized as a “cumulative catch- up adjustment” on the date of the contract modification. Part 5 (ref. Example 15) Assume a Company operates a website that enables customers to purchase goods from various suppliers. The customers pay the Company in advance, and orders are nonrefundable. The suppliers deliver the goods directly to the customer, and the Company receives a 10% commission. Should the Company report Total Revenues equal to 100% of the sales amount (gross) or Total Revenues equal to 10% of the sales amount (net)? Revenues are reported gross if the Company is acting as a Principal and net if the Company is acting as an Agent. In this example, the Company is an Agent because it isn’t primarily responsible for fulfilling the contract, doesn’t take any inventory risk or credit risk, doesn’t have discretion in setting the price, and receives compensation in the form of a commission. Because the Company is acting as an Agent, it should report only the amount of commission as its revenue. Some related costs require specific accounting treatment under the new standards. In particular, incremental costs of obtaining a contract and certain costs incurred to fulfill a contract must be capitalized under the new standards (i.e., reported as an asset on the balance sheet rather than as an expense on the income statement). If a company had previously expensed these incremental costs in the years prior to adopting the converged standard, all else equal, its profitability will initially appear higher under the converged standards. The disclosure requirements are quite extensive. Companies are required at year end11 to disclose information about contracts with customers disaggregated into differ- ent categories of contracts. The categories might be based on the type of product, the geographic region, the type of customer or sales channel, the type of contract pricing terms, the contract duration, or the timing of transfers. Companies are also required to disclose balances of any contract- related assets and liabilities and significant changes in those balances, remaining performance obligations and transaction price allocated to those obligations, and any significant judgments and changes in judgments related to revenue recognition. Significant judgments are those used in determining timing and amounts of revenue to be recognized. The converged standard is expected to affect some industries more than others. For example, industries where bundled sales are common, such as the telecommu- nications and software industries, are expected to be significantly affected by the converged standard. Exhibit 5 (Continued) 11 Interim period disclosures are required under IFRS and US GAAP but differ between them. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 36. Reading 17 ■ Understanding Income Statements 18 EXPENSE RECOGNITION: GENERAL PRINCIPLES d describe general principles of expense recognition, specific expense recogni- tion applications, and implications of expense recognition choices for financial analysis; Expenses are deducted against revenue to arrive at a company’s net profit or loss. Under the IASB Conceptual Framework, expenses are “decreases in economic ben- efits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants.”12 The IASB Conceptual Framework also states: The definition of expenses encompasses losses as well as those expenses that arise in the course of the ordinary activities of the enterprise. Expenses that arise in the course of the ordinary activities of the enterprise include, for example, cost of sales, wages and depreciation. They usually take the form of an outflow or depletion of assets such as cash and cash equivalents, inventory, property, plant and equipment. Losses represent other items that meet the definition of expenses and may, or may not, arise in the course of the ordinary activities of the enter- prise. Losses represent decreases in economic benefits and as such they are no different in nature from other expenses. Hence, they are not regarded as a separate element in this Conceptual Framework. Losses include, for example, those resulting from disasters such as fire and flood, as well as those arising on the disposal of non- current assets.13 Similar to the issues with revenue recognition, in a simple hypothetical scenario, expense recognition would not be an issue. For instance, assume a company purchased inventory for cash and sold the entire inventory in the same period. When the company paid for the inventory, absent indications to the contrary, it is clear that the inventory cost has been incurred and when that inventory is sold, it should be recognized as an expense (cost of goods sold) in the financial records. Assume also that the company paid all operating and administrative expenses in cash within each accounting period. In such a simple hypothetical scenario, no issues of expense recognition would arise. In practice, however, as with revenue recognition, determining when expenses should be recognized can be somewhat more complex. 4.1 General Principles In general, a company recognizes expenses in the period that it consumes (i.e., uses up) the economic benefits associated with the expenditure, or loses some previously recognized economic benefit.14 A general principle of expense recognition is the matching principle. Strictly speaking, IFRS do not refer to a “matching principle” but rather to a “matching con- cept” or to a process resulting in “matching of costs with revenues.”15 The distinction is relevant in certain standard setting deliberations. Under matching, a company recognizes some expenses (e.g., cost of goods sold) when associated revenues are recognized and thus, expenses and revenues are matched. Associated revenues and 4 12 IASB Conceptual Framework, paragraph 4.25(b). 13 Ibid., paragraphs 4.33–4.35. 14 Ibid., paragraph 4.49. 15 Ibid., paragraph 4.50. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 37. Expense Recognition: General Principles 19 expenses are those that result directly and jointly from the same transactions or events. Unlike the simple scenario in which a company purchases inventory and sells all of the inventory within the same accounting period, in practice, it is more likely that some of the current period’s sales are made from inventory purchased in a previous period or previous periods. It is also likely that some of the inventory purchased in the current period will remain unsold at the end of the current period and so will be sold in a following period. Matching requires that a company recognizes cost of goods sold in the same period as revenues from the sale of the goods. Period costs, expenditures that less directly match revenues, are reflected in the period when a company makes the expenditure or incurs the liability to pay. Administrative expenses are an example of period costs. Other expenditures that also less directly match revenues relate more directly to future expected benefits; in this case, the expenditures are allocated systematically with the passage of time. An example is depreciation expense. Examples 1 and 2 demonstrate matching applied to inventory and cost of goods sold. EXAMPLE 1 The Matching of Inventory Costs with Revenues Kahn Distribution Limited (KDL), a hypothetical company, purchases inventory items for resale. At the beginning of 2018, Kahn had no inventory on hand. During 2018, KDL had the following transactions: Inventory Purchases First quarter 2,000 units at $40 per unit Second quarter 1,500 units at $41 per unit Third quarter 2,200 units at $43 per unit Fourth quarter 1,900 units at $45 per unit Total 7,600 units at a total cost of $321,600 KDL sold 5,600 units of inventory during the year at $50 per unit, and received cash. KDL determines that there were 2,000 remaining units of inventory and specifically identifies that 1,900 were those purchased in the fourth quarter and 100 were purchased in the third quarter. What are the revenue and expense associated with these transactions during 2018 based on specific identification of inventory items as sold or remaining in inventory? (Assume that the company does not expect any products to be returned.) Solution: The revenue for 2018 would be $280,000 (5,600 units × $50 per unit). Initially, the total cost of the goods purchased would be recorded as inventory (an asset) in the amount of $321,600. During 2018, the cost of the 5,600 units sold would be expensed (matched against the revenue) while the cost of the 2,000 remaining unsold units would remain in inventory as follows: Cost of Goods Sold From the first quarter 2,000 units at $40 per unit = $80,000 From the second quarter 1,500 units at $41 per unit = $61,500 From the third quarter 2,100 units at $43 per unit = $90,300 Total cost of goods sold $231,800 Cost of Goods Remaining in Inventory From the third quarter 100 units at $43 per unit = $4,300 (continued) © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 38. Reading 17 ■ Understanding Income Statements 20 From the fourth quarter 1,900 units at $45 per unit = $85,500 Total remaining (or ending) inventory cost $89,800 To confirm that total costs are accounted for: $231,800 + $89,800 = $321,600. The cost of the goods sold would be expensed against the revenue of $280,000 as follows: Revenue $280,000 Cost of goods sold 231,800 Gross profit $48,200 An alternative way to think about this is that the company created an asset (inventory) of $321,600 as it made its purchases. At the end of the period, the value of the company’s inventory on hand is $89,800. Therefore, the amount of the Cost of goods sold expense recognized for the period should be the differ- ence: $231,800. The remaining inventory amount of $89,800 will be matched against revenue in a future year when the inventory items are sold. EXAMPLE 2 Alternative Inventory Costing Methods In Example 1, KDL was able to specifically identify which inventory items were sold and which remained in inventory to be carried over to later periods. This is called the specific identification method and inventory and cost of goods sold are based on their physical flow. It is generally not feasible to specifically iden- tify which items were sold and which remain on hand, so accounting standards permit the assignment of inventory costs to costs of goods sold and to ending inventory using cost formulas (IFRS terminology) or cost flow assumptions (US GAAP). The cost formula or cost flow assumption determines which goods are assumed to be sold and which goods are assumed to remain in inventory. Both IFRS and US GAAP permit the use of the first in, first out (FIFO) method, and the weighted average cost method to assign costs. Under the FIFO method, the oldest goods purchased (or manufactured) are assumed to be sold first and the newest goods purchased (or manufactured) are assumed to remain in inventory. Cost of goods in beginning inventory and costs of the first items purchased (or manufactured) flow into cost of goods sold first, as if the earliest items purchased sold first. Ending inventory would, therefore, include the most recent purchases. It turns out that those items specifically iden- tified as sold in Example 1 were also the first items purchased, so in this example, under FIFO, the cost of goods sold would also be $231,800, calculated as above. The weighted average cost method assigns the average cost of goods available for sale to the units sold and remaining in inventory. The assignment is based on the average cost per unit (total cost of goods available for sale/total units available for sale) and the number of units sold and the number remaining in inventory. For KDL, the weighted average cost per unit would be $321,600/7,600 units = $42.3158 per unit © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 39. Expense Recognition: General Principles 21 Cost of goods sold using the weighted average cost method would be 5,600 units at $42.3158 = $236,968 Ending inventory using the weighted average cost method would be 2,000 units at $42.3158 = $84,632 Another method is permitted under US GAAP but is not permitted under IFRS. This is the last in, first out (LIFO) method. Under the LIFO method, the newest goods purchased (or manufactured) are assumed to be sold first and the oldest goods purchased (or manufactured) are assumed to remain in inventory. Costs of the latest items purchased flow into cost of goods sold first, as if the most recent items purchased were sold first. Although this may seem contrary to common sense, it is logical in certain circumstances. For example, lumber in a lumberyard may be stacked up with the oldest lumber on the bottom. As lumber is sold, it is sold from the top of the stack, so the last lumber purchased and put in inventory is the first lumber out. Theoretically, a company should choose a method linked to the physical inventory flows.16 Under the LIFO method, in the KDL example, it would be assumed that the 2,000 units remaining in ending inventory would have come from the first quarter’s purchases:17 Ending inventory 2,000 units at $40 per unit = $80,000 The remaining costs would be allocated to cost of goods sold under LIFO: Total costs of $321,600 less $80,000 remaining in ending inventory = $241,600 Alternatively, the cost of the last 5,600 units purchased is allocated to cost of goods sold under LIFO: 1,900 units at $45 per unit + 2,200 units at $43 per unit + 1,500 units at $41 per unit = $241,600 An alternative way to think about expense recognition is that the company created an asset (inventory) of $321,600 as it made its purchases. At the end of the period, the value of the company’s inventory is $80,000. Therefore, the amount of the Cost of goods sold expense recognized for the period should be the difference: $241,600. Exhibit 6 summarizes and compares inventory costing methods. 16 Practically, the reason some companies choose to use LIFO in the United States is to reduce taxes. When prices and inventory quantities are rising, LIFO will normally result in higher cost of goods sold and lower income and hence lower taxes. US tax regulations require that if LIFO is used on a company’s tax return, it must also be used on the company’s GAAP financial statements. 17 If data on the precise timing of quarterly sales were available, the answer would differ because the cost of goods sold would be determined during the quarter rather than at the end of the quarter. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 40. Reading 17 ■ Understanding Income Statements 22 Exhibit 6 Summary Table on Inventory Costing Methods Method Description Cost of Goods Sold When Prices Are Rising, Relative to Other Two Methods Ending Inventory When Prices Are Rising, Relative to Other Two Methods FIFO (first in, first out) Costs of the earliest items purchased flow to cost of goods sold first Lowest Highest LIFO (last in, first out) Costs of the most recent items purchased flow to cost of goods sold first Highest* Lowest* Weighted average cost Averages total costs over total units available Middle Middle *Assumes no LIFO layer liquidation. LIFO layer liquidation occurs when the volume of sales exceeds the volume of purchases in the period so that some sales are assumed to be made from existing, relatively low- priced inventory rather than from more recent purchases. ISSUES IN EXPENSE RECOGNITION: DOUBTFUL ACCOUNTS, WARRANTIES d describe general principles of expense recognition, specific expense recogni- tion applications, and implications of expense recognition choices for financial analysis; The following sections cover applications of the principles of expense recognition to certain common situations. 5.1 Doubtful Accounts When a company sells its products or services on credit, it is likely that some cus- tomers will ultimately default on their obligations (i.e., fail to pay). At the time of the sale, it is not known which customer will default. (If it were known that a particular customer would ultimately default, presumably a company would not sell on credit to that customer.) One possible approach to recognizing credit losses on customer receivables would be for the company to wait until such time as a customer defaulted and only then recognize the loss (direct write-off method). Such an approach would usually not be consistent with generally accepted accounting principles. Under the matching principle, at the time revenue is recognized on a sale, a com- pany is required to record an estimate of how much of the revenue will ultimately be uncollectible. Companies make such estimates based on previous experience with uncollectible accounts. Such estimates may be expressed as a proportion of the overall amount of sales, the overall amount of receivables, or the amount of receivables over- due by a specific amount of time. The company records its estimate of uncollectible amounts as an expense on the income statement, not as a direct reduction of revenues. 5.2 Warranties At times, companies offer warranties on the products they sell. If the product proves deficient in some respect that is covered under the terms of the warranty, the company will incur an expense to repair or replace the product. At the time of sale, the com- pany does not know the amount of future expenses it will incur in connection with its 5 © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 41. Issues in Expense Recognition: Depreciation and Amortization 23 warranties. One possible approach would be for a company to wait until actual expenses are incurred under the warranty and to reflect the expense at that time. However, this would not result in a matching of the expense with the associated revenue. Under the matching principle, a company is required to estimate the amount of future expenses resulting from its warranties, to recognize an estimated warranty expense in the period of the sale, and to update the expense as indicated by experience over the life of the warranty. ISSUES IN EXPENSE RECOGNITION: DEPRECIATION AND AMORTIZATION d describe general principles of expense recognition, specific expense recogni- tion applications, and implications of expense recognition choices for financial analysis; Companies commonly incur costs to obtain long- lived assets. Long-lived assets are assets expected to provide economic benefits over a future period of time greater than one year. Examples are land (property), plant, equipment, and intangible assets (assets lacking physical substance) such as trademarks. The costs of most long- lived assets are allocated over the period of time during which they provide economic benefits. The two main types of long- lived assets whose costs are not allocated over time are land and those intangible assets with indefinite useful lives. Depreciation is the process of systematically allocating costs of long- lived assets over the period during which the assets are expected to provide economic benefits. “Depreciation” is the term commonly applied to this process for physical long- lived assets such as plant and equipment (land is not depreciated), and amortisation is the term commonly applied to this process for intangible long- lived assets with a finite useful life.18 Examples of intangible long- lived assets with a finite useful life include an acquired mailing list, an acquired patent with a set expiration date, and an acquired copyright with a set legal life. The term “amortisation” is also commonly applied to the systematic allocation of a premium or discount relative to the face value of a fixed- income security over the life of the security. IFRS allow two alternative models for valuing property, plant, and equipment: the cost model and the revaluation model.19 Under the cost model, the depreciable amount of that asset (cost less residual value) is allocated on a systematic basis over the remaining useful life of the asset. Under the cost model, the asset is reported at its cost less any accumulated depreciation. Under the revaluation model, the asset is reported at its fair value. The revaluation model is not permitted under US GAAP. Although the revaluation model is permitted under IFRS, as noted earlier, it is not as widely used and thus we focus on the cost model here. There are two other differences between IFRS and US GAAP to note: IFRS require each component of an asset to be depreciated separately and US GAAP do not require component depreciation; and IFRS require an annual review of residual value and useful life, and US GAAP do not explicitly require such a review. 6 18 Intangible assets with indefinite life are not amortised. Instead, they are reviewed each period as to the reasonableness of continuing to assume an indefinite useful life and are tested at least annually for impairment (i.e., if the recoverable or fair value of an intangible asset is materially lower than its value in the company’s books, the value of the asset is considered to be impaired and its value must be decreased). IAS 38, Intangible Assets and FASB ASC Topic 350 [Intangibles–Goodwill and Other]. 19 IAS No. 16, Property, Plant, and Equipment. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 42. Reading 17 ■ Understanding Income Statements 24 The method used to compute depreciation should reflect the pattern over which the economic benefits of the asset are expected to be consumed. IFRS do not pre- scribe a particular method for computing depreciation but note that several methods are commonly used, such as the straight- line method, diminishing balance method (accelerated depreciation), and the units of production method (depreciation varies depending upon production or usage). The straight-line method allocates evenly the cost of long- lived assets less esti- mated residual value over the estimated useful life of an asset. (The term “straight line” derives from the fact that the annual depreciation expense, if represented as a line graph over time, would be a straight line. In addition, a plot of the cost of the asset minus the cumulative amount of annual depreciation expense, if represented as a line graph over time, would be a straight line with a negative downward slope.) Calculating depreciation and amortisation requires two significant estimates: the estimated useful life of an asset and the estimated residual value (also known as “salvage value”) of an asset. Under IFRS, the residual value is the amount that the company expects to receive upon sale of the asset at the end of its useful life. Example 3 assumes that an item of equipment is depreciated using the straight- line method and illustrates how the annual depreciation expense varies under different estimates of the useful life and estimated residual value of an asset. As shown, annual depreciation expense is sensitive to both the estimated useful life and to the estimated residual value. EXAMPLE 3 Sensitivity of Annual Depreciation Expense to Varying Estimates of Useful Life and Residual Value Using the straight- line method of depreciation, annual depreciation expense is calculated as: Cost Residual value Estimated useful life − Assume the cost of an asset is $10,000. If, for example, the residual value of the asset is estimated to be $0 and its useful life is estimated to be 5 years, the annual depreciation expense under the straight- line method would be ($10,000 – $0)/5 years = $2,000. In contrast, holding the estimated useful life of the asset constant at 5 years but increasing the estimated residual value of the asset to $4,000 would result in annual depreciation expense of only $1,200 [calculated as ($10,000 – $4,000)/5 years]. Alternatively, holding the estimated residual value at $0 but increasing the estimated useful life of the asset to 10 years would result in annual depreciation expense of only $1,000 [calculated as ($10,000 – $0)/10 years]. Exhibit 7 shows annual depreciation expense for various combinations of estimated useful life and residual value. Exhibit 7 Annual Depreciation Expense (in Dollars) Estimated Useful Life (Years) Estimated Residual Value 0 1,000 2,000 3,000 4,000 5,000 2 5,000 4,500 4,000 3,500 3,000 2,500 © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 43. Issues in Expense Recognition: Depreciation and Amortization 25 Estimated Useful Life (Years) Estimated Residual Value 4 2,500 2,250 2,000 1,750 1,500 1,250 5 2,000 1,800 1,600 1,400 1,200 1,000 8 1,250 1,125 1,000 875 750 625 10 1,000 900 800 700 600 500 Generally, alternatives to the straight- line method of depreciation are called accel- erated methods of depreciation because they accelerate (i.e., speed up) the timing of depreciation. Accelerated depreciation methods allocate a greater proportion of the cost to the early years of an asset’s useful life. These methods are appropriate if the plant or equipment is expected to be used up faster in the early years (e.g., an auto- mobile). A commonly used accelerated method is the diminishing balance method, (also known as the declining balance method). The diminishing balance method is demonstrated in Example 4. EXAMPLE 4 An Illustration of Diminishing Balance Depreciation Assume the cost of computer equipment was $11,000, the estimated residual value is $1,000, and the estimated useful life is five years. Under the diminishing or declining balance method, the first step is to determine the straight- line rate, the rate at which the asset would be depreciated under the straight- line method. This rate is measured as 100 percent divided by the useful life or 20 percent for a five- year useful life. Under the straight- line method, 1/5 or 20 percent of the depreciable cost of the asset (here, $11,000 – $1,000 = $10,000) would be expensed each year for five years: The depreciation expense would be $2,000 per year. The next step is to determine an acceleration factor that approximates the pattern of the asset’s wear. Common acceleration factors are 150 percent and 200 percent. The latter is known as double declining balance depreciation because it depreciates the asset at double the straight- line rate. Using the 200 percent acceleration factor, the diminishing balance rate would be 40 per- cent (20 percent × 2.0). This rate is then applied to the remaining undepreciated balance of the asset each period (known as the net book value). At the beginning of the first year, the net book value is $11,000. Depreciation expense for the first full year of use of the asset would be 40 percent of $11,000, or $4,400. Under this method, the residual value, if any, is generally not used in the computation of the depreciation each period (the 40 percent is applied to $11,000 rather than to $11,000 minus residual value). However, the company will stop taking depreciation when the salvage value is reached. At the beginning of Year 2, the net book value is measured as Asset cost $11,000 Less: Accumulated depreciation (4,400) Net book value $6,600 Exhibit 7 (Continued) © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 44. Reading 17 ■ Understanding Income Statements 26 For the second full year, depreciation expense would be $6,600 × 40 percent, or $2,640. At the end of the second year (i.e., beginning of the third year), a total of $7,040 ($4,400 + $2,640) of depreciation would have been recorded. So, the remaining net book value at the beginning of the third year would be Asset cost $11,000 Less: Accumulated depreciation (7,040) Net book value $3,960 For the third full year, depreciation would be $3,960 × 40 percent, or $1,584. At the end of the third year, a total of $8,624 ($4,400 + $2,640 + $1,584) of depreciation would have been recorded. So, the remaining net book value at the beginning of the fourth year would be Asset cost $11,000 Less: Accumulated depreciation (8,624) Net book value $2,376 For the fourth full year, depreciation would be $2,376 × 40 percent, or $950. At the end of the fourth year, a total of $9,574 ($4,400 + $2,640 + $1,584 + $950) of depreciation would have been recorded. So, the remaining net book value at the beginning of the fifth year would be Asset cost $11,000 Less: Accumulated depreciation (9,574) Net book value $1,426 For the fifth year, if deprecation were determined as in previous years, it would amount to $570 ($1,426 × 40 percent). However, this would result in a remain- ing net book value of the asset below its estimated residual value of $1,000. So, instead, only $426 would be depreciated, leaving a $1,000 net book value at the end of the fifth year. Asset cost $11,000 Less: Accumulated depreciation (10,000) Net book value $1,000 Companies often use a zero or small residual value, which creates problems for diminishing balance depreciation because the asset never fully depreciates. In order to fully depreciate the asset over the initially estimated useful life when a zero or small residual value is assumed, companies often adopt a depreciation policy that combines the diminishing balance and straight- line methods. An example would be a deprecation policy of using double- declining balance depre- ciation and switching to the straight- line method halfway through the useful life. Under accelerated depreciation methods, there is a higher depreciation expense in early years relative to the straight- line method. This results in higher expenses and lower net income in the early depreciation years. In later years, there is a reversal with accelerated depreciation expense lower than straight- line depreciation. Accelerated depreciation is sometimes referred to as a conservative accounting choice because it results in lower net income in the early years of asset use. For those intangible assets that must be amortised (those with an identifiable useful life), the process is the same as for depreciation; only the name of the expense is different. IFRS state that if a pattern cannot be determined over the useful life, then © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 45. Implications for Financial Analysts: Expense Recognition 27 the straight- line method should be used.20 In most cases under IFRS and US GAAP, amortisable intangible assets are amortised using the straight- line method with no residual value. Goodwill21 and intangible assets with indefinite life are not amortised. Instead, they are tested at least annually for impairment (i.e., if the current value of an intangible asset or goodwill is materially lower than its value in the company’s books, the value of the asset is considered to be impaired and its value in the company’s books must be decreased). In summary, to calculate depreciation and amortisation, a company must choose a method, estimate the asset’s useful life, and estimate residual value. Clearly, different choices have a differing effect on depreciation or amortisation expense and, therefore, on reported net income. IMPLICATIONS FOR FINANCIAL ANALYSTS: EXPENSE RECOGNITION d describe general principles of expense recognition, specific expense recogni- tion applications, and implications of expense recognition choices for financial analysis; A company’s estimates for doubtful accounts and/or for warranty expenses can affect its reported net income. Similarly, a company’s choice of depreciation or amortisation method, estimates of assets’ useful lives, and estimates of assets’ residual values can affect reported net income. These are only a few of the choices and estimates that affect a company’s reported net income. As with revenue recognition policies, a company’s choice of expense recognition can be characterized by its relative conservatism. A policy that results in recognition of expenses later rather than sooner is considered less conservative. In addition, many items of expense require the company to make estimates that can significantly affect net income. Analysis of a company’s financial statements, and particularly comparison of one company’s financial statements with those of another, requires an understanding of differences in these estimates and their potential impact. If, for example, a company shows a significant year- to- year change in its estimates of uncollectible accounts as a percentage of sales, warranty expenses as a percentage of sales, or estimated useful lives of assets, the analyst should seek to understand the underlying reasons. Do the changes reflect a change in business operations (e.g., lower estimated warranty expenses reflecting recent experience of fewer warranty claims because of improved product quality)? Or are the changes seemingly unrelated to changes in business operations and thus possibly a signal that a company is manip- ulating estimates in order to achieve a particular effect on its reported net income? As another example, if two companies in the same industry have dramatically different estimates for uncollectible accounts as a percentage of their sales, warranty expenses as a percentage of sales, or estimated useful lives as a percentage of assets, it is important to understand the underlying reasons. Are the differences consistent with differences in the two companies’ business operations (e.g., lower uncollectible accounts for one company reflecting a different, more creditworthy customer base or possibly stricter credit policies)? Another difference consistent with differences in 7 20 IAS 38, Intangible Assets. 21 Goodwill is recorded in acquisitions and is the amount by which the price to purchase an entity exceeds the amount of net identifiable assets acquired (the total amount of identifiable assets acquired less liabilities assumed). © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 46. Reading 17 ■ Understanding Income Statements 28 business operations would be a difference in estimated useful lives of assets if one of the companies employs newer equipment. Or, alternatively, are the differences seemingly inconsistent with differences in the two companies’ business operations, possibly signaling that a company is manipulating estimates? Information about a company’s accounting policies and significant estimates are described in the notes to the financial statements and in the management discussion and analysis section of a company’s annual report. When possible, the monetary effect of differences in expense recognition policies and estimates can facilitate more meaningful comparisons with a single company’s historical performance or across a number of companies. An analyst can use the mon- etary effect to adjust the reported expenses so that they are on a comparable basis. Even when the monetary effects of differences in policies and estimates cannot be calculated, it is generally possible to characterize the relative conservatism of the policies and estimates and, therefore, to qualitatively assess how such differences might affect reported expenses and thus financial ratios. NON-RECURRING ITEMS AND NON-OPERATING ITEMS: DISCONTINUED OPERATIONS AND UNUSUAL OR INFREQUENT ITEMS e describe the financial reporting treatment and analysis of non- recurring items (including discontinued operations, unusual or infrequent items) and changes in accounting policies; From a company’s income statements, we can see its earnings from last year and in the previous year. Looking forward, the question is: What will the company earn next year and in the years after? To assess a company’s future earnings, it is helpful to separate those prior years’ items of income and expense that are likely to continue in the future from those items that are less likely to continue.22 Some items from prior years are clearly not expected to continue in the future periods and are separately disclosed on a company’s income statement. This is consistent with “An entity shall present additional line items, headings, and subtotals … when such presentation is relevant to an understanding of the entity’s financial performance.”23 IFRS describe considerations that enter into the decision to present information other than that explicitly specified by a standard. Both IFRS and US GAAP specify that the results of discontinued operations should be reported separately from continuing operations. Other items that may be reported separately on a company’s income statement, such as unusual items, items that occur infrequently, effects due to accounting changes, and non- operating income, require the analyst to make some judgments. 8.1 Discontinued Operations When a company disposes of or establishes a plan to dispose of one of its component operations and will have no further involvement in the operation, the income state- ment reports separately the effect of this disposal as a “discontinued” operation under 8 22 In business writing, items expected to continue in the future are often described as “persistent” or “permanent,” whereas those not expected to continue are described as “transitory.” 23 IAS No. 1, Presentation of Financial Statements, paragraph 85. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 47. Non-Recurring Items and Non-Operating Items: Discontinued Operations and Unusual or Infrequent items 29 both IFRS and US GAAP. Financial standards provide various criteria for reporting the effect separately, which are generally that the discontinued component must be separable both physically and operationally.24 In Exhibit 1, AB InBev reported profit from discontinued operations of $28 million in 2017 and $48 million in 2016. In Exhibit 2, Molson Coors reported income from discontinued operations of $1.5 million and $3.9 million in 2017 and 2015, respectively, and a loss from discontinued operations of $2.8 million in 2016. Because the discontinued operation will no longer provide earnings (or cash flow) to the company, an analyst may eliminate discontinued operations in formulating expectations about a company’s future financial performance. 8.2 Unusual or Infrequent Items IFRS require that items of income or expense that are material and/or relevant to the understanding of the entity’s financial performance should be disclosed separately. Unusual or infrequent items are likely to meet these criteria. Under US GAAP, mate- rial items that are unusual or infrequent, and that are both as of reporting periods beginning after December 15, 2015, are shown as part of a company’s continuing operations but are presented separately. For example, restructuring charges, such as costs to close plants and employee termination costs, are considered part of a company’s ordinary activities. As another example, gains and losses arising when a company sells an asset or part of a business, for more or less than its carrying value, are also disclosed separately on the income statement. These sales are considered ordinary business activities. Highlighting the unusual or infrequent nature of these items assists an analyst in judging the likelihood that such items will reoccur. This meets the IFRS criteria of disclosing items that are relevant to the understanding of an entity’s financial perfor- mance. In Exhibit 2, Molson Coors’ income statement showed a separate line item for “Special Items, net.” The company’s footnotes provide details on the amount and explain that this line includes revenues or expenses that either they “do not believe to be indicative of [their] core operations, or they believe are significant to [their] current operating results warranting separate classification”. In Exhibit 3, the income statement of Danone shows an amount for “Recurring operating income” followed by a separate line item for “other operating income (expense)”, which is not included as a component of recurring income. Exhibit 8 presents an excerpt from Danone’s additional disclosure about this non- recurring amount. Exhibit 8 Highlighting Infrequent Nature of Items—Excerpt from Groupe Danone footnotes to its 2017 financial statements NOTE 6. Events and Transactions Outside the Group’s Ordinary Activities [Excerpt] “Other operating income (expense) is defined under Recommendation 2013- 03 of the French CNC relating to the format of consolidated financial statements prepared under international accounting stan- dards, and comprises significant items that, because of their excep- tional nature, cannot be viewed as inherent to Danone’s current activities. These mainly include capital gains and losses on disposals of fully consolidated companies, impairment charges on goodwill, significant costs related to strategic restructuring and major external (continued) 24 IFRS No. 5, Non- Current Assets Held for Sale and Discontinued Operations, paragraphs 31–33. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 48. Reading 17 ■ Understanding Income Statements 30 growth transactions, and incurred or estimated costs related to major crises and major litigation. Furthermore, in connection with Revised IFRS 3 and Revised IAS 27, Danone also classifies in Other operating income (expense) (i) acquisition costs related to business combinations, (ii) revaluation profit or loss accounted for following a loss of control, and (iii) changes in earn- outs related to business combinations and subsequent to the acquisition date. “In 2017, the net Other operating income of €192 million consisted mainly of the following items: (in € millions) Related income (expense) Capital gain on disposal of Stonyfield 628 Compensation received following the decision of the Singapore arbitration court in the Fonterra case 105 Territorial risks, mainly in certain countries in the ALMA region (148) Costs associated with the integration of WhiteWave (118) Impairment of several intangible assets in Waters and Specialized Nutrition Reporting entities (115) Remainder of table omitted In Exhibit 8, Danone provides details on items considered to be “exceptional” items and not “inherent” to the company’s current activities. The exceptional items include gains on asset disposals, receipts from a legal case, costs of integrating an acquisition, and impairment of intangible assets, among others. Generally, in forecasting future operations, an analyst would assess whether the items reported are likely to reoccur and also possible implications for future earnings. It is generally not advisable simply to ignore all unusual items. NON-RECURRING ITEMS: CHANGES IN ACCOUNTING POLICY e describe the financial reporting treatment and analysis of non- recurring items (including discontinued operations, unusual or infrequent items) and changes in accounting policies; At times, standard setters issue new standards that require companies to change accounting policies. Depending on the standard, companies may be permitted to adopt the standards prospectively (in the future) or retrospectively (restate financial statements as though the standard existed in the past). In other cases, changes in accounting policies (e.g., from one acceptable inventory costing method to another) 9 Exhibit 8 (Continued) © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 49. Non-Recurring Items: Changes in Accounting Policy 31 are made for other reasons, such as providing a better reflection of the company’s performance. Changes in accounting policies are reported through retrospective application25 unless it is impractical to do so. Retrospective application means that the financial statements for all fiscal years shown in a company’s financial report are presented as if the newly adopted accounting principle had been used throughout the entire period. Notes to the financial statements describe the change and explain the justification for the change. Because changes in accounting principles are retrospectively applied, the financial statements that appear within a financial report are comparable. Example 5 presents an excerpt from Microsoft Corporation’s Form 10- K for the fiscal year ended 30 June 2018 describing a change in accounting principle resulting from the new revenue recognition standard. Microsoft elected to adopt the new standard 1 July 2017, earlier than the required adoption date. Microsoft also elected to use the “full retrospective method,” which requires companies to restate prior periods’ results. On its income statement, both 2016 and 2017 are presented as if the new standard had been used throughout both years. In the footnotes to its financial statements, Microsoft discloses the impact of the new standard. EXAMPLE 5 Microsoft Corporation Excerpt from Footnotes to the Financial Statements The most significant impact of the [new revenue recognition] standard relates to our accounting for software license revenue. Specifically, for Windows 10, we recognize revenue predominantly at the time of billing and delivery rather than ratably over the life of the related device. For certain multi- year commercial software subscriptions that include both distinct software licenses and SA, we recognize license revenue at the time of contract execution rather than over the subscription period. Due to the complexity of certain of our commercial license subscription contracts, the actual revenue recognition treatment required under the standard depends on contract- specific terms and in some instances may vary from recognition at the time of billing. Revenue recognition related to our hardware, cloud offerings (such as Office 365), LinkedIn, and professional services remains substan- tially unchanged. Refer to Impacts to Previously Reported Results below for the impact of adoption of the standard in our consolidated financial statements. (In $ millions, except per share amounts) As Previously Reported New Revenue Standard Adjustment As Restated Income Statements Year Ended June 30, 2017 Revenue 89,950 6,621 96,571 Provision for income taxes 1,945 2,467 4,412 (continued) 25 IAS No. 8, Accounting Policies, Changes in Accounting Estimates and Errors, and FASB ASC Topic 250 [Accounting Changes and Error Corrections]. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 50. Reading 17 ■ Understanding Income Statements 32 (In $ millions, except per share amounts) As Previously Reported New Revenue Standard Adjustment As Restated Net income 21,204 4,285 25,489 Diluted earnings per share 2.71 0.54 3.25 Year Ended June 30, 2016 Revenue 85,320 5,834 91,154 Provision for income taxes 2,953 2,147 5,100 Net income 16,798 3,741 20,539 Diluted earnings per share 2.1 0.46 2.56 Question: Based on the above information, describe whether Microsoft’s results appear better or worse under the new revenue recognition standard. Solution: Microsoft’s results appear better under the new revenue recognition standard. Revenues and income are higher under the new standard. The net profit margin is higher under the new standard. For 2017, the net profit margin is 26.4% (= 25,489/96,571) under the new standard versus 23.6% (= 21,204/89,950) under the old standard. Reported revenue grew faster under the new standard. Revenue growth under the new standard was 5.9% [= (96,571/91,154) – 1] compared to 5.4% [= (89,950/85,320) – 1)] under the old standard. Microsoft’s presentation of the effects of the new revenue recognition enables an analyst to identify the impact of the change in accounting standards. Note that the new revenue recognition standard also offered companies the option of using a “modified retrospective” method of adoption. Under the modified retrospec- tive approach, companies were not required to revise previously reported financial statements. Instead, they adjusted opening balances of retained earnings (and other applicable accounts) for the cumulative impact of the new standard. In contrast to changes in accounting policies (such as whether to expense the cost of employee stock options), companies sometimes make changes in accounting esti- mates (such as the useful life of a depreciable asset). Changes in accounting estimates are handled prospectively, with the change affecting the financial statements for the period of change and future periods. No adjustments are made to prior statements, and the adjustment is not shown on the face of the income statement. Significant changes should be disclosed in the notes. Exhibit 9 provides an excerpt from the annual Form 10- K of Catalent Inc., a US- based biotechnology company, that illustrates a change in accounting estimate. Exhibit 9 Change in Accounting Estimate Catalent Inc. discloses a change in the method it uses to calculate both annual expenses related to its defined benefit pension plans. Rather than use a single, weighted- average discount rate in its calculations, the company will use the spot rates applicable to each projected cash flow. Post- Retirement and Pension Plans © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 51. Non-Operating Items 33 …The measurement of the related benefit obligations and the net periodic benefit costs recorded each year are based upon actuarial computations, which require management’s judgment as to certain assumptions. These assumptions include the discount rates used in computing the present value of the benefit obligations and the net periodic benefit costs... Effective June 30, 2016, the approach used to estimate the service and interest components of net periodic benefit cost for benefit plans was changed to provide a more precise measurement of service and interest costs. Historically, the Company estimated these service and interest components utilizing a single weighted- average discount rate derived from the yield curve used to measure the benefit obligation at the beginning of the period. Going forward, the Company has elected to utilize an approach that discounts the individual expected cash flows using the applicable spot rates derived from the yield curve over the projected cash flow period. The Company has accounted for this change as a change in accounting estimate that is inseparable from a change in accounting principle and accordingly has accounted for it prospectively. Another possible adjustment is a correction of an error for a prior period (e.g., in financial statements issued for an earlier year). This cannot be handled by simply adjusting the current period income statement. Correction of an error for a prior period is handled by restating the financial statements (including the balance sheet, statement of owners’ equity, and cash flow statement) for the prior periods presented in the current financial statements.26 Note disclosures are required regarding the error. These disclosures should be examined carefully because they may reveal weaknesses in the company’s accounting systems and financial controls. NON-OPERATING ITEMS f contrast operating and non- operating components of the income statement; Non- operating items are typically reported separately from operating income because they are material and/or relevant to the understanding of the entity’s financial per- formance. Under IFRS, there is no definition of operating activities, and companies that choose to report operating income or the results of operating activities should ensure that these represent activities that are normally regarded as operating. Under US GAAP, operating activities generally involve producing and delivering goods and providing services and include all transactions and other events that are not defined as investing or financing activities.27 For example, if a non- financial service company invests in equity or debt securities issued by another company, any interest, dividends, or profits from sales of these securities will be shown as non- operating income. In 10 Exhibit 9 (Continued) 26 Ibid. 27 FASB ASC Master Glossary. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 52. Reading 17 ■ Understanding Income Statements 34 general, for non- financial services companies,28 non- operating income that is dis- closed separately on the income statement (or in the notes) includes amounts earned through investing activities. Among non- operating items on the income statement (or accompanying notes), non- financial service companies also disclose the interest expense on their debt securities, including amortisation of any discount or premium. The amount of inter- est expense is related to the amount of a company’s borrowings and is generally described in the notes to the financial statements. For financial service companies, interest income and expense are likely components of operating activities. (Note that the characterization of interest and dividends as non- operating items on the income statement is not necessarily consistent with the classification on the statement of cash flows. Specifically, under IFRS, interest and dividends received can be shown either as operating or as investing on the statement of cash flows, while under US GAAP interest and dividends received are shown as operating cash flows. Under IFRS, interest and dividends paid can be shown either as operating or as financing on the statement of cash flows, while under US GAAP, interest paid is shown as operating and dividends paid are shown as financing.) In practice, companies often disclose the interest expense and income separately, along with a net amount. For example, in Exhibit 1, ABN InBev’s 2017 income state- ment shows finance cost of $6,885 million, finance income of $378 million, and net finance cost of $6,507 million. Similarly, in Exhibit 3, Danone’s 2017 income statement shows interest income of €130, interest expense of €276, and cost of net debt of €146. For purposes of assessing a company’s future performance, the amount of financing expense will depend on the company’s financing policy (target capital structure) and borrowing costs. The amount of investing income will depend on the purpose and success of investing activities. For a non- financial company, a significant amount of financial income would typically warrant further exploration. What are the reasons underlying the company’s investments in the securities of other companies? Is the company simply investing excess cash in short- term securities to generate income higher than cash deposits, or is the company purchasing securities issued by other companies for strategic reasons, such as access to raw material supply or research? EARNINGS PER SHARE AND CAPITAL STRUCTURE AND BASIC EPS g describe how earnings per share is calculated and calculate and interpret a com- pany’s earnings per share (both basic and diluted earnings per share) for both simple and complex capital structures; One metric of particular importance to an equity investor is earnings per share (EPS). EPS is an input into ratios such as the price/earnings ratio. Additionally, each share- holder in a company owns a different number of shares. IFRS require the presentation of EPS on the face of the income statement for net profit or loss (net income) and profit or loss (income) from continuing operations.29 Similar presentation is required under US GAAP.30 This section outlines the calculations for EPS and explains how the calculation differs for a simple versus complex capital structure. 11 28 Examples of financial services companies are insurance companies, banks, brokers, dealers, and investment companies. 29 IAS No. 33, Earnings Per Share. 30 FASB ASC Topic 260 [Earnings Per Share]. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 53. Earnings Per Share and Capital Structure and Basic EPS 35 11.1 Simple versus Complex Capital Structure A company’s capital is composed of its equity and debt. Some types of equity have preference over others, and some debt (and other instruments) may be converted into equity. Under IFRS, the type of equity for which EPS is presented is referred to as ordinary. Ordinary shares are those equity shares that are subordinate to all other types of equity. The ordinary shareholders are basically the owners of the company—the equity holders who are paid last in a liquidation of the company and who benefit the most when the company does well. Under US GAAP, this ordinary equity is referred to as common stock or common shares, reflecting US language usage. The terms “ordinary shares,” “common stock,” and “common shares” are used interchangeably in the following discussion. When a company has issued any financial instruments that are potentially con- vertible into common stock, it is said to have a complex capital structure. Examples of financial instruments that are potentially convertible into common stock include convertible bonds, convertible preferred stock, employee stock options, and warrants.31 If a company’s capital structure does not include such potentially convertible financial instruments, it is said to have a simple capital structure. The distinction between simple versus complex capital structure is relevant to the calculation of EPS because financial instruments that are potentially convertible into common stock could, as a result of conversion or exercise, potentially dilute (i.e., decrease) EPS. Information about such a potential dilution is valuable to a company’s current and potential shareholders; therefore, accounting standards require companies to disclose what their EPS would be if all dilutive financial instruments were converted into common stock. The EPS that would result if all dilutive financial instruments were converted is called diluted EPS. In contrast, basic EPS is calculated using the reported earnings available to common shareholders of the parent company and the weighted average number of shares outstanding. Companies are required to report both basic and diluted EPS as well as amounts for continuing operations. Exhibit 10 shows the per share amounts reported by AB InBev at the bottom of its income statement that was presented in Exhibit 1. The company’s basic EPS (“before dilution”) was $4.06, and diluted EPS (“after dilution”) was $3.98 for 2017. In addition, in the same way that AB InBev’s income statement shows income from continuing operations separately from total income, EPS from continuing operations is also shown separately from total EPS. For 2017, the basic and diluted EPS from continuing operations were $4.04 and $3.96, respectively. Across all measures, AB InBev’s EPS was much higher in 2017 than in 2016. An analyst would seek to understand the causes underlying the changes in EPS, a topic we will address following an explanation of the calculations of both basic and diluted EPS. Exhibit 10 AB InBev’s Earnings Per Share 12 Months Ended December 31 2017 2016 2015 Basic earnings per share $4.06 $0.72 $5.05 Diluted earnings per share 3.98 0.71 4.96 (continued) 31 A warrant is a call option typically attached to securities issued by a company, such as bonds. A warrant gives the holder the right to acquire the company’s stock from the company at a specified price within a specified time period. IFRS and US GAAP standards regarding earnings per share apply equally to call options, warrants, and equivalent instruments. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 54. Reading 17 ■ Understanding Income Statements 36 12 Months Ended December 31 2017 2016 2015 Basic earnings per share from continuing operations 4.04 0.69 5.05 Diluted earnings per share from continuing operations $3.96 $0.68 $4.96 11.2 Basic EPS Basic EPS is the amount of income available to common shareholders divided by the weighted average number of common shares outstanding over a period. The amount of income available to common shareholders is the amount of net income remaining after preferred dividends (if any) have been paid. Thus, the formula to calculate basic EPS is: Basic EPS Net income Preferred dividends Weighted average = − number of shares outstanding The weighted average number of shares outstanding is a time weighting of common shares outstanding. For example, assume a company began the year with 2,000,000 common shares outstanding and repurchased 100,000 common shares on 1 July. The weighted average number of common shares outstanding would be the sum of 2,000,000 shares × 1/2 year + 1,900,000 shares × 1/2 year, or 1,950,000 shares. So the company would use 1,950,000 shares as the weighted average number of shares in calculating its basic EPS. If the number of shares of common stock increases as a result of a stock dividend or a stock split, the EPS calculation reflects the change retroactively to the beginning of the period. Examples 6, 7, and 8 illustrate the computation of basic EPS. EXAMPLE 6 A Basic EPS Calculation (1) For the year ended 31 December 2018, Shopalot Company had net income of $1,950,000. The company had 1,500,000 shares of common stock outstanding, no preferred stock, and no convertible financial instruments. What is Shopalot’s basic EPS? Solution: Shopalot’s basic EPS is $1.30 ($1,950,000 divided by 1,500,000 shares). EXAMPLE 7 A Basic EPS Calculation (2) For the year ended 31 December 2018, Angler Products had net income of $2,500,000. The company declared and paid $200,000 of dividends on preferred stock. The company also had the following common stock share information: (1) Exhibit 10 (Continued) © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 55. Diluted EPS: the If-Converted Method 37 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? 2 What is the company’s basic EPS? Solution to 1: 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 × (6 months/12 months) = 600,000 1,100,000 × (3 months/12 months) = 275,000 Weighted average number of shares outstanding 1,125,000 Solution to 2: Basic EPS = (Net income – Preferred dividends)/Weighted average number of shares = ($2,500,000 – $200,000)/1,125,000 = $2.04 EXAMPLE 8 A Basic EPS Calculation (3) Assume the same facts as Example 7 except that on 1 December 2018, a previ- ously declared 2- for- 1 stock split took effect. Each shareholder of record receives two shares in exchange for each current share that he or she owns. What is the company’s basic EPS? Solution: For EPS calculation purposes, a stock split is treated as if it occurred at the begin- ning of the period. The weighted average number of shares would, therefore, be 2,250,000, and the basic EPS would be $1.02 [= ($2,500,000 – $200,000)/2,250,000]. DILUTED EPS: THE IF-CONVERTED METHOD g describe how earnings per share is calculated and calculate and interpret a com- pany’s earnings per share (both basic and diluted earnings per share) for both simple and complex capital structures; If a company has a simple capital structure (in other words, one that includes no potentially dilutive financial instruments), then its basic EPS is equal to its diluted EPS. However, if a company has potentially dilutive financial instruments, its diluted EPS may differ from its basic EPS. Diluted EPS, by definition, is always equal to or less than basic EPS. The sections below describe the effects of three types of potentially 12 © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 56. Reading 17 ■ Understanding Income Statements 38 dilutive financial instruments on diluted EPS: convertible preferred, convertible debt, and employee stock options. The final section explains why not all potentially dilutive financial instruments actually result in a difference between basic and diluted EPS. 12.1 Diluted EPS When a Company Has Convertible Preferred Stock Outstanding When a company has convertible preferred stock outstanding, diluted EPS is cal- culated using the if-converted method. The if- converted method is based on what EPS would have been if the convertible preferred securities had been converted at the beginning of the period. In other words, the method calculates what the effect would have been if the convertible preferred shares converted at the beginning of the period. If the convertible shares had been converted, there would be two effects. First, the convertible preferred securities would no longer be outstanding; instead, additional common stock would be outstanding. Thus, under the if-converted method, the weighted average number of shares outstanding would be higher than in the basic EPS calculation. Second, if such a conversion had taken place, the company would not have paid preferred dividends. Thus, under the if- converted method, the net income available to common shareholders would be higher than in the basic EPS calculation. Diluted EPS using the if- converted method for convertible preferred stock is equal to net income divided by the weighted average number of shares outstanding from the basic EPS calculation plus the additional shares of common stock that would be issued upon conversion of the preferred. Thus, the formula to calculate diluted EPS using the if- converted method for preferred stock is: Diluted EPS Net income Weighted average number of shares = ( ) ( o outstanding New common shares that would have been issue + d d at conversion) A diluted EPS calculation using the if- converted method for preferred stock is provided in Example 9. EXAMPLE 9 A Diluted EPS Calculation Using the If- Converted Method for Preferred Stock For the year ended 31 December 2018, Bright- Warm Utility Company (fictitious) had net income of $1,750,000. The company had an average of 500,000 shares of common stock outstanding, 20,000 shares of convertible preferred, and no other potentially dilutive securities. Each share of preferred pays a dividend of $10 per share, and each is convertible into five shares of the company’s common stock. Calculate the company’s basic and diluted EPS. Solution: If the 20,000 shares of convertible preferred had each converted into 5 shares of the company’s common stock, the company would have had an additional 100,000 shares of common stock (5 shares of common for each of the 20,000 shares of preferred). If the conversion had taken place, the company would not have paid preferred dividends of $200,000 ($10 per share for each of the 20,000 shares of preferred). As shown in Exhibit 11, the company’s basic EPS was $3.10 and its diluted EPS was $2.92. (2) © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 57. Diluted EPS: the If-Converted Method 39 Exhibit 11 Calculation of Diluted EPS for Bright- Warm Utility Company Using the If- Converted Method: Case of Preferred Stock Basic EPS Diluted EPS Using If- Converted Method Net income $1,750,000 $1,750,000 Preferred dividend –200,000 0 Numerator $1,550,000 $1,750,000 Weighted average number of shares outstanding 500,000 500,000 Additional shares issued if preferred converted 0 100,000 Denominator 500,000 600,000 EPS $3.10 $2.92 12.2 Diluted EPS When a Company Has Convertible Debt Outstanding When a company has convertible debt outstanding, the diluted EPS calculation also uses the if- converted method. Diluted EPS is calculated as if the convertible debt had been converted at the beginning of the period. If the convertible debt had been converted, the debt securities would no longer be outstanding; instead, additional shares of common stock would be outstanding. Also, if such a conversion had taken place, the company would not have paid interest on the convertible debt, so the net income available to common shareholders would increase by the after- tax amount of interest expense on the debt converted. Thus, the formula to calculate diluted EPS using the if- converted method for convertible debt is: Diluted EPS Net income After-tax interest on convertible = + ( debt Preferred dividends Weighted average number of sh − ) a ares outstanding Additional common shares that would hav ( + e e been issued at conversion) A diluted EPS calculation using the if- converted method for convertible debt is provided in Example 10. EXAMPLE 10 A Diluted EPS Calculation Using the If- Converted Method for Convertible Debt Oppnox Company (fictitious) reported net income of $750,000 for the year ended 31 December 2018. The company had a weighted average of 690,000 shares of common stock outstanding. In addition, the company has only one potentially (3) © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 58. Reading 17 ■ Understanding Income Statements 40 dilutive security: $50,000 of 6 percent convertible bonds, convertible into a total of 10,000 shares. Assuming a tax rate of 30 percent, calculate Oppnox’s basic and diluted EPS. Solution: If the debt securities had been converted, the debt securities would no longer be outstanding and instead, an additional 10,000 shares of common stock would be outstanding. Also, if the debt securities had been converted, the company would not have paid interest of $3,000 on the convertible debt, so net income available to common shareholders would have increased by $2,100 [= $3,000(1 – 0.30)] on an after- tax basis. Exhibit 12 illustrates the calculation of diluted EPS using the if- converted method for convertible debt. Exhibit 12 Calculation of Diluted EPS for Oppnox Company Using the If- Converted Method: Case of a Convertible Bond Basic EPS Diluted EPS Using If- Converted Method Net income $750,000 $750,000 After- tax cost of interest 2,100 Numerator $750,000 $752,100 Weighted average number of shares outstanding 690,000 690,000 If converted 0 10,000 Denominator 690,000 700,000 EPS $1.09 $1.07 DILUTED EPS: THE TREASURY STOCK METHOD g describe how earnings per share is calculated and calculate and interpret a com- pany’s earnings per share (both basic and diluted earnings per share) for both simple and complex capital structures; When a company has stock options, warrants, or their equivalents32 outstanding, diluted EPS is calculated as if the financial instruments had been exercised and the company had used the proceeds from exercise to repurchase as many shares of common stock as possible at the average market price of common stock during the period. The weighted average number of shares outstanding for diluted EPS is thus increased by the number of shares that would be issued upon exercise minus the number of shares that would have been purchased with the proceeds. This method is called the treasury stock method under US GAAP because companies typically hold repurchased shares as treasury stock. The same method is used under IFRS but is not named. 13 32 Hereafter, options, warrants, and their equivalents will be referred to simply as “options” because the accounting treatment for EPS calculations is interchangeable for these instruments under IFRS and US GAAP. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 59. Diluted EPS: the Treasury Stock Method 41 For the calculation of diluted EPS using this method, the assumed exercise of these financial instruments would have the following effects: ■ ■ The company is assumed to receive cash upon exercise and, in exchange, to issue shares. ■ ■ The company is assumed to use the cash proceeds to repurchase shares at the weighted average market price during the period. As a result of these two effects, the number of shares outstanding would increase by the incremental number of shares issued (the difference between the number of shares issued to the holders and the number of shares assumed to be repurchased by the company). For calculating diluted EPS, the incremental number of shares is weighted based upon the length of time the financial instrument was outstanding in the year. If the financial instrument was issued prior to the beginning of the year, the weighted average number of shares outstanding increases by the incremental number of shares. If the financial instruments were issued during the year, then the incremental shares are weighted by the amount of time the financial instruments were outstanding during the year. The assumed exercise of these financial instruments would not affect net income. For calculating EPS, therefore, no change is made to the numerator. The formula to calculate diluted EPS using the treasury stock method (same method as used under IFRS but not named) for options is: Diluted EPS Net income Preferred dividends Weighted ave = − ( ) r rage number of shares outstanding New shares that would [ + ( ( − have been issued at option exercise Shares that could ha ave been purchased with cash received upon exercise Prop )× o ortion of year during which the financial instruments wer ( e e outstanding) A diluted EPS calculation using the treasury stock method for options is provided in Example 11. EXAMPLE 11 A Diluted EPS Calculation Using the Treasury Stock Method for Options Hihotech Company (fictitious) reported net income of $2.3 million for the year ended 30 June 2018 and had a weighted average of 800,000 common shares outstanding. At the beginning of the fiscal year, the company has outstanding 30,000 options with an exercise price of $35. No other potentially dilutive financial instruments are outstanding. Over the fiscal year, the company’s market price has averaged $55 per share. Calculate the company’s basic and diluted EPS. Solution: Using the treasury stock method, we first calculate that the company would have received $1,050,000 ($35 for each of the 30,000 options exercised) if all the options had been exercised. The options would no longer be outstanding; instead, 30,000 shares of common stock would be outstanding. Under the trea- sury stock method, we assume that shares would be repurchased with the cash received upon exercise of the options. At an average market price of $55 per (4) © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 60. Reading 17 ■ Understanding Income Statements 42 share, the $1,050,000 proceeds from option exercise, the company could have repurchased 19,091 shares. Therefore, the incremental number of shares issued is 10,909 (calculated as 30,000 minus 19,091). For the diluted EPS calculation, no change is made to the numerator. As shown in Exhibit 13, the company’s basic EPS was $2.88 and the diluted EPS was $2.84. Exhibit 13 Calculation of Diluted EPS for Hihotech Company Using the Treasury Stock Method: Case of Stock Options Basic EPS Diluted EPS Using Treasury Stock Method Net income $2,300,000 $2,300,000 Numerator $2,300,000 $2,300,000 Weighted average number of shares outstanding 800,000 800,000 If converted 0 10,909 Denominator 800,000 810,909 EPS $2.88 $2.84 As noted, IFRS require a similar computation but does not refer to it as the “treasury stock method.” The company is required to consider that any assumed proceeds are received from the issuance of new shares at the average market price for the period. These new “inferred” shares would be disregarded in the computation of diluted EPS, but the excess of the new shares that would be issued under options contracts minus the new inferred shares would be added to the weighted average number of shares outstanding. The results are the same as the treasury stock method, as shown in Example 12. EXAMPLE 12 Diluted EPS for Options under IFRS Assuming the same facts as in Example 11, calculate the weighted average number of shares outstanding for diluted EPS under IFRS. Solution: If the options had been exercised, the company would have received $1,050,000. If this amount had been received from the issuance of new shares at the average market price of $55 per share, the company would have issued 19,091 shares. IFRS refer to the 19,091 shares the company would have issued at market prices as the inferred shares. The number of shares issued under options (30,000) minus the number of inferred shares (19,091) equals 10,909. This amount is added to the weighted average number of shares outstanding of 800,000 to get diluted shares of 810,909. Note that this is the same result as that obtained under US GAAP; it is just derived in a different manner. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 61. Other Issues with Diluted EPS and Changes in EPS 43 OTHER ISSUES WITH DILUTED EPS AND CHANGES IN EPS h contrast dilutive and antidilutive securities and describe the implications of each for the earnings per share calculation; It is possible that some potentially convertible securities could be antidilutive (i.e., their inclusion in the computation would result in an EPS higher than the company’s basic EPS). Under IFRS and US GAAP, antidilutive securities are not included in the calculation of diluted EPS. Diluted EPS should reflect the maximum potential dilution from conversion or exercise of potentially dilutive financial instruments. Diluted EPS will always be less than or equal to basic EPS. Example 13 provides an illustration of an antidilutive security. EXAMPLE 13 An Antidilutive Security For the year ended 31 December 2018, Dim- Cool Utility Company (fictitious) had net income of $1,750,000. The company had an average of 500,000 shares of common stock outstanding, 20,000 shares of convertible preferred, and no other potentially dilutive securities. Each share of preferred pays a dividend of $10 per share, and each is convertible into three shares of the company’s common stock. What was the company’s basic and diluted EPS? Solution: If the 20,000 shares of convertible preferred had each converted into 3 shares of the company’s common stock, the company would have had an additional 60,000 shares of common stock (3 shares of common for each of the 20,000 shares of preferred). If the conversion had taken place, the company would not have paid preferred dividends of $200,000 ($10 per share for each of the 20,000 shares of preferred). The effect of using the if- converted method would be EPS of $3.13, as shown in Exhibit 14. Because this is greater than the company’s basic EPS of $3.10, the securities are said to be antidilutive and the effect of their conversion would not be included in diluted EPS. Diluted EPS would be the same as basic EPS (i.e., $3.10). Exhibit 14 Calculation for an Antidilutive Security Basic EPS Diluted EPS Using If- Converted Method Net income $1,750,000 $1,750,000 Preferred dividend –200,000 0 Numerator $1,550,000 $1,750,000 Weighted average number of shares outstanding 500,000 500,000 If converted 0 60,000 Denominator 500,000 560,000 14 (continued) © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 62. Reading 17 ■ Understanding Income Statements 44 Basic EPS Diluted EPS Using If- Converted Method EPS $3.10 $3.13 ←Exceeds basic EPS; security is antidilutive and, therefore, not included. Reported diluted EPS = $3.10. 14.1 Changes in EPS Having explained the calculations of both basic and diluted EPS, we return to an examination of changes in EPS. As noted above, AB InBev’s fully diluted EPS from continuing operations increased from $0.68 in 2016 to $3.96 in 2017. In general, an increase in EPS results from an increase in net income, a decrease in the number of shares outstanding, or a combination of both. In the notes to its financial statements (not shown), AB InBev discloses that the weighted average number of shares for both the basic and fully- diluted calculations was greater in 2017 than in 2016. Thus, for AB InBev, the improvement in EPS from 2016 to 2017 was driven by an increase in net income. Changes in the numerator and denominator explain the changes in EPS arithmetically. To understand the business drivers of those changes requires further research. The next section presents analytical tools that an analyst can use to highlight areas for further examination. COMMON-SIZE ANALYSIS OF THE INCOME STATEMENT i. formulate income statements into common- size income statements; j. evaluate a company’s financial performance using common- size income state- ments and financial ratios based on the income statement; In this section, we apply two analytical tools to analyze the income statement: common- size analysis and income statement ratios. The objective of this analysis is to assess a company’s performance over a period of time—compared with its own past performance or the performance of another company. 15 Exhibit 14 (Continued) © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 63. Common-Size Analysis of the Income Statement 45 15.1 Common- Size Analysis of the Income Statement Common- size analysis of the income statement can be performed by stating each line item on the income statement as a percentage of revenue.33 Common- size statements facilitate comparison across time periods (time series analysis) and across companies (cross- sectional analysis) because the standardization of each line item removes the effect of size. To illustrate, Panel A of Exhibit 15 presents an income statement for three hypo- thetical companies in the same industry. Company A and Company B, each with $10 million in sales, are larger (as measured by sales) than Company C, which has only $2 million in sales. In addition, Companies A and B both have higher operating profit: $2 million and $1.5 million, respectively, compared with Company C’s operating profit of only $400,000. How can an analyst meaningfully compare the performance of these companies? By preparing a common- size income statement, as illustrated in Panel B, an analyst can readily see that the percentages of Company C’s expenses and profit relative to its sales are exactly the same as for Company A. Furthermore, although Company C’s operating profit is lower than Company B’s in absolute dollars, it is higher in percentage terms (20 percent for Company C compared with only 15 percent for Company B). For each $100 of sales, Company C generates $5 more operating profit than Company B. In other words, Company C is relatively more profitable than Company B based on this measure. The common- size income statement also highlights differences in companies’ strategies. Comparing the two larger companies, Company A reports significantly higher gross profit as a percentage of sales than does Company B (70 percent com- pared with 25 percent). Given that both companies operate in the same industry, why can Company A generate so much higher gross profit? One possible explanation is found by comparing the operating expenses of the two companies. Company A spends significantly more on research and development and on advertising than Company B. Expenditures on research and development likely result in products with superior technology. Expenditures on advertising likely result in greater brand awareness. So, based on these differences, it is likely that Company A is selling technologically supe- rior products with a better brand image. Company B may be selling its products more cheaply (with a lower gross profit as a percentage of sales) but saving money by not investing in research and development or advertising. In practice, differences across companies are more subtle, but the concept is similar. An analyst, noting significant differences, would do more research and seek to understand the underlying reasons for the differences and their implications for the future performance of the companies. Exhibit 15 Panel A: Income Statements for Companies A, B, and C ($) A B C Sales $10,000,000 $10,000,000 $2,000,000 Cost of sales 3,000,000 7,500,000 600,000 Gross profit 7,000,000 2,500,000 1,400,000 Selling, general, and administrative expenses 1,000,000 1,000,000 200,000 (continued) 33 This format can be distinguished as “vertical common- size analysis.” As the reading on financial state- ment analysis discusses, there is another type of common- size analysis, known as “horizontal common- size analysis,” that states items in relation to a selected base year value. Unless otherwise indicated, text references to “common- size analysis” refer to vertical analysis. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 64. Reading 17 ■ Understanding Income Statements 46 Panel A: Income Statements for Companies A, B, and C ($) A B C Research and development 2,000,000 — 400,000 Advertising 2,000,000 — 400,000 Operating profit 2,000,000 1,500,000 400,000 Panel B: Common- Size Income Statements for Companies A, B, and C (%) A B C Sales 100% 100% 100% Cost of sales 30 75 30 Gross profit 70 25 70 Selling, general, and administrative expenses 10 10 10 Research and development 20 0 20 Advertising 20 0 20 Operating profit 20 15 20 Note: Each line item is expressed as a percentage of the company’s sales. For most expenses, comparison to the amount of sales is appropriate. However, in the case of taxes, it is more meaningful to compare the amount of taxes with the amount of pretax income. Using note disclosure, an analyst can then examine the causes for differences in effective tax rates. To project the companies’ future net income, an analyst would project the companies’ pretax income and apply an estimated effective tax rate determined in part by the historical tax rates. Vertical common- size analysis of the income statement is particularly useful in cross- sectional analysis—comparing companies with each other for a particular time period or comparing a company with industry or sector data. The analyst could select individual peer companies for comparison, use industry data from published sources, or compile data from databases based on a selection of peer companies or broader industry data. For example, Exhibit 16 presents median common- size income state- ment data compiled for the components of the SP 500 classified into the 10 SP/ MSCI Global Industrial Classification System (GICS) sectors using 2017 data. Note that when compiling aggregate data such as this, some level of aggregation is neces- sary and less detail may be available than from peer company financial statements. The performance of an individual company can be compared with industry or peer company data to evaluate its relative performance. Exhibit 16 Median Common- Size Income Statement Statistics for the SP 500 Classified by SP/MSCI GICS Sector Data for 2017 Energy Materials Industrials Consumer Discretionary Consumer Staples Health Care Number of observations 34 27 69 81 34 59 Gross Margin 37.7% 33.0% 36.8% 37.6% 43.4% 59.0% Operating Margin 6.4% 14.9% 13.5% 11.0% 17.2% 17.4% Net Profit Margin 4.9% 9.9% 8.8% 6.0% 10.9% 7.2% Exhibit 15 (Continued) © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 65. Income Statement Ratios 47 Financials Information Technology Telecommunication Services Utilities Real Estate Number of observations 63 64 4 29 29 Gross Margin 40.5% 62.4% 56.4% 34.3% 39.8% Operating Margin 36.5% 21.1% 15.4% 21.7% 30.1% Net Profit Margin 18.5% 11.3% 13.1% 10.1% 21.3% Source: Based on data from Compustat. Operating margin based on EBIT (earnings before interest and taxes.) INCOME STATEMENT RATIOS j evaluate a company’s financial performance using common- size income state- ments and financial ratios based on the income statement; One aspect of financial performance is profitability. One indicator of profitability is net profit margin, also known as profit margin and return on sales, which is calculated as net income divided by revenue (or sales).34 Net profit margin Net income Revenue = Net profit margin measures the amount of income that a company was able to gen- erate for each dollar of revenue. A higher level of net profit margin indicates higher profitability and is thus more desirable. Net profit margin can also be found directly on the common- size income statements. For AB InBev, net profit margin based on continuing operations for 2017 was 16.2 percent (calculated as profit from continuing operations of $9,155 million, divided by revenue of $56,444 million). To judge this ratio, some comparison is needed. AB InBev’s profitability can be compared with that of another company or with its own previous performance. Compared with previous years, AB InBev’s profitability is higher than in 2016 but lower than 2015. In 2016, net profit margin based on continuing operations was 6.0 percent, and in 2015, it was 22.9 percent. Another measure of profitability is the gross profit margin. Gross profit (gross margin) is calculated as revenue minus cost of goods sold, and the gross profit margin is calculated as the gross profit divided by revenue. Gross profit margin Gross profit Revenue = The gross profit margin measures the amount of gross profit that a company gen- erated for each dollar of revenue. A higher level of gross profit margin indicates higher profitability and thus is generally more desirable, although differences in gross profit margins across companies reflect differences in companies’ strategies. For example, consider a company pursuing a strategy of selling a differentiated product (e.g., a product differentiated based on brand name, quality, superior technology, or patent protection). The company would likely be able to sell the differentiated product at a 16 Exhibit 16 (Continued) 34 In the definition of margin ratios of this type, “sales” is often used interchangeably with “revenue.” “Return on sales” has also been used to refer to a class of profitability ratios having revenue in the denominator. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 66. Reading 17 ■ Understanding Income Statements 48 higher price than a similar, but undifferentiated, product and, therefore, would likely show a higher gross profit margin than a company selling an undifferentiated product. Although a company selling a differentiated product would likely show a higher gross profit margin, this may take time. In the initial stage of the strategy, the company would likely incur costs to create a differentiated product, such as advertising or research and development, which would not be reflected in the gross margin calculation. AB InBev’s gross profit (shown in Exhibit 1) was $35,058 million in 2017, $27,715 million in 2016, and $26,467 million in 2015. Expressing gross profit as a percentage of revenues, we see that the gross profit margin was 62.1 percent in 2017, 60.9 percent in 2016, and 60.7 percent in 2015. In absolute terms, AB InBev’s gross profit was higher in 2016 than in 2015. However, AB InBev’s gross profit margin was approximately constant between 2015 and 2016. Exhibit 17 presents a common- size income statement for AB InBev, and highlights certain profitability ratios. The net profit margin and gross profit margin described above are just two of the many subtotals that can be generated from common- size income statements. Other “margins” used by analysts include the operating profit margin (profit from operations divided by revenue) and the pretax margin (profit before tax divided by revenue). Exhibit 17 AB InBev’s Margins: Abbreviated Common- Size Income Statement 12 Months Ended December 31 2017 2016 2015 $ % $ % $ % Revenue 56,444 100.0 45,517 100.0 43,604 100.0 Cost of sales (21,386) (37.9) (17,803) (39.1) (17,137) (39.3) Gross profit 35,058 62.1 27,715 60.9 26,467 60.7 Distribution expenses (5,876) (10.4) (4,543) (10.0) (4,259) (9.8) Sales and marketing expenses (8,382) (14.9) (7,745) (17.0) (6,913) (15.9) Administrative expenses (3,841) (6.8) (2,883) (6.3) (2,560) (5.9) Portions omitted Profit from operations 17,152 30.4 12,882 28.3 13,904 31.9 Finance cost (6,885) (12.2) (9,382) (20.6) (3,142) (7.2) Finance income 378 0.7 818 1.8 1,689 3.9 Net finance income/(cost) (6,507) (11.5) (8,564) (18.8) (1,453) (3.3) Share of result of associates and joint ventures 430 0.8 16 0.0 10 0.0 Profit before tax 11,076 19.6 4,334 9.5 12,461 28.6 Income tax expense (1,920) (3.4) (1,613) (3.5) (2,594) (5.9) Profit from continuing operations 9,155 16.2 2,721 6.0 9,867 22.6 Profit from discontinued operations 28 0.0 48 0.1 — — Profit of the year 9,183 16.3 2,769 6.1 9,867 22.6 The profitability ratios and the common- size income statement yield quick insights about changes in a company’s performance. For example, AB InBev’s decrease in profitability in 2016 was not driven by a decrease in gross profit margin. Gross profit margin in 2016 was actually slightly higher than in 2015. The company’s decrease in profitability in 2016 was driven in part by higher operating expenses and, in particular, © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 67. Comprehensive Income 49 by a significant increase in finance costs. The increased finance costs resulted from the 2016 merger with SABMiller. Valued at more than $100 billion, the acquisition was one of the largest in history. The combination of AB InBev and SABMiller also explains the increase in revenue from around $45 billion to over $56 billion. The profitability ratios and the common- size income statement thus serve to highlight areas about which an analyst might wish to gain further understanding. COMPREHENSIVE INCOME k describe, calculate, and interpret comprehensive income; l describe other comprehensive income and identify major types of items included in it. The general expression for net income is revenue minus expenses. There are, however, certain items of revenue and expense that, by accounting convention, are excluded from the net income calculation. To understand how reported shareholders’ equity of one period links with reported shareholders’ equity of the next period, we must understand these excluded items, known as other comprehensive income. Under IFRS, other comprehensive income includes items of income and expense that are “not recognized in profit or loss as required or permitted by other IFRS.” Total compre- hensive income is “the change in equity during a period resulting from transaction and other events, other than those changes resulting from transactions with owners in their capacity as owners.”35 Under US GAAP, comprehensive income is defined as “the change in equity [net assets] of a business enterprise during a period from transactions and other events and circumstances from non- owner sources. It includes all changes in equity during a period except those resulting from investments by owners and distributions to owners.”36 While the wording differs, comprehensive income is conceptually the same under IFRS and US GAAP. Comprehensive income includes both net income and other revenue and expense items that are excluded from the net income calculation (collectively referred to as Other Comprehensive Income). Assume, for example, a company’s beginning share- holders’ equity is €110 million, its net income for the year is €10 million, its cash dividends for the year are €2 million, and there was no issuance or repurchase of common stock. If the company’s actual ending shareholders’ equity is €123 million, then €5 million [€123 – (€110 + €10 – €2)] has bypassed the net income calculation by being classified as other comprehensive income. If the company had no other comprehensive income, its ending shareholders’ equity would have been €118 million [€110 + €10 – €2]. Four types of items are treated as other comprehensive income under both IFRS and US GAAP. (The specific treatment of some of these items differs between the two sets of standards, but these types of items are common to both.) ■ ■ Foreign currency translation adjustments. In consolidating the financial state- ments of foreign subsidiaries, the effects of translating the subsidiaries’ balance sheet assets and liabilities at current exchange rates are included as other com- prehensive income. 17 35 IAS 1, Presentation of Financial Statements. 36 FASB ASC Section 220- 10- 05 [Comprehensive Income–Overall–Overview and Background]. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 68. Reading 17 ■ Understanding Income Statements 50 ■ ■ Unrealized gains or losses on derivatives contracts accounted for as hedges. Changes in the fair value of derivatives are recorded each period, but certain changes in value are treated as other comprehensive income and thus bypass the income statement. ■ ■ Unrealized holding gains and losses on a certain category of investment secu- rities, namely, available- for- sale debt securities under US GAAP and securities designated as “fair value through other comprehensive income” under IFRS. (Note: IFRS, but not US GAAP, also includes a category of equity investments designated at fair value through other comprehensive income.) ■ ■ Certain costs of a company’s defined benefit post- retirement plans that are not recognized in the current period. In addition, under IFRS, other comprehensive income includes certain changes in the value of long- lived assets that are measured using the revaluation model rather than the cost model. Also, under IFRS, companies are not permitted to reclassify certain items of other comprehensive income to profit or loss, and companies must present separately the items of other comprehensive income that will and will not be reclassified subsequently to profit or loss. The third type of item listed above is perhaps the simplest to illustrate. Holding gains on securities arise when a company owns securities over an accounting period, during which time the securities’ value increases. Similarly, holding losses on securities arise when a company owns securities over a period during which time the securities’ value decreases. If the company has not sold the securities (i.e., has not realized the gain or loss), its holding gain or loss is said to be unrealized. The question is: Should the company exclude unrealized gains and losses from income; reflect these unrealized holding gains and losses in its income statement (i.e., statement of profit and loss); or reflect these unrealized holding gains as other comprehensive income? According to accounting standards, the answer depends on how the company has categorized the securities. Categorization depends on what the company intends to do with the securities (i.e., the business model for managing the asset) and on the cash flows of the security. Unrealized gains and losses are excluded from income for debt securities that the company intends to hold to maturity. These held- to- maturity debt securities are reported at their amortized cost, so no unrealized gains or losses are reported. For other securities reported at fair value, the unrealized gains or losses are reflected either in the income statement or as other comprehensive income. Under US GAAP, unrealized gains and losses are reflected in the income state- ment for: (a) debt securities designated as trading securities; and (b) all investments in equity securities (other than investments giving rise to ownership positions that confer significant influence over the investee). The trading securities category pertains to a debt security that is acquired with the intent of selling it rather than holding it to collect the interest and principal payments. Also, under US GAAP, unrealized gains and losses are reflected as other comprehensive income for debt securities designated as available-for-sale securities. Available- for- sale debt securities are those not des- ignated as either held- to- maturity or trading. Under IFRS, unrealized gains and losses are reflected in the income statement for: (a) investments in equity investments, unless the company makes an irrevocable election otherwise; and (b) debt securities, if the securities do not fall into the other measurement categories or if the company makes an irrevocable election to show gains and losses on the income statement. These debt and equity investments are referred to as being measured at fair value through profit or loss. Also under IFRS, unrealized gains and losses are reflected as other comprehensive income for: (a) “debt securities held within a business model whose objective is achieved both by collecting contractual cash flows and selling financial assets”; and (b) equity investments for which the company makes an irrevocable election at initial recognition to show gains © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 69. Comprehensive Income 51 and losses as part of other comprehensive income. These debt and equity investments are referred to as being measured at fair value through other comprehensive income. Accounting for these securities is similar to accounting for US GAAP’s available- for- sale debt securities. Even where unrealized holding gains and losses are excluded from a company’s net income (profit and loss), they are included in other comprehensive income and thus form a part of a company’s comprehensive income. EXAMPLE 14 Other Comprehensive Income Assume a company’s beginning shareholders’ equity is €200 million, its net income for the year is €20 million, its cash dividends for the year are €3 million, and there was no issuance or repurchase of common stock. The company’s actual ending shareholders’ equity is €227 million. 1 What amount has bypassed the net income calculation by being classified as other comprehensive income? A €0. B €7 million. C €10 million. 2 Which of the following statements best describes other comprehensive income? A Income earned from diverse geographic and segment activities. B Income that increases stockholders’ equity but is not reflected as part of net income. C Income earned from activities that are not part of the company’s ordi- nary business activities. Solution to 1: C is correct. If the company’s actual ending shareholders’ equity is €227 mil- lion, then €10 million [€227– (€200 + €20 – €3)] has bypassed the net income calculation by being classified as other comprehensive income. Solution to 2: B is correct. Answers A and C are not correct because they do not specify whether such income is reported as part of net income and shown in the income statement. EXAMPLE 15 Other Comprehensive Income in Analysis An analyst is looking at two comparable companies. Company A has a lower price/earnings (P/E) ratio than Company B, and the conclusion that has been suggested is that Company A is undervalued. As part of examining this con- clusion, the analyst decides to explore the question: What would the company’s P/E look like if total comprehensive income per share—rather than net income per share—were used as the relevant metric? © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 70. Reading 17 ■ Understanding Income Statements 52 Company A Company B Price $35 $30 EPS $1.60 $0.90 P/E ratio 21.9× 33.3× Other comprehensive income (loss) $ million ($16.272) $(1.757) Shares (millions) 22.6 25.1 Solution: As shown in the following table, part of the explanation for Company A’s lower P/E ratio may be that its significant losses—accounted for as other comprehensive income (OCI)—are not included in the P/E ratio. Company A Company B Price $35 $30 EPS $1.60 $0.90 OCI (loss) $ million ($16.272) $(1.757) Shares (millions) 22.6 25.1 OCI (loss) per share $(0.72) $(0.07) Comprehensive EPS = EPS + OCI per share $ 0.88 $0.83 Price/Comprehensive EPS ratio 39.8× 36.1× Both IFRS and US GAAP allow companies two alternative presentations. One alternative is to present two statements—a separate income statement and a second statement additionally including other comprehensive income. The other alternative is to present a single statement of other comprehensive income. Particularly in com- paring financial statements of two companies, it is relevant to examine significant differences in comprehensive income. SUMMARY This reading has presented the elements of income statement analysis. The income statement presents information on the financial results of a company’s business activities over a period of time; it communicates how much revenue the company generated during a period and what costs it incurred in connection with generating that revenue. A company’s net income and its components (e.g., gross margin, oper- ating earnings, and pretax earnings) are critical inputs into both the equity and credit analysis processes. Equity analysts are interested in earnings because equity markets often reward relatively high- or low- earnings growth companies with above- average or below- average valuations, respectively. Fixed- income analysts examine the com- ponents of income statements, past and projected, for information on companies’ abilities to make promised payments on their debt over the course of the business cycle. Corporate financial announcements frequently emphasize income statements more than the other financial statements. Key points to this reading include the following: ■ ■ The income statement presents revenue, expenses, and net income. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 71. Summary 53 ■ ■ The components of the income statement include: revenue; cost of sales; sales, general, and administrative expenses; other operating expenses; non- operating income and expenses; gains and losses; non- recurring items; net income; and EPS. ■ ■ An income statement that presents a subtotal for gross profit (revenue minus cost of goods sold) is said to be presented in a multi- step format. One that does not present this subtotal is said to be presented in a single- step format. ■ ■ Revenue is recognized in the period it is earned, which may or may not be in the same period as the related cash collection. Recognition of revenue when earned is a fundamental principal of accrual accounting. ■ ■ An analyst should identify differences in companies’ revenue recognition methods and adjust reported revenue where possible to facilitate comparabil- ity. Where the available information does not permit adjustment, an analyst can characterize the revenue recognition as more or less conservative and thus qualitatively assess how differences in policies might affect financial ratios and judgments about profitability. ■ ■ As of the beginning of 2018, revenue recognition standards have converged. The core principle of the converged standards is that revenue should be recognized to “depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in an exchange for those goods or services.” ■ ■ To achieve the core principle, the standard describes the application of five steps in recognizing revenue. The standard also specifies the treatment of some related contract costs and disclosure requirements. ■ ■ The general principles of expense recognition include a process to match expenses either to revenue (such as, cost of goods sold) or to the time period in which the expenditure occurs (period costs such as, administrative sala- ries) or to the time period of expected benefits of the expenditures (such as, depreciation). ■ ■ In expense recognition, choice of method (i.e., depreciation method and inventory cost method), as well as estimates (i.e., uncollectible accounts, warranty expenses, assets’ useful life, and salvage value) affect a company’s reported income. An analyst should identify differences in companies’ expense recognition methods and adjust reported financial statements where possible to facilitate comparability. Where the available information does not permit adjustment, an analyst can characterize the policies and estimates as more or less conservative and thus qualitatively assess how differences in policies might affect financial ratios and judgments about companies’ performance. ■ ■ To assess a company’s future earnings, it is helpful to separate those prior years’ items of income and expense that are likely to continue in the future from those items that are less likely to continue. ■ ■ Under IFRS, a company should present additional line items, headings, 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 company’s income statement. Under US GAAP, unusual and/ or infrequently occurring items, which are material, 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 statement reports separately the effect of the disposal of a component operation as a “dis- continued” operation. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 72. Reading 17 ■ Understanding Income Statements 54 ■ ■ Basic EPS is the amount of income available to common shareholders divided by the weighted average number of common shares outstanding over a period. The amount of income available to common shareholders is the amount of net income remaining after preferred dividends (if any) have been paid. ■ ■ If a company has a simple capital structure (i.e., one with no potentially dilutive securities), then its basic EPS is equal to its diluted EPS. If, however, a company has dilutive securities, its diluted EPS is lower than its basic EPS. ■ ■ Diluted EPS is calculated using the if- converted method for convertible securi- ties and the treasury stock method for options. ■ ■ Common- size analysis of the income statement involves stating each line item on the income statement as a percentage of sales. Common- size statements facilitate comparison across time periods and across companies of different sizes. ■ ■ Two income- statement- based indicators of profitability are net profit margin and gross profit margin. ■ ■ Comprehensive income includes both net income and other revenue and expense items that are excluded from the net income calculation. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 73. Practice Problems 55 PRACTICE PROBLEMS 1 Expenses on the income statement may be grouped by: A nature, but not by function. B function, but not by nature. C either function or nature. 2 An example of an expense classification by function is: A tax expense. B interest expense. C cost of goods sold. 3 Denali Limited, a manufacturing company, had the following income statement information: Revenue $4,000,000 Cost of goods sold $3,000,000 Other operating expenses $500,000 Interest expense $100,000 Tax expense $120,000 Denali’s gross profit is equal to: A $280,000. B $500,000. C $1,000,000. 4 Under IFRS, income includes increases in economic benefits from: A increases in liabilities not related to owners’ contributions. B enhancements of assets not related to owners’ contributions. C increases in owners’ equity related to owners’ contributions. 5 Fairplay had the following information related to the sale of its products during 2009, which was its first year of business: Revenue $1,000,000 Returns of goods sold $100,000 Cash collected $800,000 Cost of goods sold $700,000 Under the accrual basis of accounting, how much net revenue would be reported on Fairplay’s 2009 income statement? A $200,000. B $900,000. C $1,000,000. 6 Apex Consignment sells items over the internet for individuals on a consign- ment basis. Apex receives the items from the owner, lists them for sale on the internet, and receives a 25 percent commission for any items sold. Apex collects the full amount from the buyer and pays the net amount after commission to the owner. Unsold items are returned to the owner after 90 days. During 2009, Apex had the following information: © 2019 CFA Institute. All rights reserved. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 74. Reading 17 ■ Understanding Income Statements 56 ● ● Total sales price of items sold during 2009 on consignment was €2,000,000. ● ● Total commissions retained by Apex during 2009 for these items was €500,000. How much revenue should Apex report on its 2009 income statement? A €500,000. B €2,000,000. C €1,500,000. 7 A company previously expensed the incremental costs of obtaining a contract. All else being equal, adopting the May 2014 IASB and FASB converged account- ing standards on revenue recognition makes the company’s profitability initially appear: A lower. B unchanged. C higher. 8 During 2009, Accent Toys 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, Accent pur- chased 5,000 additional units in November at a cost of ₤11 per unit. During 2009, Accent sold 12,000 units at a price of ₤15 per unit. Under the first in, first out (FIFO) method, what is Accent’s cost of goods sold for 2009? A ₤120,000. B ₤122,000. C ₤124,000. 9 Using the same information as in Question 8, what would Accent’s cost of goods sold be under the weighted average cost method? A ₤120,000. B ₤122,000. C ₤124,000. 10 Which inventory method is least likely to be used under IFRS? A First in, first out (FIFO). B Last in, first out (LIFO). C Weighted average. 11 At the beginning of 2009, Glass Manufacturing purchased a new machine for its assembly line at a cost of $600,000. The machine has an estimated useful life of 10 years and estimated residual value of $50,000. Under the straight- line method, how much depreciation would Glass take in 2010 for financial report- ing purposes? A $55,000. B $60,000. C $65,000. 12 Using the same information as in Question 11, how much depreciation would Glass take in 2009 for financial reporting purposes under the double- declining balance method? A $60,000. B $110,000. C $120,000. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 75. Practice Problems 57 13 Which combination of depreciation methods and useful lives is most conserva- tive in the year a depreciable asset is acquired? A Straight- line depreciation with a short useful life. B Declining balance depreciation with a long useful life. C Declining balance depreciation with a short useful life. 14 Under IFRS, a loss from the destruction of property in a fire would most likely be classified as: A continuing operations. B discontinued operations. C other comprehensive income. 15 A company chooses to change an accounting policy. This change requires that, if practical, the company restate its financial statements for: A all prior periods. B current and future periods. C prior periods shown in a report. 16 For 2009, Flamingo Products had net income of $1,000,000. At 1 January 2009, there were 1,000,000 shares outstanding. On 1 July 2009, the company issued 100,000 new shares for $20 per share. The company paid $200,000 in dividends to common shareholders. What is Flamingo’s basic earnings per share for 2009? A $0.80. B $0.91. C $0.95. 17 For its fiscal year- end, Calvan Water Corporation (CWC) reported net income of $12 million and a weighted average of 2,000,000 common shares outstanding. The company paid $800,000 in preferred dividends and had 100,000 options outstanding with an average exercise price of $20. CWC’s market price over the year averaged $25 per share. CWC’s diluted EPS is closest to: A $5.33. B $5.54. C $5.94. 18 A company with no debt or convertible securities issued publicly traded com- mon stock three times during the current fiscal year. Under both IFRS and US GAAP, the company’s: A basic EPS equals its diluted EPS. B capital structure is considered complex at year- end. C basic EPS is calculated by using a simple average number of shares outstanding. 19 Laurelli Builders (LB) reported the following financial data for year- end 31 December: Common shares outstanding, 1 January 2,020,000 Common shares issued as stock dividend, 1 June 380,000 Warrants outstanding, 1 January 500,000 Net income $3,350,000 Preferred stock dividends paid $430,000 Common stock dividends paid $240,000 Which statement about the calculation of LB’s EPS is most accurate? © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 76. Reading 17 ■ Understanding Income Statements 58 A LB’s basic EPS is $1.12. B LB’s diluted EPS is equal to or less than its basic EPS. C The weighted average number of shares outstanding is 2,210,000. 20 Cell Services Inc. (CSI) had 1,000,000 average shares outstanding during all of 2009. During 2009, CSI also had 10,000 options outstanding with exercise prices of $10 each. The average stock price of CSI during 2009 was $15. For pur- poses of computing diluted earnings per share, how many shares would be used in the denominator? A 1,003,333. B 1,006,667. C 1,010,000. 21 For its fiscal year- end, Sublyme Corporation reported net income of $200 mil- lion and a weighted average of 50,000,000 common shares outstanding. There are 2,000,000 convertible preferred shares outstanding that paid an annual div- idend of $5. Each preferred share is convertible into two shares of the common stock. The diluted EPS is closest to: A $3.52. B $3.65. C $3.70. 22 When calculating diluted EPS, which of the following securities in the capital structure increases the weighted average number of common shares outstand- ing without affecting net income available to common shareholders? A Stock options B Convertible debt that is dilutive C Convertible preferred stock that is dilutive 23 Which statement is most accurate? A common size income statement: A restates each line item of the income statement as a percentage of net income. B allows an analyst to conduct cross- sectional analysis by removing the effect of company size. C standardizes each line item of the income statement but fails to help an analyst identify differences in companies’ strategies. 24 Selected year- end financial statement data for Workhard are shown below. $ millions Beginning shareholders’ equity 475 Ending shareholders’ equity 493 Unrealized gain on available- for- sale securities 5 Unrealized loss on derivatives accounted for as hedges –3 Foreign currency translation gain on consolidation 2 Dividends paid 1 Net income 15 Workhard’s comprehensive income for the year: A is $18 million. B is increased by the derivatives accounted for as hedges. C includes $4 million in other comprehensive income. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 77. Practice Problems 59 25 When preparing an income statement, which of the following items would most likely be classified as other comprehensive income? A A foreign currency translation adjustment B An unrealized gain on a security held for trading purposes C A realized gain on a derivative contract not accounted for as a hedge © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 78. Reading 17 ■ Understanding Income Statements 60 SOLUTIONS 1 C is correct. IAS No. 1 states that expenses may be categorized by either nature or function. 2 C is correct. Cost of goods sold is a classification by function. The other two expenses represent classifications by nature. 3 C is correct. Gross margin is revenue minus cost of goods sold. Answer A rep- resents net income and B represents operating income. 4 B is correct. Under IFRS, income includes increases in economic benefits from increases in assets, enhancement of assets, and decreases in liabilities. 5 B is correct. Net revenue is revenue for goods sold during the period less any returns and allowances, or $1,000,000 minus $100,000 = $900,000. 6 A is correct. Apex is not the owner of the goods and should only report its net commission as revenue. 7 C is correct. Under the converged accounting standards, the incremental costs of obtaining a contract and certain costs incurred to fulfill a contract must be capitalized. If a company expensed these incremental costs in the years prior to adopting the converged standards, all else being equal, its profitability will appear higher under the converged standards. 8 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. 9 C is correct. Under the weighted average cost method: October purchases 10,000 units $100,000 November purchases 5,000 units $55,000 Total 15,000 units $155,000 $155,000/15,000 units = $10.3333 $10.3333 × 12,000 units = $124,000 10 B is correct. The last in, first out (LIFO) method is not permitted under IFRS. The other two methods are permitted. 11 A is correct. Straight- line depreciation would be ($600,000 – $50,000)/10, or $55,000. 12 C is correct. Double- declining balance depreciation would be $600,000 × 20 percent (twice the straight- line rate). The residual value is not subtracted from the initial book value to calculate depreciation. However, the book value (carrying amount) of the asset will not be reduced below the estimated residual value. 13 C is correct. This would result in the highest amount of depreciation in the first year and hence the lowest amount of net income relative to the other choices. 14 A is correct. A fire may be infrequent, but it would still be part of continuing operations and reported in the profit and loss statement. Discontinued opera- tions relate to a decision to dispose of an operating division. 15 C is correct. If a company changes an accounting policy, the financial state- ments for all fiscal years shown in a company’s financial report are presented, if practical, as if the newly adopted accounting policy had been used through- out the entire period; this retrospective application of the change makes the © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 79. Solutions 61 financial results of any prior years included in the report comparable. Notes to the financial statements describe the change and explain the justification for the change. 16 C is correct. The weighted average number of shares outstanding for 2009 is 1,050,000. Basic earnings per share would be $1,000,000 divided by 1,050,000, or $0.95. 17 B is correct. The formula to calculate diluted EPS is as follows: Diluted EPS = (Net income – Preferred dividends)/[Weighted average number of shares outstanding + (New shares that would have been issued at option exercise – Shares that could have been purchased with cash received upon exercise) × (Proportion of year during which the financial instruments were outstanding)]. The underlying assumption is that outstanding options are exercised, and then the proceeds from the issuance of new shares are used to repurchase shares already outstanding: Proceeds from option exercise = 100,000 × $20 = $2,000,000 Shares repurchased = $2,000,000/$25 = 80,000 The net increase in shares outstanding is thus 100,000 – 80,000 = 20,000. Therefore, the diluted EPS for CWC = ($12,000,000 – $800,000)/2,020,000 = $5.54. 18 A is correct. Basic and diluted EPS are equal for a company with a simple capital structure. A company that issues only common stock, with no financial instruments that are potentially convertible into common stock has a simple capital structure. Basic EPS is calculated using the weighted average number of shares outstanding. 19 B is correct. LB has warrants in its capital structure; if the exercise price is less than the weighted average market price during the year, the effect of their conversion is to increase the weighted average number of common shares out- standing, 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 calcula- tion of basic EPS. LB’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. 20 A is correct. With stock options, the treasury stock method must be used. Under that method, the company would receive $100,000 (10,000 × $10) and would repurchase 6,667 shares ($100,000/$15). The shares for the denominator would be: Shares outstanding 1,000,000 Options exercises 10,000 Treasury shares purchased (6,667) Denominator 1,003,333 © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 80. Reading 17 ■ Understanding Income Statements 62 21 C is correct. Diluted EPS = (Net income)/(Weighted average number of shares out- standing + New common shares that would have been issued at conversion) = $200,000,000/[50,000,000 + (2,000,000 × 2)] = $3.70 The diluted EPS assumes that the preferred dividend is not paid and that the shares are converted at the beginning of the period. 22 A is correct. When a company has stock options outstanding, diluted EPS is calculated as if the financial instruments had been exercised and the company had used the proceeds from the exercise to repurchase as many shares possible at the weighted average market price of common stock during the period. As a result, the conversion of stock options increases the number of common shares outstanding but has no effect on net income available to common sharehold- ers. The conversion of convertible debt increases the net income available to common shareholders by the after- tax amount of interest expense saved. The conversion of convertible preferred shares increases the net income available to common shareholders by the amount of preferred dividends paid; the numera- tor becomes the net income. 23 B is correct. Common size income statements facilitate comparison across time periods (time- series analysis) and across companies (cross- sectional analysis) by stating each line item of the income statement as a percentage of revenue. The relative performance of different companies can be more easily assessed because scaling the numbers removes the effect of size. A 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. 24 C is correct. Comprehensive income includes both net income and other com- prehensive income. Other comprehensive income = Unrealized gain on available- for- sale securities – Unrealized loss on derivatives accounted for as hedges + Foreign currency translation gain on consolidation = $5 million – $3 million + $2 million = $4 million Alternatively, Comprehensive income – Net income = Other comprehensive income Comprehensive income = (Ending shareholders equity – Beginning share- holders equity) + Dividends = ($493 million – $475 million) + $1 million = $18 million + $1 million = $19 million Net income is $15 million so other comprehensive income is $4 million. 25 A is correct. Other comprehensive income includes items that affect sharehold- ers’ equity but are not reflected in the company’s income statement. In consoli- dating the financial statements of foreign subsidiaries, the effects of translating the subsidiaries’ balance sheet assets and liabilities at current exchange rates are included as other comprehensive income. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 81. Understanding Balance Sheets by Elaine Henry, PhD, CFA, and Thomas R. Robinson, PhD, CFA Elaine Henry, PhD, CFA, is at Stevens Institute of Technology (USA). Thomas R. Robinson, PhD, CFA, is at AACSB International (USA). LEARNING OUTCOMES Mastery The candidate should be able to: a. describe the elements of the balance sheet: assets, liabilities, and equity; b. describe uses and limitations of the balance sheet in financial analysis; c. describe alternative formats of balance sheet presentation; d. contrast current and non- current assets and current and non- current liabilities; e. describe different types of assets and liabilities and the measurement bases of each; f. describe the components of shareholders’ equity; g. demonstrate the conversion of balance sheets to common- size balance sheets and interpret common- size balance sheets; h. calculate and interpret liquidity and solvency ratios. R E A D I N G 18 © 2019 CFA Institute. All rights reserved. Note: Changes in accounting standards as well as new rulings and/or pronouncements issued after the publication of the readings on financial reporting and analysis may cause some of the information in these readings to become dated. Candidates are not responsible for anything that occurs after the readings were published. In addition, candidates are expected to be familiar with the analytical frameworks contained in the readings, as well as the implications of alternative accounting methods for financial analysis and valuation discussed in the readings. Candidates are also responsible for the content of accounting standards, but not for the actual reference numbers. Finally, candidates should be aware that certain ratios may be defined and calculated differently. When alternative ratio definitions exist and no specific definition is given, candidates should use the ratio definitions emphasized in the readings. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 82. Reading 18 ■ Understanding Balance Sheets 64 INTRODUCTION AND COMPONENTS OF THE BALANCE SHEET a describe the elements of the balance sheet: assets, liabilities, and equity b describe uses and limitations of the balance sheet in financial analysis; The balance sheet provides information on a company’s resources (assets) and its sources of capital (equity and liabilities/debt). This information helps an analyst assess a company’s ability to pay for its near- term operating needs, meet future debt obliga- tions, and make distributions to owners. The basic equation underlying the balance sheet is Assets = Liabilities + Equity. Analysts should be aware that different types of assets and liabilities may be measured differently. For example, some items are measured at historical cost or a variation thereof and others at fair value.1 An understanding of the measurement issues will facilitate analysis. The balance sheet measurement issues are, of course, closely linked to the revenue and expense recognition issues affecting the income statement. Throughout this reading, we describe and illustrate some of the linkages between the measurement issues affecting the balance sheet and the revenue and expense recognition issues affecting the income statement. This reading is organized as follows: In Sections 1–3, we describe and give examples of the elements and formats of balance sheets. Sections 4–6 discuss current assets and current liabilities. Sections 7–11 focus on assets, and Section 12 focuses on liabilities. Sections 13–14 describe the components of equity and illustrates the statement of changes in shareholders’ equity. Sections 15–16 introduce balance sheet analysis. A summary of the key points and practice problems in the CFA Institute multiple- choice format conclude the reading. 1.1 Components and Format of the Balance Sheet The balance sheet (also called the statement of financial position or statement of financial condition) discloses what an entity owns (or controls), what it owes, and what the owners’ claims are at a specific point in time.2 The financial position of a company is described in terms of its basic elements (assets, liabilities, and equity): ■ ■ Assets (A) are what the company owns (or controls). More formally, assets are resources controlled by the company as a result of past events and from which future economic benefits are expected to flow to the entity. ■ ■ Liabilities (L) are what the company owes. More formally, liabilities represent obligations of a company arising from past events, the settlement of which is expected to result in a future outflow of economic benefits from the entity. ■ ■ Equity (E) represents the owners’ residual interest in the company’s assets after deducting its liabilities. Commonly known as shareholders’ equity or owners’ equity, equity is determined by subtracting the liabilities from the assets of a company, giving rise to the accounting equation: A – L = E or A = L + E. 1 1 IFRS and US GAAP define “fair value” as an exit price, i.e., the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (IFRS 13, FASB ASC Topic 820). 2 IFRS uses the term “statement of financial position” (IAS 1 Presentation of Financial Statements), and US GAAP uses the terms “balance sheet” and “statement of financial position” interchangeably (ASC 210- 10- 05 [Balance Sheet–Overall–Overview and Background]). © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 83. Introduction and Components of the Balance Sheet 65 The equation A = L + E is sometimes summarized as follows: The left side of the equation reflects the resources controlled by the company and the right side reflects how those resources were financed. For all financial statement items, an item should only be recognized in the financial statements if it is probable that any future economic benefit associated with the item will flow to or from the entity and if the item has a cost or value that can be measured with reliability.3 The balance sheet provides important information about a company’s financial condition, but the balance sheet amounts of equity (assets, net of liabilities) should not be viewed as a measure of either the market or intrinsic value of a company’s equity for several reasons. First, the balance sheet under current accounting standards is a mixed model with respect to measurement. Some assets and liabilities are measured based on historical cost, sometimes with adjustments, whereas other assets and lia- bilities are measured based on a fair value, which represents its current value as of the balance sheet date. The measurement bases may have a significant effect on the amount reported. Second, even the items measured at current value reflect the value that was current at the end of the reporting period. The values of those items obvi- ously can change after the balance sheet is prepared. Third, the value of a company is a function of many factors, including future cash flows expected to be generated by the company and current market conditions. Important aspects of a company’s ability to generate future cash flows—for example, its reputation and management skills—are not included in its balance sheet. 1.2 Balance Sheet Components To illustrate the components and formats of balance sheets, we show the major sub- totals from two companies’ balance sheets. Exhibit 1 and Exhibit 2 are based on the balance sheets of SAP Group and Apple Inc. SAP Group is a leading business software company based in Germany and prepares its financial statements in accordance with IFRS. Apple is a technology manufacturer based in the United States and prepares its financial statements in accordance with US GAAP. For purposes of discussion, Exhibits 1 and 2 show only the main subtotals and totals of these companies’ balance sheets. Additional exhibits throughout this reading will expand on these subtotals. Exhibit 1 SAP Group Consolidated Statements of Financial Position (Excerpt) (in millions of €) 31 December Assets 2017 2016* Total current assets 11,930 11,564 Total non- current assets 30,567 32,713 Total assets 42,497 44,277 Equity and liabilities Total current liabilities 10,210 9,675 Total non- current liabilities 6,747 8,205 Total liabilities 16,957 17,880 (continued) 3 Conceptual Framework for Financial Reporting (2018). © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 84. Reading 18 ■ Understanding Balance Sheets 66 31 December Assets 2017 2016* Total equity 25,540 26,397 Equity and liabilities 42,497 44,277 Source: SAP Group 2017 annual report. Notes: Numbers exactly from the annual report as prepared by the company, which reflects some rounding. * Numbers are the reclassified numbers from the SAP Group 2017 annual report. Exhibit 2 Apple Inc. Consolidated Balance Sheets (Excerpt)* (in millions of $) Assets 30 September 2017 24 September 2016 Total current assets 128,645 106,869 [All other assets] 246,674 214,817 Total assets 375,319 321,686 Liabilities and shareholders’ equity Total current liabilities 100,814 79,006 [Total non- current liabilities] 140,458 114,431 Total liabilities 241,272 193,437 Total shareholders’ equity 134,047 128,249 Total liabilities and shareholders’ equity 375,319 321,686 *Note: The italicized subtotals presented in this excerpt are not explicitly shown on the face of the financial statement as prepared by the company. Source: Apple Inc. 2017 annual report (Form 10K). SAP Group uses the title Statement of Financial Position and Apple uses the title Balance Sheet. Despite their different titles, both statements report the three basic elements: assets, liabilities, and equity. Both companies are reporting on a consolidated basis, i.e., including all their controlled subsidiaries. The numbers in SAP Group’s balance sheet are in millions of euro, and the numbers in Apple’s balance sheet are in millions of dollars. Balance sheet information is as of a specific point in time. These exhibits are from the companies’ annual financial statements, so the balance sheet information is as of the last day of their respective fiscal years. SAP Group’s fiscal year is the same as the calendar year and the balance sheet information is as of 31 December. Apple’s fiscal year ends on the last Saturday of September, so the actual date changes from year to year. About every six years, Apple’s fiscal year will include 53 weeks rather than 52 weeks. This feature of Apple’s fiscal year should be noted, but in general, the extra week is more relevant to evaluating statements spanning a period of time (the income and cash flow statements) rather than the balance sheet which captures information as of a specific point in time. Exhibit 1 (Continued) © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 85. Current and Non-Current Classification 67 A company’s ability to pay for its short term operating needs relates to the concept of liquidity. With respect to a company overall, liquidity refers to the availability of cash to meet those short- term needs. With respect to a particular asset or liability, liquidity refers to its “nearness to cash.” A liquid asset is one that can be easily converted into cash in a short period of time at a price close to fair market value. For example, a small holding of an actively traded stock is much more liquid than an investment in an asset such as a commercial real estate property, particularly in a weak property market. The separate presentation of current and non- current assets and liabilities facilitates analysis of a company’s liquidity position (at least as of the end of the fiscal period). Both IFRS and US GAAP require that the balance sheet distinguish between current and non- current assets and between current and non- current liabilities and present these as separate classifications. An exception to this requirement, under IFRS, is that the current and non- current classifications are not required if a liquidity- based presentation provides reliable and more relevant information. Presentations distin- guishing between current and non- current elements are shown in Exhibits 1 and 2. Exhibit 3 in Section 3 shows a liquidity- based presentation. CURRENT AND NON-CURRENT CLASSIFICATION c describe alternative formats of balance sheet presentation d contrast current and non- current assets and current and non- current liabilities Assets that are held primarily for the purpose of trading or that are expected to be sold, used up, or otherwise realized in cash within one year or one operating cycle of the business, whichever is greater, after the reporting period are classified as cur- rent assets. A company’s operating cycle is the average amount of time that elapses between acquiring inventory and collecting the cash from sales to customers. (When the entity’s normal operating cycle is not clearly identifiable, its duration is assumed to be one year.) For a manufacturer, the operating cycle is the average amount of time between acquiring raw materials and converting these into cash from a sale. Examples of companies that might be expected to have operating cycles longer than one year include those operating in the tobacco, distillery, and lumber industries. Even though these types of companies often hold inventories longer than one year, the inventory is classified as a current asset because it is expected to be sold within an operating cycle. Assets not expected to be sold or used up within one year or one operating cycle of the business, whichever is greater, are classified as non-current assets (long-term, long-lived assets). Current assets are generally maintained for operating purposes, and these assets include—in addition to cash—items expected to be converted into cash (e.g., trade receivables), used up (e.g., office supplies, prepaid expenses), or sold (e.g., invento- ries) in the current operating cycle. Current assets provide information about the operating activities and the operating capability of the entity. For example, the item “trade receivables” or “accounts receivable” would indicate that a company provides credit to its customers. Non- current assets represent the infrastructure from which the entity operates and are not consumed or sold in the current period. Investments in such assets are made from a strategic and longer term perspective. Similarly, liabilities expected to be settled within one year or within one operating cycle of the business, whichever is greater, after the reporting period are classified as current liabilities. The specific criteria for classification of a liability as current include the following: ■ ■ It is expected to be settled in the entity’s normal operating cycle; 2 © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 86. Reading 18 ■ Understanding Balance Sheets 68 ■ ■ It is held primarily for the purpose of being traded;4 ■ ■ It is due to be settled within one year after the balance sheet date; or ■ ■ The entity does not have an unconditional right to defer settlement of the liabil- ity for at least one year after the balance sheet date.5 IFRS specify that some current liabilities, such as trade payables and some accruals for employee and other operating costs, are part of the working capital used in the entity’s normal operating cycle. Such operating items are classified as current liabil- ities even if they will be settled more than one year after the balance sheet date. All other liabilities are classified as non-current liabilities. Non- current liabilities include financial liabilities that provide financing on a long- term basis. The excess of current assets over current liabilities is called working capital. The level of working capital provides analysts with information about the ability of an entity to meet liabilities as they fall due. Although adequate working capital is essential, excessive working capital should be so that funds that could be used more productively elsewhere are not inappropriately tied up. A balance sheet with separately classified current and non- current assets and lia- bilities is referred to as a classified balance sheet. Classification also refers generally to the grouping of accounts into subcategories. Both companies’ balance sheets that are summarized in Exhibits 1 and 2 are classified balance sheets. Although both com- panies’ balance sheets present current assets before non- current assets and current liabilities before non- current liabilities, this is not required. IFRS does not specify the order or format in which a company presents items on a current/non- current classified balance sheet. LIQUIDITY-BASED PRESENTATION c describe alternative formats of balance sheet presentation A liquidity- based presentation, rather than a current/non- current presentation, is used when such a presentation provides information that is reliable and more relevant. With a liquidity- based presentation, all assets and liabilities are presented broadly in order of liquidity. Entities such as banks are candidates to use a liquidity- based presentation. Exhibit 3 presents the assets portion of the balance sheet of HSBC Holdings plc (HSBC), a global financial services company that reports using IFRS. HSBC’s balance sheet is ordered using a liquidity- based presentation. As shown, the asset section begins with cash and balances at central banks. Less liquid items such as “Interest in associates and joint ventures” appear near the bottom of the asset listing. 3 4 Examples of these are financial liabilities classified as held for trading in accordance with IAS 39, which is replaced by IFRS 9 effective for periods beginning on or after 1 January 2018. 5 IAS 1, Presentation of Financial Statements, paragraph 69. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 87. Current Assets: Cash and Cash Equivalents, Marketable Securities and Trade Receivables 69 Exhibit 3 HSBC Holdings plc Consolidated Statement of Financial Position (Excerpt: Assets Only) as of 31 December (in millions of US $) Consolidated balance sheet - USD ($) $ in Millions Dec. 31, 2017 Dec. 31, 2016 Assets Cash and balances at central banks $180,624 $128,009 Items in the course of collection from other banks 6,628 5,003 Hong Kong Government certificates of indebtedness 34,186 31,228 Trading assets 287,995 235,125 Financial assets designated at fair value 29,464 24,756 Derivatives 219,818 290,872 Loans and advances to banks 90,393 88,126 Loans and advances to customers 962,964 861,504 Reverse repurchase agreements – non- trading 201,553 160,974 Financial investments 389,076 436,797 Prepayments, accrued income and other assets 67,191 63,909 Current tax assets 1,006 1,145 Interests in associates and joint ventures 22,744 20,029 Goodwill and intangible assets 23,453 21,346 Deferred tax assets 4,676 6,163 Total assets 2,521,771 2,374,986 Source: HSBC Holdings plc 2017 Annual Report and Accounts. CURRENT ASSETS: CASH AND CASH EQUIVALENTS, MARKETABLE SECURITIES AND TRADE RECEIVABLES e describe different types of assets and liabilities and the measurement bases of each This section examines current assets and current liabilities in greater detail. 4.1 Current Assets Accounting standards require that certain specific line items, if they are material, must be shown on a balance sheet. Among the current assets’ required line items are cash and cash equivalents, trade and other receivables, inventories, and financial assets (with short maturities). Companies present other line items as needed, consistent with the requirements to separately present each material class of similar items. As examples, Exhibit 4 and Exhibit 5 present balance sheet excerpts for SAP Group and Apple Inc. showing the line items for the companies’ current assets. 4 © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 88. Reading 18 ■ Understanding Balance Sheets 70 Exhibit 4 SAP Group Consolidated Statements of Financial Position (Excerpt: Current Assets Detail) (in millions of €) As of 31 December Assets 2017 2016 Cash and cash equivalents €4,011 €3,702 Other financial assets 990 1,124 Trade and other receivables 5,899 5,924 Other non- financial assets 725 581 Tax assets 306 233 Total current assets 11,930 11,564 Total non- current assets 30,567 32,713 Total assets 42,497 44,277 Total current liabilities 10,210 9,674 Total non- current liabilities 6,747 8,205 Total liabilities 16,958 17,880 Total equity 25,540 26,397 Total equity and liabilities €42,497 €44,277 Source: SAP Group 2017 annual report. Exhibit 5 Apple Inc. Consolidated Balance Sheet (Excerpt: Current Assets Detail) * (in millions of $) Assets 30 September, 2017 24 September, 2016 Cash and cash equivalents $20,289 $20,484 Short- term marketable securities 53,892 46,671 Accounts receivable, less allowances of $58 and $53, respectively 17,874 15,754 Inventories 4,855 2,132 Vendor non- trade receivables 17,799 13,545 Other current assets 13,936 8,283 Total current assets 128,645 106,869 [All other assets] 246,674 214,817 Total assets 375,319 321,686 Total current liabilities 100,814 79,006 [Total non- current liabilities] 140,458 114,431 Total liabilities 241,272 193,437 © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 89. Current Assets: Cash and Cash Equivalents, Marketable Securities and Trade Receivables 71 Assets 30 September, 2017 24 September, 2016 Total shareholders’ equity 134,047 128,249 Total liabilities and shareholders’ equity $375,319 $321,686 *Note: The italicized subtotals presented in this excerpt are not explicitly shown on the face of the financial statement as prepared by the company. Source: Apple Inc. 2017 annual report (Form 10K). 4.1.1 Cash and Cash Equivalents Cash equivalents are highly liquid, short- term investments that are so close to maturity,6 the risk is minimal that their value will change significantly with changes in interest rates. Cash and cash equivalents are financial assets. Financial assets, in general, are measured and reported at either amortised cost or fair value. Amortised cost is the historical cost (initially recognised cost) of the asset adjusted for amortisation and impairment. Under IFRS and US GAAP, fair value is based on an exit price, the price received to sell an asset or paid to transfer a liability in an orderly transaction between two market participants at the measurement date. For cash and cash equivalents, amortised cost and fair value are likely to be immaterially different. Examples of cash equivalents are demand deposits with banks and highly liquid investments (such as US Treasury bills, commercial paper, and money market funds) with original maturities of three months or less. Cash and cash equivalents excludes amounts that are restricted in use for at least 12 months. For all companies, the Statement of Cash Flows presents information about the changes in cash over a period. For the fiscal year 2017, SAP Group’s cash and cash equivalents increased from €3,702 million to €4,011 million, and Apple’s cash and cash equivalents decreased from $20,484 million to $20,289 million. 4.1.2 Marketable Securities Marketable securities are also financial assets and include investments in debt or equity securities that are traded in a public market, and whose value can be determined from price information in a public market. Examples of marketable securities include treasury bills, notes, bonds, and equity securities, such as common stocks and mutual fund shares. Companies disclose further detail in the notes to their financial statements about their holdings. For example, SAP Group discloses that its other financial assets consist of items such as time deposits, other receivables, and loans to employees and third parties. These do not fall into marketable securities and thus are more properly treated under trade receivables. Apple’s short- term marketable securities, totaling $53.9 billion and $46.7 billion at the end of fiscal 2017 and 2016, respectively, include holdings of US treasuries, corporate securities, commercial paper, and time deposits. Financial assets such as investments in debt and equity securities involve a variety of measurement issues and will be addressed in Section 10. Exhibit 5 (Continued) 6 Generally, three months or less. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 90. Reading 18 ■ Understanding Balance Sheets 72 4.1.3 Trade Receivables Trade receivables, also referred to as accounts receivable, are another type of financial asset. These are amounts owed to a company by its customers for products and services already delivered. They are typically reported at net realizable value, an approximation of fair value, based on estimates of collectability. Several aspects of accounts receivable are usually relevant to an analyst. First, the overall level of accounts receivable relative to sales (a topic to be addressed further in ratio analysis) is important because a sig- nificant increase in accounts receivable relative to sales could signal that the company is having problems collecting cash from its customers. A second relevant aspect of accounts receivable is the allowance for doubtful accounts. The allowance for doubtful accounts reflects the company’s estimate of the amount of receivables that will ultimately be uncollectible. Additions to the allow- ance in a particular period are reflected as bad debt expenses, and the balance of the allowance for doubtful accounts reduces the gross receivables amount to a net amount that is an estimate of net realizable value. When specific receivables are deemed to be uncollectible, they are written off by reducing accounts receivable and the allowance for doubtful accounts. The allowance for doubtful accounts is called a contra account because it is netted against (i.e., reduces) the balance of accounts receivable, which is an asset account. SAP Group’s balance sheet, for example, reports current net trade and other receivables of €5,899 million as of 31 December 2017. The amount of the allowance for doubtful accounts (€74 million) is disclosed in the notes7 to the financial statements. Apple discloses the allowance for doubtful accounts on the face of the balance sheet; as of 30 September 2017, the allowance was $58 million. The $17,874 million of accounts receivable on that date is net of the allowance. Apple’s disclosures state that the allowance is based on “historical experience, the age of the accounts receivable balances, credit quality of the Company’s customers, current economic conditions, and other factors that may affect customers’ abilities to pay.” The age of an accounts receivable balance refers to the length of time the receivable has been outstanding, including how many days past the due date. Another relevant aspect of accounts receivable is the concentration of credit risk. For example, SAP Group’s annual report discloses that concentration of credit risk is limited because they have a large customer base diversified across various industries, company sizes, and countries. Similarly, Apple’s annual report notes that no single customer accounted for 10 percent or more of its revenues. However, Apple’s disclo- sures for 2017 indicate that two customers individually represented 10% or more of its total trade receivables and its cellular network carriers accounted for 59% of trade receivables. Of its vendor non- trade receivables, three vendors represent 42%, 19%, and 10% of the total. 8 EXAMPLE 1 Analysis of Accounts Receivable 1 Based on the balance sheet excerpt for Apple Inc. in Exhibit 5, what percentage of its total accounts receivable in 2017 and 2016 does Apple estimate will be uncollectible? 7 Note 13 SAP Group 2017 Annual report 8 Page 53, Apple Inc 2017 10- K © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 91. Current Assets: Cash and Cash Equivalents, Marketable Securities and Trade Receivables 73 2 In general, how does the amount of allowance for doubtful accounts relate to bad debt expense? 3 In general, what are some factors that could cause a company’s allowance for doubtful accounts to decrease? Solution to 1: ($ millions) The percentage of 2017 accounts receivable estimated to be uncollect- ible is 0.32 percent, calculated as $58/($17,874 + $58). Note that the $17,874 is net of the $58 allowance, so the gross amount of accounts receivable is determined by adding the allowance to the net amount. The percentage of 2016 accounts receivable estimated to be uncollectible is 0.34 percent [$53/($15,754 + $53)]. Solution to 2: Bad debt expense is an expense of the period, based on a company’s estimate of the percentage of credit sales in the period, for which cash will ultimately not be collected. The allowance for bad debts is a contra asset account, which is netted against the asset accounts receivable. To record the estimated bad debts, a company recognizes a bad debt expense (which affects net income) and increases the balance in the allowance for doubtful accounts by the same amount. To record the write off of a particular account receivable, a company reduces the balance in the allowance for doubtful accounts and reduces the balance in accounts receivable by the same amount. Solution to 3: In general, a decrease in a company’s allowance for doubtful accounts in absolute terms could be caused by a decrease in the amount of credit sales. Some factors that could cause a company’s allowance for doubtful accounts to decrease as a percentage of accounts receivable include the following: ■ ■ Improvements in the credit quality of the company’s existing customers (whether driven by a customer- specific improvement or by an improve- ment in the overall economy); ■ ■ Stricter credit policies (for example, refusing to allow less creditworthy customers to make credit purchases and instead requiring them to pay cash, to provide collateral, or to provide some additional form of financial backing); and/or ■ ■ Stricter risk management policies (for example, buying more insurance against potential defaults). In addition to the business factors noted above, because the allowance is based on management’s estimates of collectability, management can potentially bias these estimates to manipulate reported earnings. For example, a management team aiming to increase reported income could intentionally over- estimate collectability and under- estimate the bad debt expense for a period. Conversely, in a period of good earnings, management could under- estimate collectability and over- estimate the bad debt expense with the intent of reversing the bias in a period of poorer earnings. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 92. Reading 18 ■ Understanding Balance Sheets 74 CURRENT ASSETS: INVENTORIES AND OTHER CURRENT ASSETS e describe different types of assets and liabilities and the measurement bases of each Inventories are physical products that will eventually be sold to the company’s custom- ers, either in their current form (finished goods) or as inputs into a process to man- ufacture a final product (raw materials and work- in- process). Like any manufacturer, Apple holds inventories. The 2017 balance sheet of Apple Inc. shows $4,855 million of inventories. SAP Group’s balance sheet does not include a line item for inventory, consistent with the fact that SAP Group is primarily a software and services provider. Inventories are measured at the lower of cost and net realizable value (NRV) under IFRS. The cost of inventories comprises all costs of purchase, costs of conversion, and other costs incurred in bringing the inventories to their present location and condition. NRV is the estimated selling price less the estimated costs of completion and costs necessary to complete the sale. NRV is applicable for all inventories under IFRS. Under US GAAP, inventories are also measured at the lower of cost and NRV unless they are measured using the last- in, first- out (LIFO) or retail inventory methods. When using LIFO or the retail inventory methods, inventories are measured at the lower of cost or market value. US GAAP defines market value as current replacement cost but with upper and lower limits; the recorded value cannot exceed NRV and cannot be lower than NRV less a normal profit margin. If the net realizable value or market value (under US GAAP, in certain cases) of a company’s inventory falls below its carrying amount, the company must write down the value of the inventory. The loss in value is reflected in the income statement. For example, within its Management’s Discussion and Analysis and notes, Apple indicates that the company reviews its inventory each quarter and records write- downs of inventory that has become obsolete, exceeds anticipated demand, or is carried at a value higher than its market value. Under IFRS, if inventory that was written down in a previous period subsequently increases in value, the amount of the original write- down is reversed. Subsequent reversal of an inventory write- down is not permitted under US GAAP. When inventory is sold, the cost of that inventory is reported as an expense, “cost of goods sold.” Accounting standards allow different valuation methods for determining the amounts that are included in cost of goods sold on the income statement and thus the amounts that are reported in inventory on the balance sheet. (Inventory valua- tion methods are referred to as cost formulas and cost flow assumptions under IFRS and US GAAP, respectively.) IFRS allows only the first- in, first- out (FIFO), weighted average cost, and specific identification methods. Some accounting standards (such as US GAAP) also allow last- in, first- out (LIFO) as an additional inventory valuation method. The LIFO method is not allowed under IFRS. 5.1 Other Current Assets The amounts shown in “other current assets” reflect items that are individually not material enough to require a separate line item on the balance sheet and so are aggregated into a single amount. Companies usually disclose the components of other assets in a note to the financial statements. A typical item included in other current assets is prepaid expenses. Prepaid expenses are normal operating expenses that have been paid in advance. Because expenses are recognized in the period in which they are incurred—and not necessarily the period in which the payment is made—the advance payment of a future expense creates an asset. The asset (prepaid expenses) 5 © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 93. Current liabilities 75 will be recognized as an expense in future periods as it is used up. For example, con- sider prepaid insurance. Assume a company pays its insurance premium for coverage over the next calendar year on 31 December of the current year. At the time of the payment, the company recognizes an asset (prepaid insurance expense). The expense is not incurred at that date; the expense is incurred as time passes (in this example, one- twelfth, 1/12, in each following month). Therefore, the expense is recognized and the value of the asset is reduced in the financial statements over the course of the year. SAP’s notes to the financial statements disclose components of the amount shown as other non- financial assets on the balance sheet. The largest portion pertains to prepaid expenses, primarily prepayments for operating leases, support services, and software royalties. Apple’s notes do not disclose components of other current assets. CURRENT LIABILITIES e describe different types of assets and liabilities and the measurement bases of each Current liabilities are those liabilities that are expected to be settled in the entity’s normal operating cycle, held primarily for trading, or due to be settled within 12 months after the balance sheet date. Exhibit 6 and Exhibit 7 present balance sheet excerpts for SAP Group and Apple Inc. showing the line items for the companies’ current liabilities. Some of the common types of current liabilities, including trade payables, financial liabilities, accrued expenses, and deferred income, are discussed below. Exhibit 6 SAP Group Consolidated Statements of Financial Position (Excerpt: Current Liabilities Detail) (in millions of €) As of 31 December 2017 2016 Assets Total current assets 11,930 11,564 Total non- current assets 30,567 32,713 Total assets 42,497 44,277 Equity and liabilities Trade and other payables 1,151 1,281 Tax liabilities 597 316 Financial liabilities 1,561 1,813 Other non- financial liabilities 3,946 3,699 Provisions 184 183 Deferred income 2,771 2,383 Total current liabilities 10,210 9,674 Total non- current liabilities 6,747 8,205 Total liabilities 16,958 17,880 Total equity 25,540 26,397 Total equity and liabilities €42,497 €44,277 Source: SAP Group 2017 annual report. 6 © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 94. Reading 18 ■ Understanding Balance Sheets 76 Exhibit 7 Apple Inc. Consolidated Balance Sheet (Excerpt: Current Liabilities Detail)* (in millions of $) Assets 30 September 2017 24 September 2016 Total current assets 128,645 106,869 [All other assets] 246,674 214,817 Total assets 375,319 321,686 Liabilities and shareholders’ equity Accounts payable 49,049 37,294 Accrued expenses 25,744 22,027 Deferred revenue 7,548 8,080 Commercial paper 11,977 8,105 Current portion of long- term debt 6,496 3,500 Total current liabilities 100,814 79,006 [Total non- current liabilities] 140,458 114,431 Total liabilities 241,272 193,437 Total shareholders’ equity 134,047 128,249 Total liabilities and shareholders’ equity 375,319 321,686 *Note: The italicized subtotals presented in this excerpt are not explicitly shown on the face of the financial statement as prepared by the company. Source: Apple Inc. 2017 annual report (Form 10K). Trade payables, also called accounts payable, are amounts that a company owes its vendors for purchases of goods and services. In other words, these represent the unpaid amount as of the balance sheet date of the company’s purchases on credit. An issue relevant to analysts is the trend in overall levels of trade payables relative to purchases (a topic to be addressed further in ratio analysis). Significant changes in accounts payable relative to purchases could signal potential changes in the company’s credit relationships with its suppliers. The general term “trade credit” refers to credit provided to a company by its vendors. Trade credit is a source of financing that allows the company to make purchases and then pay for those purchases at a later date. Financial liabilities that are due within one year or the operating cycle, whichever is longer, appear in the current liability section of the balance sheet. Financial liabilities include borrowings such as bank loans, notes payable (which refers to financial liabil- ities owed by a company to creditors, including trade creditors and banks, through a formal loan agreement), and commercial paper. In addition, any portions of long- term liabilities that are due within one year (i.e., the current portion of long- term liabilities) are also shown in the current liability section of the balance sheet. According to its footnote disclosures, most of SAP’s €1,561 million of current financial liabilities is for bonds payable due in the next year. Apple shows $11,977 million of commercial paper borrowing (short- term promissory notes issued by companies) and $6,496 million of long- term debt due within the next year. Accrued expenses (also called accrued expenses payable, accrued liabilities, and other non- financial liabilities) are expenses that have been recognized on a company’s income statement but not yet been paid as of the balance sheet date. For example, SAP’s 2017 balance sheet shows €597 million of tax liabilities. In addition to income taxes payable, other common examples of accrued expenses are accrued interest © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 95. Current liabilities 77 payable, accrued warranty costs, and accrued employee compensation (i.e., wages payable). SAP’s notes disclose that the €3,946 million line item of other non- financial liabilities in 2017, for example, includes €2,565 million of employee-related liabilities. Deferred income (also called deferred revenue or unearned revenue) arises when a company receives payment in advance of delivery of the goods and services associated with the payment. The company has an obligation either to provide the goods or services or to return the cash received. Examples include lease payments received at the beginning of a lease, fees for servicing office equipment received at the beginning of the service period, and payments for magazine subscriptions received at the beginning of the subscription period. SAP’s balance sheet shows deferred income of €2,771 million at the end of 2017, up slightly from €2,383 million at the end of 2016. Apple’s balance sheet shows deferred revenue of $7,548 million at the end of fiscal 2017, down slightly from $8,080 million at the end of fiscal 2016. Example 3 presents each company’s disclosures about deferred revenue and discusses some of the implications. EXAMPLE 2 Analysis of Deferred Revenue In the notes to its 2017 financial statements, SAP describes its deferred income as follows: Deferred income consists mainly of prepayments made by our custom- ers for cloud subscriptions and support; software support and services; fees from multiple- element arrangements allocated to undelivered elements; and amounts … for obligations to perform under acquired customer contracts in connection with acquisitions. Apple’s deferred revenue also arises from sales involving multiple elements, some delivered at the time of sale and others to be delivered in the future. In addition, Apple recognizes deferred revenue in connection with sales of gifts cards as well as service contracts. In the notes to its 2017 financial statements, Apple describes its deferred revenue as follows: The Company records deferred revenue when it receives payments in advance of the delivery of products or the performance of services. This includes amounts that have been deferred for unspecified and specified software upgrade rights and non- software services that are attached to hardware and software products. The Company sells gift cards redeemable at its retail and online stores ... The Company records deferred revenue upon the sale of the card, which is relieved upon redemption of the card by the customer. Revenue from AppleCare service and support contracts is deferred and recognized over the service coverage periods. AppleCare service and support contracts typically include extended phone support, repair services, web- based support resources and diagnostic tools offered under the Company’s standard limited warranty. 1 In general, in the period a transaction occurs, how would a company’s balance sheet reflect $100 of deferred revenue resulting from a sale? (Assume, for simplicity, that the company receives cash for all sales, the company’s income tax payable is 30 percent based on cash receipts, and the company pays cash for all relevant income tax obligations as they arise. Ignore any associated deferred costs.) © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 96. Reading 18 ■ Understanding Balance Sheets 78 2 In general, how does deferred revenue impact a company’s financial state- ments in the periods following its initial recognition? 3 Interpret the amounts shown by SAP as deferred income and by Apple as deferred revenue. 4 Both accounts payable and deferred revenue are classified as current lia- bilities. Discuss the following statements: A When assessing a company’s liquidity, the implication of amounts in accounts payable differs from the implication of amounts in deferred revenue. B Some investors monitor amounts in deferred revenue as an indicator of future revenue growth. Solution to 1: In the period that deferred revenue arises, the company would record a $100 increase in the asset Cash and a $100 increase in the liability Deferred Revenues. In addition, because the company’s income tax payable is based on cash receipts and is paid in the current period, the company would record a $30 decrease in the asset Cash and a $30 increase in the asset Deferred Tax Assets. Deferred tax assets increase because the company has paid taxes on revenue it has not yet recognized for accounting purposes. In effect, the company has prepaid taxes from an accounting perspective. Solution to 2: In subsequent periods, the company will recognize the deferred revenue as it is earned. When the revenue is recognized, the liability Deferred Revenue will decrease. In addition, the tax expense is recognized on the income statement as the revenue is recognized and thus the associated amounts of Deferred Tax Assets will decrease. Solution to 3: The deferred income on SAP’s balance sheet and deferred revenue on Apple’s balance sheet at the end of their respective 2017 fiscal years will be recognized as revenue, sales, or a similar item in income statements subsequent to the 2017 fiscal year, as the goods or services are provided or the obligation is reduced. The costs of delivering the goods or services will also be recognised. Solution to 4A: The amount of accounts payable represents a future obligation to pay cash to suppliers. In contrast, the amount of deferred revenue represents payments that the company has already received from its customers, and the future obligation is to deliver the related services. With respect to liquidity, settling accounts payable will require cash outflows whereas settling deferred revenue obligations will not. Solution to 4B: Some investors monitor amounts in deferred revenue as an indicator of future growth because the amounts in deferred revenue will be recognized as revenue in the future. Thus, growth in the amount of deferred revenue implies future growth of that component of a company’s revenue. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 97. Non-Current Assets: Property, Plant and Equipment and Investment Property 79 NON-CURRENT ASSETS: PROPERTY, PLANT AND EQUIPMENT AND INVESTMENT PROPERTY e describe different types of assets and liabilities and the measurement bases of each This section provides an overview of assets other than current assets, sometimes collectively referred to as non- current, long- term, or long- lived assets. The categories discussed are property, plant, and equipment; investment property; intangible assets; goodwill; financial assets; and deferred tax assets. Exhibit 8 and Exhibit 9 present balance sheet excerpts for SAP Group and Apple Inc. showing the line items for the companies’ non- current assets. Exhibit 8 SAP Group Consolidated Statements of Financial Position (Excerpt: Non- Current Assets Detail) (in millions of €) As of 31 December Assets 2017 2016 Total current assets 11,930 11,564 Goodwill 21,274 23,311 Intangible assets 2,967 3,786 Property, plant and equipment 2,967 2,580 Other financial assets 1,155 1,358 Trade and other receivables 118 126 Other non- financial assets 621 532 Tax assets 443 450 Deferred tax assets 1,022 571 Total non- current assets 30,567 32,713 Total assets 42,497 44,277 Total current liabilities 10,210 9,674 Total non- current liabilities 6,747 8,205 Total liabilities 16,958 17,880 Total equity 25,540 26,397 Total equity and liabilities €42,497 €44,277 Source: SAP Group 2017 annual report. Exhibit 9 Apple Inc. Consolidated Balance Sheet (Excerpt: Non- Current Assets Detail)* (in millions of $) Assets 30 September 2017 24 September 2016 Total current assets 128,645 106,869 Long- term marketable securities 194,714 170,430 Property, plant and equipment, net 33,783 27,010 7 (continued) © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 98. Reading 18 ■ Understanding Balance Sheets 80 Assets 30 September 2017 24 September 2016 Goodwill 5,717 5,414 Acquired intangible assets, net 2,298 3,206 Other non- current assets 10,162 8,757 [All other assets] 246,674 214,817 Total assets 375,319 321,686 Liabilities and shareholders’ equity Total current liabilities 100,814 79,006 [Total non- current liabilities] 140,458 114,431 Total liabilities 241,272 193,437 Total shareholders’ equity 134,047 128,249 Total liabilities and shareholders’ equity 375,319 321,686 *Note: The italicized subtotals presented in this excerpt are not explicitly shown on the face of the financial statement as prepared by the company. Source: Apple Inc. 2017 annual report (Form 10K). 7.1 Property, Plant, and Equipment Property, plant, and equipment (PPE) are tangible assets that are used in company operations and expected to be used (provide economic benefits) over more than one fiscal period. Examples of tangible assets treated as property, plant, and equipment, include land, buildings, equipment, machinery, furniture, and natural resources such as mineral and petroleum resources. IFRS permits companies to report PPE using either a cost model or a revaluation model.9 While IFRS permits companies to use the cost model for some classes of assets and the revaluation model for others, the company must apply the same model to all assets within a particular class of assets. US GAAP permits only the cost model for reporting PPE. Under the cost model, PPE is carried at amortised cost (historical cost less any accumulated depreciation or accumulated depletion, and less any impairment losses). Historical cost generally consists of an asset’s purchase price, plus its delivery cost, and any other additional costs incurred to make the asset operable (such as costs to install a machine). Depreciation and depletion refer to the process of allocating (rec- ognizing as an expense) the cost of a long- lived asset over its useful life. Land is not depreciated. Because PPE is presented on the balance sheet net of depreciation and depreciation expense is recognised in the income statement, the choice of deprecia- tion method and the related estimates of useful life and salvage value impact both a company’s balance sheet and income statement. Whereas depreciation is the systematic allocation of cost over an asset’s useful life, impairment losses reflect an unanticipated decline in value. Impairment occurs when the asset’s recoverable amount is less than its carrying amount, with terms defined as follows under IFRS:10 ■ ■ Recoverable amount: The higher of an asset’s fair value less cost to sell, and its value in use. Exhibit 9 (Continued) 9 IAS 16, Property, Plant and Equipment, paragraphs 29- 31. 10 IAS 36, Impairment of Assets, paragraph 6. US GAAP uses a different approach to impairment. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 99. Non-Current Assets: Intangible Assets 81 ■ ■ Fair value less cost to sell: The amount obtainable in a sale of the asset in an arms- length transaction between knowledgeable willing parties, less the costs of the sale. ■ ■ Value in use: The present value of the future cash flows expected to be derived from the asset. When an asset is considered impaired, the company recognizes the impairment loss in the income statement in the period the impairment is identified. Reversals of impairment losses are permitted under IFRS but not under US GAAP. Under the revaluation model, the reported and carrying value for PPE is the fair value at the date of revaluation less any subsequent accumulated depreciation. Changes in the value of PPE under the revaluation model affect equity directly or profit and loss depending upon the circumstances. In Exhibits 8 and 9, SAP reports €2,967 million of PPE and Apple reports $33,783 million of PPE at the end of fiscal year 2017. For SAP, PPE represents approximately 7 percent of total assets and for Apple, PPE represents approximately 9 percent of total assets. Both companies disclose in the notes that PPE are generally depreciated over their expected useful lives using the straight- line method. 7.2 Investment Property Some property is not used in the production of goods or services or for administrative purposes. Instead, it is used to earn rental income or capital appreciation (or both). Under IFRS, such property is considered to be investment property.11 US GAAP does not include a specific definition for investment property. IFRS provides compa- nies with the choice to report investment property using either a cost model or a fair value model. In general, a company must apply its chosen model (cost or fair value) to all of its investment property. The cost model for investment property is identical to the cost model for PPE: In other words, investment property is carried at cost less any accumulated depreciation and any accumulated impairment losses. Under the fair value model, investment property is carried at its fair value. When a company uses the fair value model to measure the value of its investment property, any gain or loss arising from a change in the fair value of the investment property is recognized in profit and loss, i.e., on the income statement, in the period in which it arises.12 Neither SAP Group nor Apple disclose ownership of investment property. The types of companies that typically hold investment property are real estate investment companies or property management companies. Entities such as life insurance com- panies and endowment funds may also hold investment properties as part of their investment portfolio. NON-CURRENT ASSETS: INTANGIBLE ASSETS e describe different types of assets and liabilities and the measurement bases of each 8 11 IAS 40, Investment Property. 12 IAS 40, Investment Property, paragraph 35. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 100. Reading 18 ■ Understanding Balance Sheets 82 Intangible assets are identifiable non- monetary assets without physical substance.13 An identifiable asset can be acquired singly (can be separated from the entity) or is the result of specific contractual or legal rights or privileges. Examples include patents, licenses, and trademarks. The most common asset that is not a separately identifiable asset is accounting goodwill, which arises in business combinations and is discussed further in Section 9. IFRS allows companies to report intangible assets using either a cost model or a revaluation model. The revaluation model can only be selected when there is an active market for an intangible asset. These measurement models are essentially the same as described for PPE. US GAAP permits only the cost model. For each intangible asset, a company assesses whether the useful life of the asset is finite or indefinite. Amortisation and impairment principles apply as follows: ■ ■ An intangible asset with a finite useful life is amortised on a systematic basis over the best estimate of its useful life, with the amortisation method and useful life estimate reviewed at least annually. ■ ■ Impairment principles for an intangible asset with a finite useful life are the same as for PPE. ■ ■ An intangible asset with an indefinite useful life is not amortised. Instead, at least annually, the reasonableness of assuming an indefinite useful life for the asset is reviewed and the asset is tested for impairment. Financial analysts have traditionally viewed the values assigned to intangible assets, particularly goodwill, with caution. Consequently, in assessing financial statements, analysts often exclude the book value assigned to intangibles, reducing net equity by an equal amount and increasing pretax income by any amortisation expense or impairment associated with the intangibles. An arbitrary assignment of zero value to intangibles is not advisable; instead, an analyst should examine each listed intangible and assess whether an adjustment should be made. Note disclosures about intangible assets may provide useful information to the analyst. These disclosures include infor- mation about useful lives, amortisation rates and methods, and impairment losses recognised or reversed. Further, a company may have developed intangible assets internally that can only be recognised in certain circumstances. Companies may also have assets that are never recorded on a balance sheet because they have no physical substance and are non- identifiable. These assets might include management skill, name recognition, a good reputation, and so forth. Such assets are valuable and are, in theory, reflected in the price at which the company’s equity securities trade in the market (and the price at which the entirety of the company’s equity would be sold in an acquisition transaction). Such assets may be recognised as goodwill if a company is acquired, but are not recognised until an acquisition occurs. 8.1 Identifiable Intangibles Under IFRS, identifiable intangible assets are recognised on the balance sheet if it is probable that future economic benefits will flow to the company and the cost of the asset can be measured reliably. Examples of identifiable intangible assets include patents, trademarks, copyrights, franchises, licenses, and other rights. Identifiable intangible assets may have been created internally or purchased by a company. Determining the cost of internally created intangible assets can be difficult and subjective. For these reasons, under IFRS and US GAAP, the general requirement is that internally created identifiable intangibles are expensed rather than reported on the balance sheet. 13 IAS 38, Intangible Assets, paragraph 8. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 101. Non-Current Assets: Intangible Assets 83 IFRS provides that for internally created intangible assets, the company must separately identify the research phase and the development phase.14 The research phase includes activities that seek new knowledge or products. The development phase occurs after the research phase and includes design or testing of prototypes and models. IFRS require that costs to internally generate intangible assets during the research phase must be expensed on the income statement. Costs incurred in the development stage can be capitalized as intangible assets if certain criteria are met, including technological feasibility, the ability to use or sell the resulting asset, and the ability to complete the project. US GAAP prohibits the capitalization as an asset of most costs of internally developed intangibles and research and development. All such costs usually must be expensed. Costs related to the following categories are typically expensed under IFRS and US GAAP. They include: ■ ■ internally generated brands, mastheads, publishing titles, customer lists, etc.; ■ ■ start-up costs; ■ ■ training costs; ■ ■ administrative and other general overhead costs; ■ ■ advertising and promotion; ■ ■ relocation and reorganization expenses; and ■ ■ redundancy and other termination costs. Generally, acquired intangible assets are reported as separately identifiable intangi- bles (as opposed to goodwill) if they arise from contractual rights (such as a licensing agreement), other legal rights (such as patents), or have the ability to be separated and sold (such as a customer list). EXAMPLE 3 Measuring Intangible Assets Alpha Inc., a motor vehicle manufacturer, has a research division that worked on the following projects during the year: Project 1 Research aimed at finding a steering mechanism that does not operate like a conventional steering wheel but reacts to the impulses from a driver’s fingers. Project 2 The design of a prototype welding apparatus that is controlled electronically rather than mechanically. The apparatus has been determined to be technologically feasible, salable, and feasible to produce. The following is a summary of the expenses of the research division (in thou- sands of €): General Project 1 Project 2 Material and services 128 935 620 Labor • Direct labor — 630 320 (continued) 14 IAS 38, Intangible Assets, paragraphs 51–67. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 102. Reading 18 ■ Understanding Balance Sheets 84 General Project 1 Project 2 • Administrative personnel 720 — — Design, construction, and testing 270 450 470 Five percent of administrative personnel costs can be attributed to each of Projects 1 and 2. Explain the accounting treatment of Alpha’s costs for Projects 1 and 2 under IFRS and US GAAP. Solution: Under IFRS, the capitalization of development costs for Projects 1 and 2 would be as follows: Amount Capitalized as an Asset (€’000) Project 1: Classified as in the research stage, so all costs are recognized as expenses NIL Project 2: Classified as in the development stage, so costs may be capitalized. Note that administrative costs are not capitalized. (620 + 320 + 470) = 1,410 Under US GAAP, the costs of Projects 1 and 2 are expensed. As presented in Exhibits 8 and 9, SAP’s 2017 balance sheet shows €2,967 million of intangible assets, and Apple’s 2017 balance sheet shows acquired intangible assets, net of $2,298 million. SAP’s notes disclose the types of intangible assets (software and database licenses, purchased software to be incorporated into its products, customer contracts, and acquired trademark licenses) and notes that all of its purchased intan- gible assets other than goodwill have finite useful lives and are amortised either based on expected consumption of economic benefits or on a straight- line basis over their estimated useful lives which range from two to 20 years. Apple’s notes disclose that its acquired intangible assets consist primarily of patents and licenses, and almost the entire amount represents definite- lived and amortisable assets for which the remaining weighted- average amortisation period is 3.4 years as of 2017. NON-CURRENT ASSETS: GOODWILL e describe different types of assets and liabilities and the measurement bases of each When one company acquires another, the purchase price is allocated to all the identi- fiable assets (tangible and intangible) and liabilities acquired, based on fair value. If the purchase price is greater than the acquirer’s interest in the fair value of the identifiable assets and liabilities acquired, the excess amount is recognized as an asset, described as goodwill. To understand why an acquirer would pay more to purchase a company than the fair value of the target company’s identifiable assets net of liabilities, con- sider the following three observations. First, as noted, certain items not recognized 9 © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 103. Non-Current Assets: Goodwill 85 in a company’s own financial statements (e.g., its reputation, established distribution system, trained employees) have value. Second, a target company’s expenditures in research and development may not have resulted in a separately identifiable asset that meets the criteria for recognition but nonetheless may have created some value. Third, part of the value of an acquisition may arise from strategic positioning versus a competitor or from perceived synergies. The purchase price might not pertain solely to the separately identifiable assets and liabilities acquired and thus may exceed the value of those net assets due to the acquisition’s role in protecting the value of all of the acquirer’s existing assets or to cost savings and benefits from combining the companies. The subject of recognizing goodwill in financial statements has found both propo- nents and opponents among professionals. The proponents of goodwill recognition assert that goodwill is the present value of excess returns that a company is expected to earn. This group claims that determining the present value of these excess returns is analogous to determining the present value of future cash flows associated with other assets and projects. Opponents of goodwill recognition claim that the prices paid for acquisitions often turn out to be based on unrealistic expectations, thereby leading to future write- offs of goodwill. Analysts should distinguish between accounting goodwill and economic goodwill. Economic goodwill is based on the economic performance of the entity, whereas accounting goodwill is based on accounting standards and is reported only in the case of acquisitions. Economic goodwill is important to analysts and investors, and it is not necessarily reflected on the balance sheet. Instead, economic goodwill is reflected in the stock price (at least in theory). Some financial statement users believe that good- will should not be listed on the balance sheet, because it cannot be sold separately from the entity. These financial statement users believe that only assets that can be separately identified and sold should be reflected on the balance sheet. Other financial statement users analyze goodwill and any subsequent impairment charges to assess management’s performance on prior acquisitions. Under both IFRS and US GAAP, accounting goodwill arising from acquisitions is capitalized. Goodwill is not amortised but is tested for impairment annually. If goodwill is deemed to be impaired, an impairment loss is charged against income in the current period. An impairment loss reduces current earnings. An impairment loss also reduces total assets, so some performance measures, such as return on assets (net income divided by average total assets), may actually increase in future periods. An impairment loss is a non- cash item. Accounting standards’ requirements for recognizing goodwill can be summarized by the following steps: A The total cost to purchase the target company (the acquiree) is determined. B The acquiree’s identifiable assets are measured at fair value. The acquiree’s liabilities and contingent liabilities are measured at fair value. The difference between the fair value of identifiable assets and the fair value of the liabilities and contingent liabilities equals the net identifiable assets acquired. C Goodwill arising from the purchase is the excess of a) the cost to purchase the target company over b) the net identifiable assets acquired. Occasionally, a transaction will involve the purchase of net identifiable assets with a value greater than the cost to purchase. Such a transaction is called a “bargain pur- chase.” Any gain from a bargain purchase is recognized in profit and loss in the period in which it arises.15 15 IFRS 3 Business Combinations and FASB ASC 805 [Business Combinations]. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 104. Reading 18 ■ Understanding Balance Sheets 86 Companies are also required to disclose information that enables users to evaluate the nature and financial effect of business combinations. The required disclosures include, for example, the acquisition date fair value of the total cost to purchase the target company, the acquisition date amount recognized for each major class of assets and liabilities, and a qualitative description of the factors that make up the goodwill recognized. Despite the guidance incorporated in accounting standards, analysts should be aware that the estimations of fair value involve considerable management judgment. Values for intangible assets, such as computer software, might not be easily validated when analyzing acquisitions. Management judgment about valuation in turn impacts current and future financial statements because identifiable intangible assets with definite lives are amortised over time. In contrast, neither goodwill nor identifiable intangible assets with indefinite lives are amortised; instead, as noted, both are tested annually for impairment. The recognition and impairment of goodwill can significantly affect the compa- rability of financial statements between companies. Therefore, analysts often adjust the companies’ financial statements by removing the impact of goodwill. Such adjust- ments include: ■ ■ excluding goodwill from balance sheet data used to compute financial ratios, and ■ ■ excluding goodwill impairment losses from income data used to examine oper- ating trends. In addition, analysts can develop expectations about a company’s performance fol- lowing an acquisition by taking into account the purchase price paid relative to the net assets and earnings prospects of the acquired company. Example 4 provides an historical example of goodwill impairment. EXAMPLE 4 Goodwill Impairment Safeway, Inc., is a North American food and drug retailer. On 25 February 2010, Safeway issued a press release that included the following information: Safeway Inc. today reported a net loss of $1,609.1 million ($4.06 per diluted share) for the 16- week fourth quarter of 2009. Excluding a non- cash goodwill impairment charge of $1,818.2 million, net of tax ($4.59 per diluted share), net income would have been $209.1 million ($0.53 per diluted share). Net income was $338.0 million ($0.79 per diluted share) for the 17- week fourth quarter of 2008. In the fourth quarter of 2009, Safeway recorded a non-cash good- will impairment charge of $1,974.2 million ($1,818.2 million, net of tax). The impairment was due primarily to Safeway’s reduced market capitalization and a weak economy….The goodwill originated from previous acquisitions. Safeway’s balance sheet as of 2 January 2010 showed goodwill of $426.6 million and total assets of $14,963.6 million. The company’s balance sheet as of 3 January 2009 showed goodwill of $2,390.2 million and total assets of $17,484.7 million. 1 How significant is this goodwill impairment charge? 2 With reference to acquisition prices, what might this goodwill impairment indicate? © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 105. Non-Current Assets: Financial Assets 87 Solution to 1: The goodwill impairment was more than 80 percent of the total value of good- will and 11 percent of total assets, so it was clearly significant. (The charge of $1,974.2 million equals 82.6 percent of the $2,390.2 million of goodwill at the beginning of the year and 11.3 percent of the $17,484.7 million total assets at the beginning of the year.) Solution to 2: The goodwill had originated from previous acquisitions. The impairment charge implies that the acquired operations are now worth less than the price that was paid for their acquisition. As presented in Exhibits 8 and 9, SAP’s 2017 balance sheet shows €21,274 million of goodwill, and Apple’s 2017 balance sheet shows goodwill of $5,717 million. Goodwill represents 50.1 percent of SAP’s total assets and only 1.5 percent of Apple’s total assets. An analyst may be concerned that goodwill represents such a high proportion of SAP’s total assets. NON-CURRENT ASSETS: FINANCIAL ASSETS e describe different types of assets and liabilities and the measurement bases of each IFRS define a financial instrument as a contract that gives rise to a financial asset of one entity, and a financial liability or equity instrument of another entity.16 This section will focus on financial assets such as a company’s investments in stocks issued by another company or its investments in the notes, bonds, or other fixed- income instruments issued by another company (or issued by a governmental entity). Financial liabilities such as notes payable and bonds payable issued by the company itself will be discussed in the liability portion of this reading. Some financial instruments may be classified as either an asset or a liability depending on the contractual terms and current market conditions. One example of such a financial instrument is a derivative. Derivatives are financial instruments for which the value is derived based on some underlying factor (interest rate, exchange rate, commodity price, security price, or credit rating) and for which little or no initial investment is required. Financial instruments are generally recognized when the entity becomes a party to the contractual provisions of the instrument. In general, there are two basic alter- native ways that financial instruments are measured subsequent to initial acquisition: fair value or amortised cost. Recall that fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly market transaction.17 The amortised cost of a financial asset (or liability) is the amount at which it was initially recognized, minus any principal repayments, plus or minus any amortisation of dis- count or premium, and minus any reduction for impairment. Under IFRS, financial assets are subsequently measured at amortised cost if the asset’s cash flows occur on specified dates and consist solely of principal and interest, and if the business model is to hold the asset to maturity. The concept is similar in US GAAP, where this category of asset is referred to as held-to-maturity. An example is 10 16 IAS 32, Financial Instruments: Presentation, paragraph 11. 17 IFRS 13 Fair Value Measurement and US GAAP ASC 820 Fair Value Measurement. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 106. Reading 18 ■ Understanding Balance Sheets 88 an investment in a long- term bond issued by another company or by a government; the value of the bond will fluctuate, for example with interest rate movements, but if the bond is classified as a held- to- maturity investment, it will be measured at amortised cost on the balance sheet of the investing company. Other types of financial assets measured at amortised cost are loans to other companies. Financial assets not measured at amortised cost subsequent to acquisition are mea- sured at fair value as of the reporting date. For financial instruments measured at fair value, there are two basic alternatives in how net changes in fair value are recognized: as profit or loss on the income statement, or as other comprehensive income (loss) which bypasses the income statement. Note that these alternatives refer to unrealized changes in fair value, i.e., changes in the value of a financial asset that has not been sold and is still owned at the end of the period. Unrealized gains and losses are also referred to as holding period gains and losses. If a financial asset is sold within the period, a gain is realized if the selling price is greater than the carrying value and a loss is realized if the selling price is less than the carrying value. When a financial asset is sold, any realized gain or loss is reported on the income statement. Under IFRS, financial assets are subsequently measured at fair value through other comprehensive income (i.e., any unrealized holding gains or losses are recognized in other comprehensive income) if the business model’s objective involves both collect- ing contractual cash flows and selling the financial assets. This IFRS category applies specifically to debt investments, namely assets with cash flows occurring on specified dates and consisting solely of principal and interest. However, IFRS also permits equity investments to be measured at fair value through other comprehensive income if, at the time a company buys an equity investment, the company decides to make an irre- vocable election to measure the asset in this manner.18 The concept is similar to the US GAAP investment category available-for-sale in which assets are measured at fair value, with any unrealized holding gains or losses recognized in other comprehensive income. However, unlike IFRS, the US GAAP category available- for- sale applies only to debt securities and is not permitted for investments in equity securities.19 Under IFRS, financial assets are subsequently measured at fair value through profit or loss (i.e., any unrealized holding gains or losses are recognized in the income statement) if they are not assigned to either of the other two measurement catego- ries described above. In addition, IFRS allows a company to make an irrevocable election at acquisition to measure a financial asset in this category. Under US GAAP, all investments in equity securities (other than investments giving rise to ownership positions that confer significant influence over the investee) are measured at fair value with unrealized holding gains or losses recognized in the income statement. Under US GAAP, debt securities designated as trading securities are also measured at fair value with unrealized holding gains or losses recognized in the income statement. The trading securities category pertains to a debt security that is acquired with the intent of selling it rather than holding it to collect the interest and principal payments. Exhibit 10 summarizes how various financial assets are classified and measured subsequent to acquisition. 18 IFRS 7 Financial Instruments: Disclosures, paragraph 8(h) and IFRS 9 Financial Instruments, paragraph 5.7.5. 19 US GAAP ASU 2016- 01 and ASC 32X Investments. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 107. Non-Current Assets: Financial Assets 89 Exhibit 10 Measurement of Financial Assets Measured at Cost or Amortised Cost Measured at Fair Value through Other Comprehensive Income Measured at Fair Value through Profit and Loss ■ ■ Debt securities that are to be held to maturity. ■ ■ Loans and notes receivable ■ ■ Unquoted equity instruments (in limited circumstances where the fair value is not reliably measurable, cost may serve as a proxy (esti- mate) for fair value) ■ ■ “Available-for-sale” debt securities (US GAAP); Debt securities where the business model involves both collecting interest and principal and selling the security (IFRS); ■ ■ Equity investments for which the company irrevocably elects this measurement at acqui- sition (IFRS only) ■ ■ All equity securities unless the investment gives the investor sig- nificant influence (US GAAP only) ■ ■ “Trading” debt securities (US GAAP) ■ ■ Securities not assigned to either of the other two categories, or invest- ments for which the company irrevocably elects this measurement at acquisition (IFRS only) To illustrate the different accounting treatments of the gains and losses on financial assets, consider an entity that invests €100,000,000 on 1 January 200X in a fixed- income security investment, with a 5 percent coupon paid semi- annually. After six months, the company receives the first coupon payment of €2,500,000. Additionally, market interest rates have declined such that the value of the fixed- income investment has increased by €2,000,000 as of 30 June 200X. Exhibit 11 illustrates how this situation will be portrayed in the balance sheet and income statement (ignoring taxes) of the entity concerned, under each of the following three measurement categories of financial assets: assets held for trading purposes, assets available for sale, and held- to-maturity assets. Exhibit 11 Accounting for Gains and Losses on Marketable Securities IFRS Categories Measured at Cost or Amortised Cost Measured at Fair Value through Other Comprehensive Income Measured at Fair Value through Profit and Loss US GAAP Comparable Categories Held to Maturity Available-for-Sale Debt Securities Trading Debt Securities Income Statement For period 1 January–30 June 200X Interest income 2,500,000 2,500,000 2,500,000 Unrealized gains — — 2,000,000 Impact on profit and loss 2,500,000 2,500,000 4,500,000 Balance Sheet As of 30 June 200X Assets Cash and cash equivalents 2,500,000 2,500,000 2,500,000 Cost of securities 100,000,000 100,000,000 100,000,000 (continued) © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 108. Reading 18 ■ Understanding Balance Sheets 90 Balance Sheet As of 30 June 200X Unrealized gains on securities — 2,000,000 2,000,000 102,500,000 104,500,000 104,500,000 Liabilities Equity Paid-in capital 100,000,000 100,000,000 100,000,000 Retained earnings 2,500,000 2,500,000 4,500,000 Accumulated other comprehensive income — 2,000,000 — 102,500,000 104,500,000 104,500,000 In the case of held- to- maturity securities, the income statement shows only the interest income (which is then reflected in retained earnings of the ending balance sheet). Because the securities are measured at cost rather than fair value, no unre- alized gain is recognized. On the balance sheet, the investment asset is shown at its amortised cost of €100,000,000. In the case of securities classified as Measured at Fair Value through Other Comprehensive Income (IFRS) or equivalently as Available- for- sale debt securities (US GAAP), the income statement shows only the interest income (which is then reflected in retained earnings of the balance sheet). The unrealized gain does not appear on the income statement; instead, it would appear on a Statement of Comprehensive Income as Other Comprehensive Income. On the balance sheet, the investment asset is shown at its fair value of €102,000,000. (Exhibit 11 shows the unrealized gain on a separate line solely to highlight the impact of the change in value. In practice, the investments would be shown at their fair value on a single line.) In the case of securities classified as Measured at Fair Value through Profit and Loss (IFRS) or equivalently as trading debt securities (US GAAP), both the interest income and the unrealized gain are included on the income statement and thus reflected in retained earnings on the balance sheet. In Exhibits 4 and 8, SAP’s 2017 balance sheet shows other financial assets of €990 million (current) and €1,155 million (non- current). The company’s notes disclose that the largest component of the current financial assets are loans and other financial receivables (€793 million) and the largest component of the non- current financial assets is €827 million of available- for- sale equity investments. In Exhibits 5 and 9, Apple’s 2017 balance sheet shows $53,892 million of short- term marketable securities and $194,714 million of long- term marketable securities. In total, marketable securities represent more than 66 percent of Apple’s $375.3 bil- lion in total assets. Marketable securities plus cash and cash equivalents represent around 72 percent of the company’s total assets. Apple’s notes disclose that most of the company’s marketable securities are fixed- income securities issued by the US govern- ment or its agencies ($60,237 million) and by other companies including commercial paper ($153,451 million). In accordance with its investment policy, Apple invests in highly rated securities (which the company defines as investment grade) and limits its credit exposure to any one issuer. The company classifies its marketable securities as available for sale and reports them on the balance sheet at fair value. Unrealized gains and losses are reported in other comprehensive income. Exhibit 11 (Continued) © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 109. Non-Current Liabilities 91 NON-CURRENT ASSETS: DEFERRED TAX ASSETS e describe different types of assets and liabilities and the measurement bases of each Portions of the amounts shown as deferred tax assets on SAP’s balance sheet represent income taxes incurred prior to the time that the income tax expense will be recognized on the income statement. Deferred tax assets may result when the actual income tax payable based on income for tax purposes in a period exceeds the amount of income tax expense based on the reported financial statement income due to temporary timing differences. For example, a company may be required to report certain income for tax purposes in the current period but to defer recognition of that income for financial statement purposes to subsequent periods. In this case, the company will pay income tax as required by tax laws, and the difference between the taxes payable and the tax expense related to the income for which recognition was deferred on the financial statements will be reported as a deferred tax asset. When the income is subsequently recognized on the income statement, the related tax expense is also recognized which will reduce the deferred tax asset. Also, a company may claim certain expenses for financial statement purposes that it is only allowed to claim in subsequent periods for tax purposes. In this case, as in the previous example, the financial statement income before taxes is less than taxable income. Thus, income taxes payable based on taxable income exceeds income tax expense based on accounting net income before taxes. The difference is expected to reverse in the future when the income reported on the financial statements exceeds the taxable income as a deduction for the expense becomes allowed for tax purposes. Deferred tax assets may also result from carrying forward unused tax losses and cred- its (these are not temporary timing differences). Deferred tax assets are only to be recognized if there is an expectation that there will be taxable income in the future, against which the temporary difference or carried forward tax losses or credits can be applied to reduce taxes payable. NON-CURRENT LIABILITIES e describe different types of assets and liabilities and the measurement bases of each All liabilities that are not classified as current are considered to be non- current or long-term. Exhibits 12 and 13 present balance sheet excerpts for SAP Group and Apple Inc. showing the line items for the companies’ non- current liabilities. Both companies’ balance sheets show non- current unearned revenue (deferred income for SAP Group and deferred revenue for Apple). These amounts represent the amounts of unearned revenue relating to goods and services expected to be delivered in periods beyond twelve months following the reporting period. The sections that follow focus on two common types of non- current (long- term) liabilities: long- term financial liabilities and deferred tax liabilities. 11 12 © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 110. Reading 18 ■ Understanding Balance Sheets 92 Exhibit 12 SAP Group Consolidated Statements of Financial Position (Excerpt: Non- Current Liabilities Detail) (in millions of €) as of 31 December 2017 2016 Assets Total current assets 11,930 11,564 Total non- current assets 30,567 32,713 Total assets 42,497 44,277 Total current liabilities 10,210 9,674 Trade and other payables 119 127 Tax liabilities 470 365 Financial liabilities 5,034 6,481 Other non- financial liabilities 503 461 Provisions 303 217 Deferred tax liabilities 240 411 Deferred income 79 143 Total non- current liabilities 6,747 8,205 Total liabilities 16,958 17,880 Total equity 25,540 26,397 Total equity and liabilities €42,497 €44,277 Source: SAP Group 2017 annual report. Exhibit 13 Apple Inc. Consolidated Balance Sheet (Excerpt: Non- Current Liabilities Detail)* (in millions of $) Assets 30 September 2017 24 September 2016 Total current assets 128,645 106,869 [All other assets] 246,674 214,817 Total assets 375,319 321,686 Liabilities and shareholders’ equity Total current liabilities 100,814 79,006 Deferred revenue, non- current 2,836 2,930 Long-term debt 97,207 75,427 Other non- current liabilities 40,415 36,074 [Total non- current liabilities] 140,458 114,431 Total liabilities 241,272 193,437 Total shareholders’ equity 134,047 128,249 Total liabilities and shareholders’ equity 375,319 321,686 *Note: The italicized subtotals presented in this excerpt are not explicitly shown on the face of the financial statement as prepared by the company. Source: Apple Inc. 2017 annual report (Form 10K). © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 111. Non-Current Liabilities 93 12.1 Long- term Financial Liabilities Typical long- term financial liabilities include loans (i.e., borrowings from banks) and notes or bonds payable (i.e., fixed- income securities issued to investors). Liabilities such as loans payable and bonds payable are usually reported at amortised cost on the balance sheet. At maturity, the amortised cost of the bond (carrying amount) will be equal to the face value of the bond. For example, if a company issues $10,000,000 of bonds at par, the bonds are reported as a long- term liability of $10 million. The car- rying amount (amortised cost) from the date of issue to the date of maturity remains at $10 million. As another example, if a company issues $10,000,000 of bonds at a price of 97.50 (a discount to par), the bonds are reported as a liability of $9,750,000 at issue date. Over the bond’s life, the discount of $250,000 is amortised so that the bond will be reported as a liability of $10,000,000 at maturity. Similarly, any bond premium would be amortised for bonds issued at a price in excess of face or par value. In certain cases, liabilities such as bonds issued by a company are reported at fair value. Those cases include financial liabilities held for trading, derivatives that are a liability to the company, and some non- derivative instruments such as those which are hedged by derivatives. SAP’s balance sheet in Exhibit 12 shows €5,034 million of financial liabilities, and the notes disclose that these liabilities are mostly for bonds payable. Apple’s balance sheet shows $97,207 million of long- term debt, and the notes disclose that this debt includes floating- and fixed- rate notes with varying maturities. 12.2 Deferred Tax Liabilities Deferred tax liabilities result from temporary timing differences between a company’s income as reported for tax purposes (taxable income) and income as reported for financial statement purposes (reported income). Deferred tax liabilities result when taxable income and the actual income tax payable in a period based on it is less than the reported financial statement income before taxes and the income tax expense based on it. Deferred tax liabilities are defined as the amounts of income taxes payable in future periods in respect of taxable temporary differences.20 In contrast, in the previous discussion of unearned revenue, inclusion of revenue in taxable income in an earlier period created a deferred tax asset (essentially prepaid tax). Deferred tax liabilities typically arise when items of expense are included in tax- able income in earlier periods than for financial statement net income. This results in taxable income being less than income before taxes in the earlier periods. As a result, taxes payable based on taxable income are less than income tax expense based on accounting income before taxes. The difference between taxes payable and income tax expense results in a deferred tax liability—for example, when companies use accelerated depreciation methods for tax purposes and straight- line depreciation methods for financial statement purposes. Deferred tax liabilities also arise when items of income are included in taxable income in later periods—for example, when a company’s subsidiary has profits that have not yet been distributed and thus have not yet been taxed. SAP’s balance sheet in Exhibit 12 shows €240 million of deferred tax liabilities. Apple’s balance sheet in Exhibit 13 does not show a separate line item for deferred tax liabilities, however, note disclosures indicate that most of the $40,415 million of other non- current liabilities reported on Apple’s balance sheet represents deferred tax liabilities, which totaled $31,504 million. 20 IAS 12, Income Taxes, paragraph 5. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 112. Reading 18 ■ Understanding Balance Sheets 94 COMPONENTS OF EQUITY f describe the components of shareholders’ equity Equity is the owners’ residual claim on a company’s assets after subtracting its lia- bilities.21 It represents the claim of the owner against the company. Equity includes funds directly invested in the company by the owners, as well as earnings that have been reinvested over time. Equity can also include items of gain or loss that are not recognized on the company’s income statement. 13.1 Components of Equity Six main components typically comprise total owners’ equity. The first five components listed below comprise equity attributable to owners of the parent company. The sixth component is the equity attributable to non- controlling interests. 1 Capital contributed by owners (or common stock, or issued capital). The amount contributed to the company by owners. Ownership of a corporation is evidenced through the issuance of common shares. Common shares may have a par value (or stated value) or may be issued as no par shares (depending on reg- ulations governing the incorporation). Where par or stated value requirements exist, it must be disclosed in the equity section of the balance sheet. In addition, the number of shares authorized, issued, and outstanding must be disclosed for each class of share issued by the company. The number of authorized shares is the number of shares that may be sold by the company under its articles of incorporation. The number of issued shares refers to those shares that have been sold to investors. The number of outstanding shares consists of the issued shares less treasury shares. 2 Preferred shares. Classified as equity or financial liabilities based upon their characteristics rather than legal form. For example, perpetual, non- redeemable preferred shares are classified as equity. In contrast, preferred shares with man- datory redemption at a fixed amount at a future date are classified as financial liabilities. Preferred shares have rights that take precedence over the rights of common shareholders—rights that generally pertain to receipt of dividends and receipt of assets if the company is liquidated. 3 Treasury shares (or treasury stock or own shares repurchased). Shares in the company that have been repurchased by the company and are held as treasury shares, rather than being cancelled. The company is able to sell (reissue) these shares. A company may repurchase its shares when management considers the shares undervalued, needs shares to fulfill employees’ stock options, or wants to limit the effects of dilution from various employee stock compensation plans. A repurchase of previously issued shares reduces shareholders’ equity by the amount of the cost of repurchasing the shares and reduces the number of total shares outstanding. If treasury shares are subsequently reissued, a company does not recognize any gain or loss from the reissuance on the income state- ment. Treasury shares are non- voting and do not receive any dividends declared by the company. 13 21 IASB Conceptual Framework (2018), paragraph 4.4 (c) and FASB ASC 505- 10- 05- 3 [Equity–Overview and Background]. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 113. Components of Equity 95 4 Retained earnings. The cumulative amount of earnings recognized in the company’s income statements which have not been paid to the owners of the company as dividends. 5 Accumulated other comprehensive income (or other reserves). The cumula- tive amount of other comprehensive income or loss. The term comprehensive income includes both a) net income, which is recognized on the income state- ment and is reflected in retained earnings, and b) other comprehensive income which is not recognized as part of net income and is reflected in accumulated other comprehensive income.22 6 Noncontrolling interest (or minority interest). The equity interests of minority shareholders in the subsidiary companies that have been consolidated by the parent (controlling) company but that are not wholly owned by the parent company. Exhibits 14 and 15 present excerpts of the balance sheets of SAP Group and Apple Inc., respectively, with detailed line items for each company’s equity section. SAP’s balance sheet indicates that the company has €1,229 million issued capital, and the notes to the financial statements disclose that the company has issued 1,229 million no- par common stock with a nominal value of €1 per share. SAP’s balance sheet also indicates that the company has €1,591 million of treasury shares, and the notes to the financial statements disclose that the company holds 35 million of its shares as treasury shares. The line item share premium of €570 million includes amounts from treasury share transactions (and certain other transactions). The amount of retained earnings, €24,794 million, represents the cumulative amount of earnings that the company has recognized in its income statements, net of dividends. SAP’s €508 million of “Other components of equity” includes the company’s accumulated other comprehensive income. The notes disclose that this is composed of €330 million gains on exchange differences in translation, €157 million gains on remeasuring available-for- sale financial assets, and €21 million gains on cash flow hedges. The balance sheet next presents a subtotal for the amount of equity attributable to the parent company €25,509 million followed by the amount of equity attributable to non- controlling interests €31 mil- lion. Total equity includes both equity attributable to the parent company and equity attributable to non- controlling interests. The equity section of Apple’s balance sheet consists of only three line items: com- mon stock, retained earnings, and accumulated other comprehensive income/(loss). Although Apple’s balance sheet shows no treasury stock, the company does repurchase its own shares but cancels the repurchased shares rather than holding the shares in treasury. Apple’s balance sheet shows that 5,126,201 thousand shares were issued and outstanding at the end of fiscal 2017 and 5,336,166 thousand shares were issued and outstanding at the end of fiscal 2016. Details on the change in shares outstanding is presented on the Statement of Shareholders’ Equity in Exhibit 16, which shows that in 2017 Apple repurchased 246,496 thousand shares of its previously issued common stock and issued 36,531 thousand shares to employees. 22 IFRS defines Total comprehensive income as “the change in equity during a period resulting from transactions and other events, other than those changes resulting from transactions with owners in their capacity as owners. (IAS 1, Presentation of Financial Statements, paragraph 7. Similarly, US GAAP defines comprehensive income as “the change in equity [net assets] of a business entity during a period from transactions and other events and circumstances from nonowner sources. It includes all changes in equity during a period except those resulting from investments by owners and distributions to owners.” (FASB ASC Master Glossary.) © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 114. Reading 18 ■ Understanding Balance Sheets 96 Exhibit 14 SAP Group Consolidated Statements of Financial Position (Excerpt: Equity Detail) (in millions of €) as of 31 December Assets 2017 2016 Total current assets 11,930 11,564 Total non- current assets 30,567 32,713 Total assets 42,497 44,277 Total current liabilities 10,210 9,674 Total non- current liabilities 6,747 8,205 Total liabilities 16,958 17,880 Issued capital 1,229 1,229 Share premium 570 599 Retained earnings 24,794 22,302 Other components of equity 508 3,346 Treasury shares (1,591) (1,099) Equity attributable to owners of parent 25,509 26,376 Non-controlling interests 31 21 Total equity 25,540 26,397 Total equity and liabilities €42,497 €44,277 Source: SAP Group 2017 annual report. Exhibit 15 Apple Inc. Consolidated Balance Sheet (Excerpt: Equity Detail) (in millions of $) (Number of shares are reflected in thousands) Assets 30 September 2017 24 September 2016 Total current assets 128,645 106,869 [All other assets] 246,674 214,817 Total assets 375,319 321,686 Liabilities and shareholders’ equity Total current liabilities 100,814 79,006 [Total non- current liabilities] 140,458 114,431 Total liabilities 241,272 193,437 Common stock and additional paid- in capital, $0.00001 par value: 12,600,000 shares autho- rized; 5,126,201 and 5,336,166 shares issued and outstanding, respectively 35,867 31,251 Retained earnings 98,330 96,364 Accumulated other comprehensive income/ (loss) (150) 634 © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 115. Statement of Changes in Equity 97 Assets 30 September 2017 24 September 2016 Total shareholders’ equity 134,047 128,249 Total liabilities and shareholders’ equity 375,319 321,686 Source: Apple Inc. 2017 annual report (10K). STATEMENT OF CHANGES IN EQUITY f describe the components of shareholders’ equity The statement of changes in equity (or statement of shareholders’ equity) presents information about the increases or decreases in a company’s equity over a period. IFRS requires the following information in the statement of changes in equity: ■ ■ total comprehensive income for the period; ■ ■ the effects of any accounting changes that have been retrospectively applied to previous periods; ■ ■ capital transactions with owners and distributions to owners; and ■ ■ reconciliation of the carrying amounts of each component of equity at the beginning and end of the year.23 Under US GAAP, the requirement as specified by the SEC is for companies to provide an analysis of changes in each component of stockholders’ equity that is shown in the balance sheet.24 Exhibit 16 presents an excerpt from Apple’s Consolidated Statements of Changes in Shareholders’ Equity. The excerpt shows only one of the years presented on the actual statement. It begins with the balance as of 24 September 2016 (i.e., the beginning of fiscal 2017) and presents the analysis of changes to 30 September 2017 in each com- ponent of equity that is shown on Apple’s balance sheet. As noted above, the number of shares outstanding decreased from 5,336,166 thousand to 5,126,201 thousand as the company repurchased 246,496 thousand shares of its common stock and issued 36,531 thousand new shares which reduced the dollar balance of Paid- in Capital and Retained earnings by $913 million and $581 million, respectively. The dollar balance in common stock also increased by $ 4,909 million in connection with share- based compensation. Retained earnings increased by $48,351 million net income, minus $12,803 million dividends, $33,001 million for the share repurchase and $581 million adjustment in connection with the stock issuance. For companies that pay dividends, the amount of dividends are shown separately as a deduction from retained earnings. The statement also provides details on the $784 million change in Apple’s Accumulated other comprehensive income. Note that the statement provides a subtotal for total comprehensive income that includes net income and each of the components of other comprehensive income. 14 Exhibit 15 (Continued) 23 IAS 1, Presentation of Financial Statements, paragraph 106. 24 FASB ASC 505- 10- S99 [Equity–Overall–SEC materials] indicates that a company can present the analysis of changes in stockholders’ equity either in the notes or in a separate statement. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 116. Reading 18 ■ Understanding Balance Sheets 98 Exhibit 16 Excerpt from Apple Inc.’s Consolidated Statements of Changes in Shareholders’Equity (in millions, except share amounts which are reflected in thousands) Common Stock and Additional Paid- In Capital Retained Earnings Accumulated Other Comprehensive Income/(Loss) Total Shareholders' Equity Shares Amount Balances as of September 24, 2016 5,336,166 31,251 96,364 634 128,249 Net income — — 48,351 — 48,351 Other comprehensive income/ (loss) — — — (784) (784) Dividends and dividend equiv- alents declared — — (12,803) — (12,803) Repurchase of common stock (246,496) — (33,001) — (33,001) Share-based compensation — 4,909 — — 4,909 Common stock issued, net of shares withheld for employee taxes 36,531 (913) (581) — (1,494) Tax benefit from equity awards, including transfer pricing adjustments — 620 — — 620 Balances as of September 30, 2017 5,126,201 35,867 98,330 (150) 134,047 COMMON SIZE ANALYSIS OF BALANCE SHEET g demonstrate the conversion of balance sheets to common- size balance sheets and interpret common- size balance sheets This section describes two tools for analyzing the balance sheet: common- size analysis and balance sheet ratios. Analysis of a company’s balance sheet can provide insight into the company’s liquidity and solvency—as of the balance sheet date—as well as the economic resources the company controls. Liquidity refers to a company’s abil- ity to meet its short- term financial commitments. Assessments of liquidity focus a company’s ability to convert assets to cash and to pay for operating needs. Solvency refers to a company’s ability to meet its financial obligations over the longer term. Assessments of solvency focus on the company’s financial structure and its ability to pay long- term financing obligations. 15.1 Common- Size Analysis of the Balance Sheet The first technique, vertical common- size analysis, involves stating each balance sheet item as a percentage of total assets.25 Common- size statements are useful in comparing a company’s balance sheet composition over time (time- series analysis) and across 15 25 As discussed in the curriculum reading on financial statement analysis, another type of common- size analysis, known as “horizontal common- size analysis,” states quantities in terms of a selected base- year value. Unless otherwise indicated, text references to “common- size analysis” refer to vertical analysis. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 117. Common Size Analysis of Balance Sheet 99 companies in the same industry. To illustrate, Panel A of Exhibit 17 presents a balance sheet for three hypothetical companies. Company C, with assets of $9.75 million is much larger than Company A and Company B, each with only $3.25 million in assets. The common- size balance sheet presented in Panel B facilitates a comparison of these different sized companies. Exhibit 17 Panel A: Balance Sheets for Companies A, B, and C ($ Thousands) A B C ASSETS Current assets Cash and cash equivalents 1,000 200 3,000 Short-term marketable securities 900 — 300 Accounts receivable 500 1,050 1,500 Inventory 100 950 300 Total current assets 2,500 2,200 5,100 Property, plant, and equipment, net 750 750 4,650 Intangible assets — 200 — Goodwill — 100 — Total assets 3,250 3,250 9,750 LIABILITIES AND SHAREHOLDERS’ EQUITY Current liabilities Accounts payable — 2,500 600 Total current liabilities — 2,500 600 Long term bonds payable 10 10 9,000 Total liabilities 10 2,510 9,600 Total shareholders’ equity 3,240 740 150 Total liabilities and shareholders’ equity 3,250 3,250 9,750 Panel B: Common- Size Balance Sheets for Companies A, B, and C (Percent) A B C ASSETS Current assets Cash and cash equivalents 30.8 6.2 30.8 Short-term marketable securities 27.7 0.0 3.1 Accounts receivable 15.4 32.3 15.4 Inventory 3.1 29.2 3.1 Total current assets 76.9 67.7 52.3 Property, plant and equipment, net 23.1 23.1 47.7 Intangible assets 0.0 6.2 0.0 Goodwill 0.0 3.1 0.0 Total assets 100.0 100.0 100.0 (continued) © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 118. Reading 18 ■ Understanding Balance Sheets 100 Panel B: Common- Size Balance Sheets for Companies A, B, and C (Percent) A B C LIABILITIES AND SHAREHOLDERS’ EQUITY Current liabilities Accounts payable 0.0 76.9 6.2 Total current liabilities 0.0 76.9 6.2 Long term bonds payable 0.3 0.3 92.3 Total liabilities 0.3 77.2 98.5 Total shareholders’ equity 99.7 22.8 1.5 Total liabilities and shareholders’ equity 100.0 100.0 100.0 Most of the assets of Company A and B are current assets; however, Company A has nearly 60 percent of its total assets in cash and short- term marketable securities while Company B has only 6 percent of its assets in cash. Company A is more liquid than Company B. Company A shows no current liabilities (its current liabilities round to less than $10 thousand), and it has cash on hand of $1.0 million to meet any near- term financial obligations it might have. In contrast, Company B has $2.5 million of current liabilities which exceed its available cash of only $200 thousand. To pay those near- term obligations, Company B will need to collect some of its accounts receiv- ables, sell more inventory, borrow from a bank, and/or raise more long- term capital (e.g., by issuing more bonds or more equity). Company C also appears more liquid than Company B. It holds over 30 percent of its total assets in cash and short- term marketable securities, and its current liabilities are only 6.2 percent of the amount of total assets. Company C’s $3.3 million in cash and short- term marketable securities is sub- stantially more than its current liabilities of $600 thousand. Turning to the question of solvency, however, note that 98.5 percent of Company C’s assets are financed with liabilities. If Company C experiences significant fluctuations in cash flows, it may be unable to pay the interest and principal on its long- term bonds. Company A is far more solvent than Company C, with less than one percent of its assets financed with liabilities. Note that these examples are hypothetical only. Other than general comparisons, little more can be said without further detail. In practice, a wide range of factors affect a company’s liquidity management and capital structure. The study of optimal capital structure is a fundamental issue addressed in corporate finance. Capital refers to a company’s long- term debt and equity financing; capital structure refers to the proportion of debt versus equity financing. Common- size balance sheets can also highlight differences in companies’ strat- egies. Comparing the asset composition of the companies, Company C has made a greater proportional investment in property, plant, and equipment—possibly because it manufactures more of its products in- house. The presence of goodwill on Company B’s balance sheet signifies that it has made one or more acquisitions in the past. In contrast, the lack of goodwill on the balance sheets of Company A and Company C suggests that these two companies may have pursued a strategy of internal growth rather than growth by acquisition. Company A may be in either a start- up or liquidation Exhibit 17 (Continued) © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 119. Common Size Analysis of Balance Sheet 101 stage of operations as evidenced by the composition of its balance sheet. It has rela- tively little inventory and no accounts payable. It either has not yet established trade credit or it is in the process of paying off its obligations in the process of liquidating. EXAMPLE 5 Common-Size Analysis Applying common- size analysis to the excerpts of SAP Group’s balance sheets presented in Exhibits 4, 6, 8, and 12, answer the following: In 2017 relative to 2016, which of the following line items increased as a percentage of assets? A Cash and cash equivalents. B Total current assets. C Total financial liabilities D Total deferred income. Solution: A, B, and D are correct. The following items increased as a percentage of total assets: ■ ■ Cash and cash equivalents increased from 8.4 percent of total assets in 2016 (€3,702 ÷ €44,277) to 9.4 percent in 2017 (€4,011 ÷ €42,497). ■ ■ Total current assets increased from 26.1 percent of total assets in 2016 (€11,564 ÷ €44,277) to 28.1 percent in 2017 (€11,930 ÷ €42,497). ■ ■ Total deferred income increased from 5.7 percent of total assets in 2016 ((€ 2,383 +€143) ÷ €44,277) to 6.7 percent in 2017 ((€ 2,771 +€79) ÷ €42,497). Total financial liabilities decreased both in absolute Euro amounts and as a percentage of total assets when compared with the previous year. Note that some amounts of the company’s deferred income and financial liabilities are classified as current liabilities (shown in Exhibit 6) and some amounts are classified as non- current liabilities (shown in Exhibit 12). The total amounts—current and non- current—of deferred income and financial liabilities, therefore, are obtained by summing the amounts in Exhibits 6 and 12. Overall, aspects of the company’s liquidity position are somewhat stronger in 2017 compared to 2016. The company’s cash balances as a percentage of total assets increased. While current liabilities increased as a percentage of total assets and total liabilities remained approximately the same percentage, the mix of liabilities shifted. Financial liabilities, which represent future cash outlays, decreased as a percentage of total assets, while deferred revenues, which represent cash received in advance of revenue recognition, increased. Common- size analysis of the balance sheet is particularly useful in cross- sectional analysis—comparing companies to each other for a particular time period or compar- ing a company with industry or sector data. The analyst could select individual peer companies for comparison, use industry data from published sources, or compile data from databases. When analyzing a company, many analysts prefer to select the peer companies for comparison or to compile their own industry statistics. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 120. Reading 18 ■ Understanding Balance Sheets 102 Exhibit 18 presents common- size balance sheet data compiled for the 10 sectors of the SP 500 using 2017 data. The sector classification follows the SP/MSCI Global Industrial Classification System (GICS). The exhibit presents mean and median common- size balance sheet data for those companies in the SP 500 for which 2017 data was available in the Compustat database.26 Some interesting general observations can be made from these data: ■ ■ Energy and utility companies have the largest amounts of property, plant, and equipment (PPE). Telecommunication services, followed by utilities, have the highest level of long- term debt. Utilities also use some preferred stock. ■ ■ Financial companies have the greatest percentage of total liabilities. Financial companies typically have relatively high financial leverage. ■ ■ Telecommunications services and utility companies have the lowest level of receivables. ■ ■ Inventory levels are highest for consumer discretionary. Materials and con- sumer staples have the next highest inventories. ■ ■ Information technology companies use the least amount of leverage as evi- denced by the lowest percentages for long- term debt and total liabilities and highest percentages for common and total equity. Example 6 discusses an analyst using cross- sectional common- size balance sheet data. EXAMPLE 6 Cross-Sectional Common-Size Analysis Jason Lu is comparing two companies in the computer industry to evaluate their relative financial position as reflected on their balance sheets. He has compiled the following vertical common- size data for Apple and Microsoft. Cross- Sectional Analysis: Consolidated Balance Sheets (as Percent of Total Assets) Apple Microsoft ASSETS: 30 September 2017 30 June 2017 Current assets: Cash and cash equivalents 5.4 3.2 Short-term marketable securities 14.4 52.0 Accounts receivable 4.8 8.2 Inventories 1.3 0.9 Vendor non-trade receivables 4.7 0.0 Other current assets 3.7 2.0 Total current assets 34.3 66.3 Long- term marketable securities 51.9 2.5 Property, plant and equipment, net 9.0 9.8 Goodwill 1.5 14.6 26 An entry of zero for an item (e.g., current assets) was excluded from the data, except in the case of preferred stock. Note that most financial institutions did not provide current asset or current liability data, so these are reported as not available in the database. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 121. Common Size Analysis of Balance Sheet 103 Exhibit 18 Common- S ize Balance Sheet Statistics for the SP 500 Grouped by SP/MSCI GICS Sector (in percent except No. of Observations; data for 2017) Panel A. Median Data 10 15 20 25 30 35 40 45 50 55 60 Energy Materials Industrials Consumer Discretionary Consumer Staples Health Care Financials Information Technology Telecommunication Services Utilities Real Estate Number of observation 34 27 68 81 33 59 64 64 4 29 30 Cash and short- t erm investments 6.8% 6.3% 8.1% 8.3% 4.1% 11.2% 6.2% 22.7% 1.2% 0.7% 1.4% Receivables 5.8% 8.8% 12.9% 6.8% 6.5% 9.7% 20.4% 9.6% 3.7% 3.6% 2.0% Inventories 1.6% 8.9% 6.9% 14.9% 9.6% 4.3% 0.0% 1.3% 0.3% 1.7% 0.0% Total current assets 16.1% 26.0% 30.5% 41.5% 29.1% 31.4% N.A. 48.7% 8.6% 7.3% 10.8% PPE 73.3% 36.3% 12.5% 19.8% 17.2% 8.1% 0.9% 6.2% 35.0% 72.0% 33.4% Intangibles 1.6% 27.9% 33.3% 16.8% 41.9% 37.6% 2.8% 26.4% 49.6% 6.2% 1.0% Goodwill 0.7% 20.0% 28.3% 11.3% 26.2% 22.8% 2.2% 22.3% 26.0% 4.8% 0.0% Accounts payable 5.7% 7.3% 6.2% 8.0% 8.0% 3.1% 27.0% 2.7% 2.5% 3.0% 1.3% Current liabilities 10.9% 16.5% 22.5% 25.8% 25.0% 16.5% N.A. 21.2% 11.5% 11.5% 7.1% LT debt 27.3% 31.4% 28.0% 28.7% 32.3% 24.3% 6.4% 22.9% 46.8% 32.5% 43.4% Total liabilities 49.3% 64.2% 65.5% 64.9% 63.8% 59.2% 86.7% 59.9% 75.8% 71.8% 53.3% Common equity 47.3% 33.8% 34.5% 34.7% 36.2% 39.4% 12.6% 39.3% 23.9% 27.7% 40.4% Preferred stock 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% Total equity 47.3% 33.8% 34.5% 34.7% 36.2% 39.4% 13.2% 39.3% 23.9% 28.0% 41.8% © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 122. Reading 18 ■ Understanding Balance Sheets 104 Exhibit 18 (Continued) Panel B. Mean Data 10 15 20 25 30 35 40 45 50 55 60 Energy Materials Industrials Consumer Discretionary Consumer Staples Health Care Financials Information Technology Telecommunication Services Utilities Real Estate Number of observations 34 27 68 81 33 59 64 64 4 29 30 Cash and short- t erm investments 6.9% 7.4% 9.2% 12.9% 7.3% 15.4% 11.2% 28.3% 3.6% 1.3% 2.9% Receivables 6.6% 10.5% 15.2% 9.0% 7.7% 11.2% 31.5% 11.8% 5.0% 3.8% 3.8% Inventories 3.4% 9.3% 7.8% 18.3% 10.6% 6.3% 3.8% 4.1% 0.3% 1.6% 0.1% Total current assets 17.7% 28.8% 32.9% 40.6% 27.8% 36.4% N.A. 49.4% 10.1% 8.6% 16.1% PPE 68.0% 36.9% 24.5% 25.1% 21.6% 11.2% 2.1% 10.3% 39.0% 69.9% 34.9% Intangibles 7.8% 26.6% 35.6% 23.0% 43.6% 43.9% 11.4% 31.1% 48.2% 6.8% 10.3% Goodwill 5.4% 18.4% 26.8% 14.6% 24.6% 27.3% 7.7% 24.5% 25.9% 5.7% 5.7% Accounts payable 5.9% 8.1% 7.1% 11.8% 9.8% 8.1% 35.9% 5.1% 3.1% 2.9% 2.0% Current liabilities 11.8% 17.0% 23.0% 26.8% 24.6% 21.2% N.A. 26.1% 11.9% 11.8% 12.8% LT debt 28.3% 31.2% 29.4% 31.3% 32.4% 28.5% 10.3% 24.8% 47.5% 35.0% 44.8% Total liabilities 50.3% 63.4% 67.1% 67.5% 68.3% 60.1% 80.1% 61.8% 77.6% 73.9% 54.5% Common equity 46.4% 34.2% 32.3% 32.3% 30.9% 38.9% 18.2% 37.5% 22.2% 24.7% 40.2% Preferred stock 0.0% 0.0% 0.1% 0.0% 0.0% 0.1% 0.4% 0.3% 0.0% 0.3% 2.2% Total equity 46.4% 34.2% 32.4% 32.3% 30.9% 39.0% 18.5% 37.8% 22.2% 25.0% 42.3% PPE = Property, plant, and equipment, LT = Long term. Source: Based on data from Compustat. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 123. Common Size Analysis of Balance Sheet 105 Apple Microsoft ASSETS: 30 September 2017 30 June 2017 Acquired intangible assets, net 0.6 4.2 Other assets 2.7 2.6 Total assets 100.0 100.0 LIABILITIES AND SHAREHOLDERS’ EQUITY: Current liabilities: Accounts payable 13.1 3.1 Short-term debt 3.2 3.8 Current portion of long- term debt 1.7 0.4 Accrued expenses 6.9 2.7 Deferred revenue 2.0 14.1 Other current liabilities 0.0 2.6 Total current liabilities 26.9 26.8 Long-term debt 25.9 31.6 Deferred revenue non- current 0.8 4.3 Other non- current liabilities 10.8 7.3 Total liabilities 64.3 70.0 Commitments and contingencies Total shareholders’ equity 35.7 30.0 Total liabilities and shareholders’ equity 100.0 100.0 Source: Based on data from companies’ annual reports. From this data, Lu learns the following: ■ ■ Apple and Microsoft have high levels of cash and short- term marketable securities, consistent with the information technology sector as reported in Exhibit 18. Apple also has a high balance in long- term marketable secu- rities. This may reflect the success of the company’s business model, which has generated large operating cash flows in recent years. ■ ■ Apple’s level of accounts receivable is lower than Microsoft’s and lower than the industry average. Further research is necessary to learn the extent to which this is related to Apple’s cash sales through its own retail stores. An alternative explanation would be that the company has been selling/factoring receivables to a greater degree than the other compa- nies; however, that explanation is unlikely given Apple’s cash position. Additionally, Apple shows vendor non- trade receivables, reflecting arrangements with its contract manufacturers. ■ ■ Apple and Microsoft both have low levels of inventory, similar to industry medians as reported in Exhibit 18. Apple uses contract manufacturers and can rely on suppliers to hold inventory until needed. Additionally, in the Management Discussion and Analysis section of their annual report, Apple discloses $38 billion of noncancelable manufacturing purchase obli- gations, $33 billion of which is due within twelve months. These amounts are not currently recorded as inventory and reflect the use of contract manufacturers to assemble and test some finished products. The use of (Continued) © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 124. Reading 18 ■ Understanding Balance Sheets 106 purchase commitments and contract manufacturers implies that inven- tory may be “understated.” Microsoft’s low level of inventory is consistent with its business mix which is more heavily weighted to software than to hardware. ■ ■ Apple and Microsoft have a level of property, plant, and equipment that is relatively close to the sector median as reported in Exhibit 18. ■ ■ Apple has a very low amount of goodwill, reflecting its strategy to grow organically rather than through acquisition. Microsoft’s level of goodwill, while higher than Apple’s, is lower than the industry median and mean. Microsoft made a number of major acquisitions (for example, Nokia in 2014) but subsequently (in 2015) wrote off significant amounts of goodwill as an impairment charge. ■ ■ Apple’s level of accounts payable is higher than the industry, but given the company’s high level of cash and investments, it is unlikely that this is a problem. ■ ■ Apple’s and Microsoft’s levels of long- term debt are slightly higher than industry averages. Again, given the companies’ high level of cash and investments, it is unlikely that this is a problem. BALANCE SHEET RATIOS h calculate and interpret liquidity and solvency ratios Ratios facilitate time- series and cross- sectional analysis of a company’s financial position. Balance sheet ratios are those involving balance sheet items only. Each of the line items on a vertical common- size balance sheet is a ratio in that it expresses a balance sheet amount in relation to total assets. Other balance sheet ratios compare one balance sheet item to another. For example, the current ratio expresses current assets in relation to current liabilities as an indicator of a company’s liquidity. Balance sheet ratios include liquidity ratios (measuring the company’s ability to meet its short- term obligations) and solvency ratios (measuring the company’s ability to meet long- term and other obligations). These ratios and others are discussed in a later reading. Exhibit 19 summarizes the calculation and interpretation of selected balance sheet ratios. Exhibit 19 Balance Sheet Ratios Liquidity Ratios Calculation Indicates Current Current assets ÷ Current liabilities Ability to meet current liabilities Quick (acid test) (Cash + Marketable securities + Receivables) ÷ Current liabilities Ability to meet current liabilities Cash (Cash + Marketable securi- ties) ÷ Current liabilities Ability to meet current liabilities 16 © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 125. Balance Sheet Ratios 107 Solvency Ratios Long-term debt-to-equity Total long- term debt ÷ Total equity Financial risk and financial leverage Debt-to-equity Total debt ÷ Total equity Financial risk and financial leverage Total debt Total debt ÷ Total assets Financial risk and financial leverage Financial leverage Total assets ÷ Total equity Financial risk and financial leverage EXAMPLE 7 Ratio Analysis For the following ratio questions, refer to the balance sheet information for the SAP Group presented in Exhibits 1, 4, 6, 8, and 12. 1 The current ratio for SAP Group at 31 December 2017 is closest to: A 1.17. B 1.20. C 2.00. 2 Which of the following liquidity ratios decreased in 2017 relative to 2016? A Cash. B Quick. C Current. 3 Which of the following leverage ratios decreased in 2017 relative to 2016? A Debt-to-equity. B Financial leverage. C Long-term debt-to-equity. Solution to 1: A is correct. SAP Group’s current ratio (Current assets ÷ Current liabilities) at 31 December 2017 is 1.17 (€11,930 million ÷ €10,210 million). Solution to 2: B and C are correct. The ratios are shown in the table below. The quick ratio and current ratio are lower in 2017 than in 2016. The cash ratio is slightly higher. Liquidity Ratios Calculation 2017 € in millions 2016 € in millions Current Current assets ÷ Current liabilities €11,930 ÷ €10,210 = 1.17 €11,564 ÷ €9,674 = 1.20 Quick (acid test) (Cash + Marketable securities + Receivables) ÷ Current liabilities (€4,011 + €990 + €5,899) ÷ €10,210 = 1.07 (€3,702 + €1,124 + €5,924) ÷ €9,674 = 1.11 Cash (Cash + Marketable securities) ÷ Current liabilities €4,011 ÷ €10,210 = 0.39 €3,702 ÷ €9,674 = 0.38 Exhibit 19 (Continued) © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 126. Reading 18 ■ Understanding Balance Sheets 108 Solution to 3: A, B, and C are correct. The ratios are shown in the table below. All three leverage ratios decreased in 2017 relative to 2016. Solvency Ratios Long-term debt-to-equity Total long- term debt ÷ Total equity €5,034 ÷ €25,540 =19.7% €6,481 ÷ €26,397 = 24.6% Debt-to-equity Total debt ÷ Total equity (€1,561 + €5,034 ) ÷ €25,540 = 25.8% (€ 1,813 + €6,481) ÷ €26,397 = 31.4% Financial Leverage Total assets ÷ Total equity €42,497 ÷ €25,540 = 1.66 €44,277 ÷ €26,397 = 1.68 Cross- sectional financial ratio analysis can be limited by differences in accounting methods. In addition, lack of homogeneity of a company’s operating activities can limit comparability. For diversified companies operating in different industries, using industry- specific ratios for different lines of business can provide better comparisons. Companies disclose information on operating segments. The financial position and performance of the operating segments can be compared to the relevant industry. Ratio analysis requires a significant amount of judgment. One key area requiring judgment is understanding the limitations of any ratio. The current ratio, for example, is only a rough measure of liquidity at a specific point in time. The ratio captures only the amount of current assets, but the components of current assets differ significantly in their nearness to cash (e.g., marketable securities versus inventory). Another lim- itation of the current ratio is its sensitivity to end- of- period financing and operating decisions that can potentially impact current asset and current liability amounts. Another overall area requiring judgment is determining whether a ratio for a company is within a reasonable range for an industry. Yet another area requiring judgment is evaluating whether a ratio signifies a persistent condition or reflects only a temporary condition. Overall, evaluating specific ratios requires an examination of the entire operations of a company, its competitors, and the external economic and industry setting in which it is operating. SUMMARY The balance sheet (also referred to as the statement of financial position) discloses what an entity owns (assets) and what it owes (liabilities) at a specific point in time. Equity is the owners’ residual interest in the assets of a company, net of its liabilities. The amount of equity is increased by income earned during the year, or by the issuance of new equity. The amount of equity is decreased by losses, by dividend payments, or by share repurchases. An understanding of the balance sheet enables an analyst to evaluate the liquidity, solvency, and overall financial position of a company. ■ ■ The balance sheet distinguishes between current and non- current assets and between current and non- current liabilities unless a presentation based on liquidity provides more relevant and reliable information. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 127. Summary 109 ■ ■ The concept of liquidity relates to a company’s ability to pay for its near- term operating needs. With respect to a company overall, liquidity refers to the avail- ability of cash to pay those near- term needs. With respect to a particular asset or liability, liquidity refers to its “nearness to cash.” ■ ■ Some assets and liabilities are measured on the basis of fair value and some are measured at historical cost. Notes to financial statements provide informa- tion that is helpful in assessing the comparability of measurement bases across companies. ■ ■ Assets expected to be liquidated or used up within one year or one operat- ing cycle of the business, whichever is greater, are classified as current assets. Assets not expected to be liquidated or used up within one year or one oper- ating cycle of the business, whichever is greater, are classified as non- current assets. ■ ■ Liabilities expected to be settled or paid within one year or one operating cycle of the business, whichever is greater, are classified as current liabilities. Liabilities not expected to be settled or paid within one year or one operat- ing cycle of the business, whichever is greater, are classified as non- current liabilities. ■ ■ Trade receivables, also referred to as accounts receivable, are amounts owed to a company by its customers for products and services already delivered. Receivables are reported net of the allowance for doubtful accounts. ■ ■ Inventories are physical products that will eventually be sold to the company’s customers, either in their current form (finished goods) or as inputs into a process to manufacture a final product (raw materials and work- in- process). Inventories are reported at the lower of cost or net realizable value. If the net realizable value of a company’s inventory falls below its carrying amount, the company must write down the value of the inventory and record an expense. ■ ■ Inventory cost is based on specific identification or estimated using the first- in, first- out or weighted average cost methods. Some accounting standards (includ- ing US GAAP but not IFRS) also allow last- in, first- out as an additional inven- tory valuation method. ■ ■ Accounts payable, also called trade payables, are amounts that a business owes its vendors for purchases of goods and services. ■ ■ Deferred revenue (also known as unearned revenue) arises when a company receives payment in advance of delivery of the goods and services associated with the payment received. ■ ■ Property, plant, and equipment (PPE) are tangible assets that are used in company operations and expected to be used over more than one fiscal period. Examples of tangible assets include land, buildings, equipment, machinery, fur- niture, and natural resources such as mineral and petroleum resources. ■ ■ IFRS provide companies with the choice to report PPE using either a historical cost model or a revaluation model. US GAAP permit only the historical cost model for reporting PPE. ■ ■ Depreciation is the process of recognizing the cost of a long- lived asset over its useful life. (Land is not depreciated.) ■ ■ Under IFRS, property used to earn rental income or capital appreciation is con- sidered to be an investment property. IFRS provide companies with the choice to report an investment property using either a historical cost model or a fair value model. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 128. Reading 18 ■ Understanding Balance Sheets 110 ■ ■ Intangible assets refer to identifiable non- monetary assets without physical sub- stance. Examples include patents, licenses, and trademarks. For each intangible asset, a company assesses whether the useful life is finite or indefinite. ■ ■ An intangible asset with a finite useful life is amortised on a systematic basis over the best estimate of its useful life, with the amortisation method and useful- life estimate reviewed at least annually. Impairment principles for an intangible asset with a finite useful life are the same as for PPE. ■ ■ An intangible asset with an indefinite useful life is not amortised. Instead, it is tested for impairment at least annually. ■ ■ For internally generated intangible assets, IFRS require that costs incurred during the research phase must be expensed. Costs incurred in the develop- ment stage can be capitalized as intangible assets if certain criteria are met, including technological feasibility, the ability to use or sell the resulting asset, and the ability to complete the project. ■ ■ The most common intangible asset that is not a separately identifiable asset is goodwill, which arises in business combinations. Goodwill is not amortised; instead it is tested for impairment at least annually. ■ ■ Financial instruments are contracts that give rise to both a financial asset of one entity and a financial liability or equity instrument of another entity. In general, there are two basic alternative ways that financial instruments are measured: fair value or amortised cost. For financial instruments measured at fair value, there are two basic alternatives in how net changes in fair value are recognized: as profit or loss on the income statement, or as other comprehensive income (loss) which bypasses the income statement. ■ ■ Typical long- term financial liabilities include loans (i.e., borrowings from banks) and notes or bonds payable (i.e., fixed- income securities issued to investors). Liabilities such as bonds issued by a company are usually reported at amortised cost on the balance sheet. ■ ■ Deferred tax liabilities arise from temporary timing differences between a com- pany’s income as reported for tax purposes and income as reported for financial statement purposes. ■ ■ Six potential components that comprise the owners’ equity section of the balance sheet include: contributed capital, preferred shares, treasury shares, retained earnings, accumulated other comprehensive income, and non- controlling interest. ■ ■ The statement of changes in equity reflects information about the increases or decreases in each component of a company’s equity over a period. ■ ■ Vertical common- size analysis of the balance sheet involves stating each balance sheet item as a percentage of total assets. ■ ■ Balance sheet ratios include liquidity ratios (measuring the company’s ability to meet its short- term obligations) and solvency ratios (measuring the company’s ability to meet long- term and other obligations). © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 129. Practice Problems 111 PRACTICE PROBLEMS 1 Resources controlled by a company as a result of past events are: A equity. B assets. C liabilities. 2 Equity equals: A Assets – Liabilities. B Liabilities – Assets. C Assets + Liabilities. 3 Distinguishing between current and non- current items on the balance sheet and presenting a subtotal for current assets and liabilities is referred to as: A a classified balance sheet. B an unclassified balance sheet. C a liquidity- based balance sheet. 4 Shareholders’ equity reported on the balance sheet is most likely to differ from the market value of shareholders’ equity because: A historical cost basis is used for all assets and liabilities. B some factors that affect the generation of future cash flows are excluded. C shareholders’ equity reported on the balance sheet is updated continuously. 5 The information provided by a balance sheet item is limited because of uncer- tainty regarding: A measurement of its cost or value with reliability. B the change in current value following the end of the reporting period. C the probability that any future economic benefit will flow to or from the entity. 6 Which of the following is most likely classified as a current liability? A Payment received for a product due to be delivered at least one year after the balance sheet date B Payments for merchandise due at least one year after the balance sheet date but still within a normal operating cycle C Payment on debt due in six months for which the company has the uncon- ditional right to defer settlement for at least one year after the balance sheet date 7 The most likely company to use a liquidity- based balance sheet presentation is a: A bank. B computer manufacturer holding inventories. C software company with trade receivables and payables. 8 All of the following are current assets except: A cash. B goodwill. C inventories. © 2019 CFA Institute. All rights reserved. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 130. Reading 18 ■ Understanding Balance Sheets 112 9 The most likely costs included in both the cost of inventory and property, plant, and equipment are: A selling costs. B storage costs. C delivery costs. 10 Debt due within one year is considered: A current. B preferred. C convertible. 11 Money received from customers for products to be delivered in the future is recorded as: A revenue and an asset. B an asset and a liability. C revenue and a liability. 12 An example of a contra asset account is: A depreciation expense. B sales returns and allowances. C allowance for doubtful accounts. 13 The carrying value of inventories reflects: A their historical cost. B their current value. C the lower of historical cost or net realizable value. 14 When a company pays its rent in advance, its balance sheet will reflect a reduc- tion in: A assets and liabilities. B assets and shareholders’ equity. C one category of assets and an increase in another. 15 Accrued expenses (accrued liabilities) are: A expenses that have been paid. B created when another liability is reduced. C expenses that have been reported on the income statement but not yet paid. 16 The initial measurement of goodwill is most likely affected by: A an acquisition’s purchase price. B the acquired company’s book value. C the fair value of the acquirer’s assets and liabilities. 17 Defining total asset turnover as revenue divided by average total assets, all else equal, impairment write- downs of long- lived assets owned by a company will most likely result in an increase for that company in: A the debt- to- equity ratio but not the total asset turnover. B the total asset turnover but not the debt- to- equity ratio. C both the debt- to- equity ratio and the total asset turnover. 18 A company has total liabilities of £35 million and total stockholders’ equity of £55 million. Total liabilities are represented on a vertical common- size balance sheet by a percentage closest to: A 35%. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 131. Practice Problems 113 B 39%. C 64%. 19 For financial assets classified as trading securities, how are unrealized gains and losses reflected in shareholders’ equity? A They are not recognized. B They flow through income into retained earnings. C They are a component of accumulated other comprehensive income. 20 For financial assets classified as available for sale, how are unrealized gains and losses reflected in shareholders’ equity? A They are not recognized. B They flow through retained earnings. C They are a component of accumulated other comprehensive income. 21 For financial assets classified as held to maturity, how are unrealized gains and losses reflected in shareholders’ equity? A They are not recognized. B They flow through retained earnings. C They are a component of accumulated other comprehensive income. 22 The non- controlling (minority) interest in consolidated subsidiaries is presented on the balance sheet: A as a long- term liability. B separately, but as a part of shareholders’ equity. C as a mezzanine item between liabilities and shareholders’ equity. 23 The item “retained earnings” is a component of: A assets. B liabilities. C shareholders’ equity. 24 When a company buys shares of its own stock to be held in treasury, it records a reduction in: A both assets and liabilities. B both assets and shareholders’ equity. C assets and an increase in shareholders’ equity. 25 Which of the following would an analyst most likely be able to determine from a common- size analysis of a company’s balance sheet over several periods? A An increase or decrease in sales. B An increase or decrease in financial leverage. C A more efficient or less efficient use of assets. 26 An investor concerned whether a company can meet its near- term obligations is most likely to calculate the: A current ratio. B return on total capital. C financial leverage ratio. 27 The most stringent test of a company’s liquidity is its: A cash ratio. B quick ratio. C current ratio. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 132. Reading 18 ■ Understanding Balance Sheets 114 28 An investor worried about a company’s long- term solvency would most likely examine its: A current ratio. B return on equity. C debt-to-equity ratio. 29 Using the information presented in Exhibit 4 of the reading, the quick ratio for SAP Group at 31 December 2017 is closest to: A 1.00. B 1.07. C 1.17. 30 Using the information presented in Exhibit 14 of the reading, the financial leverage ratio for SAP Group at 31 December 2017 is closest to: A 1.50. B 1.66. C 2.00. Questions 31 through 34 refer to Exhibit 1 Exhibit 1 Common- Size Balance Sheets for Company A, Company B, and Sector Average Company A Company B Sector Average ASSETS Current assets Cash and cash equivalents 5 5 7 Marketable securities 5 0 2 Accounts receivable, net 5 15 12 Inventories 15 20 16 Prepaid expenses 5 15 11 Total current assets 35 55 48 Property, plant, and equipment, net 40 35 37 Goodwill 25 0 8 Other assets 0 10 7 Total assets 100 100 100 LIABILITIES AND SHAREHOLDERS’ EQUITY Current liabilities Accounts payable 10 10 10 Short-term debt 25 10 15 Accrued expenses 0 5 3 Total current liabilities 35 25 28 © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 133. Practice Problems 115 LIABILITIES AND SHAREHOLDERS’ EQUITY Long-term debt 45 20 28 Other non- current liabilities 0 10 7 Total liabilities 80 55 63 Total shareholders’ equity 20 45 37 Total liabilities and shareholders’ equity 100 100 100 31 Based on Exhibit 1, which statement is most likely correct? A Company A has below- average liquidity risk. B Company B has above- average solvency risk. C Company A has made one or more acquisitions. 32 The quick ratio for Company A is closest to: A 0.43. B 0.57. C 1.00. 33 Based on Exhibit 1, the financial leverage ratio for Company B is closest to: A 0.55. B 1.22. C 2.22. 34 Based on Exhibit 1, which ratio indicates lower liquidity risk for Company A compared with Company B? A Cash ratio B Quick ratio C Current ratio Exhibit 1 (Continued) © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 134. Reading 18 ■ Understanding Balance Sheets 116 SOLUTIONS 1 B is correct. Assets are resources controlled by a company as a result of past events. 2 A is correct. Assets = Liabilities + Equity and, therefore, Assets – Liabilities = Equity. 3 A is correct. A classified balance sheet is one that classifies assets and liabilities as current or non- current and provides a subtotal for current assets and current liabilities. A liquidity- based balance sheet broadly presents assets and liabilities in order of liquidity. 4 B is correct. The balance sheet omits important aspects of a company’s ability to generate future cash flows, such as its reputation and management skills. The balance sheet measures some assets and liabilities based on historical cost and measures others based on current value. Market value of shareholders’ equity is updated continuously. Shareholders’ equity reported on the balance sheet is updated for reporting purposes and represents the value that was current at the end of the reporting period. 5 B is correct. Balance sheet information is as of a specific point in time, and items measured at current value reflect the value that was current at the end of the reporting period. For all financial statement items, an item should be recog- nized in the financial statements only if it is probable that any future economic benefit associated with the item will flow to or from the entity and if the item has a cost or value that can be measured with reliability. 6 B is correct. Payments due within one operating cycle of the business, even if they will be settled more than one year after the balance sheet date, are classi- fied as current liabilities. Payment received in advance of the delivery of a good or service creates an obligation or liability. If the obligation is to be fulfilled at least one year after the balance sheet date, it is recorded as a non- current liabil- ity, such as deferred revenue or deferred income. Payments that the company has the unconditional right to defer for at least one year after the balance sheet may be classified as non- current liabilities. 7 A is correct. A liquidity- based presentation, rather than a current/non- current presentation, may be used by such entities as banks if broadly presenting assets and liabilities in order of liquidity is reliable and more relevant. 8 B is correct. Goodwill is a long- term asset, and the others are all current assets. 9 C is correct. Both the cost of inventory and property, plant, and equipment include delivery costs, or costs incurred in bringing them to the location for use or resale. 10 A is correct. Current liabilities are those liabilities, including debt, due within one year. Preferred refers to a class of stock. Convertible refers to a feature of bonds (or preferred stock) allowing the holder to convert the instrument into common stock. 11 B is correct. The cash received from customers represents an asset. The obliga- tion to provide a product in the future is a liability called “unearned income” or “unearned revenue.” As the product is delivered, revenue will be recognized and the liability will be reduced. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 135. Solutions 117 12 C is correct. A contra asset account is netted against (i.e., reduces) the balance of an asset account. The allowance for doubtful accounts reduces the balance of accounts receivable. Accumulated depreciation, not depreciation expense, is a contra asset account. Sales returns and allowances create a contra account that reduce sales, not an asset. 13 C is correct. Under IFRS, inventories are carried at historical cost, unless net realizable value of the inventory is less. Under US GAAP, inventories are carried at the lower of cost or market. 14 C is correct. Paying rent in advance will reduce cash and increase prepaid expenses, both of which are assets. 15 C is correct. Accrued liabilities are expenses that have been reported on a com- pany’s income statement but have not yet been paid. 16 A is correct. Initially, goodwill is measured as the difference between the purchase price paid for an acquisition and the fair value of the acquired, not acquiring, company’s net assets (identifiable assets less liabilities). 17 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. 18 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 (£55 million), or £90 million. Total liabilities are shown on a vertical common- size balance sheet as (£35 mil- lion/£90 million) ≈ 39%. 19 B 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. 20 C is correct. For financial assets classified as available for sale, unrealized gains and losses are not recorded on the income statement and instead are part of other comprehensive income. Accumulated other comprehensive income is a component of Shareholders’ equity 21 A is correct. Financial assets classified as held to maturity are measured at amortised cost. Gains and losses are recognized only when realized. 22 B is correct. The non- controlling interest in consolidated subsidiaries is shown separately as part of shareholders’ equity. 23 C is correct. The item “retained earnings” is a component of shareholders’ equity. 24 B is correct. Share repurchases reduce the company’s cash (an asset). Shareholders’ equity is reduced because there are fewer shares outstanding and treasury stock is an offset to owners’ equity. 25 B is correct. Common- size analysis (as presented in the reading) provides infor- mation 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. 26 A is correct. The current ratio provides a comparison of assets that can be turned into cash relatively quickly and liabilities that must be paid within one year. The other ratios are more suited to longer- term concerns. 27 A is correct. The cash ratio determines how much of a company’s near- term obligations can be settled with existing amounts of cash and marketable securities. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 136. Reading 18 ■ Understanding Balance Sheets 118 28 C is correct. The debt- to- equity ratio, a solvency ratio, is an indicator of finan- cial risk. 29 B is correct. The quick ratio ([Cash + Marketable securities + Receivables] ÷ Current liabilities) is 1.07 ([= €4,011 + €990 + €5,899] ÷ €10,210). As noted in the text, the largest component of the current financial assets are loans and other financial receivables. Thus, financial assets are included in the quick ratio but not the cash ratio. 30 B is correct. The financial leverage ratio (Total assets ÷ Total equity) is 1.66 (= €42,497 ÷ €25,540). 31 C is correct. The presence of goodwill on Company A’s balance sheet signi- fies that it has made one or more acquisitions in the past. The current, cash, and quick ratios are lower for Company A than for the sector average. These lower liquidity ratios imply above- average liquidity risk. The total debt, long- term debt- to- equity, debt- to- equity, and financial leverage ratios are lower for Company B than for the sector average. These lower solvency ratios imply below- average solvency risk. Current ratio is (35/35) = 1.00 for Company A, versus (48/28) = 1.71 for the sector average. Cash ratio is (5 + 5)/35 = 0.29 for Company A, versus (7 + 2)/28 = 0.32 for the sector average. Quick ratio is (5 + 5 + 5)/35 = 0.43 for Company A, versus (7 + 2 + 12)/28 = 0.75 for the sector average. Total debt ratio is (55/100) = 0.55 for Company B, versus (63/100) = 0.63 for the sector average. Long- term debt- to- equity ratio is (20/45) = 0.44 for Company B, versus (28/37) = 0.76 for the sector average. Debt- to- equity ratio is (55/45) = 1.22 for Company B, versus (63/37) = 1.70 for the sector average. Financial leverage ratio is (100/45) = 2.22 for Company B, versus (100/37) = 2.70 for the sector average. 32 A is correct. The quick ratio is defined as (Cash and cash equivalents + Marketable securities + receivables) ÷ Current liabilities. For Company A, this calculation is (5 + 5 + 5)/35 = 0.43. 33 C is correct. The financial leverage ratio is defined as Total assets ÷ Total equity. For Company B, total assets are 100 and total equity is 45; hence, the financial leverage ratio is 100/45 = 2.22. 34 A is correct. The cash ratio is defined as (Cash + Marketable securities)/Current liabilities. Company A’s cash ratio, (5 + 5)/35 = 0.29, is higher than (5 + 0)/25 = 0.20 for Company B. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 137. Understanding Cash Flow Statements by Elaine Henry, PhD, CFA, Thomas R. Robinson, PhD, CFA, J. Hennie van Greuning, DCom, CFA, and Michael A. Broihahn, CPA, CIA, CFA Elaine Henry, PhD, CFA, is at Stevens Institute of Technology (USA). Thomas R. Robinson, PhD, CFA, is at AACSB International (USA). J. Hennie van Greuning, DCom, CFA, is at BIBD (Brunei). Michael A. Broihahn, CPA, CIA, CFA, is at Barry University (USA). LEARNING OUTCOMES Mastery The candidate should be able to: a. compare cash flows from operating, investing, and financing activities and classify cash flow items as relating to one of those three categories given a description of the items; b. describe how non- cash investing and financing activities are reported; c. contrast cash flow statements prepared under International Financial Reporting Standards (IFRS) and US generally accepted accounting principles (US GAAP); d. compare and contrast the direct and indirect methods of presenting cash from operating activities and describe arguments in favor of each method; e. describe how the cash flow statement is linked to the income statement and the balance sheet; f. describe the steps in the preparation of direct and indirect cash flow statements, including how cash flows can be computed using income statement and balance sheet data; g. demonstrate the conversion of cash flows from the indirect to direct method; h. analyze and interpret both reported and common- size cash flow statements; i. calculate and interpret free cash flow to the firm, free cash flow to equity, and performance and coverage cash flow ratios. R E A D I N G 19 © 2019 CFA Institute. All rights reserved. Note: Changes in accounting standards as well as new rulings and/or pronouncements issued after the publication of the readings on financial reporting and analysis may cause some of the information in these readings to become dated. Candidates are not responsible for anything that occurs after the readings were published. In addition, candidates are expected to be familiar with the analytical frameworks contained in the readings, as well as the implications of alternative accounting methods for financial analysis and valuation discussed in the readings. Candidates are also responsible for the content of accounting standards, but not for the actual reference numbers. Finally, candidates should be aware that certain ratios may be defined and calculated differently. When alternative ratio definitions exist and no specific definition is given, candidates should use the ratio definitions emphasized in the readings. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 138. Reading 19 ■ Understanding Cash Flow Statements 120 INTRODUCTION The cash flow statement provides information about a company’s cash receipts and cash payments during an accounting period. The cash- based information provided by the cash flow statement contrasts with the accrual- based information from the income statement. For example, the income statement reflects revenues when earned rather than when cash is collected; in contrast, the cash flow statement reflects cash receipts when collected as opposed to when the revenue was earned. A reconciliation between reported income and cash flows from operating activities provides useful information about when, whether, and how a company is able to generate cash from its operating activities. Although income is an important measure of the results of a company’s activities, cash flow is also essential. As an extreme illustration, a hypothetical com- pany that makes all sales on account, without regard to whether it will ever collect its accounts receivable, would report healthy sales on its income statement and might well report significant income; however, with zero cash inflow, the company would not survive. The cash flow statement also provides a reconciliation of the beginning and ending cash on the balance sheet. In addition to information about cash generated (or, alternatively, cash used) in operating activities, the cash flow statement provides information about cash provided (or used) in a company’s investing and financing activities. This information allows the analyst to answer such questions as: ■ ■ Does the company generate enough cash from its operations to pay for its new investments, or is the company relying on new debt issuance to finance them? ■ ■ Does the company pay its dividends to common stockholders using cash gener- ated from operations, from selling assets, or from issuing debt? Answers to these questions are important because, in theory, generating cash from operations can continue indefinitely, but generating cash from selling assets, for example, is possible only as long as there are assets to sell. Similarly, generating cash from debt financing is possible only as long as lenders are willing to lend, and the lending decision depends on expectations that the company will ultimately have adequate cash to repay its obligations. In summary, information about the sources and uses of cash helps creditors, investors, and other statement users evaluate the company’s liquidity, solvency, and financial flexibility. This reading explains how cash flow activities are reflected in a company’s cash flow statement. The reading is organized as follows. Sections 2–8 describe the compo- nents and format of the cash flow statement, including the classification of cash flows under International Financial Reporting Standards (IFRS) and US generally accepted accounting principles (GAAP) and the direct and indirect formats for presenting the cash flow statement. Sections 9–15 discuss the linkages of the cash flow statement with the income statement and balance sheet and the steps in the preparation of the cash flow statement. Sections 16–19 demonstrate the analysis of cash flow statements, including the conversion of an indirect cash flow statement to the direct method and how to use common- size cash flow analysis, free cash flow measures, and cash flow ratios used in security analysis. A summary of the key points and practice problems in the CFA Institute multiple- choice format conclude the reading. 1 © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 139. Classification Of Cash Flows and Non-Cash Activities 121 CLASSIFICATION OF CASH FLOWS AND NON-CASH ACTIVITIES a compare cash flows from operating, investing, and financing activities and clas- sify cash flow items as relating to one of those three categories given a descrip- tion of the items b describe how non- cash investing and financing activities are reported The analyst needs to be able to extract and interpret information on cash flows from financial statements. The basic components and allowable formats of the cash flow statement are well established. ■ ■ The cash flow statement has subsections relating specific items to the operating, investing, and financing activities of the company. ■ ■ Two presentation formats for the operating section are allowable: direct and indirect. The following discussion presents these topics in greater detail. 2.1 Classification of Cash Flows and Non- Cash Activities All companies engage in operating, investing, and financing activities. These activities are the classifications used in the cash flow statement under both IFRS and US GAAP and are described as follows:1 ■ ■ Operating activities include the company’s day- to- day activities that create revenues, such as selling inventory and providing services, and other activities not classified as investing or financing. Cash inflows result from cash sales and from collection of accounts receivable. Examples include cash receipts from the provision of services and royalties, commissions, and other revenue. To gener- ate revenue, companies undertake such activities as manufacturing inventory, purchasing inventory from suppliers, and paying employees. Cash outflows result from cash payments for inventory, salaries, taxes, and other operating- related expenses and from paying accounts payable. Additionally, operating activities include cash receipts and payments related to dealing securities or trading securities (as opposed to buying or selling securities as investments, as discussed below). ■ ■ Investing activities include purchasing and selling long- term assets and other investments. These long- term assets and other investments include property, plant, and equipment; intangible assets; other long- term assets; and both long- term and short- term investments in the equity and debt (bonds and loans) issued by other companies. For this purpose, investments in equity and debt securities exclude securities held for dealing or trading purposes, the purchase and sale of which are considered operating activities even for companies where this is not a primary business activity. Cash inflows in the investing category include cash receipts from the sale of non- trading securities; property, plant, and equipment; intangibles; and other long- term assets. Cash outflows include cash payments for the purchase of these assets. 2 1 IAS 7 Statement of Cash Flows. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 140. Reading 19 ■ Understanding Cash Flow Statements 122 ■ ■ Financing activities include obtaining or repaying capital, such as equity and long- term debt. The two primary sources of capital are shareholders and creditors. Cash inflows in this category include cash receipts from issuing stock (common or preferred) or bonds and cash receipts from borrowing. Cash outflows include cash payments to repurchase stock (e.g., treasury stock) and to repay bonds and other borrowings. Note that indirect borrowing using accounts payable is not considered a financing activity—such borrowing is classified as an operating activity. The new IFRS standard relating to lease accounting (IFRS 16) affects how operating leases are represented in the cash flow statement.2 Under IFRS 16, operating leases are treated similarly to finance leases—that is, the interest component of lease payments will be reflected in either the oper- ating or financing section, and the principal component of lease payments is included in the financing section. EXAMPLE 1 Net Cash Flow from Investing Activities A company recorded the following in Year 1: Proceeds from issuance of long- term debt €300,000 Purchase of equipment €200,000 Loss on sale of equipment €70,000 Proceeds from sale of equipment €120,000 Equity in earnings of affiliate €10,000 On the Year 1 statement of cash flows, the company would report net cash flow from investing activities closest to: A (€150,000). B (€80,000). C €200,000. Solution: B is correct. The only two items that would affect the investing section are the purchase of equipment and the proceeds from sale of equipment: (€200,000) + €120,000 = (€80,000). The loss on sale of equipment and the equity in earnings of affiliate affect net income but are not cash flows. The issuance of debt is a financing cash flow. IFRS provide companies with choices in reporting some items of cash flow, par- ticularly interest and dividends. IFRS explain that although for a financial institution interest paid and received would normally be classified as operating activities, for other entities, alternative classifications may be appropriate. For this reason, under IFRS, interest received may be classified either as an operating activity or as an investing activity. Under IFRS, interest paid may be classified as either an operating activity or a financing activity. Furthermore, under IFRS, dividends received may be classified as either an operating activity or an investing activity and dividends paid may be classified 2 IFRS 16 is effective for fiscal years beginning 1 January 2019, with earlier voluntary adoption allowed. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 141. Cash Flow Statement: Differences Between IFRS and US GAAP 123 as either an operating activity or a financing activity. Companies must use a consistent classification from year to year and disclose separately the amounts of interest and dividends received and paid and where the amounts are reported. Under US GAAP, discretion is not permitted in classifying interest and dividends. Interest received and interest paid are reported as operating activities for all compa- nies.3 Under US GAAP, dividends received are always reported as operating activities and dividends paid are always reported as financing activities. EXAMPLE 2 Operating versus Financing Cash Flows On 31 December 2018, a company issued a £30,000 180- day note at 8 percent and used the cash received to pay for inventory and issued £110,000 long- term debt at 11 percent annually and used the cash received to pay for new equipment. Which of the following most accurately reflects the combined effect of both transactions on the company’s cash flows for the year ended 31 December 2018 under IFRS? Cash flows from: A operations are unchanged. B financing increase £110,000. C operations decrease £30,000. Solution: C is correct. The payment for inventory would decrease cash flows from oper- ations. The issuance of debt (both short- term and long- term debt) is part of financing activities and would increase cash flows from financing activities by £140,000. The purchase of equipment is an investing activity. Note that the treatment under US GAAP would be the same for these transactions. Companies may also engage in non- cash investing and financing transactions. A non- cash transaction is any transaction that does not involve an inflow or outflow of cash. For example, if a company exchanges one non- monetary asset for another non- monetary asset, no cash is involved. Similarly, no cash is involved when a com- pany issues common stock either for dividends or in connection with conversion of a convertible bond or convertible preferred stock. Because no cash is involved in non- cash transactions (by definition), these transactions are not incorporated in the cash flow statement. However, because such transactions may affect a company’s capital or asset structures, any significant non- cash transaction is required to be disclosed, either in a separate note or a supplementary schedule to the cash flow statement. CASH FLOW STATEMENT: DIFFERENCES BETWEEN IFRS AND US GAAP c contrast cash flow statements prepared under International Financial Reporting Standards (IFRS) and US generally accepted accounting principles (US GAAP) 3 3 FASB ASC Topic 230 [Statement of Cash Flows]. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 142. Reading 19 ■ Understanding Cash Flow Statements 124 As highlighted in the previous section, there are some differences in cash flow state- ments prepared under IFRS and US GAAP that the analyst should be aware of when comparing the cash flow statements of companies prepared in accordance with different sets of standards. The key differences are summarized in Exhibit 1. Most significantly, IFRS allow more flexibility in the reporting of such items as interest paid or received and dividends paid or received and in how income tax expense is classified. US GAAP classify interest and dividends received from investments as operating activities, whereas IFRS allow companies to classify those items as either operating or investing cash flows. Likewise, US GAAP classify interest expense as an operating activity, even though the principal amount of the debt issued is classified as a financ- ing activity. IFRS allow companies to classify interest expense as either an operating activity or a financing activity. US GAAP classify dividends paid to stockholders as a financing activity, whereas IFRS allow companies to classify dividends paid as either an operating activity or a financing activity. US GAAP classify all income tax expenses as an operating activity. IFRS also classify income tax expense as an operating activity, unless the tax expense can be specifically identified with an investing or financing activity (e.g., the tax effect of the sale of a discontinued operation could be classified under investing activities). Exhibit 1 Cash Flow Statements: Differences between IFRS and US GAAP Topic IFRS US GAAP Classification of cash flows: ■ ■ Interest received Operating or investing Operating ■ ■ Interest paid Operating or financing Operating ■ ■ Dividends received Operating or investing Operating ■ ■ Dividends paid Operating or financing Financing ■ ■ Bank overdrafts Considered part of cash equivalents Not considered part of cash and cash equivalents and classified as financing ■ ■ Taxes paid Generally operating, but a portion can be allocated to investing or financing if it can be specifically identified with these categories Operating Format of statement Direct or indirect; direct is encouraged Direct or indirect; direct is encour- aged. A reconciliation of net income to cash flow from operating activi- ties must be provided regardless of method used Sources: IAS 7; FASB ASC Topic 230; and “IFRS and US GAAP: Similarities and Differences,” PricewaterhouseCoopers (November 2017), available at www.pwc.com. Under either set of standards, companies currently have a choice of formats for presenting cash flow statements, as discussed in the next section. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 143. Cash Flow Statement: Direct and Indirect Methods for Reporting Cash Flow from Operating Activities 125 CASH FLOW STATEMENT: DIRECT AND INDIRECT METHODS FOR REPORTING CASH FLOW FROM OPERATING ACTIVITIES d compare and contrast the direct and indirect methods of presenting cash from operating activities and describe arguments in favor of each method There are two acceptable formats for reporting cash flow from operating activities (also known as cash flow from operations or operating cash flow), defined as the net amount of cash provided from operating activities: the direct and the indirect methods. The amount of operating cash flow is identical under both methods; only the presentation format of the operating cash flow section differs. The presentation format of the cash flows from investing and financing is exactly the same, regardless of which method is used to present operating cash flows. The direct method shows the specific cash inflows and outflows that result in reported cash flow from operating activities. It shows each cash inflow and outflow related to a company’s cash receipts and disbursements. In other words, the direct method eliminates any impact of accruals and shows only cash receipts and cash payments. The primary argument in favor of the direct method is that it provides information on the specific sources of operating cash receipts and payments. This is in contrast to the indirect method, which shows only the net result of these receipts and payments. Just as information on the specific sources of revenues and expenses is more useful than knowing only the net result—net income—the analyst gets additional information from a direct- format cash flow statement. The additional information is useful in understanding historical performance and in predicting future operating cash flows. The indirect method shows how cash flow from operations can be obtained from reported net income as the result of a series of adjustments. The indirect format begins with net income. To reconcile net income with operating cash flow, adjustments are made for non- cash items, for non- operating items, and for the net changes in operating accruals. The main argument for the indirect approach is that it shows the reasons for differences between net income and operating cash flows. (However, the differences between net income and operating cash flows are equally visible on an indirect- format cash flow statement and in the supplementary reconciliation required under US GAAP if the company uses the direct method.) Another argument for the indirect method is that it mirrors a forecasting approach that begins by forecasting future income and then derives cash flows by adjusting for changes in balance sheet accounts that occur because of the timing differences between accrual and cash accounting. IFRS and US GAAP both encourage the use of the direct method but permit either method. US GAAP encourage the use of the direct method but also require companies to present a reconciliation between net income and cash flow (which is equivalent to the indirect method).4 If the indirect method is chosen, no direct- format disclosures are required. The majority of companies, reporting under IFRS or US GAAP, present using the indirect method for operating cash flows. Many users of financial statements prefer the direct format, particularly analysts and commercial lenders, because of the importance of information about operating receipts and payments in assessing a company’s financing needs and capacity to repay existing obligations. Preparers argue that adjusting net income to operating cash flow, as in the indirect format, is easier and less costly than reporting gross operating cash receipts and payments, as in the direct format. With advances in accounting systems 4 4 FASB ASC Section 230- 10- 45 [Statement of Cash Flows–Overall–Other Presentation Matters]. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 144. Reading 19 ■ Understanding Cash Flow Statements 126 and technology, it is not clear that gathering the information required to use the direct method is difficult or costly. CFA Institute has advocated that standard setters require the use of the direct format for the main presentation of the cash flow statement, with indirect cash flows as supplementary disclosure.5 CASH FLOW STATEMENT: INDIRECT METHOD UNDER IFRS c contrast cash flow statements prepared under International Financial Reporting Standards (IFRS) and US generally accepted accounting principles (US GAAP) d compare and contrast the direct and indirect methods of presenting cash from operating activities and describe arguments in favor of each method Exhibit 2 presents the consolidated cash flow statement prepared under IFRS from Unilever Group’s 2017 annual report. The statement, covering the fiscal years ended 31 December 2017, 2016, and 2015, shows the use of the indirect method. Unilever is an Anglo- Dutch consumer products company with headquarters in the United Kingdom and the Netherlands.6 Exhibit 2 Unilever Group Consolidated Cash Flow Statement (€ millions) For the year ended 31 December 2017 2016 2015 Cash flow from operating activities Net profit 6,486 5,547 5,259 Taxation 1,667 1,922 1,961 Share of net profit of joint ventures/associates and other income (loss) from non- current investments and associates (173) (231) (198) Net finance costs: 877 563 493 Operating profit 8,857 7,801 7,515 Depreciation, amortisation and impairment 1,538 1,464 1,370 Changes in working capital: (68) 51 720 Inventories (104) 190 (129) Trade and other current receivables (506) 142 2 Trade payables and other liabilities 542 (281) 847 Pensions and similar obligations less payments (904) (327) (385) Provisions less payments 200 65 (94) Elimination of (profits)/losses on disposals (298) 127 26 Non- cash charge for share- based compensation 284 198 150 Other adjustments (153) (81) 49 5 5 A Comprehensive Business Reporting Model: Financial Reporting for Investors, CFA Institute Centre for Financial Market Integrity (July 2007), p. 13. 6 Unilever NV and Unilever PLC have independent legal structures, but a series of agreements enable the companies to operate as a single economic entity. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 145. Cash Flow Statement: Indirect Method Under IFRS 127 For the year ended 31 December 2017 2016 2015 Cash flow from operating activities 9,456 9,298 9,351 Income tax paid (2,164) (2,251) (2,021) Net cash flow from operating activities 7,292 7,047 7,330 Interest received 154 105 119 Purchase of intangible assets (158) (232) (334) Purchase of property, plant and equipment (1,509) (1,804) (1,867) Disposal of property, plant and equipment 46 158 127 Acquisition of group companies, joint ventures and associates (4,896) (1,731) (1,897) Disposal of group companies, joint ventures and associates 561 30 199 Acquisition of other non- current investments (317) (208) (78) Disposal of other non- current investments 251 173 127 Dividends from joint ventures, associates and other non- current investments 138 186 176 (Purchase)/sale of financial assets (149) 135 (111) Net cash flow (used in)/from investing activities (5,879) (3,188) (3,539) Dividends paid on ordinary share capital (3,916) (3,609) (3,331) Interest and preference dividends paid (470) (472) (579) Net change in short- term borrowings 2,695 258 245 Additional financial liabilities 8,851 6,761 7,566 Repayment of financial liabilities (2,604) (5,213) (6,270) Capital element of finance lease rental payments (14) (35) (14) Buy back of preference shares (448) — — Repurchase of shares (5,014) — — Other movements on treasury stock (204) (257) (276) Other financing activities (309) (506) (373) Net cash flow (used in)/from financing activities (1,433) (3,073) (3,032) Net increase/(decrease) in cash and cash equivalents (20) 786 759 Cash and cash equivalents at the beginning of the year 3,198 2,128 1,910 Effect of foreign exchange rate changes (9) 284 (541) Cash and cash equivalents at the end of the year 3,169 3,198 2,128 Beginning first at the bottom of the statement, we note that cash increased from €1,910 million at the beginning of 2015 to €3,169 million at the end of 2017, with the largest increase occurring in 2016. To understand the changes, we next examine the sections of the statement. In each year, the primary cash inflow derived from operating activities, as would be expected for a mature company in a relatively stable industry. In each year, the operating cash flow was more than the reported net profit, again, as would be expected from a mature company, with the largest differences primarily arising from the add- back of depreciation. Also, in each year, the operating cash flow Exhibit 2 (Continued) © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 146. Reading 19 ■ Understanding Cash Flow Statements 128 was more than enough to cover the company’s capital expenditures. For example, in 2017, the company generated €7,292 million in net cash from operating activities and—as shown in the investing section—spent €1,509 million on property, plant, and equipment. The operating cash flow was also sufficient to cover acquisitions of other companies. The financing section of the statement shows that each year the company returned more than €3.3 billion to its common shareholders through dividends and around €500 million to its debt holders and preferred shareholders via interest and dividends. In 2017, the company used cash to repurchase about €5 billion in common stock in and generated cash from increased borrowing. The increase in short- term borrowings (€2,695 million) and additional financial liabilities (€8,851 million) exceeded the cash repayment of liabilities (€2,604 million). Having examined each section of the statement, we return to the operating activ- ities section of Unilever’s cash flow statement, which presents a reconciliation of net profit to net cash flow from operating activities (i.e., uses the indirect method). The following discussion of certain adjustments to reconcile net profit to operating cash flows explains some of the main reconciliation adjustments and refers to the amounts in 2017. The first adjustment adds back the €1,667 million income tax expense (labeled “Taxation”) that had been recognized as an expense in the computation of net profit. A €2,164 million deduction for the (cash) income taxes paid is then shown separately, as the last item in the operating activities section, consistent with the IFRS requirement that cash flows arising from income taxes be separately disclosed. The classification of taxes on income paid should be indicated. The classification is in operating activities unless the taxes can be specifically identified with financing or investing activities. The next adjustment “removes” from the operating cash flow section the €173 mil- lion representing Unilever’s share of joint ventures’ income that had been included in the computation of net profit. A €138 million inflow of (cash) dividends received from those joint ventures is then shown in the investing activities section. Similarly, a €877 million adjustment removes the net finance costs from the operating activ- ities section. Unilever then reports its €154 million (cash) interest received in the investing activities section and its €470 million (cash) interest paid (and preference dividends paid) in the financing activities section. The next adjustment in the operat- ing section of this indirect- method statement adds back €1,538 million depreciation, amortisation, and impairment, all of which are expenses that had been deducted in the computation of net income but which did not involve any outflow of cash in the period. The €68 million adjustment for changes in working capital is necessary because these changes result from applying accrual accounting and thus do not necessarily correspond to the actual cash movement. These adjustments are described in greater detail in a later section. In summary, some observations from an analysis of Unilever’s cash flow statement include: ■ ■ Total cash increased from €1,910 million at the beginning of 2015 to €3,169 mil- lion at the end of 2017, with the largest increase occurring in 2016. ■ ■ In each year, the operating cash flow was more than the reported net profit, as would generally be expected from a mature company. ■ ■ In each year, the operating cash flow was more than enough to cover the com- pany’s capital expenditures. ■ ■ The company returned cash to its equity investors through dividends in each year and through share buybacks in 2017. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 147. Cash Flow Statement: Direct Method Under IFRS 129 CASH FLOW STATEMENT: DIRECT METHOD UNDER IFRS c contrast cash flow statements prepared under International Financial Reporting Standards (IFRS) and US generally accepted accounting principles (US GAAP) d compare and contrast the direct and indirect methods of presenting cash from operating activities and describe arguments in favor of each method In the direct format of the cash flow statement, the cash received from customers, as well as other operating items, is clearly shown. Exhibit 3 presents a direct- method format cash flow statement prepared under IFRS for Telefónica Group, a diversified telecommunications company based in Madrid.7 Exhibit 3 Telefónica Group Consolidated Statement of Cash Flows (€ millions) for the years ended 31 December 2017 2016 2015 Cash flows from operating activities Cash received from operations 63,456 63,514 67,582 Cash paid from operations (46,929) (47,384) (50,833) Net interest and other financial expenses net of dividends received (1,726) (2,143) (2,445) Taxes paid (1,005) (649) (689) Net cash flow provided by operating activities 13,796 13,338 13,615 Cash flows from investing activities (Payments on investments)/proceeds from the sale in prop- erty, plant and equipment and intangible assets, net (8,992) (9,187) (10,256) Proceeds on disposals of companies, net of cash and cash equivalents disposed 40 767 354 Payments on investments in companies, net of cash and cash equivalents acquired (128) (54) (3,181) Proceeds on financial investments not included under cash equivalents 296 489 1,142 Payments made on financial investments not included under cash equivalents (1,106) (265) (426) (Payments)/proceeds on placements of cash surpluses not included under cash equivalents (357) 42 (557) Government grants received 2 — 7 Net cash used in investing activities (10,245) (8,208) (12,917) Cash flows from financing activities Dividends paid (2,459) (2,906) (2,775) Proceeds from share capital increase 2 — 4,255 Proceeds/(payments) of treasury shares and other operations with shareholders and with minority interests 1,269 (660) (1,772) 6 (continued) 7 This statement excludes the supplemental cash flow reconciliation provided at the bottom of the original cash flow statement by the company. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 148. Reading 19 ■ Understanding Cash Flow Statements 130 Operations with other equity holders 646 656 83 Proceeds on issue of debentures and bonds, and other debts 8,390 5,693 1,602 Proceeds on loans, borrowings and promissory notes 4,844 10,332 8,784 Repayments of debentures and bonds and other debts (6,687) (6,873) (3,805) Repayments of loans, borrowings and promissory notes (6,711) (8,506) (9,858) Financed operating payments and investments in property, plant and equipment and intangible assets payments (1,046) (1,956) (126) Net cash flow used in financing activities (1,752) (4,220) (3,612) Effect of changes in exchange rates (341) 185 (1,000) Effect of changes in consolidation methods and others (2) 26 — Net increase (decrease) in cash and cash equivalents during the period 1,456 1,121 (3,914) Cash and cash equivalents at 1 January 3,736 2,615 6,529 Cash and cash equivalents at 31 December 5,192 3,736 2,615 As shown at the bottom of the statement, cash and cash equivalents decreased from €6,529 million at the beginning of 2015 to €5,192 million at the end of 2017. The largest decrease in cash occurred in 2015. Cash from operations was the primary source of cash, consistent with the profile of a mature company in a relatively stable industry. Each year, the company generated significantly more cash from operations than it required for its capital expenditures. For example, in 2017, the company generated €13.8 billion cash from operations and spent—as shown in the investing section—only €9 billion on property, plant, and equipment, net of proceeds from sales. Another notable item from the investing section is the company’s limited acquisition activity in 2017 and 2016 compared with 2015. In 2015, the company made over €3 billion of acquisitions. As shown in the financing section, cash flows from financing was negative in all three years, although the components of the negative cash flows differed. In 2015, for example, the company generated cash with an equity issuance of €4.2 billion but made significant net repayments of debts resulting in negative cash from financing activities. In summary, some observations from an analysis of Telefónica’s cash flow state- ment include ■ ■ Total cash and cash equivalents decreased over the three- year period, with 2015 showing the biggest decrease. ■ ■ Cash from operating activities was large enough in each year to cover the com- pany’s capital expenditures. ■ ■ The amount paid for property, plant, and equipment and intangible assets was the largest investing expenditure each year. ■ ■ The company had a significant amount of acquisition activity in 2015. ■ ■ The company paid dividends each year although the amount in 2017 is some- what lower than in prior years. Exhibit 3 (Continued) © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 149. Cash Flow Statement: Direct Method Under US GAAP 131 CASH FLOW STATEMENT: DIRECT METHOD UNDER US GAAP c contrast cash flow statements prepared under International Financial Reporting Standards (IFRS) and US generally accepted accounting principles (US GAAP) d compare and contrast the direct and indirect methods of presenting cash from operating activities and describe arguments in favor of each method Previously, we presented cash flow statements prepared under IFRS. In this section, we illustrate cash flow statements prepared under US GAAP. This section presents the cash flow statements of two companies, Tech Data Corporation and Walmart. Tech Data reports its operating activities using the direct method, whereas Walmart reports its operating activities using the more common indirect method. Tech Data Corporation is a leading distributor of information technology prod- ucts. Exhibit 4 presents comparative cash flow statements from the company’s annual report for the fiscal years ended 31 January 2016 through 2018. Exhibit 4 Tech Data Corporation and Subsidiaries Consolidated Cash Flow Statements (in Thousands) Years Ended 31 January 2018 2017 2016 Cash flows from operating activities: Cash received from customers $42,981,601 $29,427,357 $28,119,687 Cash paid to vendors and employees (41,666,356) (28,664,222) (27,819,886) Interest paid, net (86,544) (22,020) (20,264) Income taxes paid (131,632) (84,272) (85,645) Net cash provided by operating activities 1,097,069 656,843 193,892 Cash flows from investing activities: Acquisition of business, net of cash acquired (2,249,849) (2,916) (27,848) Expenditures for property and equipment (192,235) (24,971) (20,917) Software and software development costs (39,702) (14,364) (13,055) Proceeds from sale of subsidiaries 0 0 20,020 Net cash used in investing activities (2,481,786) (42,251) (41,800) Cash flows from financing activities: Borrowings on long- term debt 1,008,148 998,405 — Principal payments on long- term debt (861,394) — (319) Cash paid for debt issuance costs (6,348) (21,581) — Net borrowings on revolving credit loans (16,028) 3,417 5,912 Cash paid for purchase of treasury stock — — (147,003) Payments for employee withholdings on equity awards (6,027) (4,479) (4,662) Proceeds from the reissuance of treasury stock 1,543 733 561 Acquisition of earn- out payments — — (2,736) Net cash provided by (used in) financing activities 119,894 976,495 (148,247) 7 (continued) © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 150. Reading 19 ■ Understanding Cash Flow Statements 132 Years Ended 31 January 2018 2017 2016 Effect of exchange rate changes on cash and cash equivalents 94,860 3,335 (15,671) Net (decrease) increase in cash and cash equivalents (1,169,963) 1,594,422 (11,826) Cash and cash equivalents at beginning of year 2,125,591 531,169 542,995 Cash and cash equivalents at end of year $955,628 $2,125,591 $531,169 Reconciliation of net income to net cash provided by operating activities: Net income $116,641 $195,095 $265,736 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 150,046 54,437 57,253 Provision for losses on accounts receivable 21,022 5,026 6,061 Stock-based compensation expense 29,381 13,947 14,890 Loss on disposal of subsidiaries — — 699 Accretion of debt discount and debt issu- ance costs 3,326 835 839 Deferred income taxes (4,261) (11,002) 2,387 Changes in operating assets and liabilities: Accounts receivable (554,627) (91,961) (297,637) Inventories (502,352) (20,838) (219,482) Prepaid expenses and other assets 32,963 66,027 (44,384) Accounts payable 1,704,307 459,146 426,412 Accrued expenses and other liabilities 100,623 (13,869) (18,882) Total adjustments 980,428 461,748 (71,844) Net cash provided by operating activities $1,097,069 $656,843 $193,892 Tech Data Corporation prepares its cash flow statements under the direct method. The company’s cash increased from $543 million at the beginning of 2016 to $956 mil- lion at the end of January 2018, with the biggest increase occurring in 2017. The 2017 increase was driven by changes in both operating cash flow and financing cash flow. In the cash flows from operating activities section of Tech Data’s cash flow statements, the company identifies the amount of cash it received from customers, $43 billion for 2018, and the amount of cash that it paid to suppliers and employees, $41.7 billion for 2018. Cash receipts increased from $29.4 billion in the prior year and cash paid also increased substantially. Net cash provided by operating activities was adequate to cover the company’s investing activities in 2016 and 2017 but not in 2018, primarily because of increased amounts of cash used for acquisition of business. Related to this investing cash outflow for an acquisition, footnotes disclose that the major acquisition in 2018 accounted for the large increase in cash receipts and cash payments in the operating section. Also related to the 2018 acquisition, the financing section shows Exhibit 4 (Continued) © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 151. Cash Flow Statement: Indirect Method Under US GAAP 133 that the company borrowed more debt that it repaid in both 2017 and 2018. In 2017, borrowings on long- term debt were $998.4 million, and net borrowings on revolving credit loans were $3.4 million. In 2018, the company generated cash by borrowing more long- term debt than it repaid but used cash to pay down its revolving credit loans. There are no dividend payments, although in 2016, the company paid $147 million to repurchase its common stock. Whenever the direct method is used, US GAAP require a disclosure note and a schedule that reconciles net income with the net cash flow from operating activities. Tech Data shows this reconciliation at the bottom of its consolidated statements of cash flows. The disclosure note and reconciliation schedule are exactly the informa- tion that would have been presented in the body of the cash flow statement if the company had elected to use the indirect method rather than the direct method. For 2018, the reconciliation highlights an increase in the company’s accounts receivable, inventory, and payables. In summary, some observations from an analysis of Tech Data’s cash flow state- ment include: ■ ■ The company’s cash increased by over $412 million over the three years ending in January 2018, with the biggest increase occurring in 2017. ■ ■ The company’s operating cash was adequate to cover the company’s investments in 2016 and 2017, but not in 2018 primarily because of a major acquisition. ■ ■ Related to the 2018 acquisition, the financing section shows an increase in long- term borrowings in 2017 and 2018, including a $998 million increase in 2017. ■ ■ The company has not paid dividends in the past three years, but the financing section shows that in 2016 the company repurchased stock. CASH FLOW STATEMENT: INDIRECT METHOD UNDER US GAAP c contrast cash flow statements prepared under International Financial Reporting Standards (IFRS) and US generally accepted accounting principles (US GAAP) d compare and contrast the direct and indirect methods of presenting cash from operating activities and describe arguments in favor of each method Walmart is a global retailer that conducts business under the names of Walmart and Sam’s Club. Exhibit 5 presents the comparative cash flow statements from the company’s annual report for the fiscal years ended 31 January 2018, 2017, and 2016. Exhibit 5 Walmart Cash Flow Statements Fiscal Years Ended 31 January ($ millions) Fiscal Year Ended 31 January 2018 2017 2016 Cash flows from operating activities: Consolidated net income 10,523 14,293 15,080 Adjustments to reconcile income from continuing operations to net cash provided by operating activities: Depreciation and amortization 10,529 10,080 9,454 Deferred income taxes (304) 761 (672) 8 (continued) © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 152. Reading 19 ■ Understanding Cash Flow Statements 134 Fiscal Year Ended 31 January 2018 2017 2016 Loss on extinguishment of debt 3,136 — — Other operating activities 1,210 206 1,410 Changes in certain assets and liabilities, net of effects of acquisitions: Receivables, net (1.074) (402) (19) Inventories (140) 1,021 (703) Accounts payable 4,086 3,942 2,008 Accrued liabilities 928 1,280 1,466 Accrued income taxes (557) 492 (472) Net cash provided by operating activities 28,337 31,673 27,552 Cash flows from investing activities: Payments for property and equipment (10,051) (10,619) (11,477) Proceeds from disposal of property and equipment 378 456 635 Proceeds from the disposal of certain operations 1,046 662 246 Purchase of available for sale securities — (1,901) — Investment and business acquisitions, net of cash acquired (375) (2,463) — Other investing activities (58) (122) (79) Net cash used in investing activities (9,060) (13,987) (10,675) Cash flows from financing activities: Net change in short- term borrowings 4,148 (1,673) 1,235 Proceeds from issuance of long- term debt 7,476 137 39 Payments of long- term debt (13,061) (2,055) (4,432) Payment for debt extinguishment or debt prepayment cost (3,059) — — Dividends paid (6,124) (6,216) (6,294) Purchase of Company stock (8,296) (8,298) (4,112) Dividends paid to noncontrolling interest (690) (479) (719) Purchase of noncontrolling interest (8) (90) (1,326) Other financing activities (261) (398) (676) Net cash used in financing activities (19,875) (19,072) (16,285) Effect of exchange rates on cash and cash equivalents 487 (452) (1,022) Net increase (decrease) in cash and cash equivalents (111) (1,838) (430) Cash and cash equivalents at beginning of yea 6,867 8,705 9,135 Cash and cash equivalents at end of yea 6,756 6,867 8,705 Supplemental disclosure of cash flow information Income taxes paid 6,179 4,507 8,111 Interest paid 2,450 2,351 2,540 Walmart’s cash flow statement indicates the following: ■ ■ Cash and cash equivalents declined over the three years, from $9.1 billion at the beginning of fiscal 2016 to $6.8 billion at the end of fiscal 2018. Exhibit 5 (Continued) © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 153. Linkages of Cash Flow Statement with the Income Statement and Balance Sheet 135 ■ ■ Operating cash flow was relatively steady at $27.6 billion, $31.7 billion, and $28.3 billion in fiscal 2016, 2017, and 2018, respectively. Further, operating cash flow was significantly greater than the company’s expenditures on property and equipment in every year. ■ ■ Over the three years, the company used significant amounts of cash to pay div- idends and to repurchase its common stock. The company also repaid borrow- ing, particularly in fiscal 2018. Walmart prepares its cash flow statements under the indirect method. In the cash flows from operating activities section of Walmart’s cash flow statement, the company reconciles its net income for 2018 of $10.5 billion to net cash provided by operating activities of $28.3 billion. The largest adjustment is for depreciation and amortiza- tion of $10.5 billion. Depreciation and amortization expense requires an adjustment because it was a non- cash expense on the income statement. As illustrated in previous examples, depreciation is the largest or one of the largest adjustments made by many companies in the reconciliation of net income to operating cash flow. Whenever the indirect method is used, US GAAP mandate disclosure of how much cash was paid for interest and income taxes. Note that these are line items in cash flow statements using the direct method, so disclosure does not have to be mandated. Walmart discloses the amount of cash paid for income tax ($6.2 billion) and interest ($2.5 billion) at the bottom of its cash flow statements. LINKAGES OF CASH FLOW STATEMENT WITH THE INCOME STATEMENT AND BALANCE SHEET e describe how the cash flow statement is linked to the income statement and the balance sheet The indirect format of the cash flow statement demonstrates that changes in balance sheet accounts are an important factor in determining cash flows. The next section addresses the linkages between the cash flow statement and other financial statements. 9.1 Linkages of the Cash Flow Statement with the Income Statement and Balance Sheet Recall the accounting equation that summarizes the balance sheet: Assets = Liabilities + Equity Cash is an asset. The statement of cash flows ultimately shows the change in cash during an accounting period. The beginning and ending balances of cash are shown on the company’s balance sheets for the previous and current years, and the bottom of the cash flow statement reconciles beginning cash with ending cash. The relationship, stated in general terms, is as shown below. Beginning Balance Sheet at 31 December 20X8 Statement of Cash Flows for Year Ended 31 December 20X9 Ending Balance Sheet at 31 December 20X9 Beginning cash Plus: Cash receipts (from operating, investing, and financing activities) Less: Cash payments (for operating, investing, and financing activities) Ending cash 9 © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 154. Reading 19 ■ Understanding Cash Flow Statements 136 In the case of cash held in foreign currencies, there would also be an impact from changes in exchange rates. For example, Walmart’s cash flow statement for 2018, pre- sented in Exhibit 5, shows overall cash flows from operating, investing, and financing activities that total $(111) million during the year, including $487 million net effect of exchange rates on cash and cash equivalents. The body of Walmart’s cash flow statement shows why the change in cash occurred; in other words, it shows the company’s operating, investing, and financing activities (as well as the impact of foreign currency translation). The beginning and ending balance sheet values of cash and cash equivalents are linked through the cash flow statement. The current assets and current liabilities sections of the balance sheet typically reflect a company’s operating decisions and activities. Because a company’s operating activities are reported on an accrual basis in the income statement, any differences between the accrual basis and the cash basis of accounting for an operating transaction result in an increase or decrease in some (usually) short- term asset or liability on the balance sheet. For example, if revenue reported using accrual accounting is higher than the cash actually collected, the result will typically be an increase in accounts receivable. If expenses reported using accrual accounting are lower than cash actually paid, the result will typically be a decrease in accounts payable or another accrued liability account8. As an example of how items on the balance sheet are related to the income statement and/or cash flow statement through the change in the beginning and ending balances, consider accounts receivable: Beginning Balance Sheet at 31 December 20X8 Income Statement for Year Ended 31 December 20X9 Statement of Cash Flows for Year Ended 31 December 20X9 Ending Balance Sheet at 31 December 20X9 Beginning accounts receivable Plus: Revenues Minus: Cash collected from customers Equals: Ending accounts receivable Knowing any three of these four items makes it easy to compute the fourth. For example, if you know beginning accounts receivable, revenues, and cash collected from customers, you can compute ending accounts receivable. Understanding the interrelationships among the balance sheet, income statement, and cash flow statement is useful not only in evaluating the company’s financial health but also in detecting accounting irregularities. Recall the extreme illustration of a hypothetical company that makes sales on account without regard to future collections and thus reports healthy sales and significant income on its income statement yet lacks cash inflow. Such a pattern would occur if a company improperly recognized revenue. A company’s investing activities typically relate to the long- term asset section of the balance sheet, and its financing activities typically relate to the equity and long- term debt sections of the balance sheet. The next section demonstrates the preparation of cash flow information based on income statement and balance sheet information. 8 There are other less typical explanations of the differences. For example, if revenue reported using accrual accounting is higher than the cash actually collected, it is possible that it is the result of a decrease in an unearned revenue liability account. If expenses reported using accrual accounting are lower than cash actually paid, it is possible that it is the result of an increase in prepaid expenses, inventory, or another asset account. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 155. Preparing the Cash Flow Statement: The Direct Method for Operating Activities 137 PREPARING THE CASH FLOW STATEMENT: THE DIRECT METHOD FOR OPERATING ACTIVITIES f describe the steps in the preparation of direct and indirect cash flow state- ments, including how cash flows can be computed using income statement and balance sheet data The preparation of the cash flow statement uses data from both the income statement and the comparative balance sheets. As noted earlier, companies often only disclose indirect operating cash flow information, whereas analysts prefer direct- format information. Understanding how cash flow information is put together will enable you to take an indirect statement apart and reconfigure it in a more useful manner. The result is an approximation of a direct cash flow statement, which—while not perfectly accurate—can be helpful to an analyst. The following demonstration of how an approximation of a direct cash flow statement is prepared uses the income statement and the comparative balance sheets for Acme Corporation (a fictitious retail company) shown in Exhibits 6 and 7. Exhibit 6 Acme Corporation Income Statement Year Ended 31 December 2018 Revenue (net) $23,598 Cost of goods sold 11,456 Gross profit 12,142 Salary and wage expense $4,123 Depreciation expense 1,052 Other operating expenses 3,577 Total operating expenses 8,752 Operating profit 3,390 Other revenues (expenses): Gain on sale of equipment 205 Interest expense (246) (41) Income before tax 3,349 Income tax expense 1,139 Net income $2,210 Exhibit 7 Acme Corporation Comparative Balance Sheets 31 December 2018 and 2017 2018 2017 Net Change Cash $1,011 $1,163 $(152) Accounts receivable 1,012 957 55 Inventory 3,984 3,277 707 Prepaid expenses 155 178 (23) 10 (continued) © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 156. Reading 19 ■ Understanding Cash Flow Statements 138 2018 2017 Net Change Total current assets 6,162 5,575 587 Land 510 510 — Buildings 3,680 3,680 — Equipment* 8,798 8,555 243 Less: accumulated depreciation (3,443) (2,891) (552) Total long-term assets 9,545 9,854 (309) Total assets $15,707 $15,429 $278 Accounts payable $3,588 $3,325 $263 Salary and wage payable 85 75 10 Interest payable 62 74 (12) Income tax payable 55 50 5 Other accrued liabilities 1,126 1,104 22 Total current liabilities 4,916 4,628 288 Long-term debt 3,075 3,575 (500) Common stock 3,750 4,350 (600) Retained earnings 3,966 2,876 1,090 Total liabilities and equity $15,707 $15,429 $278 * During 2018, Acme purchased new equipment for a total cost of $1,300. No items impacted retained earnings other than net income and dividends. The first step in preparing the cash flow statement is to determine the total cash flows from operating activities. The direct method of presenting cash from operating activities is illustrated in sections 10–13. Section 14 illustrates the indirect method of presenting cash flows from operating activities. Cash flows from investing activities and from financing activities are identical regardless of whether the direct or indirect method is used to present operating cash flows. 10.1 Operating Activities: Direct Method We first determine how much cash Acme received from its customers, followed by how much cash was paid to suppliers and to employees as well as how much cash was paid for other operating expenses, interest, and income taxes. 10.1.1 Cash Received from Customers The income statement for Acme reported revenue of $23,598 for the year ended 31 December 2018. To determine the approximate cash receipts from its customers, it is necessary to adjust this revenue amount by the net change in accounts receivable for the year. If accounts receivable increase during the year, revenue on an accrual basis is higher than cash receipts from customers, and vice versa. For Acme Corporation, accounts receivable increased by $55, so cash received from customers was $23,543, as follows: Exhibit 7 (Continued) © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 157. Preparing the Cash Flow Statement: The Direct Method for Operating Activities 139 Revenue $23,598 Less: Increase in accounts receivable (55) Cash received from customers $23,543 Cash received from customers affects the accounts receivable account as follows: Beginning accounts receivable 957 Plus revenue 23,598 Minus cash collected from customers (23,543) Ending accounts receivable $1,012 The accounts receivable account information can also be presented as follows: Beginning accounts receivable $957 Plus revenue 23,598 Minus ending accounts receivable (1,012) Cash collected from customers $23,543 EXAMPLE 3 Computing Cash Received from Customers Blue Bayou, a fictitious advertising company, reported revenues of $50 million, total expenses of $35 million, and net income of $15 million in the most recent year. If accounts receivable decreased by $12 million, how much cash did the company receive from customers? A $38 million. B $50 million. C $62 million. Solution: C is correct. Revenues of $50 million plus the decrease in accounts receivable of $12 million equals $62 million cash received from customers. The decrease in accounts receivable means that the company received more in cash than the amount of revenue it reported. “Cash received from customers” is sometimes referred to as “cash collections from customers” or “cash collections.” 10.1.2 Cash Paid to Suppliers For Acme, the cash paid to suppliers was $11,900, determined as follows: Cost of goods sold $11,456 Plus: Increase in inventory 707 Equals purchases from suppliers $12,163 Less: Increase in accounts payable (263) Cash paid to suppliers $11,900 There are two pieces to this calculation: the amount of inventory purchased and the amount paid for it. To determine purchases from suppliers, cost of goods sold is adjusted for the change in inventory. If inventory increased during the year, then © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 158. Reading 19 ■ Understanding Cash Flow Statements 140 purchases during the year exceeded cost of goods sold, and vice versa. Acme reported cost of goods sold of $11,456 for the year ended 31 December 2018. For Acme Corporation, inventory increased by $707, so purchases from suppliers was $12,163. Purchases from suppliers affect the inventory account, as shown below: Beginning inventory $3,277 Plus purchases 12,163 Minus cost of goods sold (11,456) Ending inventory $3,984 Acme purchased $12,163 of inventory from suppliers in 2018, but is this the amount of cash that Acme paid to its suppliers during the year? Not necessarily. Acme may not have yet paid for all of these purchases and may yet owe for some of the purchases made this year. In other words, Acme may have paid less cash to its suppliers than the amount of this year’s purchases, in which case Acme’s liability (accounts payable) will have increased by the difference. Alternatively, Acme may have paid even more to its suppliers than the amount of this year’s purchases, in which case Acme’s accounts payable will have decreased. Therefore, once purchases have been determined, cash paid to suppliers can be calculated by adjusting purchases for the change in accounts payable. If the company made all purchases with cash, then accounts payable would not change and cash outflows would equal purchases. If accounts payable increased during the year, then purchases on an accrual basis would be higher than they would be on a cash basis, and vice versa. In this example, Acme made more purchases than it paid in cash, so the balance in accounts payable increased. For Acme, the cash paid to suppliers was $11,900, determined as follows: Purchases from suppliers $12,163 Less: Increase in accounts payable (263) Cash paid to suppliers $11,900 The amount of cash paid to suppliers is reflected in the accounts payable account, as shown below: Beginning accounts payable $3,325 Plus purchases 12,163 Minus cash paid to suppliers (11,900) Ending accounts payable $3,588 EXAMPLE 4 Computing Cash Paid to Suppliers Orange Beverages Plc., a fictitious manufacturer of tropical drinks, reported cost of goods sold for the year of $100 million. Total assets increased by $55 million, but inventory declined by $6 million. Total liabilities increased by $45 million, but accounts payable decreased by $2 million. How much cash did the company pay to its suppliers during the year? A $96 million. B $104 million. C $108 million. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 159. Preparing the Cash Flow Statement: The Direct Method for Operating Activities 141 Solution: A is correct. Cost of goods sold of $100 million less the decrease in inventory of $6 million equals purchases from suppliers of $94 million. The decrease in accounts payable of $2 million means that the company paid $96 million in cash ($94 million plus $2 million). 10.1.3 Cash Paid to Employees To determine the cash paid to employees, it is necessary to adjust salary and wages expense by the net change in salary and wages payable for the year. If salary and wages payable increased during the year, then salary and wages expense on an accrual basis would be higher than the amount of cash paid for this expense, and vice versa. For Acme, salary and wages payable increased by $10, so cash paid for salary and wages was $4,113, as follows: Salary and wages expense $4,123 Less: Increase in salary and wages payable (10) Cash paid to employees $4,113 The amount of cash paid to employees is reflected in the salary and wages payable account, as shown below: Beginning salary and wages payable $75 Plus salary and wages expense 4,123 Minus cash paid to employees (4,113) Ending salary and wages payable $85 10.1.4 Cash Paid for Other Operating Expenses To determine the cash paid for other operating expenses, it is necessary to adjust the other operating expenses amount on the income statement by the net changes in pre- paid expenses and accrued expense liabilities for the year. If prepaid expenses increased during the year, other operating expenses on a cash basis would be higher than on an accrual basis, and vice versa. Likewise, if accrued expense liabilities increased during the year, other operating expenses on a cash basis would be lower than on an accrual basis, and vice versa. For Acme Corporation, the amount of cash paid for operating expenses in 2018 was $3,532, as follows: Other operating expenses $3,577 Less: Decrease in prepaid expenses (23) Less: Increase in other accrued liabilities (22) Cash paid for other operating expenses $3,532 EXAMPLE 5 Computing Cash Paid for Other Operating Expenses Black Ice, a fictitious sportswear manufacturer, reported other operating expenses of $30 million. Prepaid insurance expense increased by $4 million, and accrued utilities payable decreased by $7 million. Insurance and utilities are the only two components of other operating expenses. How much cash did the company pay in other operating expenses? A $19 million. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 160. Reading 19 ■ Understanding Cash Flow Statements 142 B $33 million. C $41 million. Solution: C is correct. Other operating expenses of $30 million plus the increase in prepaid insurance expense of $4 million plus the decrease in accrued utilities payable of $7 million equals $41 million. 10.1.5 Cash Paid for Interest The cash paid for interest is included in operating cash flows under US GAAP and may be included in operating or financing cash flows under IFRS. To determine the cash paid for interest, it is necessary to adjust interest expense by the net change in interest payable for the year. If interest payable increases during the year, then interest expense on an accrual basis will be higher than the amount of cash paid for interest, and vice versa. For Acme Corporation, interest payable decreased by $12, and cash paid for interest was $258, as follows: Interest expense $246 Plus: Decrease in interest payable 12 Cash paid for interest $258 Alternatively, cash paid for interest may also be determined by an analysis of the interest payable account, as shown below: Beginning interest payable $74 Plus interest expense 246 Minus cash paid for interest (258) Ending interest payable $62 10.1.6 Cash Paid for Income Taxes To determine the cash paid for income taxes, it is necessary to adjust the income tax expense amount on the income statement by the net changes in taxes receivable, taxes payable, and deferred income taxes for the year. If taxes receivable or deferred tax assets increase during the year, income taxes on a cash basis will be higher than on an accrual basis, and vice versa. Likewise, if taxes payable or deferred tax liabilities increase during the year, income tax expense on a cash basis will be lower than on an accrual basis, and vice versa. For Acme Corporation, the amount of cash paid for income taxes in 2018 was $1,134, as follows: Income tax expense $1,139 Less: Increase in income tax payable (5) Cash paid for income taxes $1,134 PREPARING THE CASH FLOW STATEMENT: INVESTING ACTIVITIES f describe the steps in the preparation of direct and indirect cash flow state- ments, including how cash flows can be computed using income statement and balance sheet data 11 © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 161. Preparing the Cash Flow Statement: Investing Activities 143 The second and third steps in preparing the cash flow statement are to determine the total cash flows from investing activities and from financing activities. The presentation of this information is identical, regardless of whether the direct or indirect method is used for operating cash flows. Purchases and sales of equipment were the only investing activities undertaken by Acme in 2018, as evidenced by the fact that the amounts reported for land and buildings were unchanged during the year. An informational note in Exhibit 7 tells us that Acme purchased new equipment in 2018 for a total cost of $1,300. However, the amount of equipment shown on Acme’s balance sheet increased by only $243 (ending balance of $8,798 minus beginning balance of $8,555); therefore, Acme must have also sold or otherwise disposed of some equipment during the year. To determine the cash inflow from the sale of equipment, we analyze the equipment and accumulated depreciation accounts as well as the gain on the sale of equipment from Exhibits 6 and 7. Assuming that the entire accumulated depreciation is related to equipment, the cash received from sale of equipment is determined as follows. The historical cost of the equipment sold was $1,057. This amount is determined as follows: Beginning balance equipment (from balance sheet) $8,555 Plus equipment purchased (from informational note) 1,300 Minus ending balance equipment (from balance sheet) (8,798) Equals historical cost of equipment sold $1,057 The accumulated depreciation on the equipment sold was $500, determined as follows: Beginning balance accumulated depreciation (from balance sheet) $2,891 Plus depreciation expense (from income statement) 1,052 Minus ending balance accumulated depreciation (from balance sheet) (3,443) Equals accumulated depreciation on equipment sold $500 The historical cost information, accumulated depreciation information, and infor- mation from the income statement about the gain on the sale of equipment can be used to determine the cash received from the sale. Historical cost of equipment sold (calculated above) $1,057 Less accumulated depreciation on equipment sold (calculated above) (500) Equals book value of equipment sold $557 Plus gain on sale of equipment (from the income statement) 205 Equals cash received from sale of equipment $762 EXAMPLE 6 Computing Cash Received from the Sale of Equipment Copper, Inc., a fictitious brewery and restaurant chain, reported a gain on the sale of equipment of $12 million. In addition, the company’s income statement shows depreciation expense of $8 million and the cash flow statement shows capital expenditure of $15 million, all of which was for the purchase of new equipment. Balance sheet item 12/31/2017 12/31/2018 Change Equipment $100 million $109 million $9 million Accumulated depreciation—equipment $30 million $36 million $6 million © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 162. Reading 19 ■ Understanding Cash Flow Statements 144 Using the above information from the comparative balance sheets, how much cash did the company receive from the equipment sale? A $12 million. B $16 million. C $18 million. Solution: B is correct. Selling price (cash inflow) minus book value equals gain or loss on sale; therefore, gain or loss on sale plus book value equals selling price (cash inflow). The amount of gain is given, $12 million. To calculate the book value of the equipment sold, find the historical cost of the equipment and the accu- mulated depreciation on the equipment. ■ ■ Beginning balance of equipment of $100 million plus equipment pur- chased of $15 million minus ending balance of equipment of $109 million equals historical cost of equipment sold, or $6 million. ■ ■ Beginning accumulated depreciation on equipment of $30 million plus depreciation expense for the year of $8 million minus ending balance of accumulated depreciation of $36 million equals accumulated depreciation on the equipment sold, or $2 million. ■ ■ Therefore, the book value of the equipment sold was $6 million minus $2 million, or $4 million. ■ ■ Because the gain on the sale of equipment was $12 million, the amount of cash received must have been $16 million. PREPARING THE CASH FLOW STATEMENT: FINANCING ACTIVITIES f describe the steps in the preparation of direct and indirect cash flow state- ments, including how cash flows can be computed using income statement and balance sheet data As with investing activities, the presentation of financing activities is identical, regardless of whether the direct or indirect method is used for operating cash flows. 12.1 Long- Term Debt and Common Stock The change in long- term debt, based on the beginning 2018 (ending 2017) and ending 2018 balances in Exhibit 7, was a decrease of $500. Absent other information, this indicates that Acme retired $500 of long- term debt. Retiring long- term debt is a cash outflow relating to financing activities. Similarly, the change in common stock during 2018 was a decrease of $600. Absent other information, this indicates that Acme repurchased $600 of its common stock. Repurchase of common stock is also a cash outflow related to financing activity. 12 © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 163. Preparing the Cash Flow Statement: Overall Statement of Cash Flows Under the Direct Method 145 12.2 Dividends Recall the following relationship: Beginning retained earnings + Net income – Dividends = Ending retained earnings Based on this relationship, the amount of cash dividends paid in 2018 can be deter- mined from an analysis of retained earnings, as follows: Beginning balance of retained earnings (from the balance sheet) $2,876 Plus net income (from the income statement) 2,210 Minus ending balance of retained earnings (from the balance sheet) (3,966) Equals dividends paid $1,120 Note that dividends paid are presented in the statement of changes in equity. PREPARING THE CASH FLOW STATEMENT: OVERALL STATEMENT OF CASH FLOWS UNDER THE DIRECT METHOD f describe the steps in the preparation of direct and indirect cash flow state- ments, including how cash flows can be computed using income statement and balance sheet data Exhibit 8 summarizes the information about Acme’s operating, investing, and financing cash flows in the statement of cash flows. At the bottom of the statement, the total net change in cash is shown to be a decrease of $152 (from $1,163 to $1,011). This decrease can also be seen on the comparative balance sheet in Exhibit 7. The cash provided by operating activities of $2,606 was adequate to cover the net cash used in investing activities of $538; however, the company’s debt repayments, cash payments for dividends, and repurchase of common stock (i.e., its financing activities) of $2,220 resulted in an overall decrease in cash of $152. Exhibit 8 Acme Corporation Cash Flow Statement (Direct Method) for Year Ended 31 December 2018 Cash flow from operating activities: Cash received from customers $23,543 Cash paid to suppliers (11,900) Cash paid to employees (4,113) Cash paid for other operating expenses (3,532) Cash paid for interest (258) Cash paid for income tax (1,134) Net cash provided by operating activities 2,606 Cash flow from investing activities: Cash received from sale of equipment 762 Cash paid for purchase of equipment (1,300) Net cash used for investing activities (538) 13 (continued) © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 164. Reading 19 ■ Understanding Cash Flow Statements 146 Cash flow from financing activities: Cash paid to retire long- term debt (500) Cash paid to retire common stock (600) Cash paid for dividends (1,120) Net cash used for financing activities (2,220) Net increase (decrease) in cash (152) Cash balance, 31 December 2017 1,163 Cash balance, 31 December 2018 $1,011 PREPARING THE CASH FLOW STATEMENT: OVERALL STATEMENT OF CASH FLOWS UNDER THE INDIRECT METHOD f describe the steps in the preparation of direct and indirect cash flow state- ments, including how cash flows can be computed using income statement and balance sheet data Using the alternative approach to reporting cash from operating activities, the indirect method, we will present the same amount of cash provided by operating activities. Under this approach, we reconcile Acme’s net income of $2,210 to its operating cash flow of $2,606. To perform this reconciliation, net income is adjusted for the following: a) any non- operating activities, b) any non- cash expenses, and c) changes in operating working capital items. The only non- operating activity in Acme’s income statement, the sale of equip- ment, resulted in a gain of $205. This amount is removed from the operating cash flow section; the cash effects of the sale are shown in the investing section. Acme’s only non- cash expense was depreciation expense of $1,052. Under the indirect method, depreciation expense must be added back to net income because it was a non- cash deduction in the calculation of net income. Changes in working capital accounts include increases and decreases in the cur- rent operating asset and liability accounts. The changes in these accounts arise from applying accrual accounting; that is, recognizing revenues when they are earned and expenses when they are incurred instead of when the cash is received or paid. To make the working capital adjustments under the indirect method, any increase in a current operating asset account is subtracted from net income and a net decrease is added to net income. As described above, the increase in accounts receivable, for example, resulted from Acme recording income statement revenue higher than the amount of cash received from customers; therefore, to reconcile back to operating cash flow, that increase in accounts receivable must be deducted from net income. For current operating liabilities, a net increase is added to net income and a net decrease is subtracted from net income. As described above, the increase in wages payable, for example, resulted from Acme recording income statement expenses higher than the amount of cash paid to employees. 14 Exhibit 8 (Continued) © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 165. Preparing the Cash Flow Statement: Overall Statement of Cash Flows Under the Indirect Method 147 Exhibit 9 presents a tabulation of the most common types of adjustments that are made to net income when using the indirect method to determine net cash flow from operating activities. Exhibit 9 Adjustments to Net Income Using the Indirect Method Additions ■ ■ Non-cash items ● ● Depreciation expense of tangible assets ● ● Amortisation 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., amortisation of bond premium) ■ ■ Non-operating items ● ● Gain on sale of assets ● ● Gain on 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 reve- nues 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) Accordingly, for Acme Corporation, the $55 increase in accounts receivable and the $707 increase in inventory are subtracted from net income and the $23 decrease in prepaid expenses is added to net income. For Acme’s current liabilities, the increases in accounts payable, salary and wage payable, income tax payable, and other accrued liabilities ($263, $10, $5, and $22, respectively) are added to net income and the $12 decrease in interest payable is subtracted from net income. Exhibit 10 presents the cash flow statement for Acme Corporation under the indirect method by using the information that we have determined from our analysis of the income statement and the comparative balance sheets. Note that the investing and financing sections are identical to the statement of cash flows prepared using the direct method. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 166. Reading 19 ■ Understanding Cash Flow Statements 148 Exhibit 10 Acme Corporation Cash Flow Statement (Indirect Method) Year Ended 31 December 2018 Cash flow from operating activities: Net income $2,210 Depreciation expense 1,052 Gain on sale of equipment (205) Increase in accounts receivable (55) Increase in inventory (707) Decrease in prepaid expenses 23 Increase in accounts payable 263 Increase in salary and wage payable 10 Decrease in interest payable (12) Increase in income tax payable 5 Increase in other accrued liabilities 22 Net cash provided by operating activities 2,606 Cash flow from investing activities: Cash received from sale of equipment 762 Cash paid for purchase of equipment (1,300) Net cash used for investing activities (538) Cash flow from financing activities: Cash paid to retire long- term debt (500) Cash paid to retire common stock (600) Cash paid for dividends (1,120) Net cash used for financing activities (2,220) Net decrease in cash (152) Cash balance, 31 December 2017 1,163 Cash balance, 31 December 2018 $1,011 EXAMPLE 7 Adjusting Net Income to Compute Operating Cash Flow Based on the following information for Pinkerly Inc., a fictitious company, what are the total adjustments that the company would make to net income in order to derive operating cash flow? Year Ended Income statement item 12/31/2018 Net income $30 million Depreciation $7 million Balance sheet item 12/31/2017 12/31/2018 Change Accounts receivable $15 million $30 million $15 million © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 167. Conversion of Cash Flows from the Indirect to Direct Method 149 Inventory $16 million $13 million ($3 million) Accounts payable $10 million $20 million $10 million A Add $5 million. B Add $21 million. C Subtract $9 million. Solution: A is correct. To derive operating cash flow, the company would make the following adjustments to net income: add depreciation (a non-cash expense) of $7 million; add the decrease in inventory of $3 million; add the increase in accounts payable of $10 million; and subtract the increase in accounts receivable of $15 million. Total additions of $20 million and total subtractions of $15 million result in net total additions of $5 million. CONVERSION OF CASH FLOWS FROM THE INDIRECT TO DIRECT METHOD g demonstrate the conversion of cash flows from the indirect to direct method An analyst may desire to review direct- format operating cash flow to review trends in cash receipts and payments (such as cash received from customers or cash paid to suppliers). If a direct- format statement is not available, cash flows from operating activities reported under the indirect method can be converted to the direct method. Accuracy of conversion depends on adjustments using data available in published financial reports. The method described here is sufficiently accurate for most ana- lytical purposes. The three- step conversion process is demonstrated for Acme Corporation in Exhibit 11. Referring again to Exhibits 6 and 7 for Acme Corporation’s income state- ment and balance sheet information, begin by disaggregating net income of $2,210 into total revenues and total expenses (Step 1). Next, remove any non- operating and non- cash items (Step 2). For Acme, we therefore remove the non- operating gain on the sale of equipment of $205 and the non- cash depreciation expense of $1,052. Then, convert accrual amounts of revenues and expenses to cash flow amounts of receipts and payments by adjusting for changes in working capital accounts (Step 3). The results of these adjustments are the items of information for the direct format of operating cash flows. These line items are shown as the results of Step 3. Exhibit 11 Conversion from the Indirect to the Direct Method Step 1 Total revenues $23,803 Aggregate all revenue and all expenses Total expenses 21,593 Net income $2,210 Step 2 Total revenue less noncash item revenues: 15 (continued) © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 168. Reading 19 ■ Understanding Cash Flow Statements 150 Remove all noncash items from aggre- gated revenues and expenses and break out remaining items into relevant cash flow items ($23,803 – $205) = $23,598 Revenue $23,598 Total expenses less noncash item expenses: ($21,593 – $1,052) = $20,541 Cost of goods sold $11,456 Salary and wage expenses 4,123 Other operating expenses 3,577 Interest expense 246 Income tax expense 1,139 Total $20,541 Step 3 Cash received from customersa $23,543 Convert accrual amounts to cash flow amounts by adjusting for working capital changes Cash paid to suppliersb (11,900) Cash paid to employeesc (4,113) Cash paid for other operating expensesd (3,532) Cash paid for intereste (258) Cash paid for income taxf (1,134) Net cash provided by operating activities $2,606 Calculations for Step 3: a Revenue of $23,598 less increase in accounts receivable of $55. b Cost of goods sold of $11,456 plus increase in inventory of $707 less increase in accounts payable of $263. c Salary and wage expense of $4,123 less increase in salary and wage payable of $10. d Other operating expenses of $3,577 less decrease in prepaid expenses of $23 less increase in other accrued liabilities of $22. e Interest expense of $246 plus decrease in interest payable of $12. f Income tax expense of $1,139 less increase in income tax payable of $5. CASH FLOW STATEMENT ANALYSIS: EVALUATION OF SOURCES AND USES OF CASH h analyze and interpret both reported and common- size cash flow statements The analysis of a company’s cash flows can provide useful information for under- standing a company’s business and earnings and for predicting its future cash flows. This section describes tools and techniques for analyzing the statement of cash flows, including the analysis of sources and uses of cash and cash flow, common- size analysis, and calculation of free cash flow measures and cash flow ratios. 16.1 Evaluation of the Sources and Uses of Cash Evaluation of the cash flow statement should involve an overall assessment of the sources and uses of cash between the three main categories as well as an assessment of the main drivers of cash flow within each category, as follows: 1 Evaluate where the major sources and uses of cash flow are between operating, investing, and financing activities. 16 Exhibit 11 (Continued) © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 169. Cash Flow Statement Analysis: Evaluation of Sources and Uses of Cash 151 2 Evaluate the primary determinants of operating cash flow. 3 Evaluate the primary determinants of investing cash flow. 4 Evaluate the primary determinants of financing cash flow. Step 1 The major sources of cash for a company can vary with its stage of growth. For a mature company, it is expected and desirable that operating activities are the primary source of cash flows. Over the long term, a company must generate cash from its operating activities. If operating cash flow were consistently negative, a company would need to borrow money or issue stock (financing activities) to fund the shortfall. Eventually, these providers of capital need to be repaid from operations or they will no longer be willing to provide capital. Cash generated from operating activities can be used in either investing or financing activities. If the company has good opportunities to grow the business or other investment opportunities, it is desirable to use the cash in investing activities. If the company does not have profitable investment opportunities, the cash should be returned to capital providers, a financing activity. For a new or growth stage company, operating cash flow may be negative for some period of time as it invests in such assets as inventory and receivables (extending credit to new cus- tomers) in order to grow the business. This situation is not sustainable over the long term, so eventually the cash must start to come primarily from operating activities so that capital can be returned to the providers of capital. Lastly, it is desirable that operating cash flows are sufficient to cover capital expenditures (in other words, the company has free cash flow as discussed further in Section 18). In summary, major points to consider at this step are: ■ ■ What are the major sources and uses of cash flow? ■ ■ Is operating cash flow positive and sufficient to cover capital expenditures? Step 2 Turning to the operating section, the analysts should examine the most significant determinants of operating cash flow. Companies need cash for use in operations (for example, to hold receivables and inventory and to pay employees and suppliers) and receive cash from operating activities (for example, payments from customers). Under the indirect method, the increases and decreases in receivables, inventory, payables, and so on can be examined to determine whether the company is using or generat- ing cash in operations and why. It is also useful to compare operating cash flow with net income. For a mature company, because net income includes non- cash expenses (depreciation and amortisation), it is expected and desirable that operating cash flow exceeds net income. The relationship between net income and operating cash flow is also an indicator of earnings quality. If a company has large net income but poor operating cash flow, it may be a sign of poor earnings quality. The company may be making aggressive accounting choices to increase net income but not be generating cash for its business. You should also examine the variability of both earnings and cash flow and consider the impact of this variability on the company’s risk as well as the ability to forecast future cash flows for valuation purposes. In summary: ■ ■ What are the major determinants of operating cash flow? ■ ■ Is operating cash flow higher or lower than net income? Why? ■ ■ How consistent are operating cash flows? © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 170. Reading 19 ■ Understanding Cash Flow Statements 152 Step 3 Within the investing section, you should evaluate each line item. Each line item rep- resents either a source or use of cash. This enables you to understand where the cash is being spent (or received). This section will tell you how much cash is being invested for the future in property, plant, and equipment; how much is used to acquire entire companies; and how much is put aside in liquid investments, such as stocks and bonds. It will also tell you how much cash is being raised by selling these types of assets. If the company is making major capital investments, you should consider where the cash is coming from to cover these investments (e.g., is the cash coming from excess operating cash flow or from the financing activities described in Step 4). If assets are being sold, it is important to determine why and to assess the effects on the company. Step 4 Within the financing section, you should examine each line item to understand whether the company is raising capital or repaying capital and what the nature of its capital sources are. If the company is borrowing each year, you should consider when repayment may be required. This section will also present dividend payments and repurchases of stock that are alternative means of returning capital to owners. It is important to assess why capital is being raised or repaid. We now provide an example of a cash flow statement evaluation. EXAMPLE 8 Analysis of the Cash Flow Statement Derek Yee, CFA, is preparing to forecast cash flow for Groupe Danone as an input into his valuation model. He has asked you to evaluate the historical cash flow statement of Groupe Danone, which is presented in Exhibit 12. Groupe Danone prepares its financial statements in conformity with IFRS. Note that Groupe Danone presents the most recent period on the right. Exhibit 13 presents excerpts from Danone’s 2017 Registration Document. Yee would like answers to the following questions: ■ ■ What are the major sources of cash for Groupe Danone? ■ ■ What are the major uses of cash for Groupe Danone? ■ ■ Is cash flow from operating activities sufficient to cover capital expenditures? ■ ■ What is the relationship between net income and cash flow from operat- ing activities? ■ ■ What types of financing cash flows does Groupe Danone have? Exhibit 12 Groupe Danone Consolidated Financial Statements Consolidated Statements of Cash Flows (in € Millions) Years Ended 31 December 2016 2017 Net income 1,827 2,563 Share of profits of associates net of dividends received 52 (54) Depreciation, amortization and impairment of tangible and intangible assets 786 974 Increases in (reversals of) provisions 51 153 Change in deferred taxes (65) (353) © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 171. Cash Flow Statement Analysis: Evaluation of Sources and Uses of Cash 153 Years Ended 31 December 2016 2017 (Gains) losses on disposal of property, plant and equipment and finan- cial investments (74) (284) Expense related to Group performance shares 24 22 Cost of net financial debt 149 265 Net interest paid (148) (186) Net change in interest income (expense) — 80 Other components with no cash impact 13 (15) Cash flows provided by operating activities, before changes in net working capital 2,615 3,085 (Increase) decrease in inventories (24) (122) (Increase) decrease in trade receivables (110) (190) Increase (decrease) in trade payables 298 145 Changes in other receivables and payables (127) 40 Change in other working capital requirements 37 (127) Cash flows provided by (used in) operating activities 2,652 2,958 Capital expenditure (925) (969) Proceeds from the disposal of property, plant and equipment 27 45 Net cash outflows on purchases of subsidiaries and financial investments (66) (10,949) Net cash inflows on disposal of subsidiaries and financial investments 110 441 (Increase) decrease in long- term loans and other long- term financial assets 6 (4) Cash flows provided by (used in) investing activities (848) (11,437) Increase in capital and additional paid- in capital 46 47 Purchases of treasury stock (net of disposals) and DANONE call options 32 13 Issue of perpetual subordinated debt securities — 1,245 Interest on perpetual subordinated debt securities — — Dividends paid to Danone shareholders (985) (279) Buyout of non- controlling interests (295) (107) Dividends paid (94) (86) Contribution from non- controlling interests to capital increases 6 1 Transactions with non- controlling interests (383) (193) Net cash flows on hedging derivatives 50 (52) Bonds issued during the period 11,237 — Bonds repaid during the period (638) (1,487) Net cash flows from other current and non- current financial debt (442) (564) Net cash flows from short- term investments (10,531) 9,559 Cash flows provided by (used in) financing activities (1,616) 8,289 Effect of exchange rate and other changes (151) 272 Increase (decrease) in cash and cash equivalents 38 81 Cash and cash equivalents at beginning of period 519 557 Cash and cash equivalents at end of period 557 638 Supplemental disclosures (continued) Exhibit 12 (Continued) © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 172. Reading 19 ■ Understanding Cash Flow Statements 154 Years Ended 31 December 2016 2017 Income tax payments during the year (891) (1,116) Note: the numbers in the consolidated statement of cash flows were derived straight from company filings; some sub- totals may not sum exactly due to rounding by the company. Exhibit 13 Groupe Danone Excerpt from 2017 Registration Statement Excerpt from Footnote 2 to the financial statements: … On July 7, 2016, Danone announced the signing of an agreement to acquire The WhiteWave Foods Company (“WhiteWave”), the global leader in plant- based foods and beverages and organic produce. The acquisition in cash, for USD 56.25 per share, represented, as of the date of the agreement, a total enterprise value of approximately USD 12.5 billion, including debt and certain other WhiteWave liabilities. … “Acquisition expenses recognized in Danone’s consolidated financial statements totaled €51 million before tax, of which €48 million was rec- ognized in 2016 in Other operating income (expense), with the balance recognized in 2017. “WhiteWave’s contribution to 2017 consolidated sales totaled €2.7 bil- lion. Had the transaction been completed on January 1, 2017, the Group’s 2017 consolidated sales would have been €25.7 billion, with recurring operating income of €3.6 billion. “Meanwhile, integration expenses for the period totaled €91 million, recognized under Other operating income (expense)… Excerpt from Overview of Activities: “… As part of its transformation plan aimed at ensuring a safe journey to deliver strong, profitable and sustainable growth, Danone set objectives for 2020 that include like- for- like sales growth between 4% and 5% …. a recurring operating margin of over 16% in 2020 … Finally, Danone will continue to focus on growing its free cash flow, which will contribute to financial deleverage with an objective of a ratio of Net debt/EBITDA below 3x in 2020. Danone is committed to reaching a ROIC level around 12% in 2020.” Solution: The major categories of cash flows can be summarized as follows (in € millions): 2016 2017 Cash flows provided by operating activities 2,652 2,958 Cash flows provided by (used in) investing activities (848) (11,437) Cash flows provided by (used in) financing activities (1,616) 8,289 Exhibit 12 (Continued) © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 173. Cash Flow Statement Analysis: Common Size Analysis 155 Exchange rate effects on cash (151) 272 Increase in cash 38 81 The primary source of cash for Groupe Danone in 2016 is operating activities. In both 2016 and 2017, there was sufficient operating cash flow to cover usual capital expenditures, and operating cash flow exceeded net income. Evaluating the five prior years [not shown in this Example], you confirm that Danone typ- ically derives most of its cash from operating activities, reports operating cash flow greater than net income, and generates sufficient operating cash flow to cover capital expenditures. The fact that the primary source of cash is from operations is positive and desirable for a mature company. Additionally, the fact that operating cash flow exceeds net income in both years is a positive sign. Finally, operating cash flows exceed normal capital expenditures, indicating that the company can fund capital expenditures from operations. In 2017, however, the primary source of cash was financing activities, and the investing section shows significant use of cash for purchase of subsidiar- ies within investing activities. Footnotes disclose a major acquisition with an aggregate value of €12.5 billion, some of which was funded through proceeds from an earlier bond issuance, which appears as a financing cash flow in the financing section for 2016. For purposes of Yee’s cash flow forecast, the company’s targets for free cash flow and debt reduction—as well as disclosures concerning the acquisition’s impact on 2017 operating results—are potentially helpful. CASH FLOW STATEMENT ANALYSIS: COMMON SIZE ANALYSIS h analyze and interpret both reported and common- size cash flow statements In common- size analysis of a company’s income statement, each income and expense line item is expressed as a percentage of net revenues (net sales). For the common- size balance sheet, each asset, liability, and equity line item is expressed as a percentage of total assets. For the common- size cash flow statement, there are two alternative approaches. The first approach is to express each line item of cash inflow (outflow) as a percentage of total inflows (outflows) of cash, and the second approach is to express each line item as a percentage of net revenue. Exhibit 14 demonstrates the total cash inflows/total cash outflows method for Acme Corporation. Under this approach, each of the cash inflows is expressed as a percentage of the total cash inflows, whereas each of the cash outflows is expressed as a percentage of the total cash outflows. In Panel A, Acme’s common- size statement is based on a cash flow statement using the direct method of presenting operating cash flows. Operating cash inflows and outflows are separately presented on the cash flow statement, and therefore, the common- size cash flow statement shows each of these operating inflows (outflows) as a percentage of total inflows (outflows). In Panel B, Acme’s common- size statement is based on a cash flow statement using the indirect method of presenting operating cash flows. When a cash flow statement has been presented using the indirect method, operating cash inflows and outflows are not separately presented; therefore, the common- size cash flow statement shows only the net operating cash flow (net cash provided by or used in operating activities) as a 17 © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 174. Reading 19 ■ Understanding Cash Flow Statements 156 percentage of total inflows or outflows, depending on whether the net amount was a cash inflow or outflow. Because Acme’s net operating cash flow is positive, it is shown as a percentage of total inflows. Exhibit 14 Acme Corporation Common- Size Cash Flow Statement Year Ended 31 December 2018 Panel A. Direct Format for Cash Flow Inflows Percentage of Total Inflows Receipts from customers $23,543 96.86% Sale of equipment 762 3.14 Total $24,305 100.00% Outflows Percentage of Total Outflows Payments to suppliers $11,900 48.66% Payments to employees 4,113 16.82 Payments for other operating expenses 3,532 14.44 Payments for interest 258 1.05 Payments for income tax 1,134 4.64 Purchase of equipment 1,300 5.32 Retirement of long- term debt 500 2.04 Retirement of common stock 600 2.45 Dividend payments 1,120 4.58 Total $24,457 100.00% Net increase (decrease) in cash ($152) Panel B. Indirect Format for Cash Flow Inflows Percentage of Total Inflows Net cash provided by operating activities $2,606 77.38% Sale of equipment 762 22.62 Total $3,368 100.00% Outflows Percentage of Total Outflows Purchase of equipment $1,300 36.93% Retirement of long- term debt 500 14.20 Retirement of common stock 600 17.05 Dividend payments 1,120 31.82 © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 175. Cash Flow Statement Analysis: Common Size Analysis 157 Outflows Percentage of Total Outflows Total $3,520 100.00% Net increase (decrease) in cash ($152) Exhibit 15 demonstrates the net revenue common- size cash flow statement for Acme Corporation. Under the net revenue approach, each line item in the cash flow statement is shown as a percentage of net revenue. The common- size statement in this exhibit has been developed based on Acme’s cash flow statement using the indi- rect method for operating cash flows and using net revenue of $23,598 as shown in Exhibit 6. Each line item of the reconciliation between net income and net operating cash flows is expressed as a percentage of net revenue. The common- size format makes it easier to see trends in cash flow rather than just looking at the total amount. This method is also useful to the analyst in forecasting future cash flows because individual items in the common- size statement (e.g., depreciation, fixed capital expenditures, debt borrowing, and repayment) are expressed as a percentage of net revenue. Thus, once the analyst has forecast revenue, the common- size statement provides a basis for forecasting cash flows for those items with an expected relation to net revenue. Exhibit 15 Acme Corporation Common- Size Cash Flow Statement: Indirect Format Year Ended 31 December 2018 Percentage of Net Revenue Cash flow from operating activities: Net income $2,210 9.37% Depreciation expense 1,052 4.46 Gain on sale of equipment (205) (0.87) Increase in accounts receivable (55) (0.23) Increase in inventory (707) (3.00) Decrease in prepaid expenses 23 0.10 Increase in accounts payable 263 1.11 Increase in salary and wage payable 10 0.04 Decrease in interest payable (12) (0.05) Increase in income tax payable 5 0.02 Increase in other accrued liabilities 22 0.09 Net cash provided by operating activities $2,606 11.04% Cash flow from investing activities: Cash received from sale of equipment $762 3.23% Cash paid for purchase of equipment (1,300) (5.51) Net cash used for investing activities $(538) (2.28)% Cash flow from financing activities: (continued) Exhibit 14 (Continued) © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 176. Reading 19 ■ Understanding Cash Flow Statements 158 Percentage of Net Revenue Cash paid to retire long- term debt $(500) (2.12)% Cash paid to retire common stock (600) (2.54) Cash paid for dividends (1,120) (4.75) Net cash used for financing activities $(2,220) (9.41)% Net decrease in cash $(152) (0.64)% EXAMPLE 9 Analysis of a Common- Size Cash Flow Statement Andrew Potter is examining an abbreviated common- size cash flow statement for Apple Inc., a multinational technology company. The common- size cash flow statement was prepared by dividing each line item by total net sales for the same year. Apple Inc. Common Size Statements OF Cash Flows as Percentage of Total Net Sales 12 Months Ended 30 Sep. 2017 24 Sep. 2016 26 Sep. 2015 Statement of Cash Flows [Abstract] Operating activities: Net income 21.1% 21.2% 22.8% Adjustments to reconcile net income to cash generated by oper- ating activities: Depreciation and amortization 4.4% 4.9% 4.8% Share- based compensation expense 2.1% 2.0% 1.5% Deferred income tax expense 2.6% 2.3% 0.6% Other –0.1% 0.2% 0.2% Changes in operating assets and liabilities: Accounts receivable, net –0.9% 0.2% 0.2% Inventories –1.2% 0.1% –0.1% Vendor non- trade receivables –1.9% 0.0% –1.6% Other current and non- current assets –2.3% 0.5% –0.1% Accounts payable 4.2% 0.9% 2.1% Deferred revenue –0.3% –0.7% 0.4% Exhibit 15 (Continued) © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 177. Cash Flow Statement Analysis: Common Size Analysis 159 12 Months Ended 30 Sep. 2017 24 Sep. 2016 26 Sep. 2015 Other current and non- current liabilities –0.1% –0.9% 3.9% Cash generated by operating activities 27.7% 30.5% 34.8% Investing activities: Purchases of marketable securities –69.6% –66.0% –71.2% Proceeds from maturities of market- able securities 13.9% 9.9% 6.2% Proceeds from sales of marketable securities 41.3% 42.0% 46.0% Payments made in connection with business acquisitions, net –0.1% –0.1% –0.1% Payments for acquisition of property, plant and equipment –5.4% –5.9% –4.8% Payments for acquisition of intangible assets –0.2% –0.4% –0.1% Payments for strategic investments, net –0.2% –0.6% 0.0% Other 0.1% –0.1% 0.0% Cash used in investing activities –20.3% –21.3% –24.1% Financing activities: Proceeds from issuance of common stock 0.2% 0.2% 0.2% Excess tax benefits from equity awards 0.3% 0.2% 0.3% Payments for taxes related to net share settlement of equity awards –0.8% –0.7% –0.6% Payments for dividends and dividend equivalents –5.6% –5.6% –4.9% Repurchases of common stock –14.4% –13.8% –15.1% Proceeds from issuance of term debt, net 12.5% 11.6% — Repayments of term debt –1.5% –1.2% 0.0% Change in commercial paper, net 1.7% –0.2% 0.9% Cash used in financing activities –7.6% –9.5% –7.6% Increase/(Decrease) in cash and cash equivalents –0.1% –0.3% 3.1% Based on the information in the above exhibit: 1 Discuss the significance of (Continued) © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 178. Reading 19 ■ Understanding Cash Flow Statements 160 A depreciation and amortization. B capital expenditures. 2 Compare Apple’s operating cash flow as a percentage of revenue with Apple’s net profit margin. 3 Discuss Apple’s use of its positive operating cash flow. Solution to 1: A Apple’s depreciation and amortization expense was consistently just less than 5% of total net revenue in 2015 and 2016, declining to 4.4% in 2017. B Apple’s level of capital expenditures is greater than depreciation and amortization in 2016 and 2017 whereas it was at about the same level as depreciation and amortization in 2015. In 2017 capital expenditures approached 6%. This is an indication that Apple is doing more than replacing property, plant, and equipment, and is expanding those invest- ments. With cash generated from operating activities exceeding 27% of sales in every year, however, Apple has more than enough cash flow from operations to fund these expenditures. Solution to 2: Apple’s operating cash flow as a percentage of sales is much higher than net profit margin in every year. This gap appears to be declining however over the three year period. In 2015 net profit margin was 22.8% while operating cash flow as a percentage of sales was 34.8%. By 2017 the net profit margin declined slightly to 21.1% while the operating cash flow as a percentage of sales declined more to 27.7%. The primary difference appears to have been an increase in the level of receivables and inventory purchases, somewhat offset by an increase in accounts payable. Solution to 3: Apple has a very strong cash flow statement. Apple generates a large amount of operating cash flow in every year, exceeding net income. This cash flow is used for relatively modest purchases of property, plant and equipment, substantial purchases of marketable securities (investments), dividend payments and repur- chases of its own stock. CASH FLOW STATEMENT ANALYSIS: FREE CASH FLOW TO FIRM AND FREE CASH FLOW TO EQUITY i. calculate and interpret free cash flow to the firm, free cash flow to equity, and performance and coverage cash flow ratios It was mentioned earlier that it is desirable that operating cash flows are sufficient to cover capital expenditures. The excess of operating cash flow over capital expenditures is known generically as free cash flow. For purposes of valuing a company or its equity securities, an analyst may want to determine and use other cash flow measures, such as free cash flow to the firm (FCFF) or free cash flow to equity (FCFE). 18 © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 179. Cash Flow Statement Analysis: Free Cash Flow to Firm and Free Cash Flow to Equity 161 FCFF is the cash flow available to the company’s suppliers of debt and equity capital after all operating expenses (including income taxes) have been paid and necessary investments in working capital and fixed capital have been made. FCFF can be com- puted starting with net income as FCFF = NI + NCC + Int(1 – Tax rate) – FCInv – WCInv where NI = Net income NCC = Non- cash charges (such as depreciation and amortisation) Int = Interest expense FCInv = Capital expenditures (fixed capital, such as equipment) WCInv = Working capital expenditures The reason for adding back interest is that FCFF is the cash flow available to the suppliers of debt capital as well as equity capital. Conveniently, FCFF can also be computed from cash flow from operating activities as FCFF = CFO + Int(1 – Tax rate) – FCInv CFO represents cash flow from operating activities under US GAAP or under IFRS where the company has included interest paid in operating activities. If interest paid was included in financing activities, then CFO does not have to be adjusted for Int(1 – Tax rate). Under IFRS, if the company has placed interest and dividends received in investing activities, these should be added back to CFO to determine FCFF. Additionally, if dividends paid were subtracted in the operating section, these should be added back in to compute FCFF. The computation of FCFF for Acme Corporation (based on the data from Exhibits 6, 7, and 8) is as follows: CFO $2,606 Plus: Interest paid times (1 – income tax rate) {$258 [1 – 0.34a]} 170 Less: Net investments in fixed capital ($1,300 – $762) (538) FCFF $2,238 a Income tax rate of 0.34 = (Tax expense ÷ Pretax income) = ($1,139 ÷ $3,349). FCFE is the cash flow available to the company’s common stockholders after all operating expenses and borrowing costs (principal and interest) have been paid and necessary investments in working capital and fixed capital have been made. FCFE can be computed as FCFE = CFO – FCInv + Net borrowing When net borrowing is negative, debt repayments exceed receipts of borrowed funds. In this case, FCFE can be expressed as FCFE = CFO – FCInv – Net debt repayment The computation of FCFE for Acme Corporation (based on the data from Exhibits 6, 7, and 8) is as follows: CFO $2,606 Less: Net investments in fixed capital ($1,300 – $762) (538) Less: Debt repayment (500) FCFE $1,568 © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 180. Reading 19 ■ Understanding Cash Flow Statements 162 Positive FCFE means that the company has an excess of operating cash flow over amounts needed for capital expenditures and repayment of debt. This cash would be available for distribution to owners. CASH FLOW STATEMENT ANALYSIS: CASH FLOW RATIOS i. calculate and interpret free cash flow to the firm, free cash flow to equity, and performance and coverage cash flow ratios The statement of cash flows provides information that can be analyzed over time to obtain a better understanding of the past performance of a company and its future prospects. This information can also be effectively used to compare the performance and prospects of different companies in an industry and of different industries. There are several ratios based on cash flow from operating activities that are useful in this analysis. These ratios generally fall into cash flow performance (profitability) ratios and cash flow coverage (solvency) ratios. Exhibit 15 summarizes the calculation and interpretation of some of these ratios. Exhibit 16 Cash Flow Ratios Performance Ratios Calculation What It Measures Cash flow to revenue CFO ÷ Net revenue Operating cash generated per dollar of revenue Cash return on assets CFO ÷ Average total assets Operating cash generated per dollar of asset investment Cash return on equity CFO ÷ Average shareholders’ equity Operating cash generated per dollar of owner investment Cash to income CFO ÷ Operating income Cash generating ability of operations Cash flow per sharea (CFO – Preferred dividends) ÷ Number of common shares outstanding Operating cash flow on a per- share basis Coverage Ratios Calculation What It Measures Debt coverage CFO ÷ Total debt Financial risk and financial leverage Interest coverageb (CFO + Interest paid + Taxes paid) ÷ Interest paid Ability to meet interest obligations Reinvestment CFO ÷ Cash paid for long- term assets Ability to acquire assets with operating cash flows Debt payment CFO ÷ Cash paid for long- term debt repayment Ability to pay debts with operating cash flows 19 © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 181. Cash Flow Statement Analysis: Cash Flow Ratios 163 Coverage Ratios Calculation What It Measures Dividend payment CFO ÷ Dividends paid Ability to pay dividends with operating cash flows Investing and financing CFO ÷ Cash outflows for investing and financing activities Ability to acquire assets, pay debts, and make distributions to owners Notes: a If the company reports under IFRS and includes total dividends paid as a use of cash in the operating section, total dividends should be added back to CFO as reported and then preferred dividends should be subtracted. Recall that CFO reported under US GAAP and IFRS may differ depending on the treatment of interest and dividends, received and paid. b If the company reports under IFRS and included interest paid as a use of cash in the financing section, then interest paid should not be added back to the numerator. EXAMPLE 10 A Cash Flow Analysis of Comparables Andrew Potter is comparing the cash- flow- generating ability of Microsoft with that of Apple Inc. He collects information from the companies’ annual reports and prepares the following table. Cash Flow from Operating Activities as a Percentage of Total Net Revenue 2017 (%) 2016 (%) 2015 (%) Microsoft 43.9 39.1 31.7 Apple Inc. 27.7 30.5 34.8 As a Percentage of Average Total Assets 2017 (%) 2016 (%) 2015 (%) Microsoft 18.2 18.1 17.1 Apple Inc. 18.2 21.5 31.1 What is Potter likely to conclude about the relative cash- flow- generating ability of these two companies? Solution: On both measures—operating cash flow divided by revenue and operating cash flow divided by assets—both companies have overall strong results. However, Microsoft has higher cash flow from operating activities as a percentage of rev- enues in both 2016 and 2017. Further, Microsoft has an increasing trend. While Apple had a higher operating cash flow as a percent of revenue in 2015 compared to Microsoft, it has had a declining trend and was below Microsoft in the two more recent years. Microsoft’s operating cash flow relative to assets is the same Exhibit 16 (Continued) © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 182. Reading 19 ■ Understanding Cash Flow Statements 164 as Apple’s in 2017 and relatively stable with a slight increase since 2015. Apple started the three years with a much stronger ratio but saw a declining trend such that its ratio is now at the same level as Microsoft. We should note that this ratio is heavily influenced by substantial investments in financial instruments that Apple has made over the years due to its strong historic cash flow. SUMMARY The cash flow statement provides important information about a company’s cash receipts and cash payments during an accounting period as well as information about a company’s operating, investing, and financing activities. Although the income statement provides a measure of a company’s success, cash and cash flow are also vital to a company’s long- term success. Information on the sources and uses of cash helps creditors, investors, and other statement users evaluate the company’s liquidity, solvency, and financial flexibility. Key concepts are as follows: ■ ■ Cash flow activities are classified into three categories: operating activities, investing activities, and financing activities. Significant non- cash transaction activities (if present) are reported by using a supplemental disclosure note to the cash flow statement. ■ ■ Cash flow statements under IFRS and US GAAP are similar; however, IFRS provide companies with more choices in classifying some cash flow items as operating, investing, or financing activities. ■ ■ Companies can use either the direct or the indirect method for reporting their operating cash flow: ● ● The direct method discloses operating cash inflows by source (e.g., cash received from customers, cash received from investment income) and oper- ating cash outflows by use (e.g., cash paid to suppliers, cash paid for inter- est) in the operating activities section of the cash flow statement. ● ● The indirect method reconciles net income to operating cash flow by adjust- ing net income for all non- cash items and the net changes in the operating working capital accounts. ■ ■ The cash flow statement is linked to a company’s income statement and com- parative balance sheets and to data on those statements. ■ ■ Although the indirect method is most commonly used by companies, an analyst can generally convert it to an approximation of the direct format by following a simple three- step process. ■ ■ An evaluation of a cash flow statement should involve an assessment of the sources and uses of cash and the main drivers of cash flow within each category of activities. ■ ■ The analyst can use common- size statement analysis for the cash flow state- ment. Two approaches to developing the common- size statements are the total cash inflows/total cash outflows method and the percentage of net revenues method. ■ ■ The cash flow statement can be used to determine free cash flow to the firm (FCFF) and free cash flow to equity (FCFE). ■ ■ The cash flow statement may also be used in financial ratios that measure a company’s profitability, performance, and financial strength. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 183. Practice Problems 165 PRACTICE PROBLEMS 1 The three major classifications of activities in a cash flow statement are: A inflows, outflows, and net flows. B operating, investing, and financing. C revenues, expenses, and net income. 2 The sale of a building for cash would be classified as what type of activity on the cash flow statement? A Operating. B Investing. C Financing. 3 Under which section of a manufacturing company’s cash flow statement are the following activities reported? Item 1: Purchases of securities held for trading Item 2: Purchases of securities held for investment A Both items are investing activities. B Only Item 1 is an operating activity. C Only Item 2 is an operating activity. 4 Which of the following is an example of a financing activity on the cash flow statement under US GAAP? A Payment of interest. B Receipt of dividends. C Payment of dividends. 5 A conversion of a face value $1 million convertible bond for $1 million of com- mon stock would most likely be: A reported as a $1 million investing cash inflow and outflow. B reported as a $1 million financing cash outflow and inflow. C reported as supplementary information to the cash flow statement. 6 A company recently engaged in a non- cash transaction that significantly affected its property, plant, and equipment. The transaction is: A reported under the investing section of the cash flow statement. B reported differently in cash flow from operations under the direct and indi- rect methods. C disclosed as a separate note or in a supplementary schedule to the cash flow statement. 7 Interest paid is classified as an operating cash flow under: A US GAAP but may be classified as either operating or investing cash flows under IFRS. B IFRS but may be classified as either operating or investing cash flows under US GAAP. C US GAAP but may be classified as either operating or financing cash flows under IFRS. 8 Cash flows from taxes on income must be separately disclosed under: © 2019 CFA Institute. All rights reserved. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 184. Reading 19 ■ Understanding Cash Flow Statements 166 A IFRS only. B US GAAP only. C both IFRS and US GAAP. 9 Which of the following components of the cash flow statement may be prepared under the indirect method under both IFRS and US GAAP? A Operating. B Investing. C Financing. 10 Which of the following is most likely to appear in the operating section of a cash flow statement under the indirect method? A Net income. B Cash paid to suppliers. C Cash received from customers. 11 A benefit of using the direct method rather than the indirect method when reporting operating cash flows is that the direct method: A mirrors a forecasting approach. B is easier and less costly. C provides specific information on the sources of operating cash flows. 12 Mabel Corporation (MC) reported accounts receivable of $66 million at the end of its second fiscal quarter. MC had revenues of $72 million for its third fiscal quarter and reported accounts receivable of $55 million at the end of its third fiscal quarter. Based on this information, the amount of cash MC collected from customers during the third fiscal quarter is: A $61 million. B $72 million. C $83 million. 13 When computing net cash flow from operating activities using the indirect method, an addition to net income is most likely to occur when there is a: A gain on the sale of an asset. B loss on the retirement of debt. C decrease in a deferred tax liability. 14 Red Road Company, a consulting company, reported total revenues of $100 mil- lion, total expenses of $80 million, and net income of $20 million in the most recent year. If accounts receivable increased by $10 million, how much cash did the company receive from customers? A $90 million. B $100 million. C $110 million. 15 In 2018, a company using US GAAP made cash payments of $6 million for sala- ries, $2 million for interest expense, and $4 million for income taxes. Additional information for the company is provided in the table: ($ millions) 2017 2018 Revenue 42 37 Cost of goods sold 18 16 Inventory 36 40 © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 185. Practice Problems 167 ($ millions) 2017 2018 Accounts receivable 22 19 Accounts payable 14 12 Based only on the information given, the company’s operating cash flow for 2018 is closest to: A $6 million. B $10 million. C $14 million. 16 Green Glory Corp., a garden supply wholesaler, reported cost of goods sold for the year of $80 million. Total assets increased by $55 million, including an increase of $5 million in inventory. Total liabilities increased by $45 million, including an increase of $2 million in accounts payable. The cash paid by the company to its suppliers is most likely closest to: A $73 million. B $77 million. C $83 million. 17 Purple Fleur S.A., a retailer of floral products, reported cost of goods sold for the year of $75 million. Total assets increased by $55 million, but inventory declined by $6 million. Total liabilities increased by $45 million, and accounts payable increased by $2 million. The cash paid by the company to its suppliers is most likely closest to: A $67 million. B $79 million. C $83 million. 18 White Flag, a women’s clothing manufacturer, reported salaries expense of $20 million. The beginning balance of salaries payable was $3 million, and the ending balance of salaries payable was $1 million. How much cash did the com- pany pay in salaries? A $18 million. B $21 million. C $22 million. 19 An analyst gathered the following information from a company’s 2018 financial statements (in $ millions): Year ended 31 December 2017 2018 Net sales 245.8 254.6 Cost of goods sold 168.3 175.9 Accounts receivable 73.2 68.3 Inventory 39.0 47.8 Accounts payable 20.3 22.9 Based only on the information above, the company’s 2018 statement of cash flows in the direct format would include amounts (in $ millions) for cash received from customers and cash paid to suppliers, respectively, that are closest to: © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 186. Reading 19 ■ Understanding Cash Flow Statements 168 cash received from customers cash paid to suppliers A 249.7 169.7 B 259.5 174.5 C 259.5 182.1 20 Golden Cumulus Corp., a commodities trading company, reported interest expense of $19 million and taxes of $6 million. Interest payable increased by $3 million, and taxes payable decreased by $4 million over the period. How much cash did the company pay for interest and taxes? A $22 million for interest and $10 million for taxes. B $16 million for interest and $2 million for taxes. C $16 million for interest and $10 million for taxes. 21 An analyst gathered the following information from a company’s 2018 financial statements (in $ millions): Balances as of Year Ended 31 December 2017 2018 Retained earnings 120 145 Accounts receivable 38 43 Inventory 45 48 Accounts payable 36 29 In 2018, the company declared and paid cash dividends of $10 million and recorded depreciation expense in the amount of $25 million. The company con- siders dividends paid a financing activity. The company’s 2018 cash flow from operations (in $ millions) was closest to A 25. B 45. C 75. 22 Silverago Incorporated, an international metals company, reported a loss on the sale of equipment of $2 million in 2018. In addition, the company’s income statement shows depreciation expense of $8 million and the cash flow statement shows capital expenditure of $10 million, all of which was for the purchase of new equipment. Using the following information from the comparative balance sheets, how much cash did the company receive from the equipment sale? Balance Sheet Item 12/31/2017 12/31/2018 Change Equipment $100 million $105 million $5 million Accumulated depreciation—equipment $40 million $46 million $6 million A $1 million. B $2 million. C $3 million. 23 Jaderong Plinkett Stores reported net income of $25 million. The company has no outstanding debt. Using the following information from the comparative balance sheets (in millions), what should the company report in the financing section of the statement of cash flows in 2018? © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 187. Practice Problems 169 Balance Sheet Item 12/31/2017 12/31/2018 Change Common stock $100 $102 $2 Additional paid- in capital common stock $100 $140 $40 Retained earnings $100 $115 $15 Total stockholders’ equity $300 $357 $57 A Issuance of common stock of $42 million; dividends paid of $10 million. B Issuance of common stock of $38 million; dividends paid of $10 million. C Issuance of common stock of $42 million; dividends paid of $40 million. 24 Based on the following information for Star Inc., what are the total net adjust- ments that the company would make to net income in order to derive operating cash flow? Year Ended Income Statement Item 12/31/2018 Net income $20 million Depreciation $2 million Balance Sheet Item 12/31/2017 12/31/2018 Change Accounts receivable $25 million $22 million ($3 million) Inventory $10 million $14 million $4 million Accounts payable $8 million $13 million $5 million A Add $2 million. B Add $6 million. C Subtract $6 million. 25 The first step in cash flow statement analysis should be to: A evaluate consistency of cash flows. B determine operating cash flow drivers. C identify the major sources and uses of cash. 26 Which of the following would be valid conclusions from an analysis of the cash flow statement for Telefónica Group presented in Exhibit 3? A The primary use of cash is financing activities. B The primary source of cash is operating activities. C Telefónica classifies dividends paid as an operating activity. 27 The following information is extracted from Sweetfall Incorporated’s financial statements. Income Statement Balance Sheet Changes Revenue $56,800 Decrease in accounts receivable $1,324 Cost of goods sold 27,264 Decrease in inventory 501 Other operating expense 562 Increase in prepaid expense 6 Depreciation expense 2,500 Increase in accounts payable 1,063 The amount of cash Sweetfall Inc. paid to suppliers is: © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 188. Reading 19 ■ Understanding Cash Flow Statements 170 A $25,700. B $26,702. C $27,826. 28 Which is an appropriate method of preparing a common- size cash flow statement? A Show each item of revenue and expense as a percentage of net revenue. B Show each line item on the cash flow statement as a percentage of net revenue. C Show each line item on the cash flow statement as a percentage of total cash outflows. 29 Which of the following is an appropriate method of computing free cash flow to the firm? A Add operating cash flows to capital expenditures and deduct after- tax inter- est payments. B Add operating cash flows to after- tax interest payments and deduct capital expenditures. C Deduct both after- tax interest payments and capital expenditures from operating cash flows. 30 An analyst has calculated a ratio using as the numerator the sum of operating cash flow, interest, and taxes and as the denominator the amount of interest. What is this ratio, what does it measure, and what does it indicate? A This ratio is an interest coverage ratio, measuring a company’s ability to meet its interest obligations and indicating a company’s solvency. B This ratio is an effective tax ratio, measuring the amount of a company’s operating cash flow used for taxes and indicating a company’s efficiency in tax management. C This ratio is an operating profitability ratio, measuring the operating cash flow generated accounting for taxes and interest and indicating a company’s liquidity. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 189. Solutions 171 SOLUTIONS 1 B is correct. Operating, investing, and financing are the three major classifica- tions of activities in a cash flow statement. Revenues, expenses, and net income are elements of the income statement. Inflows, outflows, and net flows are items of information in the statement of cash flows. 2 B is correct. Purchases and sales of long- term assets are considered investing activities. Note that if the transaction had involved the exchange of a build- ing for other than cash (for example, for another building, common stock of another company, or a long- term note receivable), it would have been consid- ered a significant non- cash activity. 3 B is correct. The purchase and sale of securities held for trading are considered operating activities even for companies in which this activity is not a primary business activity. 4 C is correct. Payment of dividends is a financing activity under US GAAP. Payment of interest and receipt of dividends are included in operating cash flows under US GAAP. Note that IFRS allow companies to include receipt of interest and dividends as either operating or investing cash flows and to include payment of interest and dividends as either operating or financing cash flows. 5 C is correct. Non- cash transactions, if significant, are reported as supplemen- tary information, not in the investing or financing sections of the cash flow statement. 6 C is correct. Because no cash is involved in non- cash transactions, these trans- actions are not incorporated in the cash flow statement. However, non- cash transactions that significantly affect capital or asset structures are required to be disclosed either in a separate note or a supplementary schedule to the cash flow statement. 7 C is correct. Interest expense is always classified as an operating cash flow under US GAAP but may be classified as either an operating or financing cash flow under IFRS. 8 C is correct. Taxes on income are required to be separately disclosed under IFRS and US GAAP. The disclosure may be in the cash flow statement or elsewhere. 9 A is correct. The operating section may be prepared under the indirect method. The other sections are always prepared under the direct method. 10 A 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. 11 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 pay- ments. Arguments for the indirect method include that it mirrors a forecasting approach and it is easier and less costly 12 C is correct. The amount of cash collected from customers during the quarter is equal to beginning accounts receivable plus revenues minus ending accounts receivable: $66 million + $72 million – $55 million = $83 million. A reduction in accounts receivable indicates that cash collected during the quarter was greater than revenue on an accrual basis. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 190. Reading 19 ■ Understanding Cash Flow Statements 172 13 B is correct. An addition to net income is made when there is a loss on the retirement of debt, which is a non- operating loss. A gain on the sale of an asset and a decrease in deferred tax liability are both subtracted from net- income. 14 A is correct. Revenues of $100 million minus the increase in accounts receivable of $10 million equal $90 million cash received from customers. The increase in accounts receivable means that the company received less in cash than it reported as revenue. 15 A is correct. Operating cash flows = Cash received from customers – (Cash paid to suppliers + Cash paid to employees + Cash paid for other operating expenses + Cash paid for interest + Cash paid for income taxes) Cash received from customers = Revenue + Decrease in accounts receivable = $37 + $3 = $40 million Cash paid to suppliers = Cost of goods sold + Increase in inven- tory + Decrease in accounts payable = $16 + $4 + $2 = $22 million Therefore, the company’s operating cash flow = $40 – $22 – Cash paid for sala- ries – Cash paid for interest – Cash paid for taxes = $40 – $22 – $6 – $2 – $4 = $6 million. 16 C is correct. Cost of goods sold of $80 million plus the increase in inventory of $5 million equals purchases from suppliers of $85 million. The increase in accounts payable of $2 million means that the company paid $83 million in cash ($85 million minus $2 million) to its suppliers. 17 A is correct. Cost of goods sold of $75 million less the decrease in inventory of $6 million equals purchases from suppliers of $69 million. The increase in accounts payable of $2 million means that the company paid $67 million in cash ($69 million minus $2 million). 18 C is correct. Beginning salaries payable of $3 million plus salaries expense of $20 million minus ending salaries payable of $1 million equals $22 million. Alternatively, the expense of $20 million plus the $2 million decrease in salaries payable equals $22 million. 19 C is correct. Cash received from customers = Sales + Decrease in accounts receivable = 254.6 + 4.9 = 259.5. Cash paid to suppliers = Cost of goods sold + Increase in inventory – Increase in accounts payable = 175.9 + 8.8 – 2.6 = 182.1. 20 C is correct. Interest expense of $19 million less the increase in interest payable of $3 million equals interest paid of $16 million. Tax expense of $6 million plus the decrease in taxes payable of $4 million equals taxes paid of $10 million. 21 B is correct. All dollar amounts are in millions. Net income (NI) for 2018 is $35. This amount is the increase in retained earnings, $25, plus the dividends paid, $10. Depreciation of $25 is added back to net income, and the increases in accounts receivable, $5, and in inventory, $3, are subtracted from net income because they are uses of cash. The decrease in accounts payable is also a use of cash and, therefore, a subtraction from net income. Thus, cash flow from opera- tions is $25 + $10 + $25 – $5 – $3 – $7 = $45. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 191. Solutions 173 22 A is correct. Selling price (cash inflow) minus book value equals gain or loss on sale; therefore, gain or loss on sale plus book value equals selling price (cash inflow). The amount of loss is given—$2 million. To calculate the book value of the equipment sold, find the historical cost of the equipment and the accumu- lated depreciation on the equipment. ● ● Beginning balance of equipment of $100 million plus equipment purchased of $10 million minus ending balance of equipment of $105 million equals the historical cost of equipment sold, or $5 million. ● ● Beginning accumulated depreciation of $40 million plus depreciation expense for the year of $8 million minus ending balance of accumulated depreciation of $46 million equals accumulated depreciation on the equip- ment sold, or $2 million. ● ● Therefore, the book value of the equipment sold was $5 million minus $2 million, or $3 million. ● ● Because the loss on the sale of equipment was $2 million, the amount of cash received must have been $1 million. 23 A is correct. The increase of $42 million in common stock and additional paid- in capital indicates that the company issued stock during the year. The increase in retained earnings of $15 million indicates that the company paid $10 million in cash dividends during the year, determined as beginning retained earnings of $100 million plus net income of $25 million minus ending retained earnings of $115 million, which equals $10 million in cash dividends. 24 B is correct. To derive operating cash flow, the company would make the following adjustments to net income: Add depreciation (a non- cash expense) of $2 million; add the decrease in accounts receivable of $3 million; add the increase in accounts payable of $5 million; and subtract the increase in inven- tory of $4 million. Total additions would be $10 million, and total subtractions would be $4 million, which gives net additions of $6 million. 25 C is correct. An overall assessment of the major sources and uses of cash should be the first step in evaluating a cash flow statement. 26 B is correct. The primary source of cash is operating activities. Cash flow pro- vided by operating activity totaled €13,796 million in the most recent year. The primary use of cash is investing activities (total of €10,245 million). Dividends paid are classified as a financing activity. 27 A is correct. The amount of cash paid to suppliers is calculated as follows: = Cost of goods sold – Decrease in inventory – Increase in accounts payable = $27,264 – $501 – $1,063 = $25,700. 28 B is correct. An appropriate method to prepare a common- size cash flow state- ment is to show each line item on the cash flow statement as a percentage of net revenue. An alternative way to prepare a statement of cash flows is to show each item of cash inflow as a percentage of total inflows and each item of cash outflows as a percentage of total outflows. 29 B is correct. Free cash flow to the firm can be computed as operating cash flows plus after- tax interest expense less capital expenditures. 30 A is correct. This ratio is an interest coverage ratio, measuring a company’s ability to meet its interest obligations and indicating a company’s solvency. This coverage ratio is based on cash flow information; another common coverage ratio uses a measure based on the income statement (earnings before interest, taxes, depreciation, and amortisation). © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 192. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 193. Financial Analysis Techniques by Elaine Henry, PhD, CFA, Thomas R. Robinson, PhD, CFA, and J. Hennie van Greuning, DCom, CFA Elaine Henry, PhD, CFA, is at Stevens Institute of Technology (USA). Thomas R. Robinson, PhD, CFA, is at AACSB International (USA). J. Hennie van Greuning, DCom, CFA, is at BIBD (Brunei). LEARNING OUTCOMES Mastery The candidate should be able to: a. describe tools and techniques used in financial analysis, including their uses and limitations; b. identify, calculate, and interpret activity, liquidity, solvency, profitability, and valuation ratios; c. describe relationships among ratios and evaluate a company using ratio analysis; d. demonstrate the application of DuPont analysis of return on equity and calculate and interpret effects of changes in its components; e. calculate and interpret ratios used in equity analysis and credit analysis; f. explain the requirements for segment reporting and calculate and interpret segment ratios; g. describe how ratio analysis and other techniques can be used to model and forecast earnings. R E A D I N G 20 © 2019 CFA Institute. All rights reserved. Note: Changes in accounting standards as well as new rulings and/or pronouncements issued after the publication of the readings on financial reporting and analysis may cause some of the information in these readings to become dated. Candidates are not responsible for anything that occurs after the readings were published. In addition, candidates are expected to be familiar with the analytical frameworks contained in the readings, as well as the implications of alternative accounting methods for financial analysis and valuation discussed in the readings. Candidates are also responsible for the content of accounting standards, but not for the actual reference numbers. Finally, candidates should be aware that certain ratios may be defined and calculated differently. When alternative ratio definitions exist and no specific definition is given, candidates should use the ratio definitions emphasized in the readings. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 194. Reading 20 ■ Financial Analysis Techniques 176 INTRODUCTION a describe tools and techniques used in financial analysis, including their uses and limitations Financial analysis tools can be useful in assessing a company’s performance and trends in that performance. In essence, an analyst converts data into financial metrics that assist in decision making. Analysts seek to answer such questions as: How successfully has the company performed, relative to its own past performance and relative to its competitors? How is the company likely to perform in the future? Based on expectations about future performance, what is the value of this company or the securities it issues? A primary source of data is a company’s annual report, including the financial statements and notes, and management commentary (operating and financial review or management’s discussion and analysis). This reading focuses on data presented in financial reports prepared under International Financial Reporting Standards (IFRS) and United States generally accepted accounting principles (US GAAP). However, financial reports do not contain all the information needed to perform effective financial analysis. Although financial statements do contain data about the past performance of a company (its income and cash flows) as well as its current financial condition (assets, liabilities, and owners’ equity), such statements do not necessarily provide all the information useful for analysis nor do they forecast future results. The finan- cial analyst must be capable of using financial statements in conjunction with other information to make projections and reach valid conclusions. Accordingly, an analyst typically needs to supplement the information found in a company’s financial reports with other information, including information on the economy, industry, comparable companies, and the company itself. This reading describes various techniques used to analyze a company’s financial statements. Financial analysis of a company may be performed for a variety of reasons, such as valuing equity securities, assessing credit risk, conducting due diligence related to an acquisition, or assessing a subsidiary’s performance. This reading will describe techniques common to any financial analysis and then discuss more specific aspects for the two most common categories: equity analysis and credit analysis. Equity analysis incorporates an owner’s perspective, either for valuation or perfor- mance evaluation. Credit analysis incorporates a creditor’s (such as a banker or bond- holder) perspective. In either case, there is a need to gather and analyze information to make a decision (ownership or credit); the focus of analysis varies because of the differing interest of owners and creditors. Both equity and credit analyses assess the entity’s ability to generate and grow earnings, and cash flow, as well as any associated risks. Equity analysis usually places a greater emphasis on growth, whereas credit analysis usually places a greater emphasis on risks. The difference in emphasis reflects the different fundamentals of these types of investments: The value of a company’s equity generally increases as the company’s earnings and cash flow increase, whereas the value of a company’s debt has an upper limit.1 The balance of this reading is organized as follows: Section 1 recaps the frame- work for financial statements and the place of financial analysis techniques within the framework. Sections 2–6 provide a description of analytical tools and techniques. Sections 7–13 explain how to compute, analyze, and interpret common financial ratios. Sections 14–19 explain the use of ratios and other analytical data in equity 1 1 The upper limit is equal to the undiscounted sum of the principal and remaining interest payments (i.e., the present value of these contractual payments at a zero percent discount rate). © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 195. Introduction 177 analysis, credit analysis, segment analysis, and forecasting, respectively. A summary of the key points and practice problems in the CFA Institute multiple- choice format conclude the reading. 1.1 The Financial Analysis Process In financial analysis, it is essential to clearly identify and understand the final objective and the steps required to reach that objective. In addition, the analyst needs to know where to find relevant data, how to process and analyze the data (in other words, know the typical questions to address when interpreting data), and how to communicate the analysis and conclusions. 1.1.1 The Objectives of the Financial Analysis Process Because of the variety of reasons for performing financial analysis, the numerous available techniques, and the often substantial amount of data, it is important that the analytical approach be tailored to the specific situation. Prior to beginning any financial analysis, the analyst should clarify the purpose and context, and clearly understand the following: ■ ■ What is the purpose of the analysis? What questions will this analysis answer? ■ ■ What level of detail will be needed to accomplish this purpose? ■ ■ What data are available for the analysis? ■ ■ What are the factors or relationships that will influence the analysis? ■ ■ What are the analytical limitations, and will these limitations potentially impair the analysis? Having clarified the purpose and context of the analysis, the analyst can select the set of techniques (e.g., ratios) that will best assist in making a decision. Although there is no single approach to structuring the analysis process, a general framework is set forth in Exhibit 1.2 The steps in this process were discussed in more detail in an earlier reading; the primary focus of this reading is on Phases 3 and 4, processing and analyzing data. 2 Components of this framework have been adapted from van Greuning and Bratanovic (2003, p. 300) and Benninga and Sarig (1997, pp. 134–156). © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 196. Reading 20 ■ Financial Analysis Techniques 178 Exhibit 1 A Financial Statement Analysis Framework Phase Sources of Information Output 1 Articulate the purpose and context of the analysis. ■ ■ The nature of the analyst’s function, such as evaluating an equity or debt investment or issuing a credit rating. ■ ■ Communication with client or supervisor on needs and concerns. ■ ■ Institutional guidelines related to developing specific work product. ■ ■ Statement of the purpose or objective of analysis. ■ ■ A list (written or unwritten) of specific questions to be answered by the analysis. ■ ■ Nature and content of report to be provided. ■ ■ Timetable and budgeted resources for completion. 2 Collect input data. ■ ■ Financial statements, other financial data, questionnaires, and industry/economic data. ■ ■ Discussions with management, suppliers, customers, and competitors. ■ ■ Company site visits (e.g., to production facilities or retail stores). ■ ■ Organized financial statements. ■ ■ Financial data tables. ■ ■ Completed questionnaires, if applicable. 3 Process data. ■ ■ Data from the previous phase. ■ ■ Adjusted financial statements. ■ ■ Common-size statements. ■ ■ Ratios and graphs. ■ ■ Forecasts. 4 Analyze/interpret the processed data. ■ ■ Input data as well as processed data. ■ ■ Analytical results. 5 Develop and communicate conclusions and recommendations (e.g., with an analysis report). ■ ■ Analytical results and previous reports. ■ ■ Institutional guidelines for pub- lished reports. ■ ■ Analytical report answering questions posed in Phase 1. ■ ■ Recommendation regarding the purpose of the analysis, such as whether to make an investment or grant credit. 6 Follow-up. ■ ■ Information gathered by periodically repeating above steps as necessary to determine whether changes to holdings or recommendations are necessary. ■ ■ Updated reports and recommendations. 1.1.2 Distinguishing between Computations and Analysis An effective analysis encompasses both computations and interpretations. A well- reasoned analysis differs from a mere compilation of various pieces of information, computations, tables, and graphs by integrating the data collected into a cohesive whole. Analysis of past performance, for example, should address not only what happened but also why it happened and whether it advanced the company’s strategy. Some of the key questions to address include: ■ ■ What aspects of performance are critical for this company to successfully com- pete in this industry? © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 197. Introduction 179 ■ ■ How well did the company’s performance meet these critical aspects? (Established through computation and comparison with appropriate bench- marks, such as the company’s own historical performance or competitors’ performance.) ■ ■ What were the key causes of this performance, and how does this performance reflect the company’s strategy? (Established through analysis.) If the analysis is forward looking, additional questions include: ■ ■ What is the likely impact of an event or trend? (Established through interpreta- tion of analysis.) ■ ■ What is the likely response of management to this trend? (Established through evaluation of quality of management and corporate governance.) ■ ■ What is the likely impact of trends in the company, industry, and economy on future cash flows? (Established through assessment of corporate strategy and through forecasts.) ■ ■ What are the recommendations of the analyst? (Established through interpreta- tion and forecasting of results of analysis.) ■ ■ What risks should be highlighted? (Established by an evaluation of major uncertainties in the forecast and in the environment within which the company operates.) Example 1 demonstrates how a company’s financial data can be analyzed in the context of its business strategy and changes in that strategy. An analyst must be able to understand the “why” behind the numbers and ratios, not just what the numbers and ratios are. EXAMPLE 1 Strategy Reflected in Financial Performance Apple Inc. engages in the design, manufacture, and sale of computer hardware, mobile devices, operating systems and related products, and services. It also operates retail and online stores. Microsoft develops, licenses, and supports software products, services, and technology devices through a variety of chan- nels including retail stores in recent years. Selected financial data for 2015 through 2017 for these two companies are given below. Apple’s fiscal year (FY) ends on the final Saturday in September (for example, FY2017 ended on 30 September 2017). Microsoft’s fiscal year ends on 30 June (for example, FY2017 ended on 30 June 2017). Selected Financial Data for Apple (Dollars in Millions) Fiscal year 2017 2016 2015 Net sales (or Revenue) 229,234 215,639 233,715 Gross margin 88,186 84,263 93,626 Operating income 61,344 60,024 71,230 © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 198. Reading 20 ■ Financial Analysis Techniques 180 Selected Financial Data for Microsoft (Dollars in Millions)* Fiscal year 2017 2016 2015 Net sales (or Revenue) 89,950 85,320 93,580 Gross margin 55,689 52,540 60,542 Operating income 22,326 20,182 18,161 * Microsoft revenue for 2017 and 2016 were subsequently revised in the company’s 2018 10- K report due to changes in revenue recognition and lease accounting standards. Source: 10- K reports for Apple and Microsoft. Apple reported a 7.7 percent decrease in net sales from FY2015 to FY2016 and an increase of 6.3 percent from FY2016 to FY2017 for an overall slight decline over the three- year period. Gross margin decreased 10.0 percent from FY2015 to FY2016 and increased 4.7 percent from FY2016 to FY2017. This also represented an overall decline in gross margin over the three- year period. The company’s operating income exhibited similar trends. Microsoft reported an 8.8 percent decrease in net sales from FY2015 to FY2016 and an increase of 5.4 percent from FY2016 to FY2017 for an overall slight decline over the three- year period. Gross margin decreased 13.2 percent from FY2015 to FY2016 and increased 6.0 percent from FY2016 to FY2017. Similar to Apple, this represented an overall decline in gross margin over the three- year period. Microsoft’s operating income on the other hand exhibited growth each year and for the three- year period. Overall growth in operating income was 23%. What caused Microsoft’s growth in operating income while Apple and Microsoft had similar negative trends in sales and gross margin? Apple’s decline in sales, gross margin, and operating income from FY2015 to FY2016 was caused by declines in iPhone sales and weakness in foreign currencies relative to the US dollar. FY2017 saw a rebound in sales of iPhones, Mac computers, and services offset somewhat by continued weaknesses in foreign currencies. Microsoft similarly had declines in revenue and gross margin from sales of its devices and Windows software in FY2016, as well as negative impacts from foreign currency weakness. Microsoft’s increase in revenue and gross margin in FY2017 was driven by the acquisition of LinkedIn, higher sales of Microsoft Office software, and higher sales of cloud services. The driver in the continuous increase in operating income for Microsoft was a large decline over the three- year period in impairment, integration, and restructuring charges. Microsoft recorded a $10 billion charge in FY2015 related to its phone business, and there were further charges of $1.1 billion in FY2016 and $306 million in FY2017. Absent these large write- offs, Microsoft would have had a trend similar to Apple’s in operating income over the three- year period. Analysts often need to communicate the findings of their analysis in a written report. Their reports should communicate how conclusions were reached and why recommendations were made. For example, a report might present the following: ■ ■ the purpose of the report, unless it is readily apparent; ■ ■ relevant aspects of the business context: ● ● economic environment (country/region, macro economy, sector); ● ● financial and other infrastructure (accounting, auditing, rating agencies); © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 199. Analytical Tools and Techniques 181 ● ● legal and regulatory environment (and any other material limitations on the company being analyzed); ■ ■ evaluation of corporate governance and assessment of management strategy, including the company’s competitive advantage(s); ■ ■ assessment of financial and operational data, including key assumptions in the analysis; and ■ ■ conclusions and recommendations, including limitations of the analysis and risks. An effective narrative and well supported conclusions and recommendations are nor- mally enhanced by using 3–10 years of data, as well as analytic techniques appropriate to the purpose of the report. ANALYTICAL TOOLS AND TECHNIQUES a describe tools and techniques used in financial analysis, including their uses and limitations The tools and techniques presented in this section facilitate evaluations of company data. Evaluations require comparisons. It is difficult to say that a company’s financial performance was “good” without clarifying the basis for comparison. In assessing a company’s ability to generate and grow earnings and cash flow, and the risks related to those earnings and cash flows, the analyst draws comparisons to other companies (cross- sectional analysis) and over time (trend or time- series analysis). For example, an analyst may wish to compare the profitability of companies com- peting in a global industry. If the companies differ significantly in size and/or report their financial data in different currencies, comparing net income as reported is not useful. Ratios (which express one number in relation to another) and common- size financial statements can remove size as a factor and enable a more relevant compari- son. To achieve comparability across companies reporting in different currencies, one approach is to translate all reported numbers into a common currency using exchange rates at the end of a period. Others may prefer to translate reported numbers using the average exchange rates during the period. Alternatively, if the focus is primarily on ratios, comparability can be achieved without translating the currencies. The analyst may also want to examine comparable performance over time. Again, the nominal currency amounts of sales or net income may not highlight significant changes. To address this challenge, horizontal financial statements (whereby quan- tities are stated in terms of a selected base year value) can make such changes more apparent. Another obstacle to comparison is differences in fiscal year end. To achieve comparability, one approach is to develop trailing twelve months data, which will be described in a section below. Finally, it should be noted that differences in accounting standards can limit comparability. EXAMPLE 2 Ratio Analysis An analyst is examining the profitability of two international companies with large shares of the global personal computer market: Acer Inc. and Lenovo Group Limited. Acer has pursued a strategy of selling its products at affordable prices. In contrast, Lenovo aims to achieve higher selling prices by stressing the high 2 © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 200. Reading 20 ■ Financial Analysis Techniques 182 engineering quality of its personal computers for business use. Acer reports in TWD,3 and Lenovo reports in USD. For Acer, fiscal year end is 31 December. For Lenovo, fiscal year end is 31 March; thus, FY2017 ended 31 March 2018. The analyst collects the data shown in Exhibit 2 below. Use this information to answer the following questions: 1 Which company is larger based on the amount of revenue, in US$, reported in fiscal year 2017? For FY2017, assume the relevant, average exchange rate was 30.95 TWD/USD. 2 Which company had the higher revenue growth from FY2016 to FY2017? FY2013 to FY2017? 3 How do the companies compare, based on profitability? Exhibit 2 Acer TWD Millions FY2013 FY2014 FY2015 FY2016 FY2017 Revenue 360,132 329,684 263,775 232,724 237,275 Gross profit 22,550 28,942 24,884 23,212 25,361 Net income (20,519) 1,791 604 (4,901) 2,797 Lenovo USD Millions FY2013* FY2014* FY2015* FY2016* FY2017* Revenue 38,707 46,296 44,912 43,035 45,350 Gross profit 5,064 6,682 6,624 6,105 6,272 Net income (Loss) 817 837 (145) 530 (127) * Fiscal years for Lenovo end 31 March. Thus FY2017 represents the fiscal year ended 31 March 2018; the same applies respectively for prior years. Solution to 1: Lenovo is much larger than Acer based on FY2017 revenues in USD terms. Lenovo’s FY2017 revenues of $USD45.35 billion are considerably higher than Acer’s USD7.67 billion (= TWD237.275 million/30.95). Acer: At the assumed average exchange rate of 30.95 TWD/USD, Acer’s FY2017 revenues are equivalent to USD7.67 billion (= TWD237.275 million ÷ 30.95 TWD/USD). Lenovo: Lenovo’s FY2017 revenues totaled USD45.35 billion. Note: Comparing the size of companies reporting in different currencies requires translating reported numbers into a common currency using exchange rates at some point in time. This solution converts the revenues of Acer to billions of USD using the average exchange rate of the fiscal period. It would be equally informative (and would yield the same conclusion) to convert the revenues of Lenovo to TWD. Solution to 2: The growth in Lenovo’s revenue was much higher than Acer’s in the most recent fiscal year and for the five- year period. 3 TWD is the three- letter ISO 4217 currency code for Taiwan New Dollar. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 201. Financial Ratio Analysis 183 Change in Revenue FY2016 versus FY2017 (%) Change in Revenue FY2013 to FY2017 (%) Acer 1.96 (34.11) Lenovo 5.38 17.16 The table shows two growth metrics. Calculations are illustrated using the revenue data for Acer: The change in Acer’s revenue for FY2016 versus FY2017 is 1.96% percent calculated as (237,275 – 232,724) ÷ 232,724 or equivalently (237,275 ÷ 232,724) – 1. The change in Acer’s revenue from FY2013 to FY2017 is a decline of 34.11%. Solution to 3: Profitability can be assessed by comparing the amount of gross profit to revenue and the amount of net income to revenue. The following table presents these two profitability ratios—gross profit margin (gross profit divided by revenue) and net profit margin (net income divided by revenue)—for each year. Acer FY2013 (%) FY2014 (%) FY2015 (%) FY2016 (%) FY2017 (%) Gross profit margin 6.26 8.78 9.43 9.97 10.69 Net profit margin (5.70) 0.54 0.23 (2.11) 1.18 Lenovo FY2013 (%) FY2014 (%) FY2015 (%) FY2016 (%) FY2017 (%) Gross profit margin 13.08 14.43 14.75 14.19 13.83 Net profit margin 2.11 1.81 (0.32) 1.23 (0.28) The net profit margins indicate that both companies’ profitability is relatively low. Acer’s net profit margin is lower than Lenovo’s in three out of the five years. Acer’s gross profit margin increased each year but remains significantly below that of Lenovo. Lenovo’s gross profit margin grew from FY2013 to FY2015 and then declined in FY2016 and FY2017. Overall, Lenovo is the more profitable company, likely attributable to its larger size and commensurate economies of scale. (Lenovo has the largest share of the personal computer market relative to other personal computer companies.) Section 3 describes the tools and techniques of ratio analysis in more detail. Sections 4 to 6 describe other tools and techniques. FINANCIAL RATIO ANALYSIS a describe tools and techniques used in financial analysis, including their uses and limitations There are many relationships among financial accounts and various expected relation- ships from one point in time to another. Ratios are a useful way of expressing these relationships. Ratios express one quantity in relation to another (usually as a quotient). Extensive academic research has examined the importance of ratios in predicting stock returns (Ou and Penman, 1989; Abarbanell and Bushee, 1998) or credit failure (Altman, 1968; Ohlson, 1980; Hopwood et al., 1994). This research has found that 3 © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 202. Reading 20 ■ Financial Analysis Techniques 184 financial statement ratios are effective in selecting investments and in predicting financial distress. Practitioners routinely use ratios to derive and communicate the value of companies and securities. Several aspects of ratio analysis are important to understand. First, the computed ratio is not “the answer.” The ratio is an indicator of some aspect of a company’s per- formance, telling what happened but not why it happened. For example, an analyst might want to answer the question: Which of two companies was more profitable? As demonstrated in the previous example, the net profit margin, which expresses profit relative to revenue, can provide insight into this question. Net profit margin is calculated by dividing net income by revenue:4 Net income Revenue Assume Company A has €100,000 of net income and Company B has €200,000 of net income. Company B generated twice as much income as Company A, but was it more profitable? Assume further that Company A has €2,000,000 of revenue, and thus a net profit margin of 5 percent, and Company B has €6,000,000 of revenue, and thus a net profit margin of 3.33 percent. Expressing net income as a percentage of revenue clarifies the relationship: For each €100 of revenue, Company A earns €5 in net income, whereas Company B earns only €3.33 for each €100 of revenue. So, we can now answer the question of which company was more profitable in percentage terms: Company A was more profitable, as indicated by its higher net profit margin of 5 percent. Note that Company A was more profitable despite the fact that Company B reported higher absolute amounts of net income and revenue. However, this ratio by itself does not tell us why Company A has a higher profit margin. Further analysis is required to determine the reason (perhaps higher relative sales prices or better cost control or lower effective tax rates). Company size sometimes confers economies of scale, so the absolute amounts of net income and revenue are useful in financial analysis. However, ratios control for the effect of size, which enhances comparisons between companies and over time. A second important aspect of ratio analysis is that differences in accounting policies (across companies and across time) can distort ratios, and a meaningful comparison may, therefore, involve adjustments to the financial data. Third, not all ratios are nec- essarily relevant to a particular analysis. The ability to select a relevant ratio or ratios to answer the research question is an analytical skill. Finally, as with financial analysis in general, ratio analysis does not stop with computation; interpretation of the result is essential. In practice, differences in ratios across time and across companies can be subtle, and interpretation is situation specific. 3.1 The Universe of Ratios There are no authoritative bodies specifying exact formulas for computing ratios or providing a standard, comprehensive list of ratios. Formulas and even names of ratios often differ from analyst to analyst or from database to database. The number of different ratios that can be created is practically limitless. There are, however, widely accepted ratios that have been found to be useful. Sections 7–13 of this reading focus primarily on these broad classes and commonly accepted definitions of key ratios. However, the analyst should be aware that different ratios may be used in practice 4 The term “sales” is often used interchangeably with the term “revenues.” Other times it is used to refer to revenues derived from sales of products versus services. The income statement usually reflects “revenues” or “sales” after returns and allowances (e.g., returns of products or discounts offered after a sale to induce the customer to not return a product). Additionally, in some countries, including the United Kingdom and South Africa, the term “turnover” is used in the sense of “revenue.” © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 203. Financial Ratio Analysis 185 and that certain industries have unique ratios tailored to the characteristics of that industry. When faced with an unfamiliar ratio, the analyst can examine the underlying formula to gain insight into what the ratio is measuring. For example, consider the following ratio formula: Operating income Average total assets Never having seen this ratio, an analyst might question whether a result of 12 per- cent is better than 8 percent. The answer can be found in the ratio itself. The numer- ator is operating income and the denominator is average total assets, so the ratio can be interpreted as the amount of operating income generated per unit of assets. For every €100 of average total assets, generating €12 of operating income is better than generating €8 of operating income. Furthermore, it is apparent that this particular ratio is an indicator of profitability (and, to a lesser extent, efficiency in use of assets in generating operating profits). When encountering a ratio for the first time, the analyst should evaluate the numerator and denominator to assess what the ratio is attempting to measure and how it should be interpreted. This is demonstrated in Example 3. EXAMPLE 3 Interpreting a Financial Ratio A US insurance company reports that its “combined ratio” is determined by dividing losses and expenses incurred by net premiums earned. It reports the following combined ratios: Fiscal Year 5 4 3 2 1 Combined ratio 90.1% 104.0% 98.5% 104.1% 101.1% Explain what this ratio is measuring and compare the results reported for each of the years shown in the chart. What other information might an analyst want to review before making any conclusions on this information? Solution: The combined ratio is a profitability measure. The ratio is explaining how much costs (losses and expenses) were incurred for every dollar of revenue (net pre- miums earned). The underlying formula indicates that a lower value for this ratio is better. The Year 5 ratio of 90.1 percent means that for every dollar of net premiums earned, the costs were $0.901, yielding a gross profit of $0.099. Ratios greater than 100 percent indicate an overall loss. A review of the data indicates that there does not seem to be a consistent trend in this ratio. Profits were achieved in Years 5 and 3. The results for Years 4 and 2 show the most significant costs at approximately 104 percent. The analyst would want to discuss this data further with management and understand the characteristics of the underlying business. He or she would want to understand why the results are so volatile. The analyst would also want to determine what should be used as a benchmark for this ratio. The Operating income/Average total assets ratio shown above is one of many versions of the return on assets (ROA) ratio. Note that there are other ways of spec- ifying this formula based on how assets are defined. Some financial ratio databases compute ROA using the ending value of assets rather than average assets. In limited cases, one may also see beginning assets in the denominator. Which one is right? It depends on what you are trying to measure and the underlying company trends. If © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 204. Reading 20 ■ Financial Analysis Techniques 186 the company has a stable level of assets, the answer will not differ greatly under the three measures of assets (beginning, average, and ending). However, if the assets are growing (or shrinking), the results will differ among the three measures. When assets are growing, operating income divided by ending assets may not make sense because some of the income would have been generated before some assets were purchased, and this would understate the company’s performance. Similarly, if beginning assets are used, some of the operating income later in the year may have been generated only because of the addition of assets; therefore, the ratio would overstate the company’s performance. Because operating income occurs throughout the period, it generally makes sense to use some average measure of assets. A good general rule is that when an income statement or cash flow statement number is in the numerator of a ratio and a balance sheet number is in the denominator, then an average should be used for the denominator. It is generally not necessary to use averages when only balance sheet numbers are used in both the numerator and denominator because both are determined as of the same date. However, in some instances, even ratios that only use balance sheet data may use averages. For example, return on equity (ROE), which is defined as net income divided by average shareholders’ equity, can be decomposed into other ratios, some of which only use balance sheet data. In decomposing ROE into component ratios, if an average is used in one of the component ratios then it should be used in the other component ratios. The decomposition of ROE is discussed further in Section 13. If an average is used, judgment is also required about what average should be used. For simplicity, most ratio databases use a simple average of the beginning and end- of- year balance sheet amounts. If the company’s business is seasonal so that levels of assets vary by interim period (semiannual or quarterly), then it may be beneficial to take an average over all interim periods, if available. (If the analyst is working within a company and has access to monthly data, this can also be used.) 3.2 Value, Purposes, and Limitations of Ratio Analysis The value of ratio analysis is that it enables a financial analyst to evaluate past perfor- mance, assess the current financial position of the company, and gain insights useful for projecting future results. As noted previously, the ratio itself is not “the answer” but is an indicator of some aspect of a company’s performance. Financial ratios pro- vide insights into: ■ ■ economic relationships within a company that help analysts project earnings and free cash flow; ■ ■ a company’s financial flexibility, or ability to obtain the cash required to grow and meet its obligations, even if unexpected circumstances develop; ■ ■ management’s ability; ■ ■ changes in the company and/or industry over time; and ■ ■ comparability with peer companies or the relevant industry(ies). There are also limitations to ratio analysis. Factors to consider include: ■ ■ The heterogeneity or homogeneity of a company’s operating activities. Companies may have divisions operating in many different industries. This can make it difficult to find comparable industry ratios to use for comparison purposes. ■ ■ The need to determine whether the results of the ratio analysis are consistent. One set of ratios may indicate a problem, whereas another set may indicate that the potential problem is only short term in nature. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 205. Financial Ratio Analysis 187 ■ ■ The need to use judgment. A key issue is whether a ratio for a company is within a reasonable range. Although financial ratios are used to help assess the growth potential and risk of a company, they cannot be used alone to directly value a company or its securities, or to determine its creditworthiness. The entire operation of the company must be examined, and the external economic and industry setting in which it is operating must be considered when interpreting financial ratios. ■ ■ The use of alternative accounting methods. Companies frequently have latitude when choosing certain accounting methods. Ratios taken from financial state- ments that employ different accounting choices may not be comparable unless adjustments are made. Some important accounting considerations include the following: ● ● FIFO (first in, first out), LIFO (last in, first out), or average cost inventory valuation methods (IFRS does not allow LIFO); ● ● Cost or equity methods of accounting for unconsolidated affiliates; ● ● Straight line or accelerated methods of depreciation; and ● ● Operating or finance lease treatment for lessors (under US GAAP, the type of lease affects classifications of expenses; under IFRS, operating lease treat- ment for lessors is not applicable). The expanding use of IFRS and past convergence efforts between IFRS and US GAAP make the financial statements of different companies more comparable and may over- come some of these difficulties. Nonetheless, there will remain accounting choices that the analyst must consider. 3.3 Sources of Ratios Ratios may be computed using data obtained directly from companies’ financial state- ments or from a database such as Bloomberg, Compustat, FactSet, or Thomson Reuters. The information provided by the database may include information as reported in companies’ financial statements and ratios calculated based on the information. These databases are popular because they provide easy access to many years of historical data so that trends over time can be examined. They also allow for ratio calculations based on periods other than the company’s fiscal year, such as for the trailing 12 months (TTM) or most recent quarter (MRQ). EXAMPLE 4 Trailing Twelve Months On 15 July, an analyst is examining a company with a fiscal year ending on 31 December. Use the following data to calculate the company’s trailing 12 month earnings (for the period ended 30 June 2018): ■ ■ Earnings for the year ended 31 December, 2017: $1,200; ■ ■ Earnings for the six months ended 30 June 2017: $550; and ■ ■ Earnings for the six months ended 30 June 2018: $750. Solution: The company’s trailing 12 months earnings is $1,400, calculated as $1,200 – $550 + $750. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 206. Reading 20 ■ Financial Analysis Techniques 188 Analysts should be aware that the underlying formulas for ratios may differ by vendor. The formula used should be obtained from the vendor, and the analyst should determine whether any adjustments are necessary. Furthermore, database providers often exercise judgment when classifying items. For example, operating income may not appear directly on a company’s income statement, and the vendor may use judg- ment to classify income statement items as “operating” or “non- operating.” Variation in such judgments would affect any computation involving operating income. It is therefore a good practice to use the same source for data when comparing different companies or when evaluating the historical record of a single company. Analysts should verify the consistency of formulas and data classifications by the data source. Analysts should also be mindful of the judgments made by a vendor in data classifi- cations and refer back to the source financial statements until they are comfortable that the classifications are appropriate. Collection of financial data from regulatory filings and calculation of ratios can be automated. The eXtensible Business Reporting Language (XBRL) is a mechanism that attaches “smart tags” to financial information (e.g., total assets), so that software can automatically collect the data and perform desired computations. The organization developing XBRL (www.xbrl.org) is an international nonprofit consortium of over 600 members from companies, associations, and agencies, including the International Accounting Standards Board. Many stock exchanges and regulatory agencies around the world now use XBRL for receiving and distributing public financial reports from listed companies. Analysts can compare a subject company to similar (peer) companies in these databases or use aggregate industry data. For non- public companies, aggregate indus- try data can be obtained from such sources as Annual Statement Studies by the Risk Management Association or Dun Bradstreet. These publications typically provide industry data with companies sorted into quartiles. By definition, twenty- five percent of companies’ ratios fall within the lowest quartile, 25 percent have ratios between the lower quartile and median value, and so on. Analysts can then determine a company’s relative standing in the industry. COMMON SIZE BALANCE SHEETS AND INCOME STATEMENTS a describe tools and techniques used in financial analysis, including their uses and limitations Common-size analysis involves expressing financial data, including entire financial statements, in relation to a single financial statement item, or base. Items used most frequently as the bases are total assets or revenue. In essence, common- size analysis creates a ratio between every financial statement item and the base item. Common- size analysis was demonstrated in readings for the income statement, balance sheet, and cash flow statement. In this section, we present common- size analysis of financial statements in greater detail and include further discussion of their interpretation. 4 © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 207. Common Size Balance Sheets and Income Statements 189 4.1 Common- Size Analysis of the Balance Sheet A vertical5 common- size balance sheet, prepared by dividing each item on the balance sheet by the same period’s total assets and expressing the results as percentages, high- lights the composition of the balance sheet. What is the mix of assets being used? How is the company financing itself? How does one company’s balance sheet composition compare with that of peer companies, and what are the reasons for any differences? A horizontal common- size balance sheet, prepared by computing the increase or decrease in percentage terms of each balance sheet item from the prior year or prepared by dividing the quantity of each item by a base year quantity of the item, highlights changes in items. These changes can be compared to expectations. The section on trend analysis below will illustrate a horizontal common- size balance sheet. Exhibit 3 presents a vertical common- size (partial) balance sheet for a hypothet- ical company in two time periods. In this example, receivables have increased from 35 percent to 57 percent of total assets and the ratio has increased by 63 percent from Period 1 to Period 2. What are possible reasons for such an increase? The increase might indicate that the company is making more of its sales on a credit basis rather than a cash basis, perhaps in response to some action taken by a competitor. Alternatively, the increase in receivables as a percentage of assets may have occurred because of a change in another current asset category, for example, a decrease in the level of inven- tory; the analyst would then need to investigate why that asset category has changed. Another possible reason for the increase in receivables as a percentage of assets is that the company has lowered its credit standards, relaxed its collection procedures, or adopted more aggressive revenue recognition policies. The analyst can turn to other comparisons and ratios (e.g., comparing the rate of growth in accounts receivable with the rate of growth in sales) to help determine which explanation is most likely. Exhibit 3 Vertical Common- Size (Partial) Balance Sheet for a Hypothetical Company Period 1 Percent of Total Assets Period 2 Percent of Total Assets Cash 25 15 Receivables 35 57 Inventory 35 20 Fixed assets, net of depreciation 5 8 Total assets 100 100 4.2 Common- Size Analysis of the Income Statement A vertical common- size income statement divides each income statement item by revenue, or sometimes by total assets (especially in the case of financial institutions). If there are multiple revenue sources, a decomposition of revenue in percentage terms is useful. Exhibit 4 presents a hypothetical company’s vertical common- size income statement in two time periods. Revenue is separated into the company’s four services, each shown as a percentage of total revenue. 5 The term vertical analysis is used to denote a common- size analysis using only one reporting period or one base financial statement, whereas horizontal analysis refers to an analysis comparing a specific financial statement with prior or future time periods or to a cross- sectional analysis of one company with another. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 208. Reading 20 ■ Financial Analysis Techniques 190 In this example, revenues from Service A have become a far greater percentage of the company’s total revenue (30 percent in Period 1 and 45 percent in Period 2). What are possible reasons for and implications of this change in business mix? Did the company make a strategic decision to sell more of Service A, perhaps because it is more profitable? Apparently not, because the company’s earnings before interest, taxes, depreciation, and amortisation (EBITDA) declined from 53 percent of sales to 45 percent, so other possible explanations should be examined. In addition, we note from the composition of operating expenses that the main reason for this decline in profitability is that salaries and employee benefits have increased from 15 percent to 25 percent of total revenue. Are more highly compensated employees required for Service A? Were higher training costs incurred in order to increase revenues from Service A? If the analyst wants to predict future performance, the causes of these changes must be understood. In addition, Exhibit 4 shows that the company’s income tax as a percentage of sales has declined dramatically (from 15 percent to 8 percent). Furthermore, taxes as a percentage of earnings before tax (EBT) (the effective tax rate, which is usually the more relevant comparison), have decreased from 36 percent (= 15/42) to 24 percent (= 8/34). Is Service A, which in Period 2 is a greater percentage of total revenue, provided in a jurisdiction with lower tax rates? If not, what is the explanation for the change in effective tax rate? The observations based on Exhibit 4 summarize the issues that can be raised through analysis of the vertical common- size income statement. Exhibit 4 Vertical Common- Size Income Statement for Hypothetical Company Period 1 Percent of Total Revenue Period 2 Percent of Total Revenue Revenue source: Service A 30 45 Revenue source: Service B 23 20 Revenue source: Service C 30 30 Revenue source: Service D 17 5 Total revenue 100 100 Operating expenses (excluding depreciation) Salaries and employee benefits 15 25 Administrative expenses 22 20 Rent expense 10 10 EBITDA 53 45 Depreciation and amortisation 4 4 EBIT 49 41 Interest paid 7 7 EBT 42 34 Income tax provision 15 8 Net income 27 26 EBIT = earnings before interest and tax. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 209. Cross-Sectional, Trend Analysis Relationships in Financial Statements 191 CROSS-SECTIONAL, TREND ANALYSIS RELATIONSHIPS IN FINANCIAL STATEMENTS a describe tools and techniques used in financial analysis, including their uses and limitations As noted previously, ratios and common- size statements derive part of their meaning through comparison to some benchmark. Cross-sectional analysis (sometimes called “relative analysis”) compares a specific metric for one company with the same metric for another company or group of companies, allowing comparisons even though the companies might be of significantly different sizes and/or operate in different curren- cies. This is illustrated in Exhibit 5. Exhibit 5 Vertical Common- Size (Partial) Balance Sheet for Two Hypothetical Companies Assets Company 1 Percent of Total Assets Company 2 Percent of Total Assets Cash 38 12 Receivables 33 55 Inventory 27 24 Fixed assets net of depreciation 1 2 Investments 1 7 Total Assets 100 100 Exhibit 5 presents a vertical common- size (partial) balance sheet for two hypothet- ical companies at the same point in time. Company 1 is clearly more liquid (liquidity is a function of how quickly assets can be converted into cash) than Company 2, which has only 12 percent of assets available as cash, compared with the highly liquid Company 1, which has 38 percent of assets available as cash. Given that cash is generally a relatively low- yielding asset and thus not a particularly efficient use of excess funds, why does Company 1 hold such a large percentage of total assets in cash? Perhaps the company is preparing for an acquisition, or maintains a large cash position as insulation from a particularly volatile operating environment. Another issue highlighted by the comparison in this example is the relatively high percentage of receivables in Company 2’s assets, which may indicate a greater proportion of credit sales, overall changes in asset composition, lower credit or collection standards, or aggressive accounting policies. 5 © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 210. Reading 20 ■ Financial Analysis Techniques 192 5.1 Trend Analysis6 When looking at financial statements and ratios, trends in the data, whether they are improving or deteriorating, are as important as the current absolute or relative levels. Trend analysis provides important information regarding historical performance and growth and, given a sufficiently long history of accurate seasonal information, can be of great assistance as a planning and forecasting tool for management and analysts. Exhibit 6A presents a partial balance sheet for a hypothetical company over five periods. The last two columns of the table show the changes for Period 5 compared with P+eriod 4, expressed both in absolute currency (in this case, dollars) and in per- centages. A small percentage change could hide a significant currency change and vice versa, prompting the analyst to investigate the reasons despite one of the changes being relatively small. In this example, the largest percentage change was in investments, which decreased by 33.3 percent.7 However, an examination of the absolute currency amount of changes shows that investments changed by only $2 million, and the more significant change was the $12 million increase in receivables. Another way to present data covering a period of time is to show each item in relation to the same item in a base year (i.e., a horizontal common- size balance sheet). Exhibits 6B and 6C illustrate alternative presentations of horizontal common- size balance sheets. Exhibit 6B presents the information from the same partial balance sheet as in Exhibit 6A, but indexes each item relative to the same item in Period 1. For example, in Period 2, the company had $29 million cash, which is 74 percent or 0.74 of the amount of cash it had in Period 1. Expressed as an index relative to Period 1, where each item in Period 1 is given a value of 1.00, the value in Period 2 would be 0.74 ($29/$39 = 0.74). In Period 3, the company had $27 million cash, which is 69 percent of the amount of cash it had in Period 1 ($27/$39 = 0.69). Exhibit 6C presents the percentage change in each item, relative to the previous year. For example, the change in cash from Period 1 to Period 2 was –25.6 percent ($29/$39 – 1 = –0.256), and the change in cash from Period 2 to Period 3 was –6.9 per- cent ($27/$29 – 1 = –0.069). An analyst will select the horizontal common- size balance that addresses the particular period of interest. Exhibit 6B clearly highlights that in Period 5 compared to Period 1, the company has less than half the amount of cash, four times the amount of investments, and eight times the amount of property, plant, and equipment. Exhibit 6C highlights year- to- year changes: For example, cash has declined in each period. Presenting data this way highlights significant changes. Again, note that a mathematically big change is not necessarily an important change. For example, fixed assets increased 100 percent, i.e., doubled between Period 1 and 2; however, as a proportion of total assets, fixed assets increased from 1 percent of total assets to 2 percent of total assets. The company’s working capital assets (receivables and inventory) are a far higher proportion of total assets and would likely warrant more attention from an analyst. An analysis of horizontal common- size balance sheets highlights structural changes that have occurred in a business. Past trends are obviously not necessarily an accurate predictor of the future, especially when the economic or competitive environment changes. An examination of past trends is more valuable when the macroeconomic and competitive environments are relatively stable and when the analyst is reviewing a stable or mature business. However, even in less stable contexts, historical analysis 6 In financial statement analysis, the term “trend analysis” usually refers to comparisons across time peri- ods of 3–10 years not involving statistical tools. This differs from the use of the term in the quantitative methods portion of the CFA curriculum, where “trend analysis” refers to statistical methods of measuring patterns in time- series data. 7 Percentage change is calculated as (Ending value – Beginning value)/Beginning value, or equivalently, (Ending value/Beginning value) – 1. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 211. Cross-Sectional, Trend Analysis Relationships in Financial Statements 193 can serve as a basis for developing expectations. Understanding of past trends is helpful in assessing whether these trends are likely to continue or if the trend is likely to change direction. Exhibit 6A Partial Balance Sheet for a Hypothetical Company over Five Periods Period Change 4 to 5 ($ Million) Change 4 to 5 (Percent) Assets ($ Millions) 1 2 3 4 5 Cash 39 29 27 19 16 –3 –15.8 Investments 1 7 7 6 4 –2 –33.3 Receivables 44 41 37 67 79 12 17.9 Inventory 15 25 36 25 27 2 8.0 Fixed assets net of depreciation 1 2 6 9 8 –1 –11.1 Total assets 100 104 113 126 134 8 6.3 Exhibit 6B Horizontal Common- Size (Partial) Balance Sheet for a Hypothetical Company over Five Periods, with Each Item Expressed Relative to the Same Item in Period One Period Assets 1 2 3 4 5 Cash 1.00 0.74 0.69 0.49 0.41 Investments 1.00 7.00 7.00 6.00 4.00 Receivables 1.00 0.93 0.84 1.52 1.80 Inventory 1.00 1.67 2.40 1.67 1.80 Fixed assets net of depreciation 1.00 2.00 6.00 9.00 8.00 Total assets 1.00 1.04 1.13 1.26 1.34 Exhibit 6C Horizontal Common- Size (Partial) Balance Sheet for a Hypothetical Company over Five Periods, with Percent Change in Each Item Relative to the Prior Period Period Assets 2 (%) 3 (%) 4 (%) 5 (%) Cash –25.6 –6.9 –29.6 –15.8 Investments 600.0 0.0 –14.3 –33.3 Receivables –6.8 –9.8 81.1 17.9 Inventory 66.7 44.0 –30.6 8.0 (continued) © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 212. Reading 20 ■ Financial Analysis Techniques 194 Period Assets 2 (%) 3 (%) 4 (%) 5 (%) Fixed assets net of depreciation 100.0 200.0 50.0 –11.1 Total assets 4.0 8.7 11.5 6.3 One measure of success is for a company to grow at a rate greater than the rate of the overall market in which it operates. Companies that grow slowly may find them- selves unable to attract equity capital. Conversely, companies that grow too quickly may find that their administrative and management information systems cannot keep up with the rate of expansion. 5.2 Relationships among Financial Statements Trend data generated by a horizontal common- size analysis can be compared across financial statements. For example, the growth rate of assets for the hypothetical company in Exhibit 6 can be compared with the company’s growth in revenue over the same period of time. If revenue is growing more quickly than assets, the com- pany may be increasing its efficiency (i.e., generating more revenue for every dollar invested in assets). As another example, consider the following year- over- year percentage changes for a hypothetical company: Revenue +20% Net income +25% Operating cash flow –10% Total assets +30% Net income is growing faster than revenue, which indicates increasing profitabil- ity. However, the analyst would need to determine whether the faster growth in net income resulted from continuing operations or from non- operating, non- recurring items. In addition, the 10 percent decline in operating cash flow despite increasing revenue and net income clearly warrants further investigation because it could indicate a problem with earnings quality (perhaps aggressive reporting of revenue). Lastly, the fact that assets have grown faster than revenue indicates the company’s efficiency may be declining. The analyst should examine the composition of the increase in assets and the reasons for the changes. Example 5 illustrates a historical example of a company where comparisons of trend data from different financial statements were actually indicative of aggressive accounting policies. EXAMPLE 5 Use of Comparative Growth Information8 In July 1996, Sunbeam, a US company, brought in new management to turn the company around. In the following year, 1997, using 1996 as the base, the following was observed based on reported numbers: Exhibit 6C (Continued) 8 Adapted from Robinson and Munter (2004, pp. 2–15). © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 213. The Use of Graphs and Regression Analysis 195 Revenue +19% Inventory +58% Receivables +38% It is generally more desirable to observe inventory and receivables growing at a slower (or similar) rate compared to revenue growth. Receivables growing faster than revenue can indicate operational issues, such as lower credit standards or aggressive accounting policies for revenue recognition. Similarly, inventory growing faster than revenue can indicate an operational problem with obsoles- cence or aggressive accounting policies, such as an improper overstatement of inventory to increase profits. In this case, the explanation lay in aggressive accounting policies. Sunbeam was later charged by the US Securities and Exchange Commission with improperly accelerating the recognition of revenue and engaging in other practices, such as billing customers for inventory prior to shipment. THE USE OF GRAPHS AND REGRESSION ANALYSIS a describe tools and techniques used in financial analysis, including their uses and limitations Graphs facilitate comparison of performance and financial structure over time, high- lighting changes in significant aspects of business operations. In addition, graphs provide the analyst (and management) with a visual overview of risk trends in a busi- ness. Graphs may also be used effectively to communicate the analyst’s conclusions regarding financial condition and risk management aspects. Exhibit 7 presents the information from Exhibit 6A in a stacked column format. The graph makes the significant decline in cash and growth in receivables (both in absolute terms and as a percentage of assets) readily apparent. In Exhibit 7, the vertical axis shows US$ millions and the horizontal axis denotes the period. Choosing the appropriate graph to communicate the most significant conclusions of a financial analysis is a skill. In general, pie graphs are most useful to communicate the composition of a total value (e.g., assets over a limited amount of time, say one or two periods). Line graphs are useful when the focus is on the change in amount for a limited number of items over a relatively longer time period. When the composition and amounts, as well as their change over time, are all important, a stacked column graph can be useful. 6 © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 214. Reading 20 ■ Financial Analysis Techniques 196 Exhibit 7 Stacked Column Graph of Asset Composition of Hypothetical Company over Five Periods 0 20 40 60 80 100 120 140 160 5 4 3 2 1 Fixed assets Inventory Receivables Investments Cash When comparing Period 5 with Period 4, the growth in receivables appears to be within normal bounds; but when comparing Period 5 with earlier periods, the dramatic growth becomes apparent. In the same manner, a simple line graph will also illustrate the growth trends in key financial variables. Exhibit 8 presents the information from Exhibit 6A as a line graph, illustrating the growth of assets of a hypothetical company over five periods. The steady decline in cash, volatile movements of inventory, and dramatic growth of receivables is clearly illustrated. Again, the vertical axis is shown in US$ millions and the horizontal axis denotes periods. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 215. Common Ratio Categories Interpretation and Context 197 Exhibit 8 Line Graph of Growth of Assets of Hypothetical Company over Five Periods 0 10 20 30 40 50 60 70 80 90 Fixed assets Inventory Receivables Investments Cash 5 4 3 2 1 6.1 Regression Analysis When analyzing the trend in a specific line item or ratio, frequently it is possible simply to visually evaluate the changes. For more complex situations, regression analysis can help identify relationships (or correlation) between variables. For example, a regres- sion analysis could relate a company’s sales to GDP over time, providing insight into whether the company is cyclical. In addition, the statistical relationship between sales and GDP could be used as a basis for forecasting sales. Other examples where regression analysis may be useful include the relationship between a company’s sales and inventory over time, or the relationship between hotel occupancy and a company’s hotel revenues. In addition to providing a basis for forecasting, regression analysis facilitates identification of items or ratios that are not behaving as expected, given historical statistical relationships. COMMON RATIO CATEGORIES INTERPRETATION AND CONTEXT b identify, calculate, and interpret activity, liquidity, solvency, profitability, and valuation ratios In the previous section, we focused on ratios resulting from common- size analysis. In this section, we expand the discussion to include other commonly used financial ratios and the broad classes into which they are categorized. There is some overlap with common- size financial statement ratios. For example, a common indicator of profitability is the net profit margin, which is calculated as net income divided by 7 © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 216. Reading 20 ■ Financial Analysis Techniques 198 sales. This ratio appears on a vertical common- size income statement. Other ratios involve information from multiple financial statements or even data from outside the financial statements. Because of the large number of ratios, it is helpful to think about ratios in terms of broad categories based on what aspects of performance a ratio is intended to detect. Financial analysts and data vendors use a variety of categories to classify ratios. The category names and the ratios included in each category can differ. Common ratio categories include activity, liquidity, solvency, profitability, and valuation. These cat- egories are summarized in Exhibit 9. Each category measures a different aspect of the company’s business, but all are useful in evaluating a company’s overall ability to generate cash flows from operating its business and the associated risks. Exhibit 9 Categories of Financial Ratios Category Description Activity Activity ratios measure how efficiently a company performs day- to- day tasks, such as the collection of receivables and management of inventory. Liquidity Liquidity ratios measure the company’s ability to meet its short- term obligations. Solvency Solvency ratios measure a company’s ability to meet long- term obligations. Subsets of these ratios are also known as “leverage” and “long- term debt” ratios. Profitability Profitability ratios measure the company’s ability to generate profits from its resources (assets). Valuation Valuation ratios measure the quantity of an asset or flow (e.g., earnings) associated with ownership of a specified claim (e.g., a share or ownership of the enterprise). These categories are not mutually exclusive; some ratios are useful in measuring multiple aspects of the business. For example, an activity ratio measuring how quickly a company collects accounts receivable is also useful in assessing the company’s liquidity because collection of revenues increases cash. Some profitability ratios also reflect the operating efficiency of the business. In summary, analysts appropriately use certain ratios to evaluate multiple aspects of the business. Analysts also need to be aware of variations in industry practice in the calculation of financial ratios. In the text that follows, alternative views on ratio calculations are often provided. 7.1 Interpretation and Context Financial ratios can only be interpreted in the context of other information, including benchmarks. In general, the financial ratios of a company are compared with those of its major competitors (cross- sectional and trend analysis) and to the company’s prior periods (trend analysis). The goal is to understand the underlying causes of divergence between a company’s ratios and those of the industry. Even ratios that remain consistent require understanding because consistency can sometimes indicate accounting policies selected to smooth earnings. An analyst should evaluate financial ratios based on the following: 1 Company goals and strategy. Actual ratios can be compared with company objectives to determine whether objectives are being attained and whether the results are consistent with the company’s strategy. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 217. Activity Ratios 199 2 Industry norms (cross-sectional analysis). A company can be compared with others in its industry by relating its financial ratios to industry norms or to a subset of the companies in an industry. When industry norms are used to make judgments, care must be taken because: ● ● Many ratios are industry specific, and not all ratios are important to all industries. ● ● Companies may have several different lines of business. This will cause aggregate financial ratios to be distorted. It is better to examine industry- specific ratios by lines of business. ● ● Differences in accounting methods used by companies can distort financial ratios. ● ● Differences in corporate strategies can affect certain financial ratios. 3 Economic conditions. For cyclical companies, financial ratios tend to improve when the economy is strong and weaken during recessions. Therefore, financial ratios should be examined in light of the current phase of the business cycle. The following sections discuss activity, liquidity, solvency, and profitability ratios in turn. Selected valuation ratios are presented later in the section on equity analysis. ACTIVITY RATIOS Activity ratios are also known as asset utilization ratios or operating efficiency ratios. This category is intended to measure how well a company manages various activities, particularly how efficiently it manages its various assets. Activity ratios are analyzed as indicators of ongoing operational performance—how effectively assets are used by a company. These ratios reflect the efficient management of both working capital and longer term assets. As noted, efficiency has a direct impact on liquidity (the ability of a company to meet its short- term obligations), so some activity ratios are also useful in assessing liquidity. 8.1 Calculation of Activity Ratios Exhibit 10 presents the most commonly used activity ratios. The exhibit shows the numerator and denominator of each ratio. Exhibit 10 Definitions of Commonly Used Activity Ratios Activity Ratios Numerator Denominator Inventory turnover Cost of sales or cost of goods sold Average inventory Days of inventory on hand (DOH) Number of days in period Inventory turnover Receivables turnover Revenue Average receivables Days of sales outstanding (DSO) Number of days in period Receivables turnover Payables turnover Purchases Average trade payables Number of days of payables Number of days in period Payables turnover Working capital turnover Revenue Average working capital 8 (continued) © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 218. Reading 20 ■ Financial Analysis Techniques 200 Activity Ratios Numerator Denominator Fixed asset turnover Revenue Average net fixed assets Total asset turnover Revenue Average total assets Activity ratios measure how efficiently the company utilizes assets. They generally combine information from the income statement in the numerator with balance sheet items in the denominator. Because the income statement measures what happened during a period whereas the balance sheet shows the condition only at the end of the period, average balance sheet data are normally used for consistency. For example, to measure inventory management efficiency, cost of sales or cost of goods sold (from the income statement) is divided by average inventory (from the balance sheet). Most databases, such as Bloomberg and Baseline, use this averaging convention when income statement and balance sheet data are combined. These databases typically average only two points: the beginning of the year and the end of the year. The examples that follow based on annual financial statements illustrate that practice. However, some analysts prefer to average more observations if they are available, especially if the business is seasonal. If a semiannual report is prepared, an average can be taken over three data points (beginning, middle, and end of year). If quarterly data are available, a five- point average can be computed (beginning of year and end of each quarterly period) or a four- point average using the end of each quarterly period. Note that if the company’s year ends at a low or high point for inventory for the year, there can still be bias in using three or five data points, because the beginning and end of year occur at the same time of the year and are effectively double counted. Because cost of goods sold measures the cost of inventory that has been sold, this ratio measures how many times per year the entire inventory was theoretically turned over, or sold. (We say that the entire inventory was “theoretically” sold because in practice companies do not generally sell out their entire inventory.) If, for example, a company’s cost of goods sold for a recent year was €120,000 and its average inventory was €10,000, the inventory turnover ratio would be 12. The company theoretically turns over (i.e., sells) its entire inventory 12 times per year (i.e., once a month). (Again, we say “theoretically” because in practice the company likely carries some inventory from one month into another.) Turnover can then be converted to days of inventory on hand (DOH) by dividing inventory turnover into the number of days in the account- ing period. In this example, the result is a DOH of 30.42 (365/12), meaning that, on average, the company’s inventory was on hand for about 30 days, or, equivalently, the company kept on hand about 30 days’ worth of inventory, on average, during the period. Activity ratios can be computed for any annual or interim period, but care must be taken in the interpretation and comparison across periods. For example, if the same company had cost of goods sold for the first quarter (90 days) of the following year of €35,000 and average inventory of €11,000, the inventory turnover would be 3.18 times. However, this turnover rate is 3.18 times per quarter, which is not directly com- parable to the 12 times per year in the preceding year. In this case, we can annualize the quarterly inventory turnover rate by multiplying the quarterly turnover by 4 (12 months/3 months; or by 4.06, using 365 days/90 days) for comparison to the annual turnover rate. So, the quarterly inventory turnover is equivalent to a 12.72 annual inventory turnover (or 12.91 if we annualize the ratio using a 90- day quarter and a 365- day year). To compute the DOH using quarterly data, we can use the quarterly turnover rate and the number of days in the quarter for the numerator—or, we can use the annualized turnover rate and 365 days; either results in DOH of around 28.3, with Exhibit 10 (Continued) © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 219. Activity Ratios 201 slight differences due to rounding (90/3.18 = 28.30 and 365/12.91 = 28.27). Another time- related computational detail is that for companies using a 52/53- week annual period and for leap years, the actual days in the year should be used rather than 365. In some cases, an analyst may want to know how many days of inventory are on hand at the end of the year rather than the average for the year. In this case, it would be appropriate to use the year- end inventory balance in the computation rather than the average. If the company is growing rapidly or if costs are increasing rapidly, analysts should consider using cost of goods sold just for the fourth quarter in this computation because the cost of goods sold of earlier quarters may not be relevant. Example 6 further demonstrates computation of activity ratios using Hong Kong Stock Exchange(HKEX)-listed Lenovo Group Limited. EXAMPLE 6 Computation of Activity Ratios An analyst would like to evaluate Lenovo Group’s efficiency in collecting its trade accounts receivable during the fiscal year ended 31 March 2018 (FY2017). The analyst gathers the following information from Lenovo’s annual and interim reports: US$ in Thousands Trade receivables as of 31 March 2017 4,468,392 Trade receivables as of 31 March 2018 4,972,722 Revenue for year ended 31 March 2018 45,349,943 Calculate Lenovo’s receivables turnover and number of days of sales out- standing (DSO) for the fiscal year ended 31 March 2018. Solution: Receivables turnover = Revenue/Average receivables = 45,349,943/[(4,468,392 + 4,972,722)/2] = 45,349,943/4,720,557 = 9.6069 times, or 9.6 rounded DSO = Number of days in period/Receivables turnover = 365/9.6 = 38.0 days On average, it took Lenovo 38 days to collect receivables during the fiscal year ended 31 March 2018. 8.2 Interpretation of Activity Ratios In the following section, we further discuss the activity ratios that were defined in Exhibit 10. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 220. Reading 20 ■ Financial Analysis Techniques 202 Inventory Turnover and DOH Inventory turnover lies at the heart of operations for many entities. It indicates the resources tied up in inventory (i.e., the carrying costs) and can, therefore, be used to indicate inventory management effectiveness. A higher inventory turnover ratio implies a shorter period that inventory is held, and thus a lower DOH. In general, inventory turnover and DOH should be benchmarked against industry norms. A high inventory turnover ratio relative to industry norms might indicate highly effective inventory management. Alternatively, a high inventory turnover ratio (and commensurately low DOH) could possibly indicate the company does not carry adequate inventory, so shortages could potentially hurt revenue. To assess which explanation is more likely, the analyst can compare the company’s revenue growth with that of the industry. Slower growth combined with higher inventory turnover could indicate inadequate inventory levels. Revenue growth at or above the industry’s growth supports the interpretation that the higher turnover reflects greater inventory management efficiency. A low inventory turnover ratio (and commensurately high DOH) relative to the rest of the industry could be an indicator of slow- moving inventory, perhaps due to technological obsolescence or a change in fashion. Again, comparing the company’s sales growth with the industry can offer insight. Receivables Turnover and DSO. The number of DSO represents the elapsed time between a sale and cash collection, reflecting how fast the company collects cash from customers to whom it offers credit. Although limiting the numerator to sales made on credit in the receivables turnover would be more appropriate, credit sales information is not always available to analysts; therefore, revenue as reported in the income statement is generally used as an approximation. A relatively high receivables turnover ratio (and commensurately low DSO) might indicate highly efficient credit and collection. Alternatively, a high receivables turnover ratio could indicate that the company’s credit or collection policies are too stringent, suggesting the possibility of sales being lost to competitors offering more lenient terms. A relatively low receivables turnover ratio would typically raise questions about the efficiency of the company’s credit and collections procedures. As with inventory management, comparison of the company’s sales growth relative to the industry can help the analyst assess whether sales are being lost due to stringent credit policies. In addition, comparing the company’s estimates of uncollectible accounts receivable and actual credit losses with past experience and with peer companies can help assess whether low turnover reflects credit management issues. Companies often provide details of receivables aging (how much receivables have been outstanding by age). This can be used along with DSO to understand trends in collection, as demonstrated in Example 7. EXAMPLE 7 Evaluation of an Activity Ratio An analyst has computed the average DSO for Lenovo for fiscal years ended 31 March 2018 and 2017: FY2017 FY2016 Days of sales outstanding 38.0 37.6 © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 221. Activity Ratios 203 Revenue increased from US$43.035 billion for fiscal year ended 31 March 2017 (FY2016) to US$45.350 billion for fiscal year ended 31 March 2018 (FY2017). The analyst would like to better understand the change in the company’s DSO from FY2016 to FY2017 and whether the increase is indicative of any issues with the customers’ credit quality. The analyst collects accounts receivable aging infor- mation from Lenovo’s annual reports and computes the percentage of accounts receivable by days outstanding. This information is presented in Exhibit 11: Exhibit 11 FY2017 FY2016 FY2015 US$000 Percent US$000 Percent US$000 Percent Accounts receivable 0–30 days 3,046,240 59.95 2,923,083 63.92 3,246,600 71.99 31–60 days 1,169,286 23.01 985,251 21.55 617,199 13.69 61–90 days 320,183 6.30 283,050 6.19 240,470 5.33 Over 90 days 545,629 10.74 381,387 8.34 405,410 8.99 Total 5,081,338 100.00 4,572,771 100.00 4,509,679 100.00 Less: Provision for impairment –108,616 –2.14 –104,379 –2.28 –106,172 –2.35 Trade receivables, net 4,972,722 97.86 4,468,392 97.72 4,403,507 97.65 Total sales 45,349,943 43,034,731 44,912,097 Note: Lenovo’s footnotes disclose that general trade customers are provided with credit terms ranging from 0 to 120 days. These data indicate that total accounts receivable increased by about 11.3% in FY2017 versus FY2016, while total sales increased by only 5.4%. Further, the percentage of receivables in all categories older than 30 days has increased over the three- year period, indicating that customers are indeed taking longer to pay. On the other hand, the provision for impairment (estimate of uncollectible accounts) has declined as a percent of total receivables. Considering all this information, the company may be increasing customer financing purposely to drive its sales growth. They also may be underestimating the impairment. This should be investigated further by the analyst. Payables Turnover and the Number of Days of Payables The number of days of payables reflects the average number of days the company takes to pay its suppliers, and the payables turnover ratio measures how many times per year the company theoretically pays off all its creditors. For purposes of calculating these ratios, an implicit assumption is that the company makes all its purchases using credit. If the amount of purchases is not directly available, it can be computed as cost of goods sold plus ending inventory less beginning inventory. Alternatively, cost of goods sold is sometimes used as an approximation of purchases. A payables turnover ratio that is high (low days payable) relative to the industry could indicate that the company is not making full use of available credit facilities; alternatively, it could result from a company taking advantage of early payment dis- counts. An excessively low turnover ratio (high days payable) could indicate trouble making payments on time, or alternatively, exploitation of lenient supplier terms. This is another example where it is useful to look simultaneously at other ratios. If liquidity © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 222. Reading 20 ■ Financial Analysis Techniques 204 ratios indicate that the company has sufficient cash and other short- term assets to pay obligations and yet the days payable ratio is relatively high, the analyst would favor the lenient supplier credit and collection policies as an explanation. Working Capital Turnover Working capital is defined as current assets minus current liabilities. Working capital turnover indicates how efficiently the company generates revenue with its working capital. For example, a working capital turnover ratio of 4.0 indicates that the com- pany generates €4 of revenue for every €1 of working capital. A high working capital turnover ratio indicates greater efficiency (i.e., the company is generating a high level of revenues relative to working capital). For some companies, working capital can be near zero or negative, rendering this ratio incapable of being interpreted. The following two ratios are more useful in those circumstances. Fixed Asset Turnover This ratio measures how efficiently the company generates revenues from its invest- ments in fixed assets. Generally, a higher fixed asset turnover ratio indicates more efficient use of fixed assets in generating revenue. A low ratio can indicate inefficiency, a capital- intensive business environment, or a new business not yet operating at full capacity—in which case the analyst will not be able to link the ratio directly to effi- ciency. In addition, asset turnover can be affected by factors other than a company’s efficiency. The fixed asset turnover ratio would be lower for a company whose assets are newer (and, therefore, less depreciated and so reflected in the financial statements at a higher carrying value) than the ratio for a company with older assets (that are thus more depreciated and so reflected at a lower carrying value). The fixed asset ratio can be erratic because, although revenue may have a steady growth rate, increases in fixed assets may not follow a smooth pattern; so, every year- to- year change in the ratio does not necessarily indicate important changes in the company’s efficiency. Total Asset Turnover The total asset turnover ratio measures the company’s overall ability to generate rev- enues with a given level of assets. A ratio of 1.20 would indicate that the company is generating €1.20 of revenues for every €1 of average assets. A higher ratio indicates greater efficiency. Because this ratio includes both fixed and current assets, inefficient working capital management can distort overall interpretations. It is therefore helpful to analyze working capital and fixed asset turnover ratios separately. A low asset turnover ratio can be an indicator of inefficiency or of relative capital intensity of the business. The ratio also reflects strategic decisions by management—for example, the decision whether to use a more labor- intensive (and less capital- intensive) approach to its business or a more capital-intensive (and less labor- intensive) approach. When interpreting activity ratios, the analysts should examine not only the individual ratios but also the collection of relevant ratios to determine the overall efficiency of a company. Example 8 demonstrates the evaluation of activity ratios, both narrow (e.g., days of inventory on hand) and broad (e.g., total asset turnover) for a hypothetical manufacturer. EXAMPLE 8 Evaluation of Activity Ratios ZZZ Company is a hypothetical manufacturing company. As part of an analysis of management’s operating efficiency, an analyst collects the following activity ratios from a data provider: © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 223. Liquidity Ratios 205 Ratio 2018 2017 2016 2015 DOH 35.68 40.70 40.47 48.51 DSO 45.07 58.28 51.27 76.98 Total asset turnover 0.36 0.28 0.23 0.22 These ratios indicate that the company has improved on all three measures of activity over the four- year period. The company appears to be managing its inventory more efficiently, is collecting receivables faster, and is generating a higher level of revenues relative to total assets. The overall trend appears good, but thus far, the analyst has only determined what happened. A more important question is why the ratios improved, because understanding good changes as well as bad ones facilitates judgments about the company’s future performance. To answer this question, the analyst examines company financial reports as well as external information about the industry and economy. In examining the annual report, the analyst notes that in the fourth quarter of 2018, the company experi- enced an “inventory correction” and that the company recorded an allowance for the decline in market value and obsolescence of inventory of about 15 percent of year- end inventory value (compared with about a 6 percent allowance in the prior year). This reduction in the value of inventory accounts for a large portion of the decline in DOH from 40.70 in 2017 to 35.68 in 2018. Management claims that this inventory obsolescence is a short- term issue; analysts can watch DOH in future interim periods to confirm this assertion. In any event, all else being equal, the analyst would likely expect DOH to return to a level closer to 40 days going forward. More positive interpretations can be drawn from the total asset turnover. The analyst finds that the company’s revenues increased more than 35 percent while total assets only increased by about 6 percent. Based on external information about the industry and economy, the analyst attributes the increased revenues both to overall growth in the industry and to the company’s increased market share. Management was able to achieve growth in revenues with a comparatively modest increase in assets, leading to an improvement in total asset turnover. Note further that part of the reason for the increase in asset turnover is lower DOH and DSO. LIQUIDITY RATIOS b identify, calculate, and interpret activity, liquidity, solvency, profitability, and valuation ratios Liquidity analysis, which focuses on cash flows, measures a company’s ability to meet its short- term obligations. Liquidity measures how quickly assets are converted into cash. Liquidity ratios also measure the ability to pay off short- term obligations. In day- to- day operations, liquidity management is typically achieved through efficient use of assets. In the medium term, liquidity in the non- financial sector is also addressed by managing the structure of liabilities. (See the discussion on financial sector below.) The level of liquidity needed differs from one industry to another. A particular company’s liquidity position may vary according to the anticipated need for funds at any given time. Judging whether a company has adequate liquidity requires analysis 9 © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 224. Reading 20 ■ Financial Analysis Techniques 206 of its historical funding requirements, current liquidity position, anticipated future funding needs, and options for reducing funding needs or attracting additional funds (including actual and potential sources of such funding). Larger companies are usually better able to control the level and composition of their liabilities than smaller companies. Therefore, they may have more potential funding sources, including public capital and money markets. Greater discretionary access to capital markets also reduces the size of the liquidity buffer needed relative to companies without such access. Contingent liabilities, such as letters of credit or financial guarantees, can also be relevant when assessing liquidity. The importance of contingent liabilities varies for the non- banking and banking sector. In the non- banking sector, contingent liabilities (usually disclosed in the footnotes to the company’s financial statements) represent potential cash outflows, and when appropriate, should be included in an assessment of a company’s liquidity. In the banking sector, contingent liabilities represent potentially significant cash outflows that are not dependent on the bank’s financial condition. Although outflows in normal market circumstances typically may be low, a general macroeconomic or market crisis can trigger a substantial increase in cash outflows related to contingent liabilities because of the increase in defaults and business bankruptcies that often accompany such events. In addition, such crises are usually characterized by diminished levels of overall liquidity, which can further exacerbate funding shortfalls. Therefore, for the banking sector, the effect of contingent liabilities on liquidity warrants particular attention. 9.1 Calculation of Liquidity Ratios Common liquidity ratios are presented in Exhibit 12. These liquidity ratios reflect a company’s position at a point in time and, therefore, typically use data from the ending balance sheet rather than averages. The current, quick, and cash ratios reflect three measures of a company’s ability to pay current liabilities. Each uses a progressively stricter definition of liquid assets. The defensive interval ratio measures how long a company can pay its daily cash expenditures using only its existing liquid assets, without additional cash flow coming in. This ratio is similar to the “burn rate” often computed for start- up internet companies in the late 1990s or for biotechnology companies. The numerator of this ratio includes the same liquid assets used in the quick ratio, and the denominator is an estimate of daily cash expenditures. To obtain daily cash expenditures, the total of cash expenditures for the period is divided by the number of days in the period. Total cash expenditures for a period can be approximated by summing all expenses on the income statement—such as cost of goods sold; selling, general, and administrative expenses; and research and development expenses—and then subtracting any non- cash expenses, such as depreciation and amortisation. (Typically, taxes are not included.) The cash conversion cycle, a financial metric not in ratio form, measures the length of time required for a company to go from cash paid (used in its operations) to cash received (as a result of its operations). The cash conversion cycle is sometimes expressed as the length of time funds are tied up in working capital. During this period of time, the company needs to finance its investment in operations through other sources (i.e., through debt or equity). © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 225. Liquidity Ratios 207 Exhibit 12 Definitions of Commonly Used Liquidity Ratios Liquidity Ratios Numerator Denominator Current ratio Current assets Current liabilities Quick ratio Cash + Short- term mar- ketable investments + Receivables Current liabilities Cash ratio Cash + Short- term market- able investments Current liabilities Defensive interval ratio Cash + Short- term mar- ketable investments + Receivables Daily cash expenditures Additional Liquidity Measure Cash conversion cycle (net operating cycle) DOH + DSO – Number of days of payables 9.2 Interpretation of Liquidity Ratios In the following, we discuss the interpretation of the five basic liquidity measures presented in Exhibit 12. Current Ratio This ratio expresses current assets in relation to current liabilities. A higher ratio indi- cates a higher level of liquidity (i.e., a greater ability to meet short- term obligations). A current ratio of 1.0 would indicate that the book value of its current assets exactly equals the book value of its current liabilities. A lower ratio indicates less liquidity, implying a greater reliance on operating cash flow and outside financing to meet short- term obligations. Liquidity affects the com- pany’s capacity to take on debt. The current ratio implicitly assumes that inventories and accounts receivable are indeed liquid (which is presumably not the case when related turnover ratios are low). Quick Ratio The quick ratio is more conservative than the current ratio because it includes only the more liquid current assets (sometimes referred to as “quick assets”) in relation to current liabilities. Like the current ratio, a higher quick ratio indicates greater liquidity. The quick ratio reflects the fact that certain current assets—such as prepaid expenses, some taxes, and employee- related prepayments—represent costs of the current period that have been paid in advance and cannot usually be converted back into cash. This ratio also reflects the fact that inventory might not be easily and quickly converted into cash, and furthermore, that a company would probably not be able to sell all of its inventory for an amount equal to its carrying value, especially if it were required to sell the inventory quickly. In situations where inventories are illiquid (as indicated, for example, by low inventory turnover ratios), the quick ratio may be a better indicator of liquidity than is the current ratio. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 226. Reading 20 ■ Financial Analysis Techniques 208 Cash Ratio The cash ratio normally represents a reliable measure of an entity’s liquidity in a crisis situation. Only highly marketable short- term investments and cash are included. In a general market crisis, the fair value of marketable securities could decrease signifi- cantly as a result of market factors, in which case even this ratio might not provide reliable information. Defensive Interval Ratio This ratio measures how long the company can continue to pay its expenses from its existing liquid assets without receiving any additional cash inflow. A defensive interval ratio of 50 would indicate that the company can continue to pay its operating expenses for 50 days before running out of quick assets, assuming no additional cash inflows. A higher defensive interval ratio indicates greater liquidity. If a company’s defensive interval ratio is very low relative to peer companies or to the company’s own history, the analyst would want to ascertain whether there is sufficient cash inflow expected to mitigate the low defensive interval ratio. Cash Conversion Cycle (Net Operating Cycle) This metric indicates the amount of time that elapses from the point when a company invests in working capital until the point at which the company collects cash. In the typical course of events, a merchandising company acquires inventory on credit, incurring accounts payable. The company then sells that inventory on credit, increasing accounts receivable. Afterwards, it pays out cash to settle its accounts payable, and it collects cash in settlement of its accounts receivable. The time between the outlay of cash and the collection of cash is called the “cash conversion cycle.” A shorter cash conversion cycle indicates greater liquidity. A short cash conversion cycle implies that the company only needs to finance its inventory and accounts receivable for a short period of time. A longer cash conversion cycle indicates lower liquidity; it implies that the company must finance its inventory and accounts receivable for a longer period of time, possibly indicating a need for a higher level of capital to fund current assets. Example 9 demonstrates the advantages of a short cash conversion cycle as well as how a company’s business strategies are reflected in financial ratios. EXAMPLE 9 Evaluation of Liquidity Measures An analyst is evaluating the liquidity of Apple and calculates the number of days of receivables, inventory, and accounts payable, as well as the overall cash conversion cycle, as follows: FY2017 FY2016 FY2015 DSO 27 28 27 DOH 9 6 6 Less: Number of days of payables 112 101 86 Equals: Cash conver- sion cycle (76) (67) (53) The minimal DOH indicates that Apple maintains lean inventories, which is attributable to key aspects of the company’s business model where manufacturing is outsourced. In isolation, the increase in number of days payable (from 86 days © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 227. Liquidity Ratios 209 in FY2015 to 112 days in FY2017) might suggest an inability to pay suppliers; however, in Apple’s case, the balance sheet indicates that the company has more than $70 billion of cash and short- term investments, which would be more than enough to pay suppliers sooner if Apple chose to do so. Instead, Apple takes advantage of the favorable credit terms granted by its suppliers. The overall effect is a negative cash cycle, a somewhat unusual result. Instead of requiring additional capital to fund working capital as is the case for most companies, Apple has excess cash to invest for over 50 days during that three- year period (reflected on the balance sheet as short- term investments) on which it is earning, rather than paying, interest. EXAMPLE 10 Bounds and Context of Financial Measures The previous example focused on the cash conversion cycle, which many com- panies identify as a key performance metric. The less positive the number of days in the cash conversion cycle, typically, the better it is considered to be. However, is this always true? This example considers the following question: If a larger negative number of days in a cash conversion cycle is considered to be a desirable performance metric, does identifying a company with a large negative cash conversion cycle necessarily imply good performance? Using a historical example, National Datacomputer, a technology company, had large negative number of days in its cash conversion cycle during the 2005 to 2009 period. In 2008 its cash conversion cycle was 275.5 days. Exhibit 13 National Datacomputer Inc. ($ millions) Fiscal year 2004 2005 2006 2007 2008 2009 Sales 3.248 2.672 2.045 1.761 1.820 1.723 Cost of goods sold 1.919 1.491 0.898 1.201 1.316 1.228 Receivables, Total 0.281 0.139 0.099 0.076 0.115 0.045 Inventories, Total 0.194 0.176 0.010 0.002 0.000 0.000 Accounts payable 0.223 0.317 0.366 1.423 0.704 0.674 DSO 28.69 21.24 18.14 19.15 16.95 DOH 45.29 37.80 1.82 0.28 0.00 Less: Number of days of payables* 66.10 138.81 271.85 294.97 204.79 Equals: Cash conversion cycle 7.88 –79.77 –251.89 –275.54 –187.84 *Notes: Calculated using Cost of goods sold as an approximation of purchases. Ending inventories 2008 and 2009 are reported as $0 million; therefore, inventory turnover for 2009 cannot be measured. However, given inventory and average sales per day, DOH in 2009 is 0.00. Source: Raw data from Compustat. Ratios calculated. The reason for the negative cash conversion cycle is that the company’s accounts payable increased substantially over the period. An increase from approximately 66 days in 2005 to 295 days in 2008 to pay trade creditors is clearly © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 228. Reading 20 ■ Financial Analysis Techniques 210 a negative signal. In addition, the company’s inventories disappeared, most likely because the company did not have enough cash to purchase new inventory and was unable to get additional credit from its suppliers. Of course, an analyst would have immediately noted the negative trends in these data, as well as additional data throughout the company’s financial state- ments. In its MDA, the company clearly reports the risks as follows: Because we have historically had losses and only a limited amount of cash has been generated from operations, we have funded our operating activities to date primarily from the sale of securities and from the sale of a product line in 2009. In order to continue to fund our operations, we may need to raise additional capital, through the sale of securities. We cannot be certain that any such financing will be available on acceptable terms, or at all. Moreover, additional equity financing, if available, would likely be dilutive to the holders of our common stock, and debt financing, if available, would likely involve restrictive covenants and a security interest in all or substantially all of our assets. If we fail to obtain acceptable financing when needed, we may not have sufficient resources to fund our normal operations which would have a material adverse effect on our business. IF WE ARE UNABLE TO GENERATE ADEQUATE WORKING CAPITAL FROM OPERATIONS OR RAISE ADDITIONAL CAPITAL THERE IS SUBSTANTIAL DOUBT ABOUT THE COMPANY’S ABILITY TO CONTINUE AS A GOING CONCERN. (emphasis added by company) Source: National Datacomputer Inc., 2009 Form 10- K, page 7. Subsequently, the company’s 2010 Form 10K reported: “In January 2011, due to our inability to meet our financial obligations and the impending loss of a critical distribution agreement grant- ing us the right to distribute certain products, our secured lenders (“Secured Parties”) acting upon an event of default, sold certain of our assets (other than cash and accounts receivable) to Micronet, Ltd. (“Micronet”), an unaffiliated corporation pursuant to the terms of an asset purchase agreement between the Secured Parties and Micronet dated January 10, 2010 (the “Asset Purchase Agreement”). In order to induce Micronet to enter into the agreement, the Company also provided certain representations and warranties regarding certain business matters.” In summary, it is always necessary to consider ratios within bounds of reason- ability and to understand the reasons underlying changes in ratios. Ratios must not only be calculated but must also be interpreted by an analyst. SOLVENCY RATIOS b identify, calculate, and interpret activity, liquidity, solvency, profitability, and valuation ratios 10 © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 229. Solvency Ratios 211 Solvency refers to a company’s ability to fulfill its long- term debt obligations. Assessment of a company’s ability to pay its long- term obligations (i.e., to make interest and principal payments) generally includes an in- depth analysis of the components of its financial structure. Solvency ratios provide information regarding the relative amount of debt in the company’s capital structure and the adequacy of earnings and cash flow to cover interest expenses and other fixed charges (such as lease or rental payments) as they come due. Analysts seek to understand a company’s use of debt for several main reasons. One reason is that the amount of debt in a company’s capital structure is important for assessing the company’s risk and return characteristics, specifically its financial leverage. Leverage is a magnifying effect that results from the use of fixed costs—costs that stay the same within some range of activity—and can take two forms: operating leverage and financial leverage. Operating leverage results from the use of fixed costs in conducting the compa- ny’s business. Operating leverage magnifies the effect of changes in sales on operating income. Profitable companies may use operating leverage because when revenues increase, with operating leverage, their operating income increases at a faster rate. The explanation is that, although variable costs will rise proportionally with revenue, fixed costs will not. When financing a company (i.e., raising capital for it), the use of debt constitutes financial leverage because interest payments are essentially fixed financing costs. As a result of interest payments, a given percent change in EBIT results in a larger per- cent change in earnings before taxes (EBT). Thus, financial leverage tends to magnify the effect of changes in EBIT on returns flowing to equity holders. Assuming that a company can earn more on funds than it pays in interest, the inclusion of some level of debt in a company’s capital structure may lower a company’s overall cost of capital and increase returns to equity holders. However, a higher level of debt in a company’s capital structure increases the risk of default and results in higher borrowing costs for the company to compensate lenders for assuming greater credit risk. Starting with Modigliani and Miller (1958, 1963), a substantial amount of research has focused on determining a company’s optimal capital structure and the subject remains an important one in corporate finance. In analyzing financial statements, an analyst aims to understand levels and trends in a company’s use of financial leverage in relation to past practices and the prac- tices of peer companies. Analysts also need to be aware of the relationship between operating leverage (results from the use of non- current assets with fixed costs) and financial leverage (results from the use of long- term debt with fixed costs). The greater a company’s operating leverage, the greater the risk of the operating income stream available to cover debt payments; operating leverage can thus limit a company’s capacity to use financial leverage. A company’s relative solvency is fundamental to valuation of its debt securities and its creditworthiness. Finally, understanding a company’s use of debt can provide analysts with insight into the company’s future business prospects because manage- ment’s decisions about financing may signal their beliefs about a company’s future. For example, the issuance of long- term debt to repurchase common shares may indicate that management believes the market is underestimating the company’s prospects and that the shares are undervalued. 10.1 Calculation of Solvency Ratios Solvency ratios are primarily of two types. Debt ratios, the first type, focus on the balance sheet and measure the amount of debt capital relative to equity capital. Coverage ratios, the second type, focus on the income statement and measure the © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 230. Reading 20 ■ Financial Analysis Techniques 212 ability of a company to cover its debt payments. These ratios are useful in assessing a company’s solvency and, therefore, in evaluating the quality of a company’s bonds and other debt obligations. Exhibit 14 describes commonly used solvency ratios. The first three of the debt ratios presented use total debt in the numerator. The definition of total debt used in these ratios varies among informed analysts and financial data vendors, with some using the total of interest- bearing short- term and long- term debt, excluding liabilities such as accrued expenses and accounts payable. (For calculations in this reading, we use this definition.) Other analysts use definitions that are more inclusive (e.g., all liabilities) or restrictive (e.g., long- term debt only, in which case the ratio is sometimes qualified as “long- term,” as in “long- term debt- to- equity ratio”). If using different definitions of total debt materially changes conclusions about a company’s solvency, the reasons for the discrepancies warrant further investigation. Exhibit 14 Definitions of Commonly Used Solvency Ratios Solvency Ratios Numerator Denominator Debt Ratios Debt-to-assets ratioa Total debtb Total assets Debt-to-capital ratio Total debtb Total debtb + Total shareholders’ equity Debt-to-equity ratio Total debtb Total shareholders’ equity Financial leverage ratioc Average total assets Average total equity Debt-to-EBITDA Total debt EBITDA Coverage Ratios Interest coverage EBIT Interest payments Fixed charge coverage EBIT + Lease payments Interest payments + Lease payments a “Total debt ratio” is another name sometimes used for this ratio. b In this reading, total debt is the sum of interest- bearing short- term and long- term debt. c Average total assets divided by average total equity is used for the purposes of this reading (in particular, Dupont analysis covered later). In practice, period- end total assets divided by period- end total equity is often used. 10.2 Interpretation of Solvency Ratios In the following, we discuss the interpretation of the basic solvency ratios presented in Exhibit 14. Debt-to-Assets Ratio This ratio measures the percentage of total assets financed with debt. For example, a debt-to-assets ratio of 0.40 or 40 percent indicates that 40 percent of the company’s assets are financed with debt. Generally, higher debt means higher financial risk and thus weaker solvency. Debt-to-Capital Ratio The debt-to-capital ratio measures the percentage of a company’s capital (debt plus equity) represented by debt. As with the previous ratio, a higher ratio generally means higher financial risk and thus indicates weaker solvency. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 231. Solvency Ratios 213 Debt-to-Equity Ratio The debt-to-equity ratio measures the amount of debt capital relative to equity cap- ital. Interpretation is similar to the preceding two ratios (i.e., a higher ratio indicates weaker solvency). A ratio of 1.0 would indicate equal amounts of debt and equity, which is equivalent to a debt- to- capital ratio of 50 percent. Alternative definitions of this ratio use the market value of stockholders’ equity rather than its book value (or use the market values of both stockholders’ equity and debt). Financial Leverage Ratio This ratio (often called simply the “leverage ratio”) measures the amount of total assets supported for each one money unit of equity. For example, a value of 3 for this ratio means that each €1 of equity supports €3 of total assets. The higher the financial leverage ratio, the more leveraged the company is in the sense of using debt and other liabilities to finance assets. This ratio is often defined in terms of average total assets and average total equity and plays an important role in the DuPont decomposition of return on equity that will be presented in Section 13. Debt-to-EBITDA Ratio This ratio estimates how many years it would take to repay total debt based on earnings before income taxes, depreciation and amortization (an approximation of operating cash flow). Interest Coverage This ratio measures the number of times a company’s EBIT could cover its interest payments. Thus, it is sometimes referred to as “times interest earned.” A higher inter- est coverage ratio indicates stronger solvency, offering greater assurance that the company can service its debt (i.e., bank debt, bonds, notes) from operating earnings. Fixed Charge Coverage This ratio relates fixed charges, or obligations, to the cash flow generated by the com- pany. It measures the number of times a company’s earnings (before interest, taxes, and lease payments) can cover the company’s interest and lease payments.9 Similar to the interest coverage ratio, a higher fixed charge coverage ratio implies stronger solvency, offering greater assurance that the company can service its debt (i.e., bank debt, bonds, notes, and leases) from normal earnings. The ratio is sometimes used as an indication of the quality of the preferred dividend, with a higher ratio indicating a more secure preferred dividend. Example 11 demonstrates the use of solvency ratios in evaluating the creditwor- thiness of a company. EXAMPLE 11 Evaluation of Solvency Ratios A credit analyst is evaluating the solvency of Eskom, a South African public utility based on financial statements for the year ended 31 March 2017. The following data are gathered from the company’s 2017 annual report: 9 For computing this ratio, an assumption sometimes made is that one- third of the lease payment amount represents interest on the lease obligation and that the rest is a repayment of principal on the obligation. For this variant of the fixed charge coverage ratio, the numerator is EBIT plus one- third of lease payments and the denominator is interest payments plus one- third of lease payments. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 232. Reading 20 ■ Financial Analysis Techniques 214 South African Rand, millions 2017 2016 2015 Total Assets 710,009 663,170 559,688 Short Term Debt 18,530 15,688 19,976 Long Term Debt 336,770 306,970 277,458 Total Liabilities 534,067 480,818 441,269 Total Equity 175,942 182,352 118,419 1 A Calculate the company’s financial leverage ratio for 2016 and 2017. B Interpret the financial leverage ratio calculated in Part A. 2 A What are the company’s debt- to- assets, debt- to- capital, and debt- to- equity ratios for the three years? B Is there any discernable trend over the three years? Solutions to 1: (Amounts are millions of Rand.) A For 2017, average total assets were (710,009 + 663,170)/2 = 686,590, and average total equity was (175,942 + 182,352)/2 = 179,147. Thus, financial leverage was 686,590/179,942 = 3.83. For 2016, financial leverage was 4.07. 2017 2016 Average Assets 686,590 611,429 Average Equity 179,147 150,386 Financial Leverage 3.83 4.07 B For 2017, every Rand in total equity supported R3.83 in total assets, on average. Financial leverage decreased from 2016 to 2017 on this measure. Solutions to 2: (Amounts are millions of Rand other than ratios) A 2017 2016 2015 Total Debt 355,300 322,658 297,434 Total Capital 531,242 505,010 415,853 Debt/Assets 50.0% 48.7% 53.1% Debt/Capital 66.9% 63.9% 71.5% Debt/Equity 2.02 1.77 2.51 B On all three metrics, the company’s leverage decreased from 2015 to 2016 and increased from 2016 to 2017. For 2016 the decrease in leverage resulted from a conversion of subordinated debt into equity as well as additional issuance of equity. However, in 2017 debt levels increased again relative to assets, capital and equity indicating that the company’s sol- vency has weakened. From a creditor’s perspective, lower solvency (higher debt) indicates higher risk of default on obligations. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 233. Profitability Ratios 215 As with all ratio analysis, it is important to consider leverage ratios in a broader context. In general, companies with lower business risk and operations that generate steady cash flows are better positioned to take on more leverage without a commen- surate increase in the risk of insolvency. In other words, a higher proportion of debt financing poses less risk of non- payment of interest and debt principal to a company with steady cash flows than to a company with volatile cash flows. PROFITABILITY RATIOS b identify, calculate, and interpret activity, liquidity, solvency, profitability, and valuation ratios; The ability to generate profit on capital invested is a key determinant of a company’s overall value and the value of the securities it issues. Consequently, many equity ana- lysts would consider profitability to be a key focus of their analytical efforts. Profitability reflects a company’s competitive position in the market, and by extension, the quality of its management. The income statement reveals the sources of earnings and the components of revenue and expenses. Earnings can be distributed to shareholders or reinvested in the company. Reinvested earnings enhance solvency and provide a cushion against short- term problems. 11.1 Calculation of Profitability Ratios Profitability ratios measure the return earned by the company during a period. Exhibit 15 provides the definitions of a selection of commonly used profitability ratios. Return- on- sales profitability ratios express various subtotals on the income statement (e.g., gross profit, operating profit, net profit) as a percentage of revenue. Essentially, these ratios constitute part of a common- size income statement discussed earlier. Return on investment profitability ratios measure income relative to assets, equity, or total capital employed by the company. For operating ROA, returns are measured as operating income, i.e., prior to deducting interest on debt capital. For ROA and ROE, returns are measured as net income, i.e., after deducting interest paid on debt capital. For return on common equity, returns are measured as net income minus preferred dividends (because preferred dividends are a return to preferred equity). Exhibit 15 Definitions of Commonly Used Profitability Ratios Profitability Ratios Numerator Denominator Return on Salesa Gross profit margin Gross profit Revenue Operating profit margin Operating incomeb Revenue Pretax margin EBT (earnings before tax but after interest) Revenue Net profit margin Net income Revenue Return on Investment Operating ROA Operating income Average total assets ROA Net income Average total assets 11 (continued) © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 234. Reading 20 ■ Financial Analysis Techniques 216 Return on Investment Return on total capital EBIT Average short- and long- term debt and equity ROE Net income Average total equity Return on common equity Net income – Preferred dividends Average common equity a “Sales” is being used as a synonym for “revenue.” b Some analysts use EBIT as a shortcut representation of operating income. Note that EBIT, strictly speaking, includes non- operating items such as dividends received and gains and losses on investment securities. Of utmost importance is that the analyst compute ratios consistently whether comparing different companies or analyzing one company over time. 11.2 Interpretation of Profitability Ratios In the following, we discuss the interpretation of the profitability ratios presented in Exhibit 15. For each of the profitability ratios, a higher ratio indicates greater profitability. Gross Profit Margin Gross profit margin indicates the percentage of revenue available to cover operating and other expenses and to generate profit. Higher gross profit margin indicates some combination of higher product pricing and lower product costs. The ability to charge a higher price is constrained by competition, so gross profits are affected by (and usu- ally inversely related to) competition. If a product has a competitive advantage (e.g., superior branding, better quality, or exclusive technology), the company is better able to charge more for it. On the cost side, higher gross profit margin can also indicate that a company has a competitive advantage in product costs. Operating Profit Margin Operating profit is calculated as gross profit minus operating costs. So, an operating profit margin increasing faster than the gross profit margin can indicate improve- ments in controlling operating costs, such as administrative overheads. In contrast, a declining operating profit margin could be an indicator of deteriorating control over operating costs. Pretax Margin Pretax income (also called “earnings before tax” or “EBT”) is calculated as operating profit minus interest, and the pretax margin is the ratio of pretax income to revenue. The pretax margin reflects the effects on profitability of leverage and other (non- operating) income and expenses. If a company’s pretax margin is increasing primarily as a result of increasing amounts of non- operating income, the analyst should evaluate whether this increase reflects a deliberate change in a company’s business focus and, therefore, the likelihood that the increase will continue. Net Profit Margin Net profit, or net income, is calculated as revenue minus all expenses. Net income includes both recurring and non- recurring components. Generally, the net income used in calculating the net profit margin is adjusted for non- recurring items to offer a better view of a company’s potential future profitability. Exhibit 15 (Continued) © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 235. Profitability Ratios 217 ROA ROA measures the return earned by a company on its assets. The higher the ratio, the more income is generated by a given level of assets. Most databases compute this ratio as: Net income Average total assets An issue with this computation is that net income is the return to equity holders, whereas assets are financed by both equity holders and creditors. Interest expense (the return to creditors) has already been subtracted in the numerator. Some analysts, therefore, prefer to add back interest expense in the numerator. In such cases, interest must be adjusted for income taxes because net income is determined after taxes. With this adjustment, the ratio would be computed as: Net income Interest expense Tax rate Average total ass + − ( ) 1 e ets Alternatively, some analysts elect to compute ROA on a pre- interest and pre- tax basis (operating ROA in Exhibit 15) as: Operating income or EBIT Average total assets In this ROA calculation, returns are measured prior to deducting interest on debt capital (i.e., as operating income or EBIT). This measure reflects the return on all assets invested in the company, whether financed with liabilities, debt, or equity. Whichever form of ROA is chosen, the analyst must use it consistently in comparisons to other companies or time periods. Return on Total Capital Return on total capital measures the profits a company earns on all of the capital that it employs (short- term debt, long- term debt, and equity). As with operating ROA, returns are measured prior to deducting interest on debt capital (i.e., as operating income or EBIT). ROE ROE measures the return earned by a company on its equity capital, including minority equity, preferred equity, and common equity. As noted, return is measured as net income (i.e., interest on debt capital is not included in the return on equity capital). A variation of ROE is return on common equity, which measures the return earned by a company only on its common equity. Both ROA and ROE are important measures of profitability and will be explored in more detail in section 13. As with other ratios, profitability ratios should be evaluated individually and as a group to gain an understanding of what is driving profitability (operating versus non- operating activities). Example 12 demonstrates the evaluation of profitability ratios and the use of the management report (sometimes called man- agement’s discussion and analysis or management commentary) that accompanies financial statements to explain the trend in ratios. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 236. Reading 20 ■ Financial Analysis Techniques 218 EXAMPLE 12 Evaluation of Profitability Ratios Recall from Example 1 that an analysis found that Apple’s gross margin declined over the three- year period FY2015 to FY2017. An analyst would like to further explore Apple’s profitability using a five- year period. He gathers the following revenue data and calculates the following profitability ratios from information in Apple’s annual reports: Dollars in millions 2017 2016 2015 2014 2013 Sales 229,234 215,639 233,715 182,795 170,910 Gross Profit 88,186 84,263 93,626 70,537 64,304 Operating Income 61,344 60,024 71,230 52,503 48,999 Pre-tax Income 64,089 61,372 72,515 53,483 50,155 Net Income 48,351 45,687 53,394 39,510 37,037 Gross profit margin 38.47% 39.08% 40.06% 38.59% 37.62% Operating income margin 26.76% 27.84% 30.48% 28.72% 28.67% Pre-tax income 27.96% 28.46% 31.03% 29.26% 29.35% Net profit margin 21.09% 21.19% 22.85% 21.61% 21.67% Evaluate the overall trend in Apple’s profitability ratios for the five- year period. Solution: Sales had increased steadily through 2015, dropped in 2016, and rebounded somewhat in 2017. As noted in Example 1, the sales decline in 2016 was related to a decline in iPhone sales and weakness in foreign currencies. Margins also rose from 2013 to 2015 and declined in 2016. However, in spite of the increase in sales in 2017, all margins declined slightly indicating costs were rising faster than sales. In spite of the fluctuations, Apple’s bottom line net profit margin was relatively stable over the five- year period. INTEGRATED FINANCIAL RATIO ANALYSIS c describe relationships among ratios and evaluate a company using ratio analysis In prior sections, the text presented separately activity, liquidity, solvency, and profit- ability ratios. Prior to discussing valuation ratios, the following sections demonstrate the importance of examining a variety of financial ratios—not a single ratio or category of ratios in isolation—to ascertain the overall position and performance of a com- pany. Experience shows that the information from one ratio category can be helpful in answering questions raised by another category and that the most accurate overall picture comes from integrating information from all sources. Section 12 provides some 12 © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 237. Integrated Financial Ratio Analysis 219 introductory examples of such analysis and Section 13 shows how return on equity can be analyzed into components related to profit margin, asset utilization (activity), and financial leverage. 12.1 The Overall Ratio Picture: Examples This section presents two simple illustrations to introduce the use of a variety of ratios to address an analytical task. Example 13 shows how the analysis of a pair of activity ratios resolves an issue concerning a company’s liquidity. Example 14 shows that examining the overall ratios of multiple companies can assist an analyst in drawing conclusions about their relative performances. EXAMPLE 13 A Variety of Ratios An analyst is evaluating the liquidity of a Canadian manufacturing company and obtains the following liquidity ratios: Fiscal Year 10 9 8 Current ratio 2.1 1.9 1.6 Quick ratio 0.8 0.9 1.0 The ratios present a contradictory picture of the company’s liquidity. Based on the increase in its current ratio from 1.6 to 2.1, the company appears to have strong and improving liquidity; however, based on the decline of the quick ratio from 1.0 to 0.8, its liquidity appears to be deteriorating. Because both ratios have exactly the same denominator, current liabilities, the difference must be the result of changes in some asset that is included in the current ratio but not in the quick ratio (e.g., inventories). The analyst collects the following activity ratios: DOH 55 45 30 DSO 24 28 30 The company’s DOH has deteriorated from 30 days to 55 days, meaning that the company is holding increasingly larger amounts of inventory relative to sales. The decrease in DSO implies that the company is collecting receivables faster. If the proceeds from these collections were held as cash, there would be no effect on either the current ratio or the quick ratio. However, if the proceeds from the collections were used to purchase inventory, there would be no effect on the current ratio and a decline in the quick ratio (i.e., the pattern shown in this example). Collectively, the ratios suggest that liquidity is declining and that the company may have an inventory problem that needs to be addressed. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 238. Reading 20 ■ Financial Analysis Techniques 220 EXAMPLE 14 A Comparison of Two Companies (1) An analyst collects the information10 shown in Exhibit 16 for two hypothetical companies: Exhibit 16 Fiscal Year Anson Industries 5 4 3 2 Inventory turnover 76.69 89.09 147.82 187.64 DOH 4.76 4.10 2.47 1.95 Receivables turnover 10.75 9.33 11.14 7.56 DSO 33.95 39.13 32.77 48.29 Accounts payable turnover 4.62 4.36 4.84 4.22 Days payable 78.97 83.77 75.49 86.56 Cash from operations/Total liabilities 31.41% 11.15% 4.04% 8.81% ROE 5.92% 1.66% 1.62% –0.62% ROA 3.70% 1.05% 1.05% –0.39% Net profit margin (Net income/ Revenue) 3.33% 1.11% 1.13% –0.47% Total asset turnover (Revenue/Average assets) 1.11 0.95 0.93 0.84 Leverage (Average assets/Average equity) 1.60 1.58 1.54 1.60 Fiscal Year Clarence Corporation 5 4 3 2 Inventory turnover 9.19 9.08 7.52 14.84 DOH 39.73 40.20 48.51 24.59 Receivables turnover 8.35 7.01 6.09 5.16 DSO 43.73 52.03 59.92 70.79 Accounts payable turnover 6.47 6.61 7.66 6.52 Days payable 56.44 55.22 47.64 56.00 Cash from operations/Total liabilities 13.19% 16.39% 15.80% 11.79% ROE 9.28% 6.82% –3.63% –6.75% ROA 4.64% 3.48% –1.76% –3.23% Net profit margin (Net income/ Revenue) 4.38% 3.48% –1.60% –2.34% Total asset turnover (Revenue/Average assets) 1.06 1.00 1.10 1.38 Leverage (Average assets/Average equity) 2.00 1.96 2.06 2.09 10 Note that ratios are expressed in terms of two decimal places and are rounded. Therefore, expected relationships may not hold perfectly. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 239. DuPont Analysis: The Decomposition of ROE 221 Which of the following choices best describes reasonable conclusions an analyst might make about the companies’ efficiency? A Over the past four years, Anson has shown greater improvement in effi- ciency than Clarence, as indicated by its total asset turnover ratio increas- ing from 0.84 to 1.11. B In FY5, Anson’s DOH of only 4.76 indicated that it was less efficient at inventory management than Clarence, which had DOH of 39.73. C In FY5, Clarence’s receivables turnover of 8.35 times indicated that it was more efficient at receivables management than Anson, which had receiv- ables turnover of 10.75. Solution: A is correct. Over the past four years, Anson has shown greater improvement in efficiency than Clarence, as indicated by its total asset turnover ratio increasing from 0.84 to 1.11. Over the same period of time, Clarence’s total asset turnover ratio has declined from 1.38 to 1.06. Choices B and C are incorrect because DOH and receivables turnover are misinterpreted. DUPONT ANALYSIS: THE DECOMPOSITION OF ROE d demonstrate the application of DuPont analysis of return on equity and calcu- late and interpret effects of changes in its components As noted earlier, ROE measures the return a company generates on its equity capital. To understand what drives a company’s ROE, a useful technique is to decompose ROE into its component parts. (Decomposition of ROE is sometimes referred to as DuPont analysis because it was developed originally at that company.) Decomposing ROE involves expressing the basic ratio (i.e., net income divided by average shareholders’ equity) as the product of component ratios. Because each of these component ratios is an indicator of a distinct aspect of a company’s performance that affects ROE, the decomposition allows us to evaluate how these different aspects of performance affected the company’s profitability as measured by ROE.11 Decomposing ROE is useful in determining the reasons for changes in ROE over time for a given company and for differences in ROE for different companies in a given time period. The information gained can also be used by management to determine which areas they should focus on to improve ROE. This decomposition will also show why a company’s overall profitability, measured by ROE, is a function of its efficiency, operating profitability, taxes, and use of financial leverage. DuPont analysis shows the relationship between the various categories of ratios discussed in this reading and how they all influence the return to the investment of the owners. Analysts have developed several different methods of decomposing ROE. The decomposition presented here is one of the most commonly used and the one found in popular research databases, such as Bloomberg. Return on equity is calculated as: ROE = Net income/Average shareholders’ equity 13 11 For purposes of analyzing ROE, this method usually uses average balance sheet factors; however, the math will work out if beginning or ending balances are used throughout. For certain purposes, these alternative methods may be appropriate. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 240. Reading 20 ■ Financial Analysis Techniques 222 The decomposition of ROE makes use of simple algebra and illustrates the relationship between ROE and ROA. Expressing ROE as a product of only two of its components, we can write: ROE Net income Average shareholders' equity Net income Avera = = g ge total assets Average total assets Average shareholders' × equity which can be interpreted as: ROE = ROA × Leverage In other words, ROE is a function of a company’s ROA and its use of financial leverage (“leverage” for short, in this discussion). A company can improve its ROE by improving ROA or making more effective use of leverage. Consistent with the definition given earlier, leverage is measured as average total assets divided by average shareholders’ equity. If a company had no leverage (no liabilities), its leverage ratio would equal 1.0 and ROE would exactly equal ROA. As a company takes on liabilities, its leverage increases. As long as a company is able to borrow at a rate lower than the marginal rate it can earn investing the borrowed money in its business, the company is mak- ing an effective use of leverage and ROE would increase as leverage increases. If a company’s borrowing cost exceeds the marginal rate it can earn on investing in the business, ROE would decline as leverage increased because the effect of borrowing would be to depress ROA. Using the data from Example 14 for Anson Industries, an analyst can examine the trend in ROE and determine whether the increase from an ROE of –0.625 percent in FY2 to 5.925 percent in FY5 is a function of ROA or the use of leverage: ROE = ROA × Leverage FY5 5.92% 3.70% 1.60 FY4 1.66% 1.05% 1.58 FY3 1.62% 1.05% 1.54 FY2 –0.62% –0.39% 1.60 Over the four- year period, the company’s leverage factor was relatively stable. The pri- mary reason for the increase in ROE is the increase in profitability measured by ROA. Just as ROE can be decomposed, the individual components such as ROA can be decomposed. Further decomposing ROA, we can express ROE as a product of three component ratios: Net income Average shareholders' equity Net income Revenue R = × e evenue Average total assets Average total assets Average sh × a areholders' equity which can be interpreted as: ROE = Net profit margin × Total asset turnover × Leverage The first term on the right- hand side of this equation is the net profit margin, an indicator of profitability: how much income a company derives per one monetary unit (e.g., euro or dollar) of sales. The second term on the right is the asset turnover ratio, an indicator of efficiency: how much revenue a company generates per one money unit of assets. Note that ROA is decomposed into these two components: net profit margin and total asset turnover. A company’s ROA is a function of profitability (net profit margin) and efficiency (total asset turnover). The third term on the right- hand side of Equation 1b is a measure of financial leverage, an indicator of solvency: the (1a) (1b) © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 241. DuPont Analysis: The Decomposition of ROE 223 total amount of a company’s assets relative to its equity capital. This decomposition illustrates that a company’s ROE is a function of its net profit margin, its efficiency, and its leverage. Again, using the data from Example 14 for Anson Industries, the analyst can evaluate in more detail the reasons behind the trend in ROE:12 ROE = Net profit margin × Total asset turnover × Leverage FY5 5.92% 3.33% 1.11 1.60 FY4 1.66% 1.11% 0.95 1.58 FY3 1.62% 1.13% 0.93 1.54 FY2 –0.62% –0.47% 0.84 1.60 This further decomposition confirms that increases in profitability (measured here as net profit margin) are indeed an important contributor to the increase in ROE over the four- year period. However, Anson’s asset turnover has also increased steadily. The increase in ROE is, therefore, a function of improving profitability and improving efficiency. As noted above, ROE decomposition can also be used to compare the ROEs of peer companies, as demonstrated in Example 15. EXAMPLE 15 A Comparison of Two Companies (2) Referring to the data for Anson Industries and Clarence Corporation in Example 14, which of the following choices best describes reasonable conclu- sions an analyst might make about the companies’ ROE? A Anson’s inventory turnover of 76.69 indicates it is more profitable than Clarence. B The main driver of Clarence’s superior ROE in FY5 is its more efficient use of assets. C The main drivers of Clarence’s superior ROE in FY5 are its greater use of debt financing and higher net profit margin. Solution: C is correct. The main driver of Clarence’s superior ROE (9.28 percent compared with only 5.92 percent for Anson) in FY5 is its greater use of debt financing (leverage of 2.00 compared with Anson’s leverage of 1.60) and higher net profit margin (4.38 percent compared with only 3.33 percent for Anson). A is incorrect because inventory turnover is not a direct indicator of profitability. An increase in inventory turnover may indicate more efficient use of inventory which in turn could affect profitability; however, an increase in inventory turnover would also be observed if a company was selling more goods even if it was not selling those goods at a profit. B is incorrect because Clarence has less efficient use of assets than Anson, indicated by turnover of 1.06 for Clarence compared with Anson’s turnover of 1.11. 12 Ratios are expressed in terms of two decimal places and are rounded. Therefore, ROE may not be the exact product of the three ratios. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 242. Reading 20 ■ Financial Analysis Techniques 224 To separate the effects of taxes and interest, we can further decompose the net profit margin and write: Net income Average shareholders' equity Net income EBT EBT EB = × I IT EBIT Revenue Revenue Average total assets Average total × × × a assets Average shareholders' equity which can be interpreted as: ROE = Tax burden × Interest burden × EBIT margin × Total asset turnover × Leverage This five- way decomposition is the one found in financial databases such as Bloomberg. The first term on the right- hand side of this equation measures the effect of taxes on ROE. Essentially, it reflects one minus the average tax rate, or how much of a com- pany’s pretax profits it gets to keep. This can be expressed in decimal or percentage form. So, a 30 percent tax rate would yield a factor of 0.70 or 70 percent. A higher value for the tax burden implies that the company can keep a higher percentage of its pretax profits, indicating a lower tax rate. A decrease in the tax burden ratio implies the opposite (i.e., a higher tax rate leaving the company with less of its pretax profits). The second term on the right- hand side captures the effect of interest on ROE. Higher borrowing costs reduce ROE. Some analysts prefer to use operating income instead of EBIT for this term and the following term. Either operating income or EBIT is acceptable as long as it is applied consistently. In such a case, the second term would measure both the effect of interest expense and non-operating income on ROE. The third term on the right- hand side captures the effect of operating margin (if operating income is used in the numerator) or EBIT margin (if EBIT is used) on ROE. In either case, this term primarily measures the effect of operating profitability on ROE. The fourth term on the right- hand side is again the total asset turnover ratio, an indicator of the overall efficiency of the company (i.e., how much revenue it generates per unit of total assets). The fifth term on the right- hand side is the financial leverage ratio described above—the total amount of a company’s assets relative to its equity capital. This decomposition expresses a company’s ROE as a function of its tax rate, interest burden, operating profitability, efficiency, and leverage. An analyst can use this frame- work to determine what factors are driving a company’s ROE. The decomposition of ROE can also be useful in forecasting ROE based upon expected efficiency, profitability, financing activities, and tax rates. The relationship of the individual factors, such as ROA to the overall ROE, can also be expressed in the form of an ROE tree to study the contribution of each of the five factors, as shown in Exhibit 17 for Anson Industries.13 Exhibit 17 shows that Anson’s ROE of 5.92 percent in FY5 can be decomposed into ROA of 3.70 percent and leverage of 1.60. ROA can further be decomposed into a net profit margin of 3.33 percent and total asset turnover of 1.11. Net profit margin can be decomposed into a tax burden of 0.70 (an average tax rate of 30 percent), an interest burden of 0.90, and an EBIT margin of 5.29 percent. Overall ROE is decom- posed into five components. (1c) 13 Note that a breakdown of net profit margin was not provided in Example 14, but is added here. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 243. DuPont Analysis: The Decomposition of ROE 225 Exhibit 17 DuPont Analysis of Anson Industries’ROE: Fiscal Year 5 Return on Equity: Net income Average shareholders’ equity = 5.92% Return on Assets: Net income Average total assets = 3.7% Leverage: Average total assets Average shareholders’ equity = 1.60 Net Profit Margin: Net income Revenues = 3.33% Total Asset Turnover: Revenues Average total assets = 1.11 Interest Burden: EBT EBIT = 0.90 EBIT Margin: EBIT Revenues = 5.29% Tax Burden: Net income EBT = 0.70 Example 16 demonstrates how the five- component decomposition can be used to determine reasons behind the trend in a company’s ROE. EXAMPLE 16 Five- Way Decomposition of ROE An analyst examining Amsterdam PLC (a hypothetical company) wishes to under- stand the factors driving the trend in ROE over a four- year period. The analyst obtains and calculates the following data from Amsterdam’s annual reports: 2017 2016 2015 2014 ROE 9.53% 20.78% 26.50% 24.72% Tax burden 60.50% 52.10% 63.12% 58.96% Interest burden 97.49% 97.73% 97.86% 97.49% EBIT margin 7.56% 11.04% 13.98% 13.98% Asset turnover 0.99 1.71 1.47 1.44 Leverage 2.15 2.17 2.10 2.14 What might the analyst conclude? Solution: The tax burden measure has varied, with no obvious trend. In the most recent year, 2017, taxes declined as a percentage of pretax profit. (Because the tax bur- den reflects the relation of after- tax profits to pretax profits, the increase from 52.10 percent in 2016 to 60.50 percent in 2017 indicates that taxes declined as a percentage of pretax profits.) This decline in average tax rates could be a result © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 244. Reading 20 ■ Financial Analysis Techniques 226 of lower tax rates from new legislation or revenue in a lower tax jurisdiction. The interest burden has remained fairly constant over the four- year period indicating that the company maintains a fairly constant capital structure. Operating margin (EBIT margin) declined over the period, indicating the company’s operations were less profitable. This decline is generally consistent with declines in oil prices in 2017 and declines in refining industry gross margins in 2016 and 2017. The company’s efficiency (asset turnover) decreased in 2017. The company’s lever- age remained constant, consistent with the constant interest burden. Overall, the trend in ROE (declining substantially over the recent years) resulted from decreases in operating profits and a lower asset turnover. Additional research on the causes of these changes is required in order to develop expectations about the company’s future performance. The most detailed decomposition of ROE that we have presented is a five- way decomposition. Nevertheless, an analyst could further decompose individual com- ponents of a five- way analysis. For example, EBIT margin (EBIT/Revenue) could be further decomposed into a non- operating component (EBIT/Operating income) and an operating component (Operating income/Revenue). The analyst can also examine which other factors contributed to these five components. For example, an improve- ment in efficiency (total asset turnover) may have resulted from better management of inventory (DOH) or better collection of receivables (DSO). EQUITY ANALYSIS AND VALUATION RATIOS e calculate and interpret ratios used in equity analysis and credit analysis One application of financial analysis is to select securities as part of the equity port- folio management process. Analysts are interested in valuing a security to assess its merits for inclusion or retention in a portfolio. The valuation process has several steps, including: 1 understanding the business and the existing financial profile 2 forecasting company performance 3 selecting the appropriate valuation model 4 converting forecasts to a valuation 5 making the investment decision Financial analysis assists in providing the core information to complete the first two steps of this valuation process: understanding the business and forecasting performance. Fundamental equity analysis involves evaluating a company’s performance and valuing its equity in order to assess its relative attractiveness as an investment. Analysts use a variety of methods to value a company’s equity, including valuation ratios (e.g., the price- to- earnings or P/E ratio), discounted cash flow approaches, and residual income approaches (ROE compared with the cost of capital), among others. The following section addresses the first of these approaches—the use of valuation ratios. 14.1 Valuation Ratios Valuation ratios have long been used in investment decision making. A well known example is the price to earnings ratio (P/E ratio)—probably the most widely cited indicator in discussing the value of equity securities—which relates share price to the 14 © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 245. Equity Analysis and Valuation Ratios 227 earnings per share (EPS). Additionally, some analysts use other market multiples, such as price to book value (P/B) and price to cash flow (P/CF). The following sections explore valuation ratios and other quantities related to valuing equities. 14.1.1 Calculation of Valuation Ratios and Related Quantities Exhibit 18 describes the calculation of some common valuation ratios and related quantities. Exhibit 18 Definitions of Selected Valuation Ratios and Related Quantities Valuation Ratios Numerator Denominator P/E Price per share Earnings per share P/CF Price per share Cash flow per share P/S Price per share Sales per share P/BV Price per share Book value per share Per-Share Quantities Numerator Denominator Basic EPS Net income minus pre- ferred dividends Weighted average number of ordinary shares outstanding Diluted EPS Adjusted income avail- able for ordinary shares, reflecting conversion of dilutive securities Weighted average number of ordinary and potential ordi- nary shares outstanding Cash flow per share Cash flow from operations Weighted average number of shares outstanding EBITDA per share EBITDA Weighted average number of shares outstanding Dividends per share Common dividends declared Weighted average number of ordinary shares outstanding Dividend-Related Quantities Numerator Denominator Dividend payout ratio Common share dividends Net income attributable to common shares Retention rate (b) Net income attributable to common shares – Net income attributable to common shares Common share dividends Sustainable growth rate b × ROE The P/E ratio expresses the relationship between the price per share and the amount of earnings attributable to a single share. In other words, the P/E ratio tells us how much an investor in common stock pays per dollar of earnings. Because P/E ratios are calculated using net income, the ratios can be sensitive to non- recurring earnings or one- time earnings events. In addition, because net income is generally considered to be more susceptible to manipulation than are cash flows, analysts may use price to cash flow as an alternative measure—particularly in situations where earnings quality may be an issue. EBITDA per share, because it is calculated using income before interest, taxes, and depreciation, can be used to eliminate the © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 246. Reading 20 ■ Financial Analysis Techniques 228 effect of different levels of fixed asset investment across companies. It facilitates com- parison between companies in the same sector but at different stages of infrastructure maturity. Price to sales is calculated in a similar manner and is sometimes used as a comparative price metric when a company does not have positive net income. Another price- based ratio that facilitates useful comparisons of companies’ stock prices is price to book value, or P/B, which is the ratio of price to book value per share. This ratio is often interpreted as an indicator of market judgment about the relationship between a company’s required rate of return and its actual rate of return. Assuming that book values reflect the fair values of the assets, a price to book ratio of one can be interpreted as an indicator that the company’s future returns are expected to be exactly equal to the returns required by the market. A ratio greater than one would indicate that the future profitability of the company is expected to exceed the required rate of return, and values of this ratio less than one indicate that the company is not expected to earn excess returns.14 14.1.2 Interpretation of Earnings per Share Exhibit 18 presented a number of per- share quantities that can be used in valuation ratios. In this section, we discuss the interpretation of one such critical quantity, earnings per share or EPS.15 EPS is simply the amount of earnings attributable to each share of common stock. In isolation, EPS does not provide adequate information for comparison of one com- pany with another. For example, assume that two companies have only common stock outstanding and no dilutive securities outstanding. In addition, assume the two com- panies have identical net income of $10 million, identical book equity of $100 million and, therefore, identical profitability (10 percent, using ending equity in this case for simplicity). Furthermore, assume that Company A has 100 million weighted average common shares outstanding, whereas Company B has 10 million weighted average common shares outstanding. So, Company A will report EPS of $0.10 per share, and Company B will report EPS of $1 per share. The difference in EPS does not reflect a difference in profitability—the companies have identical profits and profitability. The difference reflects only a different number of common shares outstanding. Analysts should understand in detail the types of EPS information that companies report: Basic EPS provides information regarding the earnings attributable to each share of common stock.16 To calculate basic EPS, the weighted average number of shares outstanding during the period is first calculated. The weighted average number of shares consists of the number of ordinary shares outstanding at the beginning of the period, adjusted by those bought back or issued during the period, multiplied by a time-weighting factor. Accounting standards generally require the disclosure of basic as well as diluted EPS (diluted EPS includes the effect of all the company’s securities whose conversion or exercise would result in a reduction of basic EPS; dilutive securities include con- vertible debt, convertible preferred, warrants, and options). Basic EPS and diluted EPS must be shown with equal prominence on the face of the income statement for each class of ordinary share. Disclosure includes the amounts used as the numera- tors in calculating basic and diluted EPS, and a reconciliation of those amounts to the company’s profit or loss for the period. Because both basic and diluted EPS are presented in a company’s financial statements, an analyst does not need to calculate these measures for reported financial statements. Understanding the calculations is, however, helpful for situations requiring an analyst to calculate expected future EPS. 14 For more detail on valuation ratios as used in equity analysis, see the curriculum reading “Equity Valuation: Concepts and Basic Tools.” 15 For more detail on EPS calculation, see the reading “Understanding Income Statements.” 16 IAS 33, Earnings per Share and FASB ASC Topic 260 [Earnings per Share]. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 247. Industry-Specific Financial Ratios 229 To calculate diluted EPS, earnings are adjusted for the after- tax effects assuming conversion, and the following adjustments are made to the weighted number of shares: ■ ■ The weighted average number of shares for basic EPS, plus those that would be issued on conversion of all potentially dilutive ordinary shares. Potential ordi- nary shares are treated as dilutive when their conversion would decrease net profit per share from continuing ordinary operations. ■ ■ These shares are deemed to have been converted into ordinary shares at the beginning of the period or, if later, at the date of the issue of the shares. ■ ■ Options, warrants (and their equivalents), convertible instruments, contingently issuable shares, contracts that can be settled in ordinary shares or cash, pur- chased options, and written put options should be considered. 14.1.3 Dividend-Related Quantities In this section, we discuss the interpretation of the dividend- related quantities pre- sented in Exhibit 18. These quantities play a role in some present value models for valuing equities. Dividend Payout Ratio The dividend payout ratio measures the percentage of earn- ings that the company pays out as dividends to shareholders. The amount of dividends per share tends to be relatively fixed because any reduction in dividends has been shown to result in a disproportionately large reduction in share price. Because dividend amounts are relatively fixed, the dividend payout ratio tends to fluctuate with earnings. Therefore, conclusions about a company’s dividend payout policies should be based on examination of payout over a number of periods. Optimal dividend policy, similar to optimal capital structure, has been examined in academic research and continues to be a topic of significant interest in corporate finance. Retention Rate The retention rate, or earnings retention rate, is the complement of the payout ratio or dividend payout ratio (i.e., 1 – payout ratio). Whereas the payout ratio measures the percentage of earnings that a company pays out as dividends, the retention rate is the percentage of earnings that a company retains. (Note that both the payout ratio and retention rate are both percentages of earnings. The difference in terminology—“ratio” versus “rate” versus “percentage”—reflects common usage rather than any substantive differences.) Sustainable Growth Rate A company’s sustainable growth rate is viewed as a func- tion of its profitability (measured as ROE) and its ability to finance itself from internally generated funds (measured as the retention rate). The sustainable growth rate is ROE times the retention rate. A higher ROE and a higher retention rate result in a higher sustainable growth rate. This calculation can be used to estimate a company’s growth rate, a factor commonly used in equity valuation. INDUSTRY-SPECIFIC FINANCIAL RATIOS e calculate and interpret ratios used in equity analysis and credit analysis As stated earlier in this reading, a universally accepted definition and classification of ratios does not exist. The purpose of ratios is to serve as indicators of important aspects of a company’s performance and value. Aspects of performance that are considered important in one industry may be irrelevant in another, and industry- specific ratios reflect these differences. For example, companies in the retail industry may report 15 © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 248. Reading 20 ■ Financial Analysis Techniques 230 same- store sales changes because, in the retail industry, it is important to distinguish between growth that results from opening new stores and growth that results from generating more sales at existing stores. Industry- specific metrics can be especially important to the value of equity in early stage industries, where companies are not yet profitable. In addition, regulated industries—especially in the financial sector—often are required to comply with specific regulatory ratios. For example, the banking sector’s liquidity and cash reserve ratios provide an indication of banking liquidity and reflect monetary and regulatory requirements. Banking capital adequacy requirements attempt to relate banks’ solvency requirements directly to their specific levels of risk exposure. Exhibit 19 presents, for illustrative purposes only, some industry- specific and task-specific ratios.17 Exhibit 19 Definitions of Some Common Industry- and Task- Specific Ratios Ratio Numerator Denominator Business Risk Coefficient of variation of operating income Standard deviation of operating income Average operating income Coefficient of variation of net income Standard deviation of net income Average net income Coefficient of variation of revenues Standard deviation of revenue Average revenue Financial Sector Ratios Numerator Denominator Capital adequacy—banks Various components of capital Various measures such as risk- weighted assets, market risk exposure, or level of operational risk assumed Monetary reserve require- ment (Cash reserve ratio) Reserves held at central bank Specified deposit liabilities Liquid asset requirement Approved “readily market- able” securities Specified deposit liabilities Net interest margin Net interest income Total interest-earning assets Retail Ratios Numerator Denominator Same (or comparable) store sales Average revenue growth year over year for stores open in both periods Not applicable Sales per square meter (or square foot) Revenue Total retail space in square meters (or square feet) 17 There are many other industry- and task- specific ratios that are outside the scope of this reading. Resources such as Standard and Poor’s Industry Surveys present useful ratios for each industry. Industry organizations may present useful ratios for the industry or a task specific to the industry. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 249. Research on Financial Ratios in Credit and Equity Analysis 231 Service Companies Numerator Denominator Revenue per employee Revenue Total number of employees Net income per employee Net income Total number of employees Hotel Numerator Denominator Average daily rate Room revenue Number of rooms sold Occupancy rate Number of rooms sold Number of rooms available RESEARCH ON FINANCIAL RATIOS IN CREDIT AND EQUITY ANALYSIS e calculate and interpret ratios used in equity analysis and credit analysis Some ratios may be particularly useful in equity analysis. The end product of equity analysis is often a valuation and investment recommendation. Theoretical valuation models are useful in selecting ratios that would be useful in this process. For exam- ple, a company’s P/B is theoretically linked to ROE, growth, and the required return. ROE is also a primary determinant of residual income in a residual income valuation model. In both cases, higher ROE relative to the required return denotes a higher valuation. Similarly, profit margin is related to justified price- to- sales (P/S) ratios. Another common valuation method involves forecasts of future cash flows that are discounted back to the present. Trends in ratios can be useful in forecasting future earnings and cash flows (e.g., trends in operating profit margin and collection of cus- tomer receivables). Future growth expectations are a key component of all of these valuation models. Trends may be useful in assessing growth prospects (when used in conjunction with overall economic and industry trends). The variability in ratios and common- size data can be useful in assessing risk, an important component of the required rate of return in valuation models. A great deal of academic research has focused on the use of these fundamental ratios in evaluating equity investments. A classic study, Ou and Penman (1989a and 1989b), found that ratios and common- size metrics generated from accounting data were useful in forecasting earnings and stock returns. Ou and Penman examined 68 such metrics and found that these could be reduced to a more parsimonious list of relevant variables, including percentage changes in a variety of measures such as current ratio, inventory, and sales; gross and pretax margins; and returns on assets and equity. These variables were found to be useful in forecasting earnings and stock returns. Subsequent studies have also demonstrated the usefulness of ratios in evaluation of equity investments and valuation. Lev and Thiagarajan (1993) examined fundamental financial variables used by analysts to assess whether they are useful in security valu- ation. They found that fundamental variables add about 70 percent to the explanatory power of earnings alone in predicting excess returns (stock returns in excess of those expected). The fundamental variables they found useful included percentage changes in inventory and receivables relative to sales, gross margin, sales per employee, and 16 Exhibit 19 (Continued) © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 250. Reading 20 ■ Financial Analysis Techniques 232 the change in bad debts relative to the change in accounts receivable, among others. Abarbanell and Bushee (1997) found some of the same variables useful in predicting future accounting earnings. Abarbanell and Bushee (1998) devised an investment strategy using these same variables and found that they can generate excess returns under this strategy. Piotroski (2000) used financial ratios to supplement a value investing strategy and found that he can generate significant excess returns. Variables used by Piotroski include ROA, cash flow ROA, change in ROA, change in leverage, change in liquidity, change in gross margin, and change in inventory turnover. This research shows that in addition to being useful in evaluating the past per- formance of a company, ratios can be useful in predicting future earnings and equity returns. CREDIT ANALYSIS e calculate and interpret ratios used in equity analysis and credit analysis Credit risk is the risk of loss caused by a counterparty’s or debtor’s failure to make a promised payment. For example, credit risk with respect to a bond is the risk that the obligor (the issuer of the bond) is not able to pay interest and principal according to the terms of the bond indenture (contract). Credit analysis is the evaluation of credit risk. Approaches to credit analysis vary and, as with all financial analysis, depend on the purpose of the analysis and the context in which it is done. Credit analysis for specific types of debt (e.g., acquisition financing and other highly leveraged financing) often involves projections of period- by- period cash flows similar to projections made by equity analysts. Whereas the equity analyst may discount projected cash flows to determine the value of the company’s equity, a credit analyst would use the projected cash flows to assess the likelihood of a company complying with its financial covenants in each period and paying interest and principal as due.18 The analysis would also include expectations about asset sales and refinancing options open to the company. Credit analysis may relate to the borrower’s credit risk in a particular transaction or to its overall creditworthiness. In assessing overall creditworthiness, one general approach is credit scoring, a statistical analysis of the determinants of credit default. Another general approach to credit analysis is the credit rating process that is used, for example, by credit rating agencies to assess and communicate the probabil- ity of default by an issuer on its debt obligations (e.g., commercial paper, notes, and bonds). A credit rating can be either long term or short term and is an indication of the rating agency’s opinion of the creditworthiness of a debt issuer with respect to a specific debt security or other obligation. Where a company has no debt outstanding, a rating agency can also provide an issuer credit rating that expresses an opinion of the issuer’s overall capacity and willingness to meet its financial obligations. The fol- lowing sections review research on the use of ratios in credit analysis and the ratios commonly used in credit analysis. 17 18 Financial covenants are clauses in bond indentures relating to the financial condition of the bond issuer. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 251. Credit Analysis 233 17.1 The Credit Rating Process The credit rating process involves both the analysis of a company’s financial reports as well as a broad assessment of a company’s operations. In assigning credit ratings, rating agencies emphasize the importance of the relationship between a company’s business risk profile and its financial risk. For corporate entities, credit ratings typically reflect a combination of qualitative and quantitative factors. Qualitative factors generally include an industry’s growth prospects, volatility, technological change, and competitive environment. At the individual company level, qualitative factors may include operational effectiveness, strategy, governance, financial policies, risk management practices, and risk tolerance. In contrast, quantitative factors generally include profitability, leverage, cash flow adequacy, and liquidity.19 When analyzing financial ratios, rating agencies normally investigate deviations of ratios from the median ratios of the universe of companies for which such ratios have been calculated and also use the median ratings as an indicator for the ratings grade given to a specific debt issuer. This so- called universe of rated companies frequently changes, and any calculations are obviously affected by economic factors as well as by mergers and acquisitions. International ratings include the influence of country and economic risk factors. Exhibit 20 presents a few key financial ratios used by Standard Poor’s in evaluating industrial companies. Note that before calculating ratios, rating agencies make certain adjustments to reported financials such as adjusting debt to include off- balance sheet debt in a company’s total debt. Exhibit 20 Selected Credit Ratios Credit Ratio Numeratora Denominatora EBITDA interest coverage EBITDAb Interest expense, including non- cash interest on conventional debt instruments FFOc (Funds from operations) to debt FFO Total debt Free operating cash flow to debt CFOd (adjusted) minus capital expenditures Total debt EBIT margin EBITe Total revenues EBITDA margin EBITDA Total revenues Debt to EBITDA Total debt EBITDA Return on capital EBIT Average beginning-of-year and end-of-year capitalf a Note that both the numerator and the denominator definitions are adjusted from ratio to ratio and may not correspond to the definitions used elsewhere in this reading. b EBITDA = earnings before interest, taxes, depreciation, and amortization. c FFO = funds from operations, defined as EBITDA minus net interest expense minus current tax expense (plus or minus all applicable adjustments). d CFO = cash flow from operations. e EBIT = earnings before interest and taxes. f Capital = debt plus noncurrent deferred taxes plus equity (plus or minus all applicable adjustments). Source: Based on data from Standard Poor’s Corporate Methodology: Ratios And Adjustments (2013). This represents the last updated version at the time of publication. 19 Concepts in this paragraph are based on Standard Poor’s General Criteria: Principles of Credit Ratings (2011). This represents the last updated version at the time of publication. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 252. Reading 20 ■ Financial Analysis Techniques 234 17.2 Historical Research on Ratios in Credit Analysis A great deal of academic and practitioner research has focused on determining which ratios are useful in assessing the credit risk of a company, including the risk of bankruptcy. One of the earliest studies examined individual ratios to assess their ability to predict failure of a company up to five years in advance. Beaver (1967) found that six ratios could correctly predict company failure one year in advance 90 percent of the time and five years in advance at least 65 percent of the time. The ratios found effective by Beaver were cash flow to total debt, ROA, total debt to total assets, working capital to total assets, the current ratio, and the no- credit interval ratio (the length of time a company could go without borrowing). Altman (1968) and Altman, Haldeman, and Narayanan (1977) found that financial ratios could be combined in an effective model for predicting bankruptcy. Altman’s initial work involved creation of a Z-score that was able to correctly predict financial distress. The Z-score was computed as Z = 1.2 × (Current assets – Current liabilities)/Total assets + 1.4 × (Retained earnings/Total assets) + 3.3 × (EBIT/Total assets) + 0.6 × (Market value of stock/Book value of liabilities) + 1.0 × (Sales/Total assets) In his initial study, a Z-score of lower than 1.81 predicted failure and the model was able to accurately classify 95 percent of companies studied into a failure group and a non- failure group. The original model was designed for manufacturing companies. Subsequent refinements to the models allow for other company types and time peri- ods. Generally, the variables found to be useful in prediction include profitability ratios, coverage ratios, liquidity ratios, capitalization ratios, and earnings variability (Altman 2000). Similar research has been performed on the ability of ratios to predict bond ratings and bond yields. For example, Ederington, Yawtiz, and Roberts (1987) found that a small number of variables (total assets, interest coverage, leverage, variability of cov- erage, and subordination status) were effective in explaining bond yields. Similarly, Ederington (1986) found that nine variables in combination could correctly classify more than 70 percent of bond ratings. These variables included ROA, long- term debt to assets, interest coverage, cash flow to debt, variability of coverage and cash flow, total assets, and subordination status. These studies have shown that ratios are effective in evaluating credit risk, bond yields, and bond ratings. BUSINESS AND GEOGRAPHIC SEGMENTS f explain the requirements for segment reporting and calculate and interpret segment ratios Analysts often need to evaluate the performance underlying business segments (subsidiary companies, operating units, or simply operations in different geographic areas) to understand in detail the company as a whole. Although companies are not required to provide full financial statements for segments, they are required to provide segment information under both IFRS and US GAAP.20 18 20 IFRS 8, Operating Segments and FASB ASC Topic 280 [Segment Reporting]. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 253. Business and Geographic Segments 235 18.1 Segment Reporting Requirements An operating segment is defined as a component of a company: a) that engages in activities that may generate revenue and create expenses, including a start- up segment that has yet to earn revenues, b) whose results are regularly reviewed by the company’s senior management, and c) for which discrete financial information is available.21 A company must disclose separate information about any operating segment which meets certain quantitative criteria—namely, the segment constitutes 10 percent or more of the combined operating segments’ revenue, assets, or profit. (For purposes of determining whether a segment constitutes 10 percent or more of combined prof- its or losses, the criteria is expressed in terms of the absolute value of the segment’s profit or loss as a percentage of the greater of (i) the combined profits of all profitable segments and (ii) the absolute amount of the combined losses of all loss- making segments.) If, after applying these quantitative criteria, the combined revenue from external customers for all reportable segments combined is less than 75 percent of the total company revenue, the company must identify additional reportable segments until the 75 percent level is reached. Small segments might be combined as one if they share a substantial number of factors that define a business or geographical segment, or they might be combined with a similar significant reportable segment. Information about operating segments and businesses that are not reportable is combined in an “all other segments” category. Companies may internally report business results in a variety of ways (e.g., product segments and geographical segments). Companies identify the segments for external reporting purposes considering the definition of an operating segment and using factors such as what information is reported to the board of directors and whether a manager is responsible for each segment. Companies must disclose the factors used to identify reportable segments and the types of products and services sold by each reportable segment. For each reportable segment, the following should also be disclosed: ■ ■ a measure of profit or loss; ■ ■ a measure of total assets and liabilities22 (if these amounts are regularly reviewed by the company’s chief decision- making officer); ■ ■ segment revenue, distinguishing between revenue to external customers and revenue from other segments; ■ ■ interest revenue and interest expense; ■ ■ cost of property, plant, and equipment, and intangible assets acquired; ■ ■ depreciation and amortisation expense; ■ ■ other non- cash expenses; ■ ■ income tax expense or income; and ■ ■ share of the net profit or loss of an investment accounted for under the equity method. Companies also must provide a reconciliation between the information of reportable segments and the consolidated financial statements in terms of segment revenue, profit or loss, assets, and liabilities. 21 IFRS 8, Operating Segments, paragraph 5. 22 IFRS 8 and FASB ASC Topic 280 are largely converged. One notable difference is that US GAAP does not require disclosure of segment liabilities, while IFRS requires disclosure of segment liabilities if that information is regularly provided to the company’s “chief operating decision maker.” © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 254. Reading 20 ■ Financial Analysis Techniques 236 Another disclosure required is the company’s reliance on any single customer. If any single customer represents 10 percent or more of the company’s total revenues, the company must disclose that fact. From an analysts’ perspective, information about a concentrated customer base can be useful in assessing the risks faced by the company. 18.2 Segment Ratios Based on the segment information that companies are required to present, a variety of useful ratios can be computed, as shown in Exhibit 21. Exhibit 21 Definitions of Segment Ratios Segment Ratios Numerator Denominator Segment margin Segment profit (loss) Segment revenue Segment turnover Segment revenue Segment assets Segment ROA Segment profit (loss) Segment assets Segment debt ratio Segment liabilities Segment assets The segment margin measures the operating profitability of the segment relative to revenues, whereas the segment ROA measures the operating profitability relative to assets. Segment turnover measures the overall efficiency of the segment: how much revenue is generated per unit of assets. The segment debt ratio examines the level of liabilities (hence solvency) of the segment. Example 17 demonstrates the evaluation of segment ratios. EXAMPLE 17 The Evaluation of Segment Ratios The information contained in Exhibit 22 relates to the business segments of Groupe Danone for 2016 and 2017 in millions of euro. According to the compa- ny’s 2017 annual report the company operates in four business segments which are primarily evaluated on operating income and operating margin and in two geographic segments for which they also provide information on assets deployed. Evaluate the performance of the segments using the relative proportion of sales of each segment, the segment margins, segment ROA where available, and segment turnover where available. Exhibit 22 Group Danone Segment Disclosures (in € millions) 2016 2017 Business Segments Sales Recurring Operating Income Sales Recurring Operating Income Fresh Dairy Products – International 8,229 731 8,424 760 Fresh Dairy Products – North America 2,506 351 4,530 556 Specialized Nutrition 6,634 1,419 7,102 1,685 Waters 4,574 521 4,621 541 Group Total 21,944 3,022 24,677 3,542 © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 255. Business and Geographic Segments 237 2016 2017 Geographic Segments Sales Recurring Operating Income Non- Current Assets Sales Recurring Operating Income Non- Current Assets Europe and North America 10,933 1,842 11,532 13,193 2,048 22,517 Rest of World 11,011 1,180 9,307 11,484 1,495 8,433 Group Total 21,944 3,022 20,839 24,677 3,543 30,950 Source: Company’s 2017 Annual Report. Solution: 2016 2017 Business Segments Segment Revenue Percent Recurring Operating Margin Segment Revenue Percent Recurring Operating Margin Fresh Dairy Products – International 37.5% 8.9% 34.1% 9.0% Fresh Dairy Products – North America 11.4% 14.0% 18.4% 12.3% Specialized Nutrition 30.2% 21.4% 28.8% 23.7% Waters 20.8% 11.4% 18.7% 11.7% Group Total 100.0% 13.8% 100.0% 14.4% Business Segments 2017 % change in revenue Fresh Dairy Products – International 2.4% Fresh Dairy Products – North America 80.8% Specialized Nutrition 7.1% Waters 1.0% Group Total 12.5% The business segment analysis shows that the largest proportion of the com- pany’s revenues occurs in the Fresh Dairy Products – International segment: 37.5% and 34.1% of the total in 2016 and 2017, respectively. The greatest increase in relative revenue, however, came from the Fresh Dairy Products – North America segment which grew by 80.8% and increased from 11.4% of total reve- nues in 2016 to 18.4% of total revenues in 2017. Examination of the company’s full annual report reveals that Danone Group acquired a large health- oriented North American food company, Whitewave, in 2017. This caused the shift in the relative proportion of sales. The highest segment operating margin in both years comes from the Specialized Nutrition segment with operating margins of 21.4% in 2016 increasing to 23.7% in 2017. Margins increased slightly in the Fresh Dairy Products – International and Waters segments, while margins declined in Fresh Dairy Products – North America. The latter is likely due to costs associated with the Whitewave acquisition. Exhibit 22 (Continued) © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 256. Reading 20 ■ Financial Analysis Techniques 238 2016 2017 Geographic Segments Segment Revenue Percent Recurring Operating Margin Segment ROA Segment Asset Turnover Segment Revenue Percent Recurring Operating Margin Segment ROA Segment Asset Turnover Europe and North America 49.8% 16.8% 16.0% 0.9 53.5% 15.5% 9.1% 0.6 Rest of World 50.2% 10.7% 12.7% 1.2 46.5% 13.0% 17.7% 1.4 Group Total 100.0% 13.8% 14.5% 1.1 100.0% 14.4% 11.4% 0.8 As used in this table, ROA refers to operating income divided by ending assets, and Asset Turnover is defined as Revenue divided by non- current assets. The geographic segment analysis shows that the company’s sales are split roughly evenly between the two geographic segments. Operating margins were higher in the Europe and North America segment in both years but declined from 16.8% in 2016 to 15.5% in 2017, likely in connection with the North American acquisition of Whitewave. Operating margins in the rest of the world, however, increased in 2017. Segment return on assets and segment asset turn- over declined significantly for the Europe and North America segment in 2017, again largely due to the acquisition of Whitewave. An examination of the annual report disclosures reveals that the large increase in segment assets came from intangible assets (mainly goodwill) recorded in the Whitewave acquisition. In contrast, segment return on assets and turnover improved significantly in the Rest of World segment. MODEL BUILDING AND FORECASTING g describe how ratio analysis and other techniques can be used to model and forecast earnings Analysts often need to forecast future financial performance. For example, analysts’ EPS forecasts and related equity valuations are widely followed by Wall Street. Analysts use data about the economy, industry, and company in arriving at a company’s forecast. The results of an analyst’s financial analysis, including common- size and ratio analyses, are integral to this process, along with the judgment of the analysts. Based upon forecasts of growth and expected relationships among the financial statement data, the analyst can build a model (sometimes referred to as an “earnings model”) to forecast future performance. In addition to budgets, pro forma financial statements are widely used in financial forecasting within companies, especially for use by senior executives and boards of directors. Last but not least, these budgets and forecasts are also used in presentations to credit analysts and others in obtaining external financing. 19 © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 257. Summary 239 For example, based on a revenue forecast, an analyst may budget expenses based on expected common- size data. Forecasts of balance sheet and cash flow statements can be derived from expected ratio data, such as DSO. Forecasts are not limited to a single point estimate but should involve a range of possibilities. This can involve several techniques: ■ ■ Sensitivity analysis: Also known as “what if” analysis, sensitivity analysis shows the range of possible outcomes as specific assumptions are changed; this could, in turn, influence financing needs or investment in fixed assets. ■ ■ Scenario analysis: This type of analysis shows the changes in key financial quantities that result from given (economic) events, such as the loss of cus- tomers, the loss of a supply source, or a catastrophic event. If the list of events is mutually exclusive and exhaustive and the events can be assigned probabili- ties, the analyst can evaluate not only the range of outcomes but also standard statistical measures such as the mean and median value for various quantities of interest. ■ ■ Simulation: This is computer- generated sensitivity or scenario analysis based on probability models for the factors that drive outcomes. Each event or possi- ble outcome is assigned a probability. Multiple scenarios are then run using the probability factors assigned to the possible values of a variable. SUMMARY Financial analysis techniques, including common- size financial statements and ratio analysis, are useful in summarizing financial reporting data and evaluating the performance and financial position of a company. The results of financial analysis techniques provide important inputs into security valuation. Key facets of financial analysis include the following: ■ ■ Common- size financial statements and financial ratios remove the effect of size, allowing comparisons of a company with peer companies (cross- sectional analysis) and comparison of a company’s results over time (trend or time- series analysis). ■ ■ Activity ratios measure the efficiency of a company’s operations, such as col- lection of receivables or management of inventory. Major activity ratios include inventory turnover, days of inventory on hand, receivables turnover, days of sales outstanding, payables turnover, number of days of payables, working capi- tal turnover, fixed asset turnover, and total asset turnover. ■ ■ Liquidity ratios measure the ability of a company to meet short- term obliga- tions. Major liquidity ratios include the current ratio, quick ratio, cash ratio, and defensive interval ratio. ■ ■ Solvency ratios measure the ability of a company to meet long- term obligations. Major solvency ratios include debt ratios (including the debt- to- assets ratio, debt- to- capital ratio, debt- to- equity ratio, and financial leverage ratio) and cov- erage ratios (including interest coverage and fixed charge coverage). ■ ■ Profitability ratios measure the ability of a company to generate profits from revenue and assets. Major profitability ratios include return on sales ratios (including gross profit margin, operating profit margin, pretax margin, and net profit margin) and return on investment ratios (including operating ROA, ROA, return on total capital, ROE, and return on common equity). © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 258. Reading 20 ■ Financial Analysis Techniques 240 REFERENCES Abarbanell, J.S., and B. J. Bushee. 1997. “Fundamental Analysis, Future Earnings, and Stock Prices.” Journal of Accounting Research, vol. 35, no. 1:1–24. Abarbanell, J.S., and B.J. Bushee. 1998. “Abnormal Returns to a Fundamental Analysis Strategy.” Accounting Review, vol. 73, no. 1:19–46. Altman, E. 1968. “Financial Ratios, Discriminant Analysis and the Prediction of Corporate Bankruptcy.” Journal of Finance, vol. 23, no. 4:589–609. Altman, E.I. 2013, “Predicting Financial Distress of Companies: Revisiting the Z-Score and Zeta Models,” in Prokopczuk, Marcel; Brooks, Chris; Bell, Adrian R., Handbook of Research Methods and Applications in Empirical Finance: 428-456. Altman, E., R. Haldeman, and P. Narayanan. 1977. “Zeta Analysis: A New Model to Identify Bankruptcy Risk of Corporations.” Journal of Banking Finance, vol. 1, no. 1. Beaver, W. 1967. “Financial Ratios as Predictors of Failures.” Empirical Research in Accounting, selected studies supple- ment to Journal of Accounting Research, 4 (1). Benninga, Simon Z., and Oded H. Sarig. 1997. Corporate Finance: A Valuation Approach. New York: McGraw-Hill Publishing. Ederington, L.H. 1986. “Why Split Ratings Occur.” Financial Management, vol. 15, no. 1:37–47. Ederington, L.H., J.B. Yawitz, and B.E. Robert. 1987. “The Information Content of Bond Ratings.” Journal of Financial Research, vol. 10, no. 3:211–226. Lev, B., and S.R. Thiagarajan. 1993. “Fundamental Information Analysis.” Journal of Accounting Research, vol. 31, no. 2:190–215. Modigliani, F., and M. Miller. 1958. “The Cost of Capital, Corporation Finance and the Theory of Investment.” American Economic Review, vol. 48:261–298. Modigliani, F., and M. Miller. 1963. “Corporate Income Taxes and the Cost of Capital: A Correction.” American Economic Review, vol. 53:433–444. Ou, J.A., and S.H. Penman. 1989a. “Financial Statement Analysis and the Prediction of Stock Returns.” Journal of Accounting and Economics, vol. 11, no. 4:295–329. Ou, J.A., and S.H. Penman. 1989b. “Accounting Measurement, Price- Earnings Ratio, and the Information Content of Security Prices.” Journal of Accounting Research, vol. 27, no. Supplement:111–144. Piotroski, J.D. 2000. “Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers.” Journal of Accounting Research, vol. 38, no. Supplement:1–41. Robinson, T., and P. Munter. 2004. “Financial Reporting Quality: Red Flags and Accounting Warning Signs.” Commercial Lending Review, vol. 19, no. 1:2–15. van Greuning, H., and S. Brajovic Bratanovic. 2003. Analyzing and Managing Banking Risk: A Framework for Assessing Corporate Governance and Financial Risk. Washington, DC: World Bank. ■ ■ Ratios can also be combined and evaluated as a group to better understand how they fit together and how efficiency and leverage are tied to profitability. ■ ■ ROE can be analyzed as the product of the net profit margin, asset turnover, and financial leverage. This decomposition is sometimes referred to as DuPont analysis. ■ ■ Valuation ratios express the relation between the market value of a company or its equity (for example, price per share) and some fundamental financial metric (for example, earnings per share). ■ ■ Ratio analysis is useful in the selection and valuation of debt and equity securi- ties and is a part of the credit rating process. ■ ■ Ratios can also be computed for business segments to evaluate how units within a business are performing. ■ ■ The results of financial analysis provide valuable inputs into forecasts of future earnings and cash flow. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 259. Practice Problems 241 PRACTICE PROBLEMS 1 Comparison of a company’s financial results to other peer companies for the same time period is called: A technical analysis. B time-series analysis. C cross-sectional analysis. 2 In order to assess a company’s ability to fulfill its long- term obligations, an ana- lyst would most likely examine: A activity ratios. B liquidity ratios. C solvency ratios. 3 Which ratio would a company most likely use to measure its ability to meet short-term obligations? A Current ratio. B Payables turnover. C Gross profit margin. 4 Which of the following ratios would be most useful in determining a company’s ability to cover its lease and interest payments? A ROA. B Total asset turnover. C Fixed charge coverage. 5 An analyst is interested in assessing both the efficiency and liquidity of Spherion PLC. The analyst has collected the following data for Spherion: FY3 FY2 FY1 Days of inventory on hand 32 34 40 Days sales outstanding 28 25 23 Number of days of payables 40 35 35 Based on this data, what is the analyst least likely to conclude? A Inventory management has contributed to improved liquidity. B Management of payables has contributed to improved liquidity. C Management of receivables has contributed to improved liquidity. 6 An analyst is evaluating the solvency and liquidity of Apex Manufacturing and has collected the following data (in millions of euro): FY5 (€) FY4 (€) FY3 (€) Total debt 2,000 1,900 1,750 Total equity 4,000 4,500 5,000 Which of the following would be the analyst’s most likely conclusion? A The company is becoming increasingly less solvent, as evidenced by the increase in its debt- to- equity ratio from 0.35 to 0.50 from FY3 to FY5. © 2011 CFA Institute. All rights reserved. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 260. Reading 20 ■ Financial Analysis Techniques 242 B The company is becoming less liquid, as evidenced by the increase in its debt- to- equity ratio from 0.35 to 0.50 from FY3 to FY5. C The company is becoming increasingly more liquid, as evidenced by the increase in its debt- to- equity ratio from 0.35 to 0.50 from FY3 to FY5. 7 With regard to the data in Problem 6, what would be the most reasonable expla- nation of the financial data? A The decline in the company’s equity results from a decline in the market value of this company’s common shares. B The €250 increase in the company’s debt from FY3 to FY5 indicates that lenders are viewing the company as increasingly creditworthy. C The decline in the company’s equity indicates that the company may be incurring losses, paying dividends greater than income, and/or repurchasing shares. 8 An analyst observes a decrease in a company’s inventory turnover. Which of the following would most likely explain this trend? A The company installed a new inventory management system, allowing more efficient inventory management. B Due to problems with obsolescent inventory last year, the company wrote off a large amount of its inventory at the beginning of the period. C The company installed a new inventory management system but expe- rienced some operational difficulties resulting in duplicate orders being placed with suppliers. 9 Which of the following would best explain an increase in receivables turnover? A The company adopted new credit policies last year and began offering credit to customers with weak credit histories. B Due to problems with an error in its old credit scoring system, the company had accumulated a substantial amount of uncollectible accounts and wrote off a large amount of its receivables. C To match the terms offered by its closest competitor, the company adopted new payment terms now requiring net payment within 30 days rather than 15 days, which had been its previous requirement. 10 Brown Corporation had average days of sales outstanding of 19 days in the most recent fiscal year. Brown wants to improve its credit policies and collec- tion practices and decrease its collection period in the next fiscal year to match the industry average of 15 days. Credit sales in the most recent fiscal year were $300 million, and Brown expects credit sales to increase to $390 million in the next fiscal year. To achieve Brown’s goal of decreasing the collection period, the change in the average accounts receivable balance that must occur is closest to: A +$0.41 million. B –$0.41 million. C –$1.22 million. 11 An analyst observes the following data for two companies: Company A ($) Company B ($) Revenue 4,500 6,000 Net income 50 1,000 Current assets 40,000 60,000 Total assets 100,000 700,000 © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 261. Practice Problems 243 Company A ($) Company B ($) Current liabilities 10,000 50,000 Total debt 60,000 150,000 Shareholders’ equity 30,000 500,000 Which of the following choices best describes reasonable conclusions that the analyst might make about the two companies’ ability to pay their current and long-term obligations? A Company A’s current ratio of 4.0 indicates it is more liquid than Company B, whose current ratio is only 1.2, but Company B is more solvent, as indicated by its lower debt- to- equity ratio. B Company A’s current ratio of 0.25 indicates it is less liquid than Company B, whose current ratio is 0.83, and Company A is also less solvent, as indicated by a debt- to- equity ratio of 200 percent compared with Company B’s debt- to- equity ratio of only 30 percent. C Company A’s current ratio of 4.0 indicates it is more liquid than Company B, whose current ratio is only 1.2, and Company A is also more solvent, as indicated by a debt- to- equity ratio of 200 percent compared with Company B’s debt- to- equity ratio of only 30 percent. The following information relates to Questions 12–15 The data in Exhibit 1 appear in the five- year summary of a major international com- pany. A business combination with another major manufacturer took place in FY13. Exhibit 1 FY10 FY11 FY12 FY13 FY14 Financial statements GBP m GBP m GBP m GBP m GBP m Income statements Revenue 4,390 3,624 3,717 8,167 11,366 Profit before interest and taxation (EBIT) 844 700 704 933 1,579 Net interest payable –80 –54 –98 –163 –188 Taxation –186 –195 –208 –349 –579 Minorities –94 –99 –105 –125 –167 Profit for the year 484 352 293 296 645 Balance sheets Fixed assets 3,510 3,667 4,758 10,431 11,483 Current asset investments, cash at bank and in hand 316 218 290 561 682 Other current assets 558 514 643 1,258 1,634 Total assets 4,384 4,399 5,691 12,250 13,799 Interest bearing debt (long term) –602 –1,053 –1,535 –3,523 –3,707 (continued) © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 262. Reading 20 ■ Financial Analysis Techniques 244 FY10 FY11 FY12 FY13 FY14 Other creditors and provisions (current) –1,223 –1,054 –1,102 –2,377 –3,108 Total liabilities –1,825 –2,107 –2,637 –5,900 –6,815 Net assets 2,559 2,292 3,054 6,350 6,984 Shareholders’ funds 2,161 2,006 2,309 5,572 6,165 Equity minority interests 398 286 745 778 819 Capital employed 2,559 2,292 3,054 6,350 6,984 Cash flow Working capital movements –53 5 71 85 107 Net cash inflow from operating activities 864 859 975 1,568 2,292 12 The company’s total assets at year- end FY9 were GBP 3,500 million. Which of the following choices best describes reasonable conclusions an analyst might make about the company’s efficiency? A Comparing FY14 with FY10, the company’s efficiency improved, as indi- cated by a total asset turnover ratio of 0.86 compared with 0.64. B Comparing FY14 with FY10, the company’s efficiency deteriorated, as indi- cated by its current ratio. C Comparing FY14 with FY10, the company’s efficiency deteriorated due to asset growth faster than turnover revenue growth. 13 Which of the following choices best describes reasonable conclusions an analyst might make about the company’s solvency? A Comparing FY14 with FY10, the company’s solvency improved, as indicated by an increase in its debt- to- assets ratio from 0.14 to 0.27. B Comparing FY14 with FY10, the company’s solvency deteriorated, as indi- cated by a decrease in interest coverage from 10.6 to 8.4. C Comparing FY14 with FY10, the company’s solvency improved, as indicated by the growth in its profits to GBP 645 million. 14 Which of the following choices best describes reasonable conclusions an analyst might make about the company’s liquidity? A Comparing FY14 with FY10, the company’s liquidity improved, as indicated by an increase in its debt- to- assets ratio from 0.14 to 0.27. B Comparing FY14 with FY10, the company’s liquidity deteriorated, as indi- cated by a decrease in interest coverage from 10.6 to 8.4. C Comparing FY14 with FY10, the company’s liquidity improved, as indicated by an increase in its current ratio from 0.71 to 0.75. 15 Which of the following choices best describes reasonable conclusions an analyst might make about the company’s profitability? A Comparing FY14 with FY10, the company’s profitability improved, as indi- cated by an increase in its debt- to- assets ratio from 0.14 to 0.27. Exhibit 1 (Continued) © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 263. Practice Problems 245 B Comparing FY14 with FY10, the company’s profitability deteriorated, as indicated by a decrease in its net profit margin from 11.0 percent to 5.7 percent. C Comparing FY14 with FY10, the company’s profitability improved, as indi- cated by the growth in its shareholders’ equity to GBP 6,165 million. 16 Assuming no changes in other variables, which of the following would decrease ROA? A A decrease in the effective tax rate. B A decrease in interest expense. C An increase in average assets. 17 An analyst compiles the following data for a company: FY13 FY14 FY15 ROE 19.8% 20.0% 22.0% Return on total assets 8.1% 8.0% 7.9% Total asset turnover 2.0 2.0 2.1 Based only on the information above, the most appropriate conclusion is that, over the period FY13 to FY15, the company’s: A net profit margin and financial leverage have decreased. B net profit margin and financial leverage have increased. C net profit margin has decreased but its financial leverage has increased. 18 A decomposition of ROE for Integra SA is as follows: FY12 FY11 ROE 18.90% 18.90% Tax burden 0.70 0.75 Interest burden 0.90 0.90 EBIT margin 10.00% 10.00% 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 Profitability and the liquidity position both improved in FY12. B The higher average tax rate in FY12 offset the improvement in profitability, leaving ROE unchanged. C The higher average tax rate in FY12 offset the improvement in efficiency, leaving ROE unchanged. 19 A decomposition of ROE for Company A and Company B is as follows: Company A Company B FY15 FY14 FY15 FY14 ROE 26.46% 18.90% 26.33% 18.90% Tax burden 0.7 0.75 0.75 0.75 Interest burden 0.9 0.9 0.9 0.9 (continued) © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 264. Reading 20 ■ Financial Analysis Techniques 246 Company A Company B FY15 FY14 FY15 FY14 EBIT margin 7.00% 10.00% 13.00% 10.00% Asset turnover 1.5 1.4 1.5 1.4 Leverage 4 2 2 2 An analyst is most likely to conclude that: A Company A’s ROE is higher than Company B’s in FY15, and one explanation consistent with the data is that Company A may have purchased new, more efficient equipment. B Company A’s ROE is higher than Company B’s in FY15, and one explanation consistent with the data is that Company A has made a strategic shift to a product mix with higher profit margins. C The difference between the two companies’ ROE in FY15 is very small and Company A’s ROE remains similar to Company B’s ROE mainly due to Company A increasing its financial leverage. 20 What does the P/E ratio measure? A The “multiple” that the stock market places on a company’s EPS. B The relationship between dividends and market prices. C The earnings for one common share of stock. 21 A creditor most likely would consider a decrease in which of the following ratios to be positive news? A Interest coverage (times interest earned). B Debt-to-total assets. C Return on assets. 22 When developing forecasts, analysts should most likely: A develop possibilities relying exclusively on the results of financial analysis. B use the results of financial analysis, analysis of other information, and judgment. C aim to develop extremely precise forecasts using the results of financial analysis. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 265. Solutions 247 SOLUTIONS 1 C is correct. Cross- sectional analysis involves the comparison of companies with each other for the same time period. Technical analysis uses price and volume data as the basis for investment decisions. Time- series or trend analysis is the comparison of financial data across different time periods. 2 C is correct. Solvency ratios are used to evaluate the ability of a company to meet its long- term obligations. An analyst is more likely to use activity ratios to evaluate how efficiently a company uses its assets. An analyst is more likely to use liquidity ratios to evaluate the ability of a company to meet its short- term obligations. 3 A is correct. The current ratio is a liquidity ratio. It compares the net amount of current assets expected to be converted into cash within the year with liabilities falling due in the same period. A current ratio of 1.0 would indicate that the company would have just enough current assets to pay current liabilities. 4 C is correct. The fixed charge coverage ratio is a coverage ratio that relates known fixed charges or obligations to a measure of operating profit or cash flow generated by the company. Coverage ratios, a category of solvency ratios, mea- sure the ability of a company to cover its payments related to debt and leases. 5 C is correct. The analyst is unlikely to reach the conclusion given in Statement C because days of sales outstanding increased from 23 days in FY1 to 25 days in FY2 to 28 days in FY3, indicating that the time required to collect receivables has increased over the period. This is a negative factor for Spherion’s liquidity. By contrast, days of inventory on hand dropped over the period FY1 to FY3, a positive for liquidity. The company’s increase in days payable, from 35 days to 40 days, shortened its cash conversion cycle, thus also contributing to improved liquidity. 6 A is correct. The company is becoming increasingly less solvent, as evidenced by its debt- to- equity ratio increasing from 0.35 to 0.50 from FY3 to FY5. The amount of a company’s debt and equity do not provide direct information about the company’s liquidity position. Debt to equity: FY5: 2,000/4,000 = 0.5000 FY4: 1,900/4,500 = 0.4222 FY3: 1,750/5,000 = 0.3500 7 C is correct. The decline in the company’s equity indicates that the company may be incurring losses, paying dividends greater than income, or repurchasing shares. Recall that Beginning equity + New shares issuance – Shares repur- chased + Comprehensive income – Dividends = Ending equity. The book value of a company’s equity is not affected by changes in the market value of its common stock. An increased amount of lending does not necessarily indicate that lenders view a company as increasingly creditworthy. Creditworthiness is not evaluated based on how much a company has increased its debt but rather on its willingness and ability to pay its obligations. (Its financial strength is indicated by its solvency, liquidity, profitability, efficiency, and other aspects of credit analysis.) 8 C is correct. The company’s problems with its inventory management system causing duplicate orders would likely result in a higher amount of inventory and would, therefore, result in a decrease in inventory turnover. A more efficient inventory management system and a write off of inventory at the beginning of © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 266. Reading 20 ■ Financial Analysis Techniques 248 the period would both likely decrease the average inventory for the period (the denominator of the inventory turnover ratio), thus increasing the ratio rather than decreasing it. 9 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 receiv- ables turnover. Longer payment terms would likely increase the average amount of accounts receivable and thus decrease receivables turnover. 10 A is correct. The average accounts receivable balances (actual and desired) must be calculated to determine the desired change. The average accounts receivable balance can be calculated as an average day’s credit sales times the DSO. For the most recent fiscal year, the average accounts receivable balance is $15.62 million [= ($300,000,000/365) × 19]. The desired average accounts receivable balance for the next fiscal year is $16.03 million (= ($390,000,000/365) × 15). This is an increase of $0.41 million (= 16.03 million – 15.62 million). An alternative approach is to calculate the turnover and divide sales by turnover to determine the average accounts receivable balance. Turnover equals 365 divided by DSO. Turnover is 19.21 (= 365/19) for the most recent fiscal year and is targeted to be 24.33 (= 365/15) for the next fiscal year. The average accounts receivable balances are $15.62 million (= $300,000,000/19.21), and $16.03 million (= $390,000,000/24.33). The change is an increase in receivables of $0.41 million 11 A is correct. Company A’s current ratio of 4.0 (= $40,000/$10,000) indi- cates it is more liquid than Company B, whose current ratio is only 1.2 (= $60,000/$50,000). Company B is more solvent, as indicated by its lower debt- to- equity ratio of 30 percent (= $150,000/$500,000) compared with Company A’s debt- to- equity ratio of 200 percent (= $60,000/$30,000). 12 C is correct. The company’s efficiency deteriorated, as indicated by the decline in its total asset turnover ratio from 1.11 {= 4,390/[(4,384 + 3,500)/2]} for FY10 to 0.87 {= 11,366/[(12,250 + 13,799)/2]} for FY14. The decline in the total asset turnover ratio resulted from an increase in average total assets from GBP3,942 [= (4,384 + 3,500)/2] for FY10 to GBP13,024.5 for FY14, an increase of 230 percent, compared with an increase in revenue from GBP4,390 in FY10 to GBP11,366 in FY14, an increase of only 159 percent. The current ratio is not an indicator of efficiency. 13 B is correct. Comparing FY14 with FY10, the company’s solvency deteriorated, as indicated by a decrease in interest coverage from 10.6 (= 844/80) in FY10 to 8.4 (= 1,579/188) in FY14. The debt- to- asset ratio increased from 0.14 (= 602/4,384) in FY10 to 0.27 (= 3,707/13,799) in FY14. This is also indicative of deteriorating solvency. In isolation, the amount of profits does not provide enough information to assess solvency. 14 C is correct. Comparing FY14 with FY10, the company’s liquidity improved, as indicated by an increase in its current ratio from 0.71 [= (316 + 558)/1,223] in FY10 to 0.75 [= (682 + 1,634)/3,108] in FY14. Note, however, comparing only current investments with the level of current liabilities shows a decline in liquidity from 0.26 (= 316/1,223) in FY10 to 0.22 (= 682/3,108) in FY14. Debt- to- assets ratio and interest coverage are measures of solvency not liquidity. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 267. Solutions 249 15 B is correct. Comparing FY14 with FY10, the company’s profitability deterio- rated, as indicated by a decrease in its net profit margin from 11.0 percent (= 484/4,390) to 5.7 percent (= 645/11,366). Debt- to- assets ratio is a measure of solvency not an indicator of profitability. Growth in shareholders’ equity, in isolation, does not provide enough information to assess profitability. 16 C is correct. Assuming no changes in other variables, an increase in average assets (an increase in the denominator) would decrease ROA. A decrease in either the effective tax rate or interest expense, assuming no changes in other variables, would increase ROA. 17 C is correct. The company’s net profit margin has decreased and its financial leverage has increased. ROA = Net profit margin × Total asset turnover. ROA decreased over the period despite the increase in total asset turnover; therefore, the net profit margin must have decreased. ROE = Return on assets × Financial leverage. ROE increased over the period despite the drop in ROA; therefore, financial leverage must have increased. 18 C is correct. The increase in the average tax rate in FY12, 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 FY12 and no information is given on liquidity. 19 C is correct. The difference between the two companies’ ROE in 2010 is very small and is mainly the result of Company A’s increase in its financial leverage, indicated by the increase in its Assets/Equity ratio from 2 to 4. The impact of efficiency on ROE is identical for the two companies, as indicated by both com- panies’ asset turnover ratios of 1.5. Furthermore, if Company A had purchased newer equipment to replace older, depreciated equipment, then the company’s asset turnover ratio (computed as sales/assets) would have declined, assuming constant sales. Company A has experienced a significant decline in its operating margin, from 10 percent to 7 percent which, all else equal, would not suggest that it is selling more products with higher profit margins. 20 A is correct. The P/E ratio measures the “multiple” that the stock market places on a company’s EPS. 21 B is correct. In general, a creditor would consider a decrease in debt to total assets as positive news. A higher level of debt in a company’s capital structure increases the risk of default and will, in general, result in higher borrowing costs for the company to compensate lenders for assuming greater credit risk. A decrease in either interest coverage or return on assets is likely to be considered negative news. 22 B is correct. The results of an analyst’s financial analysis are integral to the pro- cess 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. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 268. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 269. Financial Statement Analysis (3) This study session examines financial reporting for specific categories of assets and liabilities. Inventories, long- lived assets, income taxes, and non- current liabilities are examined in greater detail because of their effect on financial statements and reported measures of profitability, liquidity, and solvency. For these items in particular, the analyst should be attentive to chosen accounting treatment, corresponding effect on reported performance, and the potential for financial statement manipulation. READING ASSIGNMENTS Reading 21 Inventories by Michael Broihahn, CPA, CIA, CFA Reading 22 Long-lived Assets by Elaine Henry, PhD, CFA, and Elizabeth A. Gordon, PhD, MBA, CPA Reading 23 Income Taxes by Elbie Louw, PhD, CFA, CIPM, and Michael A. Broihahn, CPA, CIA, CFA Reading 24 Non-current (Long-term) Liabilities by Elizabeth A. Gordon, PhD, MBA, CPA, and Elaine Henry, PhD, CFA F inancial S tatement A nalysis S T U D Y S E S S I O N 7 © 2021 CFA Institute. All rights reserved. Note: Changes in accounting standards as well as new rulings and/or pronouncements issued after the publication of the readings on financial reporting and analysis may cause some of the information in these readings to become dated. Candidates are not responsible for anything that occurs after the readings were published. In addition, candidates are expected to be familiar with the analytical frameworks contained in the readings, as well as the implications of alternative accounting methods for financial analysis and valuation discussed in the readings. Candidates are also responsible for the content of accounting standards, but not for the actual reference numbers. Finally, candidates should be aware that certain ratios may be defined and calculated differently. When alternative ratio definitions exist and no specific definition is given, candidates should use the ratio definitions emphasized in the readings. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 270. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 271. Inventories by Michael A. Broihahn, CPA, CIA, CFA Michael A. Broihahn, CPA, CIA, CFA, is at Barry University (USA). LEARNING OUTCOMES Mastery The candidate should be able to: a. contrast costs included in inventories and costs recognised as expenses in the period in which they are incurred; b. describe different inventory valuation methods (cost formulas); c. calculate and compare cost of sales, gross profit, and ending inventory using different inventory valuation methods and using perpetual and periodic inventory systems; d. calculate and explain how inflation and deflation of inventory costs affect the financial statements and ratios of companies that use different inventory valuation methods; e. explain LIFO reserve and LIFO liquidation and their effects on financial statements and ratios; f. demonstrate the conversion of a company’s reported financial statements from LIFO to FIFO for purposes of comparison; g. describe the measurement of inventory at the lower of cost and net realisable value; h. describe implications of valuing inventory at net realisable value for financial statements and ratios; i. describe the financial statement presentation of and disclosures relating to inventories; j. explain issues that analysts should consider when examining a company’s inventory disclosures and other sources of information; k. calculate and compare ratios of companies, including companies that use different inventory methods; l. analyze and compare the financial statements of companies, including companies that use different inventory methods. R E A D I N G 21 © 2019 CFA Institute. All rights reserved. Note: Changes in accounting standards as well as new rulings and/or pronouncements issued after the publication of the readings on financial reporting and analysis may cause some of the information in these readings to become dated. Candidates are not responsible for anything that occurs after the readings were published. In addition, candidates are expected to be familiar with the analytical frameworks contained in the readings, as well as the implications of alternative accounting methods for financial analysis and valuation discussed in the readings. Candidates are also responsible for the content of accounting standards, but not for the actual reference numbers. Finally, candidates should be aware that certain ratios may be defined and calculated differently. When alternative ratio definitions exist and no specific definition is given, candidates should use the ratio definitions emphasized in the readings. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 272. Reading 21 ■ Inventories 254 INTRODUCTION Merchandising and manufacturing companies generate revenues and profits through the sale of inventory. Further, inventory may represent a significant asset on these companies’ balance sheets. Merchandisers (wholesalers and retailers) purchase inven- tory, ready for sale, from manufacturers and thus account for only one type of inven- tory—finished goods inventory. Manufacturers, however, purchase raw materials from suppliers and then add value by transforming the raw materials into finished goods. They typically classify inventory into three different categories:1 raw materials, work in progress,2 and finished goods. Work- in- progress inventories have started the conversion process from raw materials but are not yet finished goods ready for sale. Manufacturers may report either the separate carrying amounts of their raw materi- als, work- in- progress, and finished goods inventories on the balance sheet or simply the total inventory amount. If the latter approach is used, the company must then disclose the carrying amounts of its raw materials, work- in- progress, and finished goods inventories in a footnote to the financial statements. Inventories and cost of sales (cost of goods sold)3 are significant items in the finan- cial statements of many companies. Comparing the performance of these companies is challenging because of the allowable choices for valuing inventories: Differences in the choice of inventory valuation method can result in significantly different amounts being assigned to inventory and cost of sales. Financial statement analysis would be much easier if all companies used the same inventory valuation method or if inventory price levels remained constant over time. If there was no inflation or deflation with respect to inventory costs and thus unit costs were unchanged, the choice of inventory valuation method would be irrelevant. However, inventory price levels typically do change over time. International Financial Reporting Standards (IFRS) permit the assignment of inven- tory costs (costs of goods available for sale) to inventories and cost of sales by three cost formulas: specific identification, first- in, first- out (FIFO), and weighted average cost.4 US generally accepted accounting principles (US GAAP) allow the same three inventory valuation methods, referred to as cost flow assumptions in US GAAP, but also include a fourth method called last- in, first- out (LIFO).5 The choice of inventory valuation method affects the allocation of the cost of goods available for sale to ending inventory and cost of sales. Analysts must understand the various inventory valuation methods and the related impact on financial statements and financial ratios in order to evaluate a company’s performance over time and relative to industry peers. The company’s financial statements and related notes provide important information that the analyst can use in assessing the impact of the choice of inventory valuation method on financial statements and financial ratios. This reading is organized as follows: Section 2 discusses the costs that are included in inventory and the costs that are recognised as expenses in the period in which they are incurred. Sections 3–6 describe inventory valuation methods and compare the measurement of ending inventory, cost of sales and gross profit under each method, and when using periodic versus perpetual inventory systems. Sections 7 and 8 describe the LIFO method, LIFO reserve, and effects of LIFO liquidations, and demonstrate the adjustments required to compare a company that uses LIFO with one that uses 1 1 Other classifications are possible. Inventory classifications should be appropriate to the entity. 2 This category is commonly referred to as work in process under US GAAP. 3 Typically, cost of sales is IFRS terminology and cost of goods sold is US GAAP terminology. 4 International Accounting Standard (IAS) 2 [Inventories]. 5 Financial Accounting Standards Board Accounting Standards Codification (FASB ASC) Topic 330 [Inventory]. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 273. Cost of inventories 255 FIFO. Section 9 describes the financial statement effects of a change in inventory valuation method. Section 10 discusses the measurement and reporting of inventory when its value changes. Sections 11–13 describe the presentation of inventories on the financial statements and related disclosures, discuss inventory ratios and their interpretation, and show examples of financial analysis with respect to inventories. A summary and practice problems conclude the reading. COST OF INVENTORIES a contrast costs included in inventories and costs recognised as expenses in the period in which they are incurred Under IFRS, the costs to include in inventories are “all costs of purchase, costs of conversion, and other costs incurred in bringing the inventories to their present loca- tion and condition.”6 The costs of purchase include the purchase price, import and tax- related duties, transport, insurance during transport, handling, and other costs directly attributable to the acquisition of finished goods, materials, and services. Trade discounts, rebates, and similar items reduce the price paid and the costs of purchase. The costs of conversion include costs directly related to the units produced, such as direct labour, and fixed and variable overhead costs.7 Including these product- related costs in inventory (i.e., as an asset) means that they will not be recognised as an expense (i.e., as cost of sales) on the income statement until the inventory is sold. US GAAP provide a similar description of the costs to be included in inventory.8 Both IFRS and US GAAP exclude the following costs from inventory: abnormal costs incurred as a result of waste of materials, labour or other production conver- sion inputs, any storage costs (unless required as part of the production process), and all administrative overhead and selling costs. These excluded costs are treated as expenses and recognised on the income statement in the period in which they are incurred. Including costs in inventory defers their recognition as an expense on the income statement until the inventory is sold. Therefore, including costs in inventory that should be expensed will overstate profitability on the income statement (because of the inappropriate deferral of cost recognition) and create an overstated inventory value on the balance sheet. EXAMPLE 1 Treatment of Inventory- Related Costs Acme Enterprises, a hypothetical company that prepares its financial statements in accordance with IFRS, manufactures tables. In 2018, the factory produced 900,000 finished tables and scrapped 1,000 tables. For the finished tables, raw material costs were €9 million, direct labour conversion costs were €18 million, and production overhead costs were €1.8 million. The 1,000 scrapped tables (attributable to abnormal waste) had a total production cost of €30,000 (€10,000 raw material costs and €20,000 conversion costs; these costs are not included in 2 6 International Accounting Standard (IAS) 2 [Inventories]. 7 Fixed production overhead costs (depreciation, factory maintenance, and factory management and administration) represent indirect costs of production that remain relatively constant regardless of the volume of production. Variable production overhead costs are indirect production costs (indirect labour and materials) that vary with the volume of production. 8 FASB Accounting Standards Codification™ (ASC) Topic 330 [Inventory]. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 274. Reading 21 ■ Inventories 256 the €9 million raw material and €19.8 million total conversion costs of the finished tables). During the year, Acme spent €1 million for freight delivery charges on raw materials and €500,000 for storing finished goods inventory. Acme does not have any work- in- progress inventory at the end of the year. 1 What costs should be included in inventory in 2018? 2 What costs should be expensed in 2018? Solution to 1: Total inventory costs for 2018 are as follows: Raw materials €9,000,000 Direct labour 18,000,000 Production overhead 1,800,000 Transportation for raw materials 1,000,000 Total inventory costs €29,800,000 Solution to 2: Total costs that should be expensed (not included in inventory) are as follows: Abnormal waste €30,000 Storage of finished goods inventory 500,000 Total €530,000 INVENTORY VALUATION METHODS b describe different inventory valuation methods (cost formulas) Generally, inventory purchase costs and manufacturing conversion costs change over time. As a result, the allocation of total inventory costs (i.e., cost of goods available for sale) between cost of sales on the income statement and inventory on the balance sheet will vary depending on the inventory valuation method used by the company. As mentioned in the introduction, inventory valuation methods are referred to as cost formulas and cost flow assumptions under IFRS and US GAAP, respectively. If the choice of method results in more cost being allocated to cost of sales and less cost being allocated to inventory than would be the case with other methods, the chosen method will cause, in the current year, reported gross profit, net income, and inventory carrying amount to be lower than if alternative methods had been used. Accounting for inventory, and consequently the allocation of costs, thus has a direct impact on financial statements and their comparability. Both IFRS and US GAAP allow companies to use the following inventory valuation methods: specific identification; first- in, first- out (FIFO); and weighted average cost. US GAAP allow companies to use an additional method: last- in, first- out (LIFO). A company must use the same inventory valuation method for all items that have a similar nature and use. For items with a different nature or use, a different inventory 3 © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 275. Inventory valuation methods 257 valuation method can be used.9 When items are sold, the carrying amount of the inventory is recognised as an expense (cost of sales) according to the cost formula (cost flow assumption) in use. Specific identification is used for inventory items that are not ordinarily inter- changeable, whereas FIFO, weighted average cost, and LIFO are typically used when there are large numbers of interchangeable items in inventory. Specific identification matches the actual historical costs of the specific inventory items to their physical flow; the costs remain in inventory until the actual identifiable inventory is sold. FIFO, weighted average cost, and LIFO are based on cost flow assumptions. Under these methods, companies must make certain assumptions about which goods are sold and which goods remain in ending inventory. As a result, the allocation of costs to the units sold and to the units in ending inventory can be different from the physical movement of the items. The choice of inventory valuation method would be largely irrelevant if inventory costs remained constant or relatively constant over time. Given relatively constant prices, the allocation of costs between cost of goods sold and ending inventory would be very similar under each of the four methods. Given changing price levels, however, the choice of inventory valuation method can have a significant impact on the amount of reported cost of sales and inventory. And the reported cost of sales and inventory balances affect other items, such as gross profit, net income, current assets, and total assets. 3.1 Specific Identification The specific identification method is used for inventory items that are not ordinarily interchangeable and for goods that have been produced and segregated for specific projects. This method is also commonly used for expensive goods that are uniquely identifiable, such as precious gemstones. Under this method, the cost of sales and the cost of ending inventory reflect the actual costs incurred to purchase (or manu- facture) the items specifically identified as sold and the items specifically identified as remaining in inventory. Therefore, this method matches the physical flow of the specific items sold and remaining in inventory to their actual cost. 3.2 First-In, First-Out (FIFO) FIFO assumes that the oldest goods purchased (or manufactured) are sold first and the newest goods purchased (or manufactured) remain in ending inventory. In other words, the first units included in inventory are assumed to be the first units sold from inventory. Therefore, cost of sales reflects the cost of goods in beginning inventory plus the cost of items purchased (or manufactured) earliest in the accounting period, and the value of ending inventory reflects the costs of goods purchased (or manufactured) more recently. In periods of rising prices, the costs assigned to the units in ending inventory are higher than the costs assigned to the units sold. Conversely, in periods of declining prices, the costs assigned to the units in ending inventory are lower than the costs assigned to the units sold. 9 For example, if a clothing manufacturer produces both a retail line and one- of- a-kind designer garments, the retail line might be valued using FIFO and the designer garments using specific identification. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 276. Reading 21 ■ Inventories 258 3.3 Weighted Average Cost Weighted average cost assigns the average cost of the goods available for sale (beginning inventory plus purchase, conversion, and other costs) during the accounting period to the units that are sold as well as to the units in ending inventory. In an accounting period, the weighted average cost per unit is calculated as the total cost of the units available for sale divided by the total number of units available for sale in the period (Total cost of goods available for sale/Total units available for sale). 3.4 Last-In, First-Out (LIFO) LIFO is permitted only under US GAAP. This method assumes that the newest goods purchased (or manufactured) are sold first and the oldest goods purchased (or manu- factured), including beginning inventory, remain in ending inventory. In other words, the last units included in inventory are assumed to be the first units sold from inven- tory. Therefore, cost of sales reflects the cost of goods purchased (or manufactured) more recently, and the value of ending inventory reflects the cost of older goods. In periods of rising prices, the costs assigned to the units in ending inventory are lower than the costs assigned to the units sold. Conversely, in periods of declining prices, the costs assigned to the units in ending inventory are higher than the costs assigned to the units sold. CALCULATIONS OF COST OF SALES, GROSS PROFIT, AND ENDING INVENTORY c calculate and compare cost of sales, gross profit, and ending inventory using dif- ferent inventory valuation methods and using perpetual and periodic inventory systems In periods of changing prices, the allocation of total inventory costs (i.e., cost of goods available for sale) between cost of sales on the income statement and inventory on the balance sheet will vary depending on the inventory valuation method used by the company. The following example illustrates how cost of sales, gross profit, and ending inventory differ based on the choice of inventory valuation method. EXAMPLE 2 Inventory Cost Flow Illustration for the Specific Identification, Weighted Average Cost, FIFO, and LIFO Methods Global Sales, Inc. (GSI) is a hypothetical Dubai- based distributor of consumer products, including bars of luxury soap. The soap is sold by the kilogram. GSI began operations in 2018, during which it purchased and received initially 100,000 kg of soap at 110 dirham (AED)/kg, then 200,000 kg of soap at 100 AED/kg, and finally 300,000 kg of soap at 90 AED/kg. GSI sold 520,000 kg of soap at 240 AED/kg. GSI stores its soap in its warehouse so that soap from each shipment received is readily identifiable. During 2018, the entire 100,000 kg from the first 4 © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 277. Calculations of cost of sales, gross profit, and ending inventory 259 shipment received, 180,000 kg of the second shipment received, and 240,000 kg of the final shipment received was sent to customers. Answers to the following questions should be rounded to the nearest 1,000 AED. 1 What are the reported cost of sales, gross profit, and ending inventory balances for 2018 under the specific identification method? 2 What are the reported cost of sales, gross profit, and ending inventory balances for 2018 under the weighted average cost method? 3 What are the reported cost of sales, gross profit, and ending inventory balances for 2018 under the FIFO method? 4 What are the reported cost of sales, gross profit, and ending inventory balances for 2018 under the LIFO method? Solution to 1: Under the specific identification method, the physical flow of the specific inven- tory items sold is matched to their actual cost. Sales = 520,000 × 240 = 124,800,000 AED Cost of sales = (100,000 × 110) + (180,000 × 100) + (240,000 × 90) = 50,600,000 AED Gross profit = 124,800,000 – 50,600,000 = 74,200,000 AED Ending inventory = (20,000 × 100) + (60,000 × 90) = 7,400,000 AED Note that in spite of the segregation of inventory within the warehouse, it would be inappropriate to use specific identification for this inventory of interchange- able items. The use of specific identification could potentially result in earnings manipulation through the shipment decision. Solution to 2: Under the weighted average cost method, costs are allocated to cost of sales and ending inventory by using a weighted average mix of the actual costs incurred for all inventory items. The weighted average cost per unit is determined by dividing the total cost of goods available for sale by the number of units available for sale. Weighted average cost = [(100,000 × 110) + (200,000 × 100) + (300,000 × 90)]/600,000 = 96.667 AED/kg Sales = 520,000 × 240 = 124,800,000 AED Cost of sales = 520,000 × 96.667 = 50,267,000 AED Gross profit = 124,800,000 – 50,267,000 = 74,533,000 AED Ending inventory = 80,000 × 96.667 = 7,733,360 AED Solution to 3: Under the FIFO method, the oldest inventory units acquired are assumed to be the first units sold. Ending inventory, therefore, is assumed to consist of those inventory units most recently acquired. Sales = 520,000 × 240 = 124,800,000 AED Cost of sales = (100,000 × 110) + (200,000 × 100) + (220,000 × 90) = 50,800,000 AED Gross profit = 124,800,000 – 50,800,000 = 74,000,000 AED Ending inventory = 80,000 × 90 = 7,200,000 AED © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 278. Reading 21 ■ Inventories 260 Solution to 4: Under the LIFO method, the newest inventory units acquired are assumed to be the first units sold. Ending inventory, therefore, is assumed to consist of the oldest inventory units. Sales = 520,000 × 240 = 124,800,000 AED Cost of sales = (20,000 × 110) + (200,000 × 100) + (300,000 × 90) = 49,200,000 AED Gross profit = 124,800,000 – 49,200,000 = 75,600,000 AED Ending inventory = 80,000 × 110 = 8,800,000 AED The following table (in thousands of AED) summarizes the cost of sales, the ending inventory, and the cost of goods available for sale that were calculated for each of the four inventory valuation methods. Note that in the first year of operation, the total cost of goods available for sale is the same under all four methods. Subsequently, the cost of goods available for sale will typically differ because beginning inventories will differ. Also shown is the gross profit figure for each of the four methods. Because the cost of a kg of soap declined over the period, LIFO had the highest ending inventory amount, the lowest cost of sales, and the highest gross profit. FIFO had the lowest ending inventory amount, the highest cost of sales, and the lowest gross profit. Inventory Valuation Method Specific ID Weighted Average Cost FIFO LIFO Cost of sales 50,600 50,267 50,800 49,200 Ending inventory 7,400 7,733 7,200 8,800 Total cost of goods available for sale 58,000 58,000 58,000 58,000 Gross profit 74,200 74,533 74,000 75,600 PERIODIC VERSUS PERPETUAL INVENTORY SYSTEMS c calculate and compare cost of sales, gross profit, and ending inventory using dif- ferent inventory valuation methods and using perpetual and periodic inventory systems Companies typically record changes to inventory using either a periodic inventory system or a perpetual inventory system. Under a periodic inventory system, inventory values and costs of sales are determined at the end of an accounting period. Purchases are recorded in a purchases account. The total of purchases and beginning inventory is the amount of goods available for sale during the period. The ending inventory amount is subtracted from the goods available for sale to arrive at the cost of sales. The quantity of goods in ending inventory is usually obtained or verified through a physical count of the units in inventory. Under a perpetual inventory system, inven- tory values and cost of sales are continuously updated to reflect purchases and sales. Under either system, the allocation of goods available for sale to cost of sales and ending inventory is the same if the inventory valuation method used is either specific identification or FIFO. This is not generally true for the weighted average cost method. 5 © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 279. Periodic versus perpetual inventory systems 261 Under a periodic inventory system, the amount of cost of goods available for sale allocated to cost of sales and ending inventory may be quite different using the FIFO method compared to the weighted average cost method. Under a perpetual inventory system, inventory values and cost of sales are continuously updated to reflect purchases and sales. As a result, the amount of cost of goods available for sale allocated to cost of sales and ending inventory is similar under the FIFO and weighted average cost methods. Because of lack of disclosure and the dominance of perpetual inventory systems, analysts typically do not make adjustments when comparing a company using the weighted average cost method with a company using the FIFO method. Using the LIFO method, the periodic and perpetual inventory systems will generally result in different allocations to cost of sales and ending inventory. Under either a per- petual or periodic inventory system, the use of the LIFO method will generally result in significantly different allocations to cost of sales and ending inventory compared to other inventory valuation methods. When inventory costs are increasing and inventory unit levels are stable or increasing, using the LIFO method will result in higher cost of sales and lower inventory carrying amounts than using the FIFO method. The higher cost of sales under LIFO will result in lower gross profit, operating income, income before taxes, and net income. Income tax expense will be lower under LIFO, causing the company’s net operating cash flow to be higher. On the balance sheet, the lower inventory carrying amount will result in lower reported current assets, working capital, and total assets. Analysts must carefully assess the financial statement implications of the choice of inventory valuation method when comparing companies that use the LIFO method with companies that use the FIFO method. Example 3 illustrates the impact of the choice of system under LIFO. EXAMPLE 3 Perpetual versus Periodic Inventory Systems If GSI (the company in Example 2) had used a perpetual inventory system, the timing of purchases and sales would affect the amounts of cost of sales and inventory. Below is a record of the purchases, sales, and quantity of inventory on hand after the transaction in 2018. Date Purchased Sold Inventory on Hand 5 January 100,000 kg at 110 AED/kg 100,000 kg 1 February 80,000 kg at 240 AED/kg 20,000 kg 8 March 200,000 kg at 100 AED/kg 220,000 kg 6 April 100,000 kg at 240 AED/kg 120,000 kg 23 May 60,000 kg at 240 AED/kg 60,000 kg 7 July 40,000 kg at 240 AED/kg 20,000 kg 2 August 300,000 kg at 90 AED/kg 320,000 kg 5 September 70,000 kg at 240 AED/kg 250,000 kg 17 November 90,000 kg at 240 AED/kg 160,000 kg 8 December 80,000 kg at 240 AED/kg 80,000 kg Total goods available for sale = 58,000,000 AED Total sales = 124,800,000 AED The amounts for total goods available for sale and sales are the same under either the perpetual or periodic system in this first year of operation. The carry- ing amount of the ending inventory, however, may differ because the perpetual © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 280. Reading 21 ■ Inventories 262 system will apply LIFO continuously throughout the year. Under the periodic system, it was assumed that the ending inventory was composed of 80,000 units of the oldest inventory, which cost 110 AED/kg. What are the ending inventory, cost of sales, and gross profit amounts using the perpetual system and the LIFO method? How do these compare with the amounts using the periodic system and the LIFO method, as in Example 2? Solution: The carrying amounts of the inventory at the different time points using the perpetual inventory system are as follows: Date Quantity on Hand Quantities and Cost Carrying Amount 5 January 100,000 kg 100,000 kg at 110 AED/kg 11,000,000 AED 1 February 20,000 kg 20,000 kg at 110 AED/kg 2,200,000 AED 8 March 220,000 kg 20,000 kg at 110 AED/kg + 200,000 kg at 100 AED/kg 22,200,000 AED 6 April 120,000 kg 20,000 kg at 110 AED/kg + 100,000 kg at 100 AED/kg 12,200,000 AED 23 May 60,000 kg 20,000 kg at 110 AED/kg + 40,000 kg at 100 AED/kg 6,200,000 AED 7 July 20,000 kg 20,000 kg at 110 AED/kg 2,200,000 AED 2 August 320,000 kg 20,000 kg at 110 AED/kg + 300,000 kg at 90 AED/kg 29,200,000 AED 5 September 250,000 kg 20,000 kg at 110 AED/kg + 230,000 kg at 90 AED/kg 22,900,000 AED 17 November 160,000 kg 20,000 kg at 110 AED/kg + 140,000 kg at 90 AED/kg 14,800,000 AED 8 December 80,000 kg 20,000 kg at 110 AED/kg + 60,000 kg at 90 AED/kg 7,600,000 AED Perpetual system Sales = 520,000 × 240 = 124,800,000 AED Cost of sales = 58,000,000 – 7,600,000 = 50,400,000 AED Gross profit = 124,800,000 – 50,400,000 = 74,400,000 AED Ending inventory = 7,600,000 AED Periodic system from Example 2 Sales = 520,000 × 240 = 124,800,000 AED Cost of sales = (20,000 × 110) + (200,000 × 100) + (300,000 × 90) = 49,200,000 AED Gross profit = 124,800,000 – 49,200,000 = 75,600,000 AED Ending inventory = 80,000 × 110 = 8,800,000 AED In this example, the ending inventory amount is lower under the perpetual system because only 20,000 kg of the oldest inventory with the highest cost is assumed to remain in inventory. The cost of sales is higher and the gross profit is lower under the perpetual system compared to the periodic system. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 281. Comparison of inventory valuation methods 263 COMPARISON OF INVENTORY VALUATION METHODS d calculate and explain how inflation and deflation of inventory costs affect the financial statements and ratios of companies that use different inventory valua- tion methods As shown in Example 2, the allocation of the total cost of goods available for sale to cost of sales on the income statement and to ending inventory on the balance sheet varies under the different inventory valuation methods. In an environment of declining inventory unit costs and constant or increasing inventory quantities, FIFO (in comparison with weighted average cost or LIFO) will allocate a higher amount of the total cost of goods available for sale to cost of sales on the income statement and a lower amount to ending inventory on the balance sheet. Accordingly, because cost of sales will be higher under FIFO, a company’s gross profit, operating profit, and income before taxes will be lower. Conversely, in an environment of rising inventory unit costs and constant or increasing inventory quantities, FIFO (in comparison with weighted average cost or LIFO) will allocate a lower amount of the total cost of goods available for sale to cost of sales on the income statement and a higher amount to ending inventory on the balance sheet. Accordingly, because cost of sales will be lower under FIFO, a company’s gross profit, operating profit, and income before taxes will be higher. The carrying amount of inventories under FIFO will more closely reflect current replacement values because inventories are assumed to consist of the most recently purchased items. The cost of sales under LIFO will more closely reflect current replace- ment value. LIFO ending inventory amounts are typically not reflective of current replacement value because the ending inventory is assumed to be the oldest inventory and costs are allocated accordingly. Example 4 illustrates the different results obtained by using either the FIFO or LIFO methods to account for inventory. EXAMPLE 4 Impact of Inflation Using LIFO Compared to FIFO Company L and Company F are identical in all respects except that Company L uses the LIFO method and Company F uses the FIFO method. Each company has been in business for five years and maintains a base inventory of 2,000 units each year. Each year, except the first year, the number of units purchased equaled the number of units sold. Over the five year period, unit sales increased 10 percent each year and the unit purchase and selling prices increased at the beginning of each year to reflect inflation of 4 percent per year. In the first year, 20,000 units were sold at a price of $15.00 per unit and the unit purchase price was $8.00. 1 What was the end of year inventory, sales, cost of sales, and gross profit for each company for each of the five years? 2 Compare the inventory turnover ratios (based on ending inventory carrying amounts) and gross profit margins over the five year period and between companies. 6 © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 282. Reading 21 ■ Inventories 264 Solution to 1: Company L using LIFO Year 1 Year 2 Year 3 Year 4 Year 5 Ending inventorya $16,000 $16,000 $16,000 $16,000 $16,000 Salesb $300,000 $343,200 $392,621 $449,158 $513,837 Cost of salesc 160,000 183,040 209,398 239,551 274,046 Gross profit $140,000 $160,160 $183,223 $209,607 $239,791 a Inventory is unchanged at $16,000 each year (2,000 units × $8). 2,000 of the units acquired in the first year are assumed to remain in inventory. b Sales Year X = (20,000 × $15)(1.10)X–1(1.04)X–1. The quantity sold increases by 10 percent each year and the selling price increases by 4 percent each year. c Cost of sales Year X = (20,000 × $8)(1.10)X–1(1.04)X–1. In Year 1, 20,000 units are sold with a cost of $8. In subsequent years, the number of units pur- chased equals the number of units sold and the units sold are assumed to be those purchased in the year. The quantity purchased increases by 10 percent each year and the purchase price increases by 4 percent each year. Note that if the company sold more units than it purchased in a year, inventory would decrease. This is referred to as LIFO liquidation. The cost of sales of the units sold in excess of those purchased would reflect the inventory carrying amount. In this example, each unit sold in excess of those purchased would have a cost of sales of $8 and a higher gross profit. Company F using FIFO Year 1 Year 2 Year 3 Year 4 Year 5 Ending inventorya $16,000 $16,640 $17,306 $17,998 $18,718 Salesb $300,000 $343,200 $392,621 $449,158 $513,837 Cost of salesc 160,000 182,400 208,732 238,859 273,326 Gross profit $140,000 $160,800 $183,889 $210,299 $240,511 a Ending Inventory Year X = 2,000 units × Cost in Year X = 2,000 units [$8 × (1.04)X–1]. 2,000 units of the units acquired in Year X are assumed to remain in inventory. b Sales Year X = (20,000 × $15)(1.10)X–1(1.04)X–1 c Cost of sales Year 1 = $160,000 (= 20,000 units × $8). There was no begin- ning inventory. Cost of sales Year X (where X ≠ 1) = Beginning inventory plus purchases less ending inventory = (Inventory at Year X–1) + [(20,000 × $8)(1.10)X–1(1.04)X–1] − (Inventory at Year X) = 2,000($8)(1.04)X–2 + [(20,000 × $8)(1.10)X–1(1.04)X–1] – [2,000 ($8)(1.04) X–1] For example, cost of sales Year 2 = 2,000($8) + [(20,000 × $8)(1.10)(1.04)] – [2,000 ($8)(1.04)] = $16,000 + 183,040 – 16,640 = $182,400 © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 283. The LIFO method and LIFO reserve 265 Solution to 2: Company L Company F Year 1 2 3 4 5 1 2 3 4 5 Inventory turnover 10.0 11.4 13.1 15.0 17.1 10.0 11.0 12.1 13.3 14.6 Gross profit margin (%) 46.7 46.7 46.7 46.7 46.7 46.7 46.9 46.8 46.8 46.8 Inventory turnover ratio = Cost of sales ÷ Ending inventory. The inventory turnover ratio increased each year for both companies because the units sold increased, whereas the units in ending inventory remained unchanged. The increase in the inventory turnover ratio is higher for Company L because Company L’s cost of sales is increasing for inflation but the inventory carrying amount is unaffected by inflation. It might appear that a company using the LIFO method manages its inventory more effectively, but this is deceptive. Both companies have identical quantities and prices of purchases and sales and only differ in the inventory valuation method used. Gross profit margin = Gross profit ÷ Sales. The gross profit margin is stable under LIFO because both sales and cost of sales increase at the same rate of inflation. The gross profit margin is slightly higher under the FIFO method after the first year because a proportion of the cost of sales reflects an older purchase price. THE LIFO METHOD AND LIFO RESERVE e explain LIFO reserve and LIFO liquidation and their effects on financial state- ments and ratios f demonstrate the conversion of a company’s reported financial statements from LIFO to FIFO for purposes of comparison The potential income tax savings are a benefit of using the LIFO method when inven- tory costs are increasing. The higher cash flows due to lower income taxes may make the company more valuable because the value of a company is based on the present value of its future cash flows. Under the LIFO method, ending inventory is assumed to consist of those units that have been held the longest. This generally results in ending inventories with carrying amounts lower than current replacement costs because inventory costs typically increase over time. Cost of sales will more closely reflect current replacement costs. If the purchase prices (purchase costs) or production costs of inventory are increas- ing, the income statement consequences of using the LIFO method compared to other methods will include higher cost of sales, and lower gross profit, operating profit, income tax expense, and net income. The balance sheet consequences include lower ending inventory, working capital, total assets, retained earnings, and shareholders’ equity. The lower income tax paid will result in higher net cash flow from operating activities. Some of the financial ratio effects are a lower current ratio, higher debt- to- equity ratios, and lower profitability ratios. If the purchase prices or production costs of inventory are decreasing, it is unlikely that a company will use the LIFO method for tax purposes (and therefore for financial reporting purposes due to the LIFO conformity rule) because this will result in lower cost of sales, and higher taxable income and income taxes. However, if the company 7 © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 284. Reading 21 ■ Inventories 266 had elected to use the LIFO method and cannot justify changing the inventory valu- ation method for tax and financial reporting purposes when inventory costs begin to decrease, the income statement, balance sheet, and ratio effects will be opposite to the effects during a period of increasing costs. 7.1 LIFO Reserve For companies using the LIFO method, US GAAP requires disclosure, in the notes to the financial statements or on the balance sheet, of the amount of the LIFO reserve. The LIFO reserve is the difference between the reported LIFO inventory carrying amount and the inventory amount that would have been reported if the FIFO method had been used (in other words, the FIFO inventory value less the LIFO inventory value). The disclosure provides the information that analysts need to adjust a company’s cost of sales (cost of goods sold) and ending inventory balance based on the LIFO method, to the FIFO method. To compare companies using LIFO with companies not using LIFO, inventory is adjusted by adding the disclosed LIFO reserve to the inventory balance that is reported on the balance sheet. The reported inventory balance, using LIFO, plus the LIFO reserve equals the inventory that would have been reported under FIFO. Cost of sales is adjusted by subtracting the increase in the LIFO reserve during the period from the cost of sales amount that is reported on the income statement. If the LIFO reserve has declined during the period,10 the decrease in the reserve is added to the cost of sales amount that is reported on the income statement. The LIFO reserve dis- closure can be used to adjust the financial statements of a US company using the LIFO method to make them comparable with a similar company using the FIFO method. LIFO LIQUIDATIONS e explain LIFO reserve and LIFO liquidation and their effects on financial state- ments and ratios In periods of rising inventory unit costs, the carrying amount of inventory under FIFO will always exceed the carrying amount of inventory under LIFO. The LIFO reserve may increase over time as the result of the increasing difference between the older costs used to value inventory under LIFO and the more recent costs used to value inventory under FIFO. Also, when the number of inventory units manufactured or purchased exceeds the number of units sold, the LIFO reserve may increase as the result of the addition of new LIFO layers (the quantity of inventory units is increasing and each increase in quantity creates a new LIFO layer). When the number of units sold exceeds the number of units purchased or manu- factured, the number of units in ending inventory is lower than the number of units in beginning inventory and a company using LIFO will experience a LIFO liquidation (some of the older units held in inventory are assumed to have been sold). If inven- tory unit costs have been rising from period to period and LIFO liquidation occurs, this will produce an inventory- related increase in gross profits. The increase in gross profits occurs because of the lower inventory carrying amounts of the liquidated units. The lower inventory carrying amounts are used for cost of sales and the sales are at 8 10 This typically results from a reduction in inventory units and is referred to as LIFO liquidation. LIFO liquidation is discussed in the next section. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 285. LIFO liquidations 267 the current prices. The gross profit on these units is higher than the gross profit that would be recognised using more current costs. These inventory profits caused by a LIFO liquidation, however, are one- time events and are not sustainable. LIFO liquidations can occur for a variety of reasons. The reduction in inventory levels may be outside of management’s control; for example, labour strikes at a sup- plier may force a company to reduce inventory levels to meet customer demands. In periods of economic recession or when customer demand is declining, a company may choose to reduce existing inventory levels rather than invest in new inventory. Analysts should be aware that management can potentially manipulate and inflate their company’s reported gross profits and net income at critical times by intentionally reducing inventory quantities and liquidating older layers of LIFO inventory (selling some units of beginning inventory). During economic downturns, LIFO liquidation may result in higher gross profit than would otherwise be realised. If LIFO layers of inventory are temporarily depleted and not replaced by fiscal year-end, LIFO liquidation will occur resulting in unsustainable higher gross profits. Therefore, it is imperative to review the LIFO reserve footnote disclosures to determine if LIFO liquidation has occurred. A decline in the LIFO reserve from the prior period may be indicative of LIFO liquidation. EXAMPLE 5 Inventory Conversion from LIFO to FIFO Caterpillar Inc. (CAT), based in Peoria, Illinois, USA, is the largest maker of construction and mining equipment, diesel and natural gas engines, and indus- trial gas turbines in the world. Excerpts from CAT’s consolidated financial state- ments are shown in Exhibits 1 and 2; notes pertaining to CAT’s inventories are presented in Exhibit 3. CAT’s Management Discussion and Analysis (MDA) disclosure states that effective income tax rates were 28 percent for 2017 and 36 percent for 2016. 1 What inventory values would CAT report for 2017, 2016, and 2015 if it had used the FIFO method instead of the LIFO method? 2 What amount would CAT’s cost of goods sold for 2017 and 2016 be if it had used the FIFO method instead of the LIFO method? 3 What net income (profit) would CAT report for 2017 and 2016 if it had used the FIFO method instead of the LIFO method? 4 By what amount would CAT’s 2017 and 2016 net cash flow from operat- ing activities decline if CAT used the FIFO method instead of the LIFO method? 5 What is the cumulative amount of income tax savings that CAT has generated through 2017 by using the LIFO method instead of the FIFO method? 6 What amount would be added to CAT’s retained earnings (profit employed in the business) at 31 December 2017 if CAT had used the FIFO method instead of the LIFO method? 7 What would be the change in Cat’s cash balance if CAT had used the FIFO method instead of the LIFO method? 8 Calculate and compare the following for 2017 under the LIFO method and the FIFO method: inventory turnover ratio, days of inventory on hand, gross profit margin, net profit margin, return on assets, current ratio, and total liabilities-to-equity ratio. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 286. Reading 21 ■ Inventories 268 Exhibit 1 Caterpillar Inc. Consolidated Results of Operation (US$ millions) For the years ended 31 December 2017 2016 2015 Sales and revenues: Sales of Machinery and Engines 42,676 35,773 44,147 Revenue of Financial Products 2,786 2,764 2,864 Total sales and revenues 45,462 38,537 47,011 Operating costs: Cost of goods sold 31,049 28,309 33,546 ⋮ ⋮ ⋮ ⋮ Interest expense of Financial Products 646 596 587 ⋮ ⋮ ⋮ ⋮ Total operating costs 41,056 38,039 43,226 Operating profit 4,406 498 3,785 Interest expense excluding Financial Products 531 505 507 Other income (expense) 207 146 161 Consolidated profit before taxes 4,082 139 4,439 Provision for income taxes 3,339 192 916 Profit (loss) of consolidated companies 743 (53) 2,523 Equity in profit (loss) of unconsolidated affili- ated companies 16 (6) — Profit attributable to noncontrolling interests 5 8 11 Profit (loss) 754 (67) 2,512 Exhibit 2 Caterpillar Inc. Consolidated Financial Position (US$ millions) 31 December 2017 2016 2015 Assets Current assets: Cash and short- term investments 8,261 7,168 6,460 ⋮ ⋮ ⋮ ⋮ Inventories 10,018 8,614 9,700 Total current assets 36,244 31,967 33,508 ⋮ ⋮ ⋮ ⋮ Total assets 76,962 74,704 78,342 Liabilities Total current liabilities 26,931 26,132 26,242 ⋮ ⋮ ⋮ ⋮ Total liabilities 63,196 61,491 63,457 Stockholders’ equity © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 287. LIFO liquidations 269 31 December 2017 2016 2015 Common stock of $1.00 par value: Authorized shares: 2,000,000,000 Issued shares (2017, 2016 and 2015 – 814,894,624) at paid- in amount 5,593 5,277 5,238 Treasury stock (2017 – 217,268,852 shares; 2016 – 228,408,600 shares and 2015 – 232,572,734 shares) at cost (17,005) (17,478) (17,640) Profit employed in the business 26,301 27,377 29,246 Accumulated other comprehensive income (loss) (1,192) (2,039) (2,035) Noncontrolling interests 69 76 76 Total stockholders’ equity 13,766 13,213 14,885 Total liabilities and stockholders’ equity 76,962 74,704 78,342 Exhibit 3 Caterpillar Inc. Selected Notes to Consolidated Financial Statements Note 1. Operations and Summary of Significant Accounting Policies D. Inventories Inventories are stated at the lower of cost or net realizable value. Cost is principally determined using the last- in, first- out (LIFO) method. The value of inventories on the LIFO basis represented about 65% of total inventories at December 31, 2017 and about 60% of total inventories at December 31, 2016 and 2015. If the FIFO (first- in, first- out) method had been in use, inventories would have been $1,924 million, $2,139 million and $2,498 million higher than reported at December 31, 2017, 2016 and 2015, respectively. Note 7. Inventories 31 December (millions of dollars) 2017 2016 2015 Raw Materials 2,802 2,102 2,467 Work-in-process 2,254 1,719 1,857 Finished goods 4,761 4,576 5,122 Supplies 201 217 254 Total inventories 10,018 8,614 9,700 We had long- term material purchase obligations of approximately $813 mil- lion at December 31, 2017. Exhibit 2 (Continued) © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 288. Reading 21 ■ Inventories 270 Solution to 1: 31 December (millions of dollars) 2017 2016 2015 Total inventories (LIFO method) 10,018 8,614 9,700 From Note 1.D (LIFO reserve) 1,924 2,139 2,498 Total inventories (FIFO method) 11,942 10,753 12,198 Note that the decrease in the LIFO reserve from 2015–2016 and again from 2016–2017 likely indicates a LIFO liquidation for both 2016 and 2017. Solution to 2: 31 December (millions of dollars) 2017 2016 Cost of goods sold (LIFO method) 31,049 28,309 Plus: Decrease in LIFO reserve* 215 359 Cost of goods sold (FIFO method) 31,264 28,668 * From Note 1.D, the decrease in LIFO reserve for 2017 is 215 (1,924 – 2,139) and for 2016 is 359 (2,139 – 2,498). Solution to 3: 31 December (millions of dollars) 2017 2016 Net income (loss) (LIFO method) 754 −67 Less: Increase in cost of goods sold (decrease in operating profit) −215 −359 Tax reduction on decreased operating profit* 60 129 Net income (loss) (FIFO method) 599 −297 * The reduction in taxes on the decreased operating profit are 60 (215 × 28%) for 2017 and 129 (359 × 36%) for 2016. Solution to 4: The effect on a company’s net cash flow from operating activities is limited to the impact of the change on income taxes paid; changes in allocating inventory costs to ending inventory and cost of goods sold does not change any cash flows except income taxes. Consequently, the effect of using FIFO on CAT’s net operating cash flow from operating activities would be an increase of $60 million in 2017 and an increase of $129 million in 2016. These are the approximate incremental decreases in income taxes that CAT would have incurred if the FIFO method were used instead of the LIFO method (see solution to 3 above). Solution to 5: Using the previously mentioned effective tax rates of 28 percent for 2017 and 36 percent for 2016 (as well as for earlier years), the cumulative amount of income tax savings that CAT has generated by using the LIFO method instead of FIFO is approximately $710 million (−215 × 28% + 2,139 × 36%). Note 1.D indicates a LIFO reserve of $2,139 million at the end of 2016 and a decrease in © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 289. LIFO liquidations 271 the LIFO reserve of $215 million in 2017. Therefore, under the FIFO method, cumulative gross profits would have been $2,139 million higher as of the end of 2016 and $1,924 million higher as of the end of 2017. The estimated tax savings would be higher (lower) if income tax rates were assumed to be higher (lower). Solution to 6: The amount that would be added to CAT’s retained earnings is $1,214 million (1,924 – 710) or (–215 × 72% + 2,139 × 64%). This represents the cumulative increase in operating profit due to the decrease in cost of goods sold (LIFO reserve of $1,924 million) less the assumed taxes on that profit ($710 million, see solution to 5 above). Some analysts advocate ignoring the tax consequences and suggest simply adjusting inventory and equity by the same amount. They argue that the reported equity of the firm is understated by the difference between the current value of its inventory (approximated by the value under FIFO) and its carrying value (value under LIFO). Solution to 7: Under the FIFO method, an additional $710 million is assumed to have been incurred for tax expenses. If CAT switched to FIFO, it would have an additional tax liability of $710 million as a consequence of the restatement of financial statements to the FIFO method. This illustrates the significant immediate income tax liabilities that may arise in the year of transition from the LIFO method to the FIFO method. If CAT switched to FIFO for tax purposes, there would be a cash outflow of $710 million for the additional taxes. However, because the company is not actually converting at this point for either tax or reporting purposes, it is appropriate to reflect a deferred tax liability rather than a reduc- tion in cash. In this case for analysis purposes, under FIFO, inventory would increase by $1,924 million, equity by $1,214 million, and non- current liabilities by $710 million. Solution to 8: CAT’s ratios for 2017 under the LIFO and FIFO methods are as follows: LIFO FIFO Inventory turnover 3.33 2.76 Days of inventory on hand 109.6 days 132.2 days Gross profit margin 27.24% 26.74% Net profit margin 1.66% 1.32% Return on assets 0.99% 0.77% Current ratio 1.35 1.42 Total liabilities-to-equity ratio 4.59 4.27 Inventory turnover ratio = Cost of goods sold ÷ Average inventory LIFO = 3.33 = 31,049 ÷ [(10,018 + 8,614) ÷ 2] FIFO = 2.76 = 31,264 ÷ [(11,942 + 10,753) ÷ 2] The ratio is higher under LIFO because, given rising inventory costs, cost of goods sold will be higher and inventory carrying amounts will be lower under LIFO. If an analyst made no adjustment for the difference in inventory methods, it might appear that a company using the LIFO method manages its inventory more effectively. Days of inventory on hand = Number of days in period ÷ Inventory turnover ratio LIFO = 109.6 days = (365 days ÷ 3.33) © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 290. Reading 21 ■ Inventories 272 FIFO = 132.2 days = (365 days ÷ 2.76) Without adjustment, a company using the LIFO method might appear to manage its inventory more effectively. This is primarily the result of the lower inventory carrying amounts under LIFO. Gross profit margin = Gross profit ÷ Total revenue LIFO = 27.24 percent = [(42,676 – 31,049) ÷ 42,676] FIFO = 26.74 percent = [(42,676 – 31,264) ÷ 42,676] Revenue of financial products is excluded from the calculation of gross profit. Gross profit is sales of machinery and engines less cost of goods sold. The gross profit margin is lower under FIFO because the cost of goods sold is higher from the LIFO reserve reduction. Net profit margin = Net income ÷ Total revenue LIFO = 1.66 percent = (754 ÷ 45,462) FIFO = 1.32 percent = (599 ÷ 45,462] The net profit margin is higher under LIFO because the cost of goods sold is lower due to the LIFO liquidation. The absolute percentage difference is less than that of the gross profit margin because of lower income taxes on the decreased income reported under FIFO and because net income is divided by total revenue including sales of machinery and engines and revenue of financial products. The company appears to be more profitable under LIFO. Return on assets = Net income ÷ Average total assets LIFO = 0.99 percent = 754 ÷ [(76,962 + 74,704) ÷ 2] FIFO = 0.77 percent = 599 ÷ [(76,962 + 1,924) + (74,704 + 2,139) ÷ 2] The total assets under FIFO are the LIFO total assets increased by the LIFO reserve. The return on assets is lower under FIFO because the of the lower net income due to the higher cost of goods sold as well as higher total assets due to the LIFO reserve adjustment. The company appears to be less profitable under FIFO. Current ratio = Current assets ÷ Current liabilities LIFO = 1.35 = (36,244 ÷ 26,931) FIFO = 1.42 = [(36,244 + 1,924) ÷ 26,931] The current ratio is lower under LIFO primarily because of lower inventory carrying amount. The company appears to be less liquid under LIFO. Total liabilities-to-equity ratio = Total liabilities ÷ Total shareholders’ equity LIFO = 4.59 = (63,196 ÷ 13,766) FIFO = 4.27 = [(63,196 + 710) ÷ (13,766 + 1,214)] The ratio is higher under LIFO because the addition to retained earnings under FIFO reduces the ratio. The company appears to be more highly leveraged under LIFO. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 291. LIFO liquidations 273 In summary, the company appears to be more profitable, less liquid, and more highly leveraged under LIFO. Yet, because a company’s value is based on the present value of future cash flows, LIFO will increase the company’s value because the cash flows are higher in earlier years due to lower taxes. LIFO is primarily used for the tax benefits it provides. EXAMPLE 6 LIFO Liquidation Illustration Reliable Fans, Inc. (RF), a hypothetical company, sells high quality fans and has been in business since 2015. Exhibit 4 provides relevant data and financial state- ment information about RF’s inventory purchases and sales of fan inventory for the years 2015 through 2018. RF uses the LIFO method and a periodic inventory system. What amount of RF’s 2018 gross profit is due to LIFO liquidation? Exhibit 4 RF Financial Statement Information under LIFO 2015 2016 2017 2018 Fans units purchased 12,000 12,000 12,000 12,000 Purchase cost per fan $100 $105 $110 $115 Fans units sold 10,000 12,000 12,000 13,000 Sales price per fan $200 $205 $210 $215 LIFO Method Beginning inventory $0 $200,000 $200,000 $200,000 Purchases 1,200,000 1,260,000 1,320,000 1,380,000 Goods available for sale 1,200,000 1,460,000 1,520,000 1,580,000 Ending inventory* (200,000) (200,000) (200,000) (100,000) Cost of goods sold $1,000,000 1,260,000 $1,320,000 $1,480,000 Income Statement Sales $2,000,000 $2,460,000 $2,520,000 $2,795,000 Cost of goods sold 1,000,000 1,260,000 1,320,000 1,480,000 Gross profit $1,000,000 $1,200,000 $1,200,000 $1,315,000 Balance Sheet Inventory $200,000 $200,000 $200,000 $100,000 * Ending inventory 2015, 2016, and 2017 = (2,000 × $100); Ending inventory 2018 = (1,000 × $100). Solution: RF’s reported gross profit for 2018 is $1,315,000. RF’s 2018 gross profit due to LIFO liquidation is $15,000. If RF had purchased 13,000 fans in 2018 rather than 12,000 fans, the cost of goods sold under the LIFO method would have been $1,495,000 (13,000 fans sold at $115.00 purchase cost per fan), and the reported gross profit would have been $1,300,000 ($2,795,000 less $1,495,000). The gross profit due to LIFO liquidation is $15,000 ($1,315,000 reported gross profit less the $1,300,000 gross profit that would have been reported without the LIFO © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 292. Reading 21 ■ Inventories 274 liquidation). The gross profit due to LIFO liquidation may also be determined by multiplying the number of units liquidated times the difference between the replacement cost of the units liquidated and their historical purchase cost. For RF, 1,000 units times $15 ($115 replacement cost per fan less the $100 historical cost per fan) equals the $15,000 gross profit due to LIFO liquidation. INVENTORY METHOD CHANGES b describe different inventory valuation methods (cost formulas) f demonstrate the conversion of a company’s reported financial statements from LIFO to FIFO for purposes of comparison Companies on rare occasion change inventory valuation methods. Under IFRS, a change in method is acceptable only if the change “results in the financial statements providing reliable and more relevant information about the effects of transactions, other events, or conditions on the business entity’s financial position, financial perfor- mance, or cash flows.”11 If the change is justifiable, then it is applied retrospectively. This means that the change is applied to comparative information for prior peri- ods as far back as is practicable. The cumulative amount of the adjustments relating to periods prior to those presented in the current financial statements is made to the opening balance of each affected component of equity (i.e., retained earnings or comprehensive income) of the earliest period presented. For example, if a company changes its inventory method in 2018 and it presents three years of comparative financial statements (2016, 2017, and 2018) in its annual report, it would retrospec- tively reflect this change as far back as possible. The change would be reflected in the three years of financial statements presented; the financial statements for 2016 and 2017 would be restated as if the new method had been used in these periods, and the cumulative effect of the change on periods prior to 2016 would be reflected in the 2016 opening balance of each affected component of equity. An exemption to the restatement applies when it is impracticable to determine either the period- specific effects or the cumulative effect of the change. Under US GAAP, the conditions to make a change in accounting policy and the accounting for a change in inventory policy are similar to IFRS.12 US GAAP, however, requires companies to thoroughly explain why the newly adopted inventory account- ing method is superior and preferable to the old method. If a company decides to change from LIFO to another inventory method, US GAAP requires a retrospective restatement as described above. However, if a company decides to change to the LIFO method, it must do so on a prospective basis and retrospective adjustments are not made to the financial statements. The carrying amount of inventory under the old method becomes the initial LIFO layer in the year of LIFO adoption. Analysts should carefully evaluate changes in inventory valuation methods. Although the stated reason for the inventory change may be to better match inven- tory costs with sales revenue (or some other plausible business explanation), the real underlying (and unstated) purpose may be to reduce income tax expense (if changing to LIFO from FIFO or average cost), or to increase reported profits (if changing from LIFO to FIFO or average cost). As always, the choice of inventory valuation method can have a significant impact on financial statements and the financial ratios that are 9 11 IAS 8 [Accounting Policies, Changes in Accounting Estimates and Errors]. 12 FASB ASC Topic 250 [Accounting Changes and Error Corrections]. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 293. Inventory adjustments 275 derived from them. As a consequence, analysts must carefully consider the impact of the change in inventory valuation methods and the differences in inventory valuation methods when comparing a company’s performance with that of its industry or its competitors. INVENTORY ADJUSTMENTS g describe the measurement of inventory at the lower of cost and net realisable value h describe implications of valuing inventory at net realisable value for financial statements and ratios Significant financial risk can result from the holding of inventory. The cost of inventory may not be recoverable due to spoilage, obsolescence, or declines in selling prices. IFRS state that inventories shall be measured (and carried on the balance sheet) at the lower of cost and net realisable value.13 Net realisable value is the estimated selling price in the ordinary course of business less the estimated costs necessary to make the sale and estimated costs to get the inventory in condition for sale. The assessment of net realisable value is typically done item by item or by groups of similar or related items. In the event that the value of inventory declines below the carrying amount on the balance sheet, the inventory carrying amount must be written down to its net realisable value14 and the loss (reduction in value) recognised as an expense on the income statement. This expense may be included as part of cost of sales or reported separately. In each subsequent period, a new assessment of net realisable value is made. Reversal (limited to the amount of the original write- down) is required for a sub- sequent increase in value of inventory previously written down. The reversal of any write- down of inventories is recognised as a reduction in cost of sales (reduction in the amount of inventories recognised as an expense). US GAAP used to specify the lower of cost or market to value inventories.15 For fiscal years beginning after December 15, 2016, inventories measured using other than LIFO and retail inventory methods are measured at the lower of cost or net realisable value. This is broadly consistent with IFRS with one major difference: US GAAP prohibit the reversal of write- downs. For inventories measured using LIFO and retail inventory methods, market value is defined as current replacement cost subject to upper and lower limits. Market value cannot exceed net realisable value (selling price less reasonably estimated costs of completion and disposal). The lower limit of market value is net realisable value less a normal profit margin. Any write- down to market value or net realisable value reduces the value of the inventory, and the loss in value (expense) is generally reflected in the income statement in cost of goods sold. An inventory write- down reduces both profit and the carrying amount of inven- tory on the balance sheet and thus has a negative effect on profitability, liquidity, and solvency ratios. However, activity ratios (for example, inventory turnover and total asset turnover) will be positively affected by a write- down because the asset base (denominator) is reduced. The negative impact on some key ratios, due to the decrease in profit, may result in the reluctance by some companies to record inventory 10 13 IAS 2 paragraphs 28–33 [Inventories – Net realisable value]. 14 Frequently, rather than writing inventory down directly, an inventory valuation allowance account is used. The allowance account is netted with the inventory accounts to arrive at the carrying amount that appears on the balance sheet. 15 FASB ASC Section 330- 10- 35 [Inventory – Overall – Subsequent Measurement]. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 294. Reading 21 ■ Inventories 276 write- downs unless there is strong evidence that the decline in the value of inventory is permanent. This is especially true under US GAAP where reversal of a write- down is prohibited. IAS 2 [Inventories] does not apply to the inventories of producers of agricultural and forest products and minerals and mineral products, nor to commodity broker– traders. These inventories may be measured at net realisable value (fair value less costs to sell and complete) according to well- established industry practices. If an active market exists for these products, the quoted market price in that market is the appropriate basis for determining the fair value of that asset. If an active market does not exist, a company may use market determined prices or values (such as the most recent market transaction price) when available for determining fair value. Changes in the value of inventory (increase or decrease) are recognised in profit or loss in the period of the change. US GAAP is similar to IFRS in its treatment of inventories of agricultural and forest products and mineral ores. Mark- to- market inventory account- ing is allowed for bullion. EXAMPLE 7 Accounting for Declines and Recoveries of Inventory Value Hatsumei Enterprises, a hypothetical company, manufactures computers and prepares its financial statements in accordance with IFRS. In 2017, the cost of ending inventory was €5.2 million but its net realisable value was €4.9 million. The current replacement cost of the inventory is €4.7 million. This figure exceeds the net realisable value less a normal profit margin. In 2018, the net realisable value of Hatsumei’s inventory was €0.5 million greater than the carrying amount. 1 What was the effect of the write- down on Hatsumei’s 2017 financial state- ments? What was the effect of the recovery on Hatsumei’s 2018 financial statements? 2 Under US GAAP, if Hatsumei used the LIFO method, what would be the effects of the write- down on Hatsumei’s 2017 financial statements and of the recovery on Hatsumei’s 2018 financial statements? 3 What would be the effect of the recovery on Hatsumei’s 2018 financial statements if Hatsumei’s inventory were agricultural products instead of computers? Solution to 1: For 2017, Hatsumei would write its inventory down to €4.9 million and record the change in value of €0.3 million as an expense on the income statement. For 2018, Hatsumei would increase the carrying amount of its inventory and reduce the cost of sales by €0.3 million (the recovery is limited to the amount of the original write-down). Solution to 2: Under US GAAP, for 2017, Hatsumei would write its inventory down to €4.7 mil- lion and typically include the change in value of €0.5 million in cost of goods sold on the income statement. For 2018, Hatsumei would not reverse the write-down. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 295. Inventory adjustments 277 Solution to 3: If Hatsumei’s inventory were agricultural products instead of computers, inven- tory would be measured at net realisable value and Hatsumei would, therefore, increase inventory by and record a gain of €0.5 million for 2018. Analysts should consider the possibility of an inventory write- down because the impact on a company’s financial ratios may be substantial. The potential for inventory write- downs can be high for companies in industries where technological obsolescence of inventories is a significant risk. Analysts should carefully evaluate prospective inven- tory impairments (as well as other potential asset impairments) and their potential effects on the financial ratios when debt covenants include financial ratio requirements. The breaching of debt covenants can have a significant impact on a company. Companies that use specific identification, weighted average cost, or FIFO methods are more likely to incur inventory write- downs than companies that use the LIFO method. Under the LIFO method, the oldest costs are reflected in the inventory car- rying amount on the balance sheet. Given increasing inventory costs, the inventory carrying amounts under the LIFO method are already conservatively presented at the oldest and lowest costs. Thus, it is far less likely that inventory write- downs will occur under LIFO—and if a write- down does occur, it is likely to be of a lesser magnitude. EXAMPLE 8 Effect of Inventory Write- downs on Financial Ratios The Volvo Group, based in Göteborg, Sweden, is a leading supplier of commercial transport products such as construction equipment, trucks, busses, and drive systems for marine and industrial applications as well as aircraft engine com- ponents.16 Excerpts from Volvo’s consolidated financial statements are shown in Exhibits 5 and 6. Notes pertaining to Volvo’s inventories are presented in Exhibit 7. 1 What inventory values would Volvo have reported for 2017, 2016, and 2015 if it had no allowance for inventory obsolescence? 2 Assuming that any changes to the allowance for inventory obsolescence are reflected in the cost of sales, what amount would Volvo’s cost of sales be for 2017 and 2016 if it had not recorded inventory write- downs in 2017 and 2016? 3 What amount would Volvo’s profit (net income) be for 2017 and 2016 if it had not recorded inventory write- downs in 2017 and 2016? Volvo’s effec- tive income tax rate was reported as 25 percent for 2017 and 31 percent for 2016. 4 What would Volvo’s 2017 profit (net income) have been if it had reversed all past inventory write- downs in 2017? This question is independent of 1, 2, and 3. The effective income tax rate was 25 percent for 2017. 5 Compare the following for 2017 based on the numbers as reported and those assuming no allowance for inventory obsolescence as in questions 1, 2, and 3: inventory turnover ratio, days of inventory on hand, gross profit margin, and net profit margin. 16 The Volvo line of automobiles has not been under the control and management of the Volvo Group since 1999. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 296. Reading 21 ■ Inventories 278 6 CAT (Example 5) has no disclosures indicative of either inventory write- downs or a cumulative allowance for inventory obsolescence in its 2017 financial statements. Provide a conceptual explanation as to why Volvo incurred inventory write- downs for 2017 but CAT did not. Exhibit 5 Volvo Group Consolidated Income Statements (Swedish Krona in millions, except per share data) For the years ended 31 December 2017 2016 2015 Net sales 334,748 301,914 312,515 Cost of sales (254,581) (231,602) (240,653) Gross income 80,167 70,312 71,862 ⋮ ⋮ ⋮ ⋮ Operating income 30,327 20,826 23,318 Interest income and similar credits 164 240 257 Income expenses and similar charges (1,852) (1,847) (2,366) Other financial income and expenses (386) 11 (792) Income after financial items 28,254 19,230 20,418 Income taxes (6,971) (6,008) (5,320) Income for the period 21,283 13,223 15,099 Attributable to: Equity holders of the parent company 20,981 13,147 15,058 Minority interests 302 76 41 Profit 21,283 13,223 15,099 Exhibit 6 Volvo Group Consolidated Balance Sheets (Swedish Krona in millions) 31 December 2017 2016 2015 Assets Total non- current assets 213,455 218,465 203,478 Current assets: Inventories 52,701 48,287 44,390 ⋮ ⋮ ⋮ ⋮ Cash and cash equivalents 36,092 23,949 21,048 Total current assets 199,039 180,301 170,687 Total assets 412,494 398,916 374,165 Shareholders’ equity and liabilities Equity attributable to equity holders of the parent company 107,069 96,061 83,810 Minority interests 1,941 1,703 1,801 Total shareholders’ equity 109,011 97,764 85,610 Total non- current provisions 29,147 29,744 26,704 © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 297. Inventory adjustments 279 31 December 2017 2016 2015 Total non- current liabilities 96,213 104,873 91,814 Total current provisions 10,806 11,333 14,176 Total current liabilities 167,317 155,202 155,860 Total shareholders’ equity and liabilities 412,404 398,916 374,165 Exhibit 7 Volvo Group Selected Notes to Consolidated Financial Statements Note 17. Inventories Accounting Policy Inventories are reported at the lower of cost and net realisable value. The cost is established using the first- in, first- out principle (FIFO) and is based on the standard cost method, including costs for all direct manu- facturing expenses and the attributable share of capacity and other related manufacturing- related costs. The standard costs are tested regularly and adjustments are made based on current conditions. Costs for research and development, selling, administration and financial expenses are not included. Net realisable value is calculated as the selling price less costs attributable to the sale. Sources of Estimation Uncertainty Inventory obsolescence If the net realisable value is lower than cost, a valuation allowance is established for inventory obsolescence. The total inventory value, net of inventory obsolescence allowance, was: SEK (in millions) 52,701 as of December 2017 and 48,287 as of 31 December 2016. Inventory 31 December (millions of Krona) 2017 2016 2015 Finished products 32,304 31,012 27,496 Production materials, etc. 20,397 17,275 16,894 Total 52,701 48,287 44,390 Increase (decrease) in allowance for inventory obsolescence 31 December (millions of Krona) 2017 2016 2015 Opening balance 3,683 3,624 3,394 Change in allowance for inventory obsolescence charged to income 304 480 675 Scrapping (391) (576) (435) Translation differences (116) 177 (29) (continued) Exhibit 6 (Continued) © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 298. Reading 21 ■ Inventories 280 31 December (millions of Krona) 2017 2016 2015 Reclassifications, etc. 8 (23) 20 Allowance for inventory obsoles- cence as of 31 December 3,489 3,683 3,624 Solution to 1: 31 December (Swedish krona in millions) 2017 2016 2015 Total inventories, net 52,701 48,287 44,390 From Note 17. (Allowance for obsolescence) 3,489 3,683 3,624 Total inventories (without allowance) 56,190 51,970 48,014 Solution to 2: 31 December (Swedish krona in millions) 2017 2016 Cost of sales 254,581 231,602 (Increase) decrease in allowance for obsolescence* 194 (59) Cost of sales without allowance 254,775 231,543 * From Note 17, the decrease in allowance for obsolescence for 2017 is 194 (3,489 – 3,683) and the increase for 2016 is 59 (3,683 – 3,624). Solution to 3: 31 December (Swedish krona in millions) 2017 2016 Profit (Net income) 21,283 13,223 Increase (reduction) in cost of sales (194) 59 Taxes (tax reduction) on operating profit* 49 (18) Profit (without allowance) 21,138 13,264 * Taxes (tax reductions) on the operating profit are assumed to be 49 (194 × 25%) for 2017 and −18 (−59 × 31%) for 2016. Solution to 4: 31 December (Swedish krona in millions) 2017 Profit (Net income) 21,283 Reduction in cost of sales (increase in operating profit) 3,489 © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 299. Inventory adjustments 281 31 December (Swedish krona in millions) 2017 Taxes on increased operating profit* −872 Profit (after recovery of previous write- downs) 23,900 * Taxes on the increased operating profit are assumed to be 872 (3,489 × 25%) for 2017. Solution to 5: The Volvo Group’s financial ratios for 2017 with the allowance for inventory obsolescence and without the allowance for inventory obsolescence are as follows: With Allowance (As Reported) Without Allowance (Adjusted) Inventory turnover ratio 5.04 4.71 Days of inventory on hand 72.4 77.5 Gross profit margin 23.95% 23.89% Net profit margin 6.36% 6.31% Inventory turnover ratio = Cost of sales ÷ Average inventory With allowance (as reported) = 5.04 = 254,581 ÷ [(52,701 + 48,287) ÷ 2] Without allowance (adjusted) = 4.71 = 254,775 ÷ [(56,190 + 51,970) ÷ 2] Inventory turnover is higher based on the numbers as reported because inventory carrying amounts will be lower with an allowance for inventory obsolescence. The company might appear to manage its inventory more efficiently when it has inventory write- downs. Days of inventory on hand = Number of days in period ÷ Inventory turnover ratio With allowance (as reported) = 72.4 days = (365 days ÷ 5.04) Without allowance (adjusted) = 77.5 days = (365 days ÷ 4.71) Days of inventory on hand are lower based on the numbers as reported because the inventory turnover is higher. A company with inventory write- downs might appear to manage its inventory more effectively. This is primarily the result of the lower inventory carrying amounts. Gross profit margin = Gross income ÷ Net sales With allowance (as reported) = 23.95 percent = (80,167 ÷ 334,748) Without allowance (adjusted) = 23.89 percent = [(80,167 − 194) ÷ 334,748] In this instance, the gross profit margin is slightly higher with inventory write- downs because the cost of sales is lower (due to the reduction in the allowance for inventory obsolescence). This assumes that inventory write- downs (and inventory write- down recoveries) are reported as part of cost of sales. Net profit margin = Profit ÷ Net sales With allowance (as reported) = 6.36 percent = (21,283 ÷ 334,748) Without allowance (adjusted) = 6.31 percent = (21,138 ÷ 334,748) © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 300. Reading 21 ■ Inventories 282 In this instance, the net profit margin is higher with inventory write- downs because the cost of sales is lower (due to the reduction in the allowance for inventory obsolescence). The absolute percentage difference is less than that of the gross profit margin because of the income tax reduction on the decreased income without write- downs. The profitability ratios (gross profit margin and net profit margin) for Volvo Group would have been slightly lower for 2017 if the company had not recorded inventory write- downs. The activity ratio (inventory turnover ratio) would appear less attractive without the write- downs. The inventory turnover ratio is slightly better (higher) with inventory write- downs because inventory write- downs decrease the average inventory (denominator), making inventory management appear more efficient with write- downs. Solution to 6: CAT uses the LIFO method whereas Volvo uses the FIFO method. Given increas- ing inventory costs, companies that use the FIFO inventory method are far more likely to incur inventory write- downs than those companies that use the LIFO method. This is because under the LIFO method, the inventory carrying amounts reflect the oldest costs and therefore the lowest costs given increasing inventory costs. Because inventory carrying amounts under the LIFO method are already conservatively presented, it is less likely that inventory write- downs will occur. EVALUATION OF INVENTORY MANAGEMENT: DISCLOSURES RATIOS i. describe the financial statement presentation of and disclosures relating to inventories j. explain issues that analysts should consider when examining a company’s inven- tory disclosures and other sources of information The choice of inventory valuation method impacts the financial statements. The financial statement items impacted include cost of sales, gross profit, net income, inventories, current assets, and total assets. Therefore, the choice of inventory valuation method also affects financial ratios that contain these items. Ratios such as current ratio, return on assets, gross profit margin, and inventory turnover are impacted. As a consequence, analysts must carefully consider inventory valuation method differences when evaluating a company’s performance over time or when comparing its perfor- mance with the performance of the industry or industry competitors. Additionally, the financial statement items and ratios may be impacted by adjustments of inventory carrying amounts to net realisable value or current replacement cost. 11.1 Presentation and Disclosure Disclosures are useful when analyzing a company. IFRS require the following financial statement disclosures concerning inventory: a the accounting policies adopted in measuring inventories, including the cost formula (inventory valuation method) used; b the total carrying amount of inventories and the carrying amount in classifica- tions (for example, merchandise, raw materials, production supplies, work in progress, and finished goods) appropriate to the entity; 11 © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 301. Evaluation of inventory management: Disclosures ratios 283 c the carrying amount of inventories carried at fair value less costs to sell; d the amount of inventories recognised as an expense during the period (cost of sales); e the amount of any write- down of inventories recognised as an expense in the period; f the amount of any reversal of any write- down that is recognised as a reduction in cost of sales in the period; g the circumstances or events that led to the reversal of a write- down of invento- ries; and h the carrying amount of inventories pledged as security for liabilities. Inventory- related disclosures under US GAAP are very similar to the disclosures above, except that requirements (f) and (g) are not relevant because US GAAP do not permit the reversal of prior- year inventory write- downs. US GAAP also require disclosure of significant estimates applicable to inventories and of any material amount of income resulting from the liquidation of LIFO inventory. 11.2 Inventory Ratios Three ratios often used to evaluate the efficiency and effectiveness of inventory man- agement are inventory turnover, days of inventory on hand, and gross profit mar- gin.17 These ratios are directly impacted by a company’s choice of inventory valuation method. Analysts should be aware, however, that many other ratios are also affected by the choice of inventory valuation method, although less directly. These include the current ratio, because inventory is a component of current assets; the return- on- assets ratio, because cost of sales is a key component in deriving net income and inventory is a component of total assets; and even the debt- to- equity ratio, because the cumulative measured net income from the inception of a business is an aggregate component of retained earnings. The inventory turnover ratio measures the number of times during the year a company sells (i.e., turns over) its inventory. The higher the turnover ratio, the more times that inventory is sold during the year and the lower the relative investment of resources in inventory. Days of inventory on hand can be calculated as days in the period divided by inventory turnover. Thus, inventory turnover and days of inventory on hand are inversely related. It may be that inventory turnover, however, is calculated using average inventory in the year whereas days of inventory on hand is based on the ending inventory amount. In general, inventory turnover and the number of days of inventory on hand should be benchmarked against industry norms and compared across years. A high inventory turnover ratio and a low number of days of inventory on hand might indicate highly effective inventory management. Alternatively, a high inventory ratio and a low number of days of inventory on hand could indicate that the company does not carry an adequate amount of inventory or that the company has written down inventory values. Inventory shortages could potentially result in lost sales or production problems in the case of the raw materials inventory of a manufacturer. To assess which explanation is more likely, analysts can compare the company’s inven- tory turnover and sales growth rate with those of the industry and review financial statement disclosures. Slower growth combined with higher inventory turnover could indicate inadequate inventory levels. Write- downs of inventory could reflect poor 17 Days of inventory on hand is also referred to as days in inventory and average inventory days outstanding. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 302. Reading 21 ■ Inventories 284 inventory management. Minimal write- downs and sales growth rates at or above the industry+’s growth rates would support the interpretation that the higher turnover reflects greater efficiency in managing inventory. A low inventory turnover ratio and a high number of days of inventory on hand relative to industry norms could be an indicator of slow- moving or obsolete inventory. Again, comparing the company’s sales growth across years and with the industry and reviewing financial statement disclosures can provide additional insight. The gross profit margin, the ratio of gross profit to sales, indicates the percentage of sales being contributed to net income as opposed to covering the cost of sales. Firms in highly competitive industries generally have lower gross profit margins than firms in industries with fewer competitors. A company’s gross profit margin may be a function of its type of product. A company selling luxury products will generally have higher gross profit margins than a company selling staple products. The inventory turnover of the company selling luxury products, however, is likely to be much lower than the inventory turnover of the company selling staple products. ILLUSTRATIONS OF INVENTORY ANALYSIS: ADJUSTING LIFO TO FIFO k calculate and compare ratios of companies, including companies that use differ- ent inventory methods l analyze and compare the financial statements of companies, including compa- nies that use different inventory methods IFRS and US GAAP require companies to disclose, either on the balance sheet or in the notes to the financial statements, the carrying amounts of inventories in classifications suitable to the company. For manufacturing companies, these classifications might include production supplies, raw materials, work in progress, and finished goods. For a retailer, these classifications might include significant categories of merchandise or the grouping of inventories with similar attributes. These disclosures may provide signals about a company’s future sales and profits. For example, a significant increase (attributable to increases in unit volume rather than increases in unit cost) in raw materials and/or work- in- progress inventories may signal that the company expects an increase in demand for its products. This suggests an anticipated increase in sales and profit. However, a substantial increase in finished goods inventories while raw materials and work- in- progress inventories are declining may signal a decrease in demand for the company’s products and hence lower future sales and profit. This may also signal a potential future write down of finished goods inventory. Irrespective of the signal, an analyst should thoroughly investigate the underlying reasons for any significant changes in a company’s raw materials, work- in- progress, and finished goods inventories. Analysts also should compare the growth rate of a company’s sales to the growth rate of its finished goods inventories, because this could also provide a signal about future sales and profits. For example, if the growth of inventories is greater than the growth of sales, this could indicate a decline in demand and a decrease in future earn- ings. The company may have to lower (mark down) the selling price of its products to reduce its inventory balances, or it may have to write down the value of its inventory because of obsolescence, both of which would negatively affect profits. Besides the potential for mark- downs or write- downs, having too much inventory on hand or the wrong type of inventory can have a negative financial effect on a company because 12 © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 303. Illustrations of inventory analysis: Adjusting LIFO to FIFO 285 it increases inventory related expenses such as insurance, storage costs, and taxes. In addition, it means that the company has less cash and working capital available to use for other purposes. Inventory write- downs may have a substantial impact on a company’s activity, profitability, liquidity, and solvency ratios. It is critical for the analyst to be aware of industry trends toward product obsolescence and to analyze the financial ratios for their sensitivity to potential inventory impairment. Companies can minimise the impact of inventory write- downs by better matching their inventory composition and growth with prospective customer demand. To obtain additional information about a company’s inventory and its future sales, a variety of sources of information are available. Analysts should consider the Management Discussion and Analysis (MDA) or similar sections of the company’s financial reports, industry related news and publications, and industry economic data. When conducting comparisons, differences in the choice of inventory valuation method can significantly affect the comparability of financial ratios between compa- nies. A restatement from the LIFO method to the FIFO method is critical to make a valid comparison with companies using a method other than the LIFO method such as those companies reporting under IFRS. Analysts should seek out as much infor- mation as feasible when analyzing the performance of companies. EXAMPLE 9 Comparative Illustration 1 Using CAT’s LIFO numbers as reported and FIFO adjusted numbers (Example 5) and Volvo’s numbers as reported (Example 8), compare the following for 2017: inventory turnover ratio, days of inventory on hand, gross profit margin, net profit margin, return on assets, current ratio, total liabilities- to- equity ratio, and return on equity. For the current ratio, include current provisions as part of current liabilities. For the total liabilities- to- equity ratio, include provisions in total liabilities. 2 How much do inventories represent as a component of total assets for CAT using LIFO numbers as reported and FIFO adjusted numbers, and for Volvo using reported numbers in 2017 and 2016? Discuss any changes that would concern an analyst. 3 Using the reported numbers, compare the 2016 and 2017 growth rates of CAT and Volvo for sales, finished goods inventory, and inventories other than finished goods. Solution to 1: The comparisons between Caterpillar and Volvo for 2017 are as follows: CAT (LIFO) CAT (FIFO) Volvo Inventory turnover ratio 3.33 2.76 5.04 Days of inventory on hand 109.6 days 132.2 days 72.4 days Gross profit margin 27.24% 26.74% 23.95% Net profit margin 1.66% 1.32% 6.36% Return on assetsa 0.99% 0.77% 5.25% Current ratiob 1.35 1.42 1.12 (continued) © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 304. Reading 21 ■ Inventories 286 CAT (LIFO) CAT (FIFO) Volvo Total liabilities-to-equity ratioc 4.59 4.27 2.78 Return on equityd 5.59% 4.05% 20.59% Calculations for ratios previously calculated (see Examples 5 and 8) are not shown again. a Return on assets = Net income ÷ Average total assets Volvo = 5.25 percent = 21,283 ÷ [(412,494 + 398,916) ÷ 2] b Current ratio = Current assets ÷ Current liabilities Volvo = 1.12 = [199,039 ÷ (10,806 + 167,317)] The question indicates to include current provisions in current liabilities. c Total liabilities- to- equity ratio = Total liabilities ÷ Total shareholders’ equity Volvo = 2.78 = [(29,147 + 96,213 + 10,806 + 167,317) ÷ 109,011] The question indicates to include provisions in total liabilities. d Return on equity = Net income ÷ Average shareholders’ equity CAT (LIFO) = 5.59 percent = 754 ÷ [(13,766 + 13,213) ÷ 2] CAT (FIFO) = 4.05 percent = 599 ÷ {[(13,766 + 1,924 – 710) + (13,213 + 2,139 – 770)] ÷ 2} Volvo = 20.59 percent = 21,283 ÷ [(109,011 + 97,764) ÷ 2] Comparing CAT (FIFO) and Volvo, it appears that Volvo manages its inven- tory more effectively. It has higher inventory turnover and fewer days of inventory on hand. Volvo appears to have superior profitability based on net profit margin. A primary reason for CAT’s low profitability in 2017 was due to a substantial increase in the provision for income taxes. An analyst would likely further inves- tigate CAT’s increase in provision for income taxes, as well as other reported numbers, rather than reaching a conclusion based on ratios alone (in other words, try to identify the underlying causes of changes or differences in ratios). Solution to 2: The 2017 and 2016 inventory to total assets ratios for CAT using LIFO and adjusted to FIFO and for Volvo as reported, are as follows: CAT (LIFO) CAT (FIFO) Volvo 2017 13.02% 15.28% 12.78% 2016 11.53% 14.14% 12.10% Inventory to total assets CAT (LIFO) 2017 =13.02 percent = 10,018 ÷ 76,962 CAT (LIFO) 2016 = 11.53 percent = 8,614 ÷ 74,704 CAT (FIFO) 2017 = 15.28 percent = 11,942 ÷ (76,962 + 1,924 – 710) CAT (FIFO) 2016 = 14.14 percent = 10,753 ÷ (74,704 + 2,139 – 770) Volvo 2017 = 12.78 percent = 52,701 ÷ 412,494 Volvo 2016 = 12.10 percent = 48,287 ÷ 398,916 Based on the numbers as reported, CAT appears to have a similar percentage of assets tied up in inventory as Volvo. However, when CAT’s inventory is adjusted to FIFO, it has a higher percentage of its assets tied up in inventory than Volvo. The increase in inventory as a percentage of total assets is cause for some concern. Higher inventory typically results in higher maintenance costs (for example, storage and financing costs). A build- up of slow moving or obsolete © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 305. Illustrations of inventory analysis: Adjusting LIFO to FIFO 287 inventories may result in future inventory write- downs. In Volvo’s Note 17, the breakdown by inventory classification shows a significant increase in the inven- tory of production materials. Volvo may be planning on increasing production of more finished goods inventory (which has also increased). Looking at CAT’s Note 7, all classifications of inventory seem to be increasing and because these are valued using the LIFO method, there is some cause for concern. The company must be increasing inventory quantities and adding new LIFO layers. Solution to 3: CAT’s and Volvo’s 2017 and 2016 growth rates for sales (“Sales of machinery and engines” for CAT and “Net sales” for Volvo), finished goods, and inventories other than finished goods” are as follows: 2017 CAT Volvo Sales 19.3% 10.9% Finished goods 4.0% 4.2% Inventories other than finished goods 30.2% 18.1% 2016 CAT Volvo Sales –19.0% –3.4% Finished goods –10.7% 12.8% Inventories other than finished goods –11.8% 2.3% Growth rate = (Value for year – Value for previous year)/Value for previous year 2017 CAT Sales = 19.3 percent = (42,676 – 35,773) ÷ 35,773 Finished goods = 4.0 percent = (4,761 – 4,576) ÷ 4,576 Inventories other than finished goods = 30.2 percent = [(2,802 + 2,254 + 201) – (2,102 + 1,719 + 217)] ÷ (2,102 + 1,719 + 217) 2017 Volvo Sales = 10.9 percent = (334,748 – 301,914) ÷ 301,914 Finished products = 4.2 percent = (32,304 – 31,012) ÷ 31,012 Inventories other than finished products =18.1 percent = (20,397 – 17,275) ÷ 17,275 2016 CAT Sales = –19.0 percent = (35,773 – 44,147) ÷ 44,147 Finished goods = –10.7 percent = (4,576 – 5,122) ÷ 5,122 Inventories other than finished goods = –11.8 percent = [(2,102+ 1,719 + 217) – (2,467 + 1,857 + 254)] ÷ (2,467 + 1,857 + 254) 2016 Volvo Sales = – 3.4 percent = (301,914 – 312,515) ÷ 312,515 Finished products = 12.8 percent = (31,012 – 27,496) ÷ 27,496 Inventories other than finished products = 2.3 percent = (17,275 – 16,894) ÷ 16,894 For both companies, the growth rates in finished goods inventory exceeds the growth rate in sales; this could be indicative of accumulating excess inventory. Volvo’s growth rate in finished goods compared to its growth rate in sales is significantly higher but the lower growth rates in finished goods inventory for © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 306. Reading 21 ■ Inventories 288 CAT is potentially a result of using the LIFO method versus the FIFO method. It appears Volvo is aware that an issue exists and is planning on cutting back production given the relatively small increase in inventories other than finished products. Regardless, an analyst should do further investigation before reaching any conclusion about a company’s future prospects for sales and profit. ILLUSTRATIONS OF INVENTORY ANALYSIS: IMPACTS OF WRITEDOWNS k calculate and compare ratios of companies, including companies that use differ- ent inventory methods l analyze and compare the financial statements of companies, including compa- nies that use different inventory methods EXAMPLE 10 Single Company Illustration Selected excerpts from the consolidated financial statements and notes to con- solidated financial statements for Jollof Inc., a hypothetical telecommunications company providing networking and communications solutions, are presented in Exhibits 8, 9, and 10. Exhibit 8 contains excerpts from the consolidated income statements, and Exhibit 9 contains excerpts from the consolidated balance sheets. Exhibit 10 contains excerpts from three of the notes to consolidated financial statements. Note 1 (a) discloses that Jollof’s finished goods inventories and work in progress are valued at the lower of cost or net realisable value. Note 2 (a) dis- closes that the impact of inventory and work in progress write- downs on Jollof’s income before tax was a net reduction of €239 million in 2017, a net reduction of €156 million in 2016, and a net reduction of €65 million in 2015.18 The inven- tory impairment loss amounts steadily increased from 2015 to 2017 and are included as a component, (additions)/reversals, of Jollof’s change in valuation allowance as disclosed in Note 3 (b) from Exhibit 10. Observe also that Jollof discloses its valuation allowance at 31 December 2017, 2016, and 2015 in Note 3 (b) and details on the allocation of the allowance are included in Note 3 (a). The €549 million valuation allowance is the total of a €528 million allowance for inventories and a €21 million allowance for work in progress on construc- tion contracts. Finally, observe that the €1,845 million net value for inventories (excluding construction contracts) at 31 December 2017 in Note 3 (a) reconciles with the balance sheet amount for inventories and work in progress, net, on 31 December 2017, as presented in Exhibit 9. The inventory valuation allowance represents the total amount of inventory write- downs taken for the inventory reported on the balance sheet (which is measured at the lower of cost or net realisable value). Therefore, an analyst can determine the historical cost of the company’s inventory by adding the inventory 13 18 This reduction is often referred to as a charge. An accounting charge is the recognition of a loss or expense. In this case, the charge is attributable to the impairment of assets. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 307. Illustrations of inventory analysis: Impacts of writedowns 289 valuation allowance to the reported inventory carrying amount on the balance sheet. The valuation allowance increased in magnitude and as a percentage of gross inventory values from 2015 to 2017. Exhibit 8 Alcatel- Lucent Consolidated Income Statements (€ millions) For years ended 31 December 2017 2016 2015 Revenues 14,267 14,945 10,317 Cost of sales (9,400) (10,150) (6,900) Gross profit 4,867 4,795 3,417 Administrative and selling expenses (2,598) (2,908) (1,605) Research and development costs (2,316 (2,481) (1,235) Income from operating activities before restructuring costs, impair- ment of assets, gain/(loss) on disposal of consolidated entities, and post- retirement benefit plan amendments (47) (594) 577 Restructuring costs (472) (719) (594) Impairment of assets (3,969) (2,473) (118) Gain/(loss) on disposal of consolidated entities (6) — 13 Post- retirement benefit plan amendments 39 217 — Income (loss) from operating activities (4,455) (3,569) (122) ⋮ ⋮ ⋮ ⋮ Income (loss) from continuing operations (4,373) (3,433) (184) Income (loss) from discontinued operations 28 512 133 Net income (loss) (4,345) (2,921) 51 Exhibit 9 Alcatel- Lucent Consolidated Balance Sheets (€ millions) 31 December 2017 2016 2015 ⋮ ⋮ ⋮ ⋮ Total non- current assets 10,703 16,913 21,559 Inventories and work in progress, net 1,845 1,877 1,898 Amounts due from customers on construction contracts 416 591 517 Trade receivables and related accounts, net 3,637 3,497 3,257 Advances and progress payments 83 92 73 ⋮ ⋮ ⋮ ⋮ Total current assets 12,238 11,504 13,629 Total assets 22,941 28,417 35,188 ⋮ ⋮ ⋮ ⋮ Retained earnings, fair value, and other reserves (7,409) (3,210) (2,890) ⋮ ⋮ ⋮ ⋮ Total shareholders’ equity 4,388 9,830 13,711 Pensions, retirement indemnities, and other post- retirement benefits 4,038 3,735 4,577 Bonds and notes issued, long- term 3,302 3,794 4,117 (continued) © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 308. Reading 21 ■ Inventories 290 31 December 2017 2016 2015 Other long- term debt 56 40 123 Deferred tax liabilities 968 1,593 2,170 Other non- current liabilities 372 307 232 Total non- current liabilities 8,736 9,471 11,219 Provisions 2,036 2,155 1,987 Current portion of long- term debt 921 406 975 Customers’ deposits and advances 780 711 654 Amounts due to customers on construction contracts 158 342 229 Trade payables and related accounts 3,840 3,792 3,383 Liabilities related to disposal groups held for sale — — 1,349 Current income tax liabilities 155 59 55 Other current liabilities 1,926 1,651 1,625 Total current liabilities 9,817 9,117 10,257 Total liabilities and shareholders’ equity 22,941 28,417 35,188 Exhibit 10 Jollof Inc. Selected Notes to Consolidated Financial Statements Note 1. Summary of Significant Accounting Policies (a) Inventories and work in progress Inventories and work in progress are valued at the lower of cost (includ- ing indirect production costs where applicable) or net realizable value.19 Net realizable value is the estimated sales revenue for a normal period of activity less expected completion and selling costs. Note 2. Principal uncertainties regarding the use of estimates (a) Valuation allowance for inventories and work in progress Inventories and work in progress are measured at the lower of cost or net realizable value. Valuation allowances for inventories and work in progress are calculated based on an analysis of foreseeable changes in demand, technology, or the market, in order to determine obsolete or excess inventories and work in progress. The valuation allowances are accounted for in cost of sales or in restructuring costs, depending on the nature of the amounts concerned. Exhibit 9 (Continued) 19 Cost approximates cost on a first- in, first- out basis. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 309. Illustrations of inventory analysis: Impacts of writedowns 291 31 December (€ millions) 2017 2016 2015 Valuation allowance for inventories and work in progress on construction contracts (549) (432) 318 Impact of inventory and work in prog- ress write- downs on income (loss) before income tax related reduction of goodwill and discounted operations (239) (156) (65) Note 3. Inventories and work in progress (a) Analysis of net value (€ millions) 2017 2016 2015 Raw materials and goods 545 474 455 Work in progress excluding con- struction contracts 816 805 632 Finished goods 1,011 995 1,109 Gross value (excluding construc- tion contracts) 2,373 2,274 2,196 Valuation allowance (528) (396) (298) Net value (excluding construction contracts) 1,845 1,877 1,898 Work in progress on construction contracts, gross* 184 228 291 Valuation allowance (21) (35) (19) Work in progress on construction contracts, net 163 193 272 Total, net 2,008 2,071 2,170 * Included in the amounts due from/to construction contracts. (b) Change in valuation allowance (€ millions) 2017 2016 2015 At 1 January (432) (318) (355) (Additions)/reversals (239) (156) (65) Utilization 58 32 45 Changes in consolidation group — — 45 (continued) Exhibit 10 (Continued) © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 310. Reading 21 ■ Inventories 292 (€ millions) 2017 2016 2015 Net effect of exchange rate changes and other changes 63 10 12 At 31 December (549) (432) (318) Rounding differences may result in totals that are slightly different from the sum and from corresponding numbers in the note. 1 Calculate Jollof’s inventory turnover, number of days of inventory on hand, gross profit margin, current ratio, debt- to- equity ratio, and return on total assets for 2017 and 2016 based on the numbers reported. Use an average for inventory and total asset amounts and year- end numbers for other ratio items. For debt, include only bonds and notes issued, long- term; other long- term debt; and current portion of long- term debt. 2 Based on the answer to Question 1, comment on the changes from 2016 to 2017. 3 If Jollof had used the weighted average cost method instead of the FIFO method during 2017, 2016, and 2015, what would be the effect on Jollof’s reported cost of sales and inventory carrying amounts? What would be the directional impact on the financial ratios that were calculated for Jollof in Question 1? Solution to 1: The financial ratios are as follows: 2017 2016 Inventory turnover ratio 5.05 5.38 Number of days of inventory on hand 72.3 days 67.8 days Gross profit margin 34.1% 32.1% Current ratio 1.25 1.26 Debt-to-equity ratio 0.98 0.43 Return on total assets –16.9% –9.2% Inventory turnover ratio = Cost of sales ÷ Average inventory 2017 inventory turnover ratio = 5.05 = 9,400 ÷ [(1,845 + 1,877) ÷ 2] 2016 inventory turnover ratio = 5.38 = 10,150 ÷ [(1,877 + 1,898) ÷ 2] Number of days of inventory = 365 days ÷ Inventory turnover ratio 2017 number of days of inventory = 72.3 days = 365 days ÷ 5.05 2016 number of days of inventory = 67.8 days = 365 days ÷ 5.38 Gross profit margin = Gross profit ÷ Total revenue 2017 gross profit margin = 34.1% = 4,867 ÷ 14,267 2016 gross profit margin = 32.1% = 4,795 ÷ 14,945 © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 311. Illustrations of inventory analysis: Impacts of writedowns 293 Current ratio = Current assets ÷ Current liabilities 2017 current ratio = 1.25 = 12,238 ÷ 9,817 2016 current ratio = 1.26 = 11,504 ÷ 9,117 Debt- to- equity ratio = Total debt ÷ Total shareholders’ equity 2017 debt- to- equity ratio = 0.98 = (3,302 + 56 + 921) ÷ 4,388 2016 debt- to- equity ratio = 0.43 = (3,794 + 40 + 406) ÷ 9,830 Return on assets = Net income ÷ Average total assets 2017 return on assets = –16.9% = –4,345 ÷ [(22,941 + 28,417) ÷ 2] 2016 return on assets = –9.2% = –2,921 ÷ [(28,417 + 35,188) ÷ 2] Solution to 2: From 2016 to 2017, the inventory turnover ratio declined and the number of days of inventory increased by 4.5 days. Jollof appears to be managing inventory less efficiently. The gross profit margin improved by 2.0 percent, from 32.1 percent in 2016 to 34.1 percent in 2017. The current ratio is relatively unchanged from 2016 to 2017. The debt- to- equity ratio has risen significantly in 2017 compared to 2016. Although Jollofn’s total debt has been relatively stable during this time period, the company’s equity has been declining rapidly because of the cumu- lative effect of its net losses on retained earnings. The return on assets is negative and deteriorated in 2017 compared to 2016. A larger net loss and lower total assets in 2017 resulted in a higher negative return on assets. The analyst should investigate the underlying reasons for the sharp decline in Jollof’s return on assets. From Exhibit 8, it is apparent that Jollof’s gross profit margins were insufficient to cover the administrative and selling expenses and research and development costs in 2016 and 2017. Large restructuring costs and asset impairment losses contributed to the loss from operating activities in both 2016 and 2017. Solution to 3: If inventory replacement costs were increasing during 2015, 2016, and 2017 (and inventory quantity levels were stable or increasing), Jollof’s cost of sales would have been higher and its gross profit margin would have been lower under the weighted average cost inventory method than what was reported under the FIFO method (assuming no inventory write- downs that would otherwise neutralize the differences between the inventory valuation methods). FIFO allocates the oldest inventory costs to cost of sales; the reported cost of sales would be lower under FIFO given increasing inventory costs. Inventory carrying amounts would be higher under the FIFO method than under the weighted average cost method because the more recently purchased inventory items would be included in inventory at their higher costs (again assuming no inventory write- downs that would otherwise neutralize the differences between the inventory valuation methods). Consequently, Jollof’s reported gross profit, net income, and retained earnings would also be higher for those years under the FIFO method. The effects on ratios are as follows: ■ ■ The inventory turnover ratios would all be higher under the weighted average cost method because the numerator (cost of sales) would be higher and the denominator (inventory) would be lower than what was reported by Jollof under the FIFO method. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 312. Reading 21 ■ Inventories 294 ■ ■ The number of days of inventory would be lower under the weighted aver- age cost method because the inventory turnover ratios would be higher. ■ ■ The gross profit margin ratios would all be lower under the weighted aver- age cost method because cost of sales would be higher under the weighted average cost method than under the FIFO method. ■ ■ The current ratios would all be lower under the weighted average cost method because inventory carrying values would be lower than under the FIFO method (current liabilities would be the same under both methods). ■ ■ The return- on- assets ratios would all be lower under the weighted average cost method because the incremental profit added to the numerator (net income) has a greater impact than the incremental increase to the denominator (total assets). By way of example, assume that a company has €3 million in net income and €100 million in total assets using the weighted average cost method. If the company reports another €1 million in net income by using FIFO instead of weighted average cost, it would then also report an additional €1 million in total assets (after tax). Based on this example, the return on assets is 3.00 percent (€3/€100) under the weighted average cost method and 3.96 percent (€4/€101) under the FIFO method. ■ ■ The debt- to- equity ratios would all be higher under the weighted aver- age cost method because retained earnings would be lower than under the FIFO method (again assuming no inventory write- downs that would otherwise neutralize the differences between the inventory valuation methods). Conversely, if inventory replacement costs were decreasing during 2015, 2016, and 2017 (and inventory quantity levels were stable or increasing), Jollof’s cost of sales would have been lower and its gross profit and inventory would have been higher under the weighted average cost method than were reported under the FIFO method (assuming no inventory write- downs that would oth- erwise neutralize the differences between the inventory valuation methods). As a result, the ratio assessment that was performed above would result in directly opposite conclusions. SUMMARY The choice of inventory valuation method (cost formula or cost flow assumption) can have a potentially significant impact on inventory carrying amounts and cost of sales. These in turn impact other financial statement items, such as current assets, total assets, gross profit, and net income. The financial statements and accompanying notes provide important information about a company’s inventory accounting policies that the analyst needs to correctly assess financial performance and compare it with that of other companies. Key concepts in this reading are as follows: ■ ■ Inventories are a major factor in the analysis of merchandising and manufactur- ing companies. Such companies generate their sales and profits through inven- tory transactions on a regular basis. An important consideration in determining profits for these companies is measuring the cost of sales when inventories are sold. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 313. Summary 295 ■ ■ The total cost of inventories comprises all costs of purchase, costs of conver- sion, and other costs incurred in bringing the inventories to their present loca- tion and condition. Storage costs of finished inventory and abnormal costs due to waste are typically treated as expenses in the period in which they occurred. ■ ■ The allowable inventory valuation methods implicitly involve different assump- tions about cost flows. The choice of inventory valuation method determines how the cost of goods available for sale during the period is allocated between inventory and cost of sales. ■ ■ IFRS allow three inventory valuation methods (cost formulas): first- in, first- out (FIFO); weighted average cost; and specific identification. The specific identi- fication method is used for inventories of items that are not ordinarily inter- changeable and for goods or services produced and segregated for specific proj- ects. US GAAP allow the three methods above plus the last- in, first- out (LIFO) method. The LIFO method is widely used in the United States for both tax and financial reporting purposes because of potential income tax savings. ■ ■ The choice of inventory method affects the financial statements and any financial ratios that are based on them. As a consequence, the analyst must carefully consider inventory valuation method differences when evaluating a company’s performance over time or in comparison to industry data or industry competitors. ■ ■ A company must use the same cost formula for all inventories having a similar nature and use to the entity. ■ ■ The inventory accounting system (perpetual or periodic) may result in different values for cost of sales and ending inventory when the weighted average cost or LIFO inventory valuation method is used. ■ ■ Under US GAAP, companies that use the LIFO method must disclose in their financial notes the amount of the LIFO reserve or the amount that would have been reported in inventory if the FIFO method had been used. This information can be used to adjust reported LIFO inventory and cost of goods sold balances to the FIFO method for comparison purposes. ■ ■ LIFO liquidation occurs when the number of units in ending inventory declines from the number of units that were present at the beginning of the year. If inventory unit costs have generally risen from year to year, this will produce an inventory- related increase in gross profits. ■ ■ Consistency of inventory costing is required under both IFRS and US GAAP. If a company changes an accounting policy, the change must be justifiable and applied retrospectively to the financial statements. An exception to the retro- spective restatement is when a company reporting under US GAAP changes to the LIFO method. ■ ■ Under IFRS, inventories are measured at the lower of cost and net realis- able value. Net realisable value is the estimated selling price in the ordinary course of business less the estimated costs necessary to make the sale. Under US GAAP, inventories are measured at the lower of cost, market value, or net realisable value depending upon the inventory method used. Market value is defined as current replacement cost subject to an upper limit of net realizable value and a lower limit of net realizable value less a normal profit margin. Reversals of previous write- downs are permissible under IFRS but not under US GAAP. ■ ■ Reversals of inventory write- downs may occur under IFRS but are not allowed under US GAAP. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 314. Reading 21 ■ Inventories 296 ■ ■ Changes in the carrying amounts within inventory classifications (such as raw materials, work- in- process, and finished goods) may provide signals about a company’s future sales and profits. Relevant information with respect to inven- tory management and future sales may be found in the Management Discussion and Analysis or similar items within the annual or quarterly reports, industry news and publications, and industry economic data. ■ ■ The inventory turnover ratio, number of days of inventory ratio, and gross profit margin ratio are useful in evaluating the management of a company’s inventory. ■ ■ Inventory management may have a substantial impact on a company’s activ- ity, profitability, liquidity, and solvency ratios. It is critical for the analyst to be aware of industry trends and management’s intentions. ■ ■ Financial statement disclosures provide information regarding the accounting policies adopted in measuring inventories, the principal uncertainties regarding the use of estimates related to inventories, and details of the inventory carrying amounts and costs. This information can greatly assist analysts in their evalua- tion of a company’s inventory management. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 315. Practice Problems 297 PRACTICE PROBLEMS 1 Inventory cost is least likely to include: A production- related storage costs. B costs incurred as a result of normal waste of materials. C transportation costs of shipping inventory to customers. 2 Mustard Seed PLC adheres to IFRS. It recently purchased inventory for €100 million and spent €5 million for storage prior to selling the goods. The amount it charged to inventory expense (€ millions) was closest to: A €95. B €100. C €105. 3 Carrying inventory at a value above its historical cost would most likely be per- mitted if: A the inventory was held by a producer of agricultural products. B financial statements were prepared using US GAAP. C the change resulted from a reversal of a previous write- down. The following information relates to Questions 4 and 5 A retail company is comparing different approaches to valuing inventory. The company has one product that it sells for $50. Table 1 Units Purchased and Sold (first quarter) Date Units Purchased Purchase Price Units Sold Selling Price Inventory Units on Hand 2 Jan 1,000 $20.00 1,000 17 Jan 500 $50.00 500 16 Feb 1,000 $18.00 1,500 3 Mar 1,200 $50.00 300 13 Mar 1,000 $17.00 1,300 23 Mar 500 $50.00 800 End of quarter totals: 3,000 $55,000 2,200 $110,000 © 2019 CFA Institute. All rights reserved. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 316. Reading 21 ■ Inventories 298 Table 2 Comparison of Inventory Methods and Models End of Quarter Valuations 31 March Perpetual LIFO Periodic LIFO Perpetual FIFO Sales $110,000 $110,000 $110,000 Ending inventory $16,000 $13,600 Cost of goods sold $39,000 $41,400 Gross profit $71,000 $68,600 Inventory turnover ratio 279% Note: LIFO is last in, first out and FIFO is first in, first out. 4 What is the value of ending inventory for the first quarter if the company uses a perpetual LIFO inventory valuation method? A $14,500 B $15,000 C $16,000 5 Which inventory accounting method results in the lowest inventory turnover ratio for the first quarter? A Periodic LIFO B Perpetual LIFO C Perpetual FIFO 6 During periods of rising inventory unit costs, a company using the FIFO method rather than the LIFO method will report a lower: A current ratio. B inventory turnover. C gross profit margin. 7 LIFO reserve is most likely to increase when inventory unit: A costs are increasing. B costs are decreasing. C levels are decreasing. 8 If inventory unit costs are increasing from period-to-period, a LIFO liquidation is most likely to result in an increase in: A gross profit. B LIFO reserve. C inventory carrying amounts. 9 A company using the LIFO method reports the following in £: 2018 2017 Cost of goods sold (COGS) 50,800 48,500 Ending inventories 10,550 10,000 LIFO reserve 4,320 2,600 Cost of goods sold for 2018 under the FIFO method is closest to: © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 317. Practice Problems 299 A £48,530. B £49,080. C £52,520. 10 Eric’s Used Book Store prepares its financial statements in accordance with IFRS. Inventory was purchased for £1 million and later marked down to £550,000. One of the books, however, was later discovered to be a rare collect- ible item, and the inventory is now worth an estimated £3 million. The inven- tory is most likely reported on the balance sheet at: A £550,000. B £1,000,000. C £3,000,000. 11 Fernando’s Pasta purchased inventory and later wrote it down. The current net realisable value is higher than the value when written down. Fernando’s inven- tory balance will most likely be: A higher if it complies with IFRS. B higher if it complies with US GAAP. C the same under US GAAP and IFRS. 12 A write down of the value of inventory to its net realizable value will have a positive effect on the: A balance sheet. B income statement. C inventory turnover ratio. For questions 13–24, assume the companies use a periodic inventory system 13 Cinnamon Corp. started business in 2017 and uses the weighted average cost method. During 2017, it purchased 45,000 units of inventory at €10 each and sold 40,000 units for €20 each. In 2018, it purchased another 50,000 units at €11 each and sold 45,000 units for €22 each. Its 2018 cost of sales (€ thousands) was closest to: A €490. B €491. C €495. 14 Zimt AG started business in 2017 and uses the FIFO method. During 2017, it purchased 45,000 units of inventory at €10 each and sold 40,000 units for €20 each. In 2018, it purchased another 50,000 units at €11 each and sold 45,000 units for €22 each. Its 2018 ending inventory balance (€ thousands) was closest to: A €105. B €109. C €110. 15 Zimt AG uses the FIFO method, and Nutmeg Inc. uses the LIFO method. Compared to the cost of replacing the inventory, during periods of rising prices, the cost of sales reported by: © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 318. Reading 21 ■ Inventories 300 A Zimt is too low. B Nutmeg is too low. C Nutmeg is too high. 16 Zimt AG uses the FIFO method, and Nutmeg Inc. uses the LIFO method. Compared to the cost of replacing the inventory, during periods of rising prices the ending inventory balance reported by: A Zimt is too high. B Nutmeg is too low. C Nutmeg is too high. 17 Like many technology companies, TechnoTools operates in an environment of declining prices. Its reported profits will tend to be highest if it accounts for inventory using the: A FIFO method. B LIFO method. C weighted average cost method. 18 Compared to using the weighted average cost method to account for inventory, during a period in which prices are generally rising, the current ratio of a com- pany using the FIFO method would most likely be: A lower. B higher. C dependent upon the interaction with accounts payable. 19 Zimt AG wrote down the value of its inventory in 2017 and reversed the write- down in 2018. Compared to the ratios that would have been calculated if the write- down had never occurred, Zimt’s reported 2017: A current ratio was too high. B gross margin was too high. C inventory turnover was too high. 20 Zimt AG wrote down the value of its inventory in 2017 and reversed the write- down in 2018. Compared to the results the company would have reported if the write- down had never occurred, Zimt’s reported 2018: A profit was overstated. B cash flow from operations was overstated. C year- end inventory balance was overstated. 21 Compared to a company that uses the FIFO method, during periods of rising prices a company that uses the LIFO method will most likely appear more: A liquid. B efficient. C profitable. 22 Nutmeg, Inc. uses the LIFO method to account for inventory. During years in which inventory unit costs are generally rising and in which the company purchases more inventory than it sells to customers, its reported gross profit margin will most likely be: A lower than it would be if the company used the FIFO method. B higher than it would be if the company used the FIFO method. C about the same as it would be if the company used the FIFO method. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 319. Practice Problems 301 23 Compared to using the FIFO method to account for inventory, during peri- ods of rising prices, a company using the LIFO method is most likely to report higher: A net income. B cost of sales. C income taxes. 24 Carey Company adheres to US GAAP, whereas Jonathan Company adheres to IFRS. It is least likely that: A Carey has reversed an inventory write-down. B Jonathan has reversed an inventory write-down. C Jonathan and Carey both use the FIFO inventory accounting method. 25 Company A adheres to US GAAP and Company B adheres to IFRS. Which of the following is most likely to be disclosed on the financial statements of both companies? A Any material income resulting from the liquidation of LIFO inventory B The amount of inventories recognized as an expense during the period C The circumstances that led to the reversal of a write down of inventories 26 Which of the following most likely signals that a manufacturing company expects demand for its product to increase? A Finished goods inventory growth rate higher than the sales growth rate B Higher unit volumes of work in progress and raw material inventories C Substantially higher finished goods, with lower raw materials and work-in-process 27 Compared with a company that uses the FIFO method, during a period of rising unit inventory costs, a company using the LIFO method will most likely appear more: A liquid. B efficient. C profitable. 28 In a period of declining inventory unit costs and constant or increasing inven- tory quantities, which inventory method is most likely to result in a higher debt- to-equity ratio? A LIFO B FIFO C Weighted average cost The following information relates to Questions 29–36 Hans Annan, CFA, a food and beverage analyst, is reviewing Century Chocolate’s inventory policies as part of his evaluation of the company. Century Chocolate, based in Switzerland, manufactures chocolate products and purchases and resells other confectionery products to complement its chocolate line. Annan visited Century Chocolate’s manufacturing facility last year. He learned that cacao beans, imported © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 320. Reading 21 ■ Inventories 302 from Brazil, represent the most significant raw material and that the work-in- progress inventory consists primarily of three items: roasted cacao beans, a thick paste pro- duced from the beans (called chocolate liquor), and a sweetened mixture that needs to be “conched” to produce chocolate. On the tour, Annan learned that the conch- ing process ranges from a few hours for lower- quality products to six days for the highest- quality chocolates. While there, Annan saw the facility’s climate- controlled area where manufactured finished products (cocoa and chocolate) and purchased finished goods are stored prior to shipment to customers. After touring the facility, Annan had a discussion with Century Chocolate’s CFO regarding the types of costs that were included in each inventory category. Annan has asked his assistant, Joanna Kern, to gather some preliminary information regarding Century Chocolate’s financial statements and inventories. He also asked Kern to calculate the inventory turnover ratios for Century Chocolate and another chocolate manufacturer for the most recent five years. Annan does not know Century Chocolate’s most direct competitor, so he asks Kern to do some research and select the most appropriate company for the ratio comparison. Kern reports back that Century Chocolate prepares its financial statements in accordance with IFRS. She tells Annan that the policy footnote states that raw materials and purchased finished goods are valued at purchase cost whereas work in progress and manufactured finished goods are valued at production cost. Raw material inven- tories and purchased finished goods are accounted for using the FIFO (first- in, first- out) method, and the weighted average cost method is used for other inventories. An allowance is established when the net realisable value of any inventory item is lower than the value calculated above. Kern provides Annan with the selected financial statements and inventory data for Century Chocolate shown in Exhibits 1 through 5. The ratio exhibit Kern pre- pared compares Century Chocolate’s inventory turnover ratios to those of Gordon’s Goodies, a US- based company. Annan returns the exhibit and tells Kern to select a different competitor that reports using IFRS rather than US GAAP. During this initial review, Annan asks Kern why she has not indicated whether Century Chocolate uses a perpetual or a periodic inventory system. Kern replies that she learned that Century Chocolate uses a perpetual system but did not include this information in her report because inventory values would be the same under either a perpetual or periodic inventory system. Annan tells Kern she is wrong and directs her to research the matter. While Kern is revising her analysis, Annan reviews the most recent month’s Cocoa Market Review from the International Cocoa Organization. He is drawn to the state- ment that “the ICCO daily price, averaging prices in both futures markets, reached a 29- year high in US$ terms and a 23- year high in SDRs terms (the SDR unit comprises a basket of major currencies used in international trade: US$, euro, pound sterling and yen).” Annan makes a note that he will need to factor the potential continuation of this trend into his analysis. Exhibit 1 Century Chocolate Income Statements (CHF Millions) For Years Ended 31 December 2018 2017 Sales 95,290 93,248 Cost of sales –41,043 –39,047 Marketing, administration, and other expenses –35,318 –42,481 Profit before taxes 18,929 11,720 Taxes –3,283 –2,962 Profit for the period 15,646 8,758 © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 321. Practice Problems 303 Exhibit 2 Century Chocolate Balance Sheets (CHF Millions) 31 December 2018 2017 Cash, cash equivalents, and short- term investments 6,190 8,252 Trade receivables and related accounts, net 11,654 12,910 Inventories, net 8,100 7,039 Other current assets 2,709 2,812 Total current assets 28,653 31,013 Property, plant, and equipment, net 18,291 19,130 Other non- current assets 45,144 49,875 Total assets 92,088 100,018 Trade and other payables 10,931 12,299 Other current liabilities 17,873 25,265 Total current liabilities 28,804 37,564 Non-current liabilities 15,672 14,963 Total liabilities 44,476 52,527 Equity Share capital 332 341 Retained earnings and other reserves 47,280 47,150 Total equity 47,612 47,491 Total liabilities and shareholders’ equity 92,088 100,018 Exhibit 3 Century Chocolate Supplementary Footnote Disclosures: Inventories (CHF Millions) 31 December 2018 2017 Raw Materials 2,154 1,585 Work in Progress 1,061 1,027 Finished Goods 5,116 4,665 Total inventories before allowance 8,331 7,277 Allowance for write- downs to net realisable value –231 –238 Total inventories net of allowance 8,100 7,039 Exhibit 4 Century Chocolate Inventory Record for Purchased Lemon Drops Date Cartons Per Unit Amount (CHF) Beginning inventory 100 22 4 Feb 09 Purchase 40 25 (continued) © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 322. Reading 21 ■ Inventories 304 Date Cartons Per Unit Amount (CHF) 3 Apr 09 Sale 50 32 23 Jul 09 Purchase 70 30 16 Aug 09 Sale 100 32 9 Sep 09 Sale 35 32 15 Nov 09 Purchase 100 28 Exhibit 5 Century Chocolate Net Realisable Value Information for Black Licorice Jelly Beans 2018 2017 FIFO cost of inventory at 31 December (CHF) 314,890 374,870 Ending inventory at 31 December (Kilograms) 77,750 92,560 Cost per unit (CHF) 4.05 4.05 Net Realisable Value (CHF per Kilograms) 4.20 3.95 29 The costs least likely to be included by the CFO as inventory are: A storage costs for the chocolate liquor. B excise taxes paid to the government of Brazil for the cacao beans. C storage costs for chocolate and purchased finished goods awaiting shipment to customers. 30 What is the most likely justification for Century Chocolate’s choice of inventory valuation method for its purchased finished goods? A It is the preferred method under IFRS. B It allocates the same per unit cost to both cost of sales and inventory. C Ending inventory reflects the cost of goods purchased most recently. 31 In Kern’s comparative ratio analysis, the 2018 inventory turnover ratio for Century Chocolate is closest to: A 5.07. B 5.42. C 5.55. 32 The most accurate statement regarding Annan’s reasoning for requiring Kern to select a competitor that reports under IFRS for comparative purposes is that under US GAAP: A fair values are used to value inventory. B the LIFO method is permitted to value inventory. C the specific identification method is permitted to value inventory. 33 Annan’s statement regarding the perpetual and periodic inventory systems is most significant when which of the following costing systems is used? A LIFO. Exhibit 4 (Continued) © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 323. Practice Problems 305 B FIFO. C Specific identification. 34 Using the inventory record for purchased lemon drops shown in Exhibit 4, the cost of sales for 2018 will be closest to: A CHF 3,550. B CHF 4,550. C CHF 4,850. 35 Ignoring any tax effect, the 2018 net realisable value reassessment for the black licorice jelly beans will most likely result in: A an increase in gross profit of CHF 7,775. B an increase in gross profit of CHF 11,670. C no impact on cost of sales because under IFRS, write-downs cannot be reversed. 36 If the trend noted in the ICCO report continues and Century Chocolate plans to maintain constant or increasing inventory quantities, the most likely impact on Century Chocolate’s financial statements related to its raw materials inven- tory will be: A a cost of sales that more closely reflects current replacement values. B a higher allocation of the total cost of goods available for sale to cost of sales. C a higher allocation of the total cost of goods available for sale to ending inventory. The following information relates to Questions 37–42 John Martinson, CFA, is an equity analyst with a large pension fund. His supervisor, Linda Packard, asks him to write a report on Karp Inc. Karp prepares its financial statements in accordance with US GAAP. Packard is particularly interested in the effects of the company’s use of the LIFO method to account for its inventory. For this purpose, Martinson collects the financial data presented in Exhibits 1 and 2. Exhibit 1 Balance Sheet Information (US$ Millions) As of 31 December 2018 2017 Cash and cash equivalents 172 157 Accounts receivable 626 458 Inventories 620 539 Other current assets 125 65 Total current assets 1,543 1,219 Property and equipment, net 3,035 2,972 Total assets 4,578 4,191 Total current liabilities 1,495 1,395 Long-term debt 644 604 (continued) © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 324. Reading 21 ■ Inventories 306 As of 31 December 2018 2017 Total liabilities 2,139 1,999 Common stock and paid in capital 1,652 1,652 Retained earnings 787 540 Total shareholders’ equity 2,439 2,192 Total liabilities and shareholders’ equity 4,578 4,191 Exhibit 2 Income Statement Information (US$ Millions) For the Year Ended 31 December 2018 2017 Sales 4,346 4,161 Cost of goods sold 2,211 2,147 Depreciation and amortisation expense 139 119 Selling, general, and administrative expense 1,656 1,637 Interest expense 31 18 Income tax expense 62 48 Net income 247 192 Martinson finds the following information in the notes to the financial statements: ■ ■ The LIFO reserves as of 31 December 2018 and 2017 are $155 million and $117 million respectively, and ■ ■ The effective income tax rate applicable to Karp for 2018 and earlier periods is 20 percent. 37 If Karp had used FIFO instead of LIFO, the amount of inventory reported as of 31 December 2018 would have been closest to: A $465 million. B $658 million. C $775 million. 38 If Karp had used FIFO instead of LIFO, the amount of cost of goods sold reported by Karp for the year ended 31 December 2018 would have been closest to: A $2,056 million. B $2,173 million. C $2,249 million. 39 If Karp had used FIFO instead of LIFO, its reported net income for the year ended 31 December 2018 would have been higher by an amount closest to: A $30 million. B $38 million. C $155 million. Exhibit 1 (Continued) © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 325. Practice Problems 307 40 If Karp had used FIFO instead of LIFO, Karp’s retained earnings as of 31 December 2018 would have been higher by an amount closest to: A $117 million. B $124 million. C $155 million. 41 If Karp had used FIFO instead of LIFO, which of the following ratios computed as of 31 December 2018 would most likely have been lower? A Cash ratio. B Current ratio. C Gross profit margin. 42 If Karp had used FIFO instead of LIFO, its debt to equity ratio computed as of 31 December 2018 would have: A increased. B decreased. C remained unchanged. The following information relates to Questions 43–48 Robert Groff, an equity analyst, is preparing a report on Crux Corp. As part of his report, Groff makes a comparative financial analysis between Crux and its two main competitors, Rolby Corp. and Mikko Inc. Crux and Mikko report under US GAAP and Rolby reports under IFRS. Groff gathers information on Crux, Rolby, and Mikko. The relevant financial infor- mation he compiles is in Exhibit 1. Some information on the industry is in Exhibit 2. Exhibit 1 Selected Financial Information (US$ Millions) Crux Rolby Mikko Inventory valuation method LIFO FIFO LIFO From the Balance Sheets As of 31 December 2018 Inventory, gross 480 620 510 Valuation allowance 20 25 14 Inventory, net 460 595 496 Total debt 1,122 850 732 Total shareholders’ equity 2,543 2,403 2,091 As of 31 December 2017 Inventory, gross 465 602 401 Valuation allowance 23 15 12 Inventory, net 442 587 389 From the Income Statements Year Ended 31 December 2018 (continued) © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 326. Reading 21 ■ Inventories 308 Crux Rolby Mikko Revenues 4,609 5,442 3,503 Cost of goods solda 3,120 3,782 2,550 Net income 229 327 205 aCharges included in cost of goods sold for inventory write-downs* 13 15 15 * This does not match the change in the inventory valuation allowance because the valuation allowance is reduced to reflect the valuation allowance attached to items sold and increased for additional necessary write- downs. LIFO Reserve As of 31 December 2018 55 0 77 As of 31 December 2017 72 0 50 As of 31 December 2016 96 0 43 Tax Rate Effective tax rate 30% 30% 30% Exhibit 2 Industry Information 2018 2017 2016 Raw materials price index 112 105 100 Finished goods price index 114 106 100 To compare the financial performance of the three companies, Groff decides to convert LIFO figures into FIFO figures, and adjust figures to assume no valuation allowance is recognized by any company. After reading Groff’s draft report, his supervisor, Rachel Borghi, asks him the following questions: Question 1 Which company’s gross profit margin would best reflect current costs of the industry? Question 2 Would Rolby’s valuation method show a higher gross profit mar- gin than Crux’s under an inflationary, a deflationary, or a stable price scenario? Question 3 Which group of ratios usually appears more favorable with an inventory write-down? 43 Crux’s inventory turnover ratio computed as of 31 December 2018, after the adjustments suggested by Groff, is closest to: A 5.67. B 5.83. C 6.13. Exhibit 1 (Continued) © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 327. Practice Problems 309 44 Rolby’s net profit margin for the year ended 31 December 2018, after the adjust- ments suggested by Groff, is closest to: A 6.01%. B 6.20%. C 6.28%. 45 Compared with its unadjusted debt-to-equity ratio, Mikko’s debt-to-equity ratio as of 31 December 2018, after the adjustments suggested by Groff, is: A lower. B higher. C the same. 46 The best answer to Borghi’s Question 1 is: A Crux’s. B Rolby’s. C Mikko’s. 47 The best answer to Borghi’s Question 2 is: A Stable. B Inflationary. C Deflationary. 48 The best answer to Borghi’s Question 3 is: A Activity ratios. B Solvency ratios. C Profitability ratios. The following information relates to Questions 49–55 ZP Corporation is a (hypothetical) multinational corporation headquartered in Japan that trades on numerous stock exchanges. ZP prepares its consolidated financial statements in accordance with US GAAP. Excerpts from ZP’s 2018 annual report are shown in Exhibits 1–3. Exhibit 1 Consolidated Balance Sheets (¥ Millions) 31 December 2017 2018 Current Assets Cash and cash equivalents ¥542,849 ¥814,760 ⋮ ⋮ ⋮ Inventories 608,572 486,465 ⋮ ⋮ ⋮ Total current assets 4,028,742 3,766,309 ⋮ ⋮ ⋮ Total assets ¥10,819,440 ¥9,687,346 (continued) © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 328. Reading 21 ■ Inventories 310 31 December 2017 2018 ⋮ ⋮ ⋮ Total current liabilities ¥3,980,247 ¥3,529,765 ⋮ ⋮ ⋮ Total long- term liabilities 2,663,795 2,624,002 Minority interest in consolidated subsidiaries 218,889 179,843 Total shareholders’ equity 3,956,509 3,353,736 Total liabilities and shareholders’ equity ¥10,819,440 ¥9,687,346 Exhibit 2 Consolidated Statements of Income (¥ Millions) For the years ended 31 December 2016 2017 2018 Net revenues Sales of products ¥7,556,699 ¥8,273,503 ¥6,391,240 Financing operations 425,998 489,577 451,950 7,982,697 8,763,080 6,843,190 Cost and expenses Cost of products sold 6,118,742 6,817,446 5,822,805 Cost of financing operations 290,713 356,005 329,128 Selling, general and administrative 827,005 832,837 844,927 ⋮ ⋮ ⋮ ⋮ Operating income (loss) 746,237 756,792 –153,670 ⋮ ⋮ ⋮ ⋮ Net income ¥548,011 ¥572,626 –¥145,646 Exhibit 3 Selected Disclosures in the 2018 Annual Report Management’s Discussion and Analysis of Financial Condition and Results of Operations Cost reduction efforts were offset by increased prices of raw mate- rials, other production materials and parts … Inventories decreased during fiscal 2018 by ¥122.1 billion, or 20.1%, to ¥486.5 billion. This reflects the impacts of decreased sales volumes and fluctuations in foreign currency translation rates. Management Corporate Information Risk Factors Industry and Business Risks Exhibit 1 (Continued) © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 329. Practice Problems 311 The worldwide market for our products is highly competitive. ZP faces intense competition from other manufacturers in the respective markets in which it operates. Competition has intensified due to the worldwide deterioration in economic conditions. In addition, com- petition is likely to further intensify because of continuing globaliza- tion, possibly resulting in industry reorganization. Factors affecting competition include product quality and features, the amount of time required for innovation and development, pricing, reliability, safety, economy in use, customer service and financing terms. Increased competition may lead to lower unit sales and excess production capacity and excess inventory. This may result in a further downward price pressure. ZP’s ability to adequately respond to the recent rapid changes in the industry and to maintain its competitiveness will be fundamental to its future success in maintaining and expanding its market share in existing and new markets. Notes to Consolidated Financial Statements 2. Summary of significant accounting policies: Inventories. Inventories are valued at cost, not in excess of market. Cost is determined on the “average- cost” basis, except for the cost of finished products carried by certain subsidiary companies which is determined “last- in, first- out” (“LIFO”) basis. Inventories valued on the LIFO basis totaled ¥94,578 million and ¥50,037 million at December 31, 2017 and 2018, respectively. Had the “first- in, first- out” basis been used for those companies using the LIFO basis, inventories would have been ¥10,120 million and ¥19,660 million higher than reported at December 31, 2017 and 2018, respectively. 9. Inventories: Inventories consist of the following: 31 December (¥ Millions) 2017 2018 Finished goods ¥ 403,856 ¥ 291,977 Raw materials 99,869 85,966 Work in process 79,979 83,890 Supplies and other 24,868 24,632 ¥ 608,572 ¥ 486,465 49 The MDA indicated that the prices of raw material, other production materi- als, and parts increased. Based on the inventory valuation methods described in Note 2, which inventory classification would least accurately reflect current prices? A Raw materials. B Finished goods. C Work in process. Exhibit 3 (Continued) © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 330. Reading 21 ■ Inventories 312 50 The 2017 inventory value as reported on the 2018 Annual Report if the com- pany had used the FIFO inventory valuation method instead of the LIFO inven- tory valuation method for a portion of its inventory would be closest to: A ¥104,698 million. B ¥506,125 million. C ¥618,692 million. 51 If ZP had prepared its financial statement in accordance with IFRS, the inven- tory turnover ratio (using average inventory) for 2018 would be: A lower. B higher. C the same. 52 Inventory levels decreased from 2017 to 2018 for all of the following reasons except: A LIFO liquidation. B decreased sales volume. C fluctuations in foreign currency translation rates. 53 Which observation is most likely a result of looking only at the information reported in Note 9? A Increased competition has led to lower unit sales. B There have been significant price increases in supplies. C Management expects a further downturn in sales during 2019. 54 Note 2 indicates that, “Inventories valued on the LIFO basis totaled ¥94,578 million and ¥50,037 million at December 31, 2017 and 2018, respec- tively.” Based on this, the LIFO reserve should most likely: A increase. B decrease. C remain the same. 55 The Industry and Business Risk excerpt states that, “Increased competition may lead to lower unit sales and excess production capacity and excess inventory. This may result in a further downward price pressure.” The downward price pressure could lead to inventory that is valued above current market prices or net realisable value. Any write-downs of inventory are least likely to have a significant effect on the inventory valued using: A weighted average cost. B first-in, first-out (FIFO). C last-in, first-out (LIFO). © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 331. Solutions 313 SOLUTIONS 1 C is correct. Transportation costs incurred to ship inventory to customers are an expense and may not be capitalized in inventory. (Transportation costs incurred to bring inventory to the business location can be capitalized in inven- tory.) Storage costs required as part of production, as well as costs incurred as a result of normal waste of materials, can be capitalized in inventory. (Costs incurred as a result of abnormal waste must be expensed.) 2 B is correct. Inventory expense includes costs of purchase, costs of conversion, and other costs incurred in bringing the inventories to their present loca- tion and condition. It does not include storage costs not required as part of production. 3 A is correct. IFRS allow the inventories of producers and dealers of agricultural and forest products, agricultural produce after harvest, and minerals and min- eral products to be carried at net realisable value even if above historical cost. (US GAAP treatment is similar.) 4 A is correct. A perpetual inventory system updates inventory values and quan- tities and cost of goods sold continuously to reflect purchases and sales. The ending inventory of 800 units consists of 300 units at $20 and 500 units at $17. (300 × $20) + (500 × $17) = $14,500 5 A is correct. In an environment with falling inventory costs and declining inventory levels, periodic LIFO will result in a higher ending inventory value and lower cost of goods sold versus perpetual LIFO and perpetual FIFO meth- ods. This results in a lower inventory turnover ratio, which is calculated as follows: Inventory turnover ratio = Cost of goods sold/Ending inventory The inventory turnover ratio using periodic LIFO is $39,000/$16,000 = 244% or 2.44 times. The inventory turnover ratio using perpetual LIFO is 279% or 2.79 times, which is provided in Table 2 (= 40,500/14,500 from previous question). The inventory turnover for perpetual FIFO is $41,400/$13,600 = 304% or 3.04 times. 6 B is correct. During a period of rising inventory costs, a company using the FIFO method will allocate a lower amount to cost of goods sold and a higher amount to ending inventory as compared with the LIFO method. The inventory turnover ratio is the ratio of cost of sales to ending inventory. A company using the FIFO method will produce a lower inventory turnover ratio as compared with the LIFO method. The current ratio (current assets/current liabilities) and the gross profit margin [gross profit/sales = (sales less cost of goods sold)/sales] will be higher under the FIFO method than under the LIFO method in periods of rising inventory unit costs. 7 A is correct. LIFO reserve is the FIFO inventory value less the LIFO inventory value. In periods of rising inventory unit costs, the carrying amount of inven- tory under FIFO will always exceed the carrying amount of inventory under LIFO. The LIFO reserve may increase over time as a result of the increasing difference between the older costs used to value inventory under LIFO and the © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 332. Reading 21 ■ Inventories 314 more recent costs used to value inventory under FIFO. When inventory unit levels are decreasing, the company will experience a LIFO liquidation, reducing the LIFO reserve. 8 A is correct. When the number of units sold exceeds the number of units purchased, a company using LIFO will experience a LIFO liquidation. If inven- tory unit costs have been rising from period- to- period and a LIFO liquida- tion occurs, it will produce an increase in gross profit as a result of the lower inventory carrying amounts of the liquidated units (lower cost per unit of the liquidated units). 9 B is correct. The adjusted COGS under the FIFO method is equal to COGS under the LIFO method less the increase in LIFO reserve: COGS (FIFO) = COGS (LIFO) – Increase in LIFO reserve COGS (FIFO) = £50,800 – (£4,320 – £2,600) COGS (FIFO) = £49,080 10 B is correct. Under IFRS, the reversal of write- downs is required if net real- isable value increases. The inventory will be reported on the balance sheet at £1,000,000. The inventory is reported at the lower of cost or net realisable value. Under US GAAP, inventory is carried at the lower of cost or market value. After a write- down, a new cost basis is determined and additional revisions may only reduce the value further. The reversal of write- downs is not permitted. 11 A is correct. IFRS require the reversal of inventory write- downs if net realisable values increase; US GAAP do not permit the reversal of write- downs. 12 C is correct. Activity ratios (for example, inventory turnover and total asset turnover) will be positively affected by a write down to net realizable value because the asset base (denominator) is reduced. On the balance sheet, the inventory carrying amount is written down to its net realizable value and the loss in value (expense) is generally reflected on the income statement in cost of goods sold, thus reducing gross profit, operating profit, and net income. 13 B is correct. Cinnamon uses the weighted average cost method, so in 2018, 5,000 units of inventory were 2017 units at €10 each and 50,000 were 2008 purchases at €11. The weighted average cost of inventory during 2008 was thus (5,000 × 10) + (50,000 × 11) = 50,000 + 550,000 = €600,000, and the weighted average cost was approximately €10.91 = €600,000/55,000. Cost of sales was €10.91 × 45,000, which is approximately €490,950. 14 C is correct. Zimt uses the FIFO method, and thus the first 5,000 units sold in 2018 depleted the 2017 inventory. Of the inventory purchased in 2018, 40,000 units were sold and 10,000 remain, valued at €11 each, for a total of €110,000. 15 A is correct. Zimt uses the FIFO method, so its cost of sales represents units purchased at a (no longer available) lower price. Nutmeg uses the LIFO method, so its cost of sales is approximately equal to the current replacement cost of inventory. 16 B is correct. Nutmeg uses the LIFO method, and thus some of the inventory on the balance sheet was purchased at a (no longer available) lower price. Zimt uses the FIFO method, so the carrying value on the balance sheet represents the most recently purchased units and thus approximates the current replacement cost. 17 B is correct. In a declining price environment, the newest inventory is the lowest- cost inventory. In such circumstances, using the LIFO method (selling the newer, cheaper inventory first) will result in lower cost of sales and higher profit. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 333. Solutions 315 18 B is correct. In a rising price environment, inventory balances will be higher for the company using the FIFO method. Accounts payable are based on amounts due to suppliers, not the amounts accrued based on inventory accounting. 19 C is correct. The write- down reduced the value of inventory and increased cost of sales in 2017. The higher numerator and lower denominator mean that the inventory turnover ratio as reported was too high. Gross margin and the cur- rent ratio were both too low. 20 A is correct. The reversal of the write- down shifted cost of sales from 2018 to 2017. The 2017 cost of sales was higher because of the write- down, and the 2018 cost of sales was lower because of the reversal of the write- down. As a result, the reported 2018 profits were overstated. Inventory balance in 2018 is the same because the write- down and reversal cancel each other out. Cash flow from operations is not affected by the non- cash write- down, but the higher profits in 2018 likely resulted in higher taxes and thus lower cash flow from operations. 21 B is correct. LIFO will result in lower inventory and higher cost of sales. Gross margin (a profitability ratio) will be lower, the current ratio (a liquidity ratio) will be lower, and inventory turnover (an efficiency ratio) will be higher. 22 A is correct. LIFO will result in lower inventory and higher cost of sales in periods of rising costs compared to FIFO. Consequently, LIFO results in a lower gross profit margin than FIFO. 23 B is correct. The LIFO method increases cost of sales, thus reducing profits and the taxes thereon. 24 A is correct. US GAAP do not permit inventory write- downs to be reversed. 25 B is correct. Both US GAAP and IFRS require disclosure of the amount of inventories recognized as an expense during the period. Only US GAAP allows the LIFO method and requires disclosure of any material amount of income resulting from the liquidation of LIFO inventory. US GAAP does not permit the reversal of prior- year inventory write downs. 26 B is correct. A significant increase (attributable to increases in unit volume rather than increases in unit cost) in raw materials and/or work- in- progress inventories may signal that the company expects an increase in demand for its products. If the growth of finished goods inventories is greater than the growth of sales, it could indicate a decrease in demand and a decrease in future earn- ings. A substantial increase in finished goods inventories while raw materials and work- in- progress inventories are declining may signal a decrease in demand for the company’s products. 27 B is correct. During a period of rising inventory prices, a company using the LIFO method will have higher cost of cost of goods sold and lower inventory compared with a company using the FIFO method. The inventory turnover ratio will be higher for the company using the LIFO method, thus making it appear more efficient. Current assets and gross profit margin will be lower for the company using the LIFO method, thus making it appear less liquid and less profitable. 28 B is correct. In an environment of declining inventory unit costs and constant or increasing inventory quantities, FIFO (in comparison with weighted average cost or LIFO) will have higher cost of goods sold and lower net income and inventory. Because both inventory and net income are lower, total equity is lower, resulting in a higher debt- to- equity ratio. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 334. Reading 21 ■ Inventories 316 29 C is correct. The storage costs for inventory awaiting shipment to customers are not costs of purchase, costs of conversion, or other costs incurred in bringing the inventories to their present location and condition and are not included in inventory. The storage costs for the chocolate liquor occur during the produc- tion process and are thus part of the conversion costs. Excise taxes are part of the purchase cost. 30 C is correct. The carrying amount of inventories under FIFO will more closely reflect current replacement values because inventories are assumed to consist of the most recently purchased items. FIFO is an acceptable, but not preferred, method under IFRS. Weighted average cost, not FIFO, is the cost formula that allocates the same per unit cost to both cost of sales and inventory. 31 B is correct. Inventory turnover = Cost of sales/Average inventory = 41,043/7,569.5 = 5.42. Average inventory is (8,100 + 7,039)/2 = 7,569.5. 32 B is correct. For comparative purposes, the choice of a competitor that reports under IFRS is requested because LIFO is permitted under US GAAP. 33 A is correct. The carrying amount of the ending inventory may differ because the perpetual system will apply LIFO continuously throughout the year, liqui- dating layers as sales are made. Under the periodic system, the sales will start from the last layer in the year. Under FIFO, the sales will occur from the same layers regardless of whether a perpetual or periodic system is used. Specific identification identifies the actual products sold and remaining in inventory, and there will be no difference under a perpetual or periodic system. 34 B is correct. The cost of sales is closest to CHF 4,550. Under FIFO, the inven- tory acquired first is sold first. Using Exhibit 4, a total of 310 cartons were available for sale (100 + 40 + 70 + 100) and 185 cartons were sold (50 + 100 + 35), leaving 125 in ending inventory. The FIFO cost would be as follows: 100 (beginning inventory) × 22 = 2,200 40 (4 February 2009) × 25 = 1,000 45 (23 July 2009) × 30 = 1,350 Cost of sales = 2,200 + 1,000 + 1,350 = CHF 4,550 35 A is correct. Gross profit will most likely increase by CHF 7,775. The net realis- able value has increased and now exceeds the cost. The write- down from 2017 can be reversed. The write- down in 2017 was 9,256 [92,560 × (4.05 – 3.95)]. IFRS require the reversal of any write- downs for a subsequent increase in value of inventory previously written down. The reversal is limited to the lower of the subsequent increase or the original write- down. Only 77,750 kilograms remain in inventory; the reversal is 77,750 × (4.05 – 3.95) = 7,775. The amount of any reversal of a write- down is recognised as a reduction in cost of sales. This reduction results in an increase in gross profit. 36 C is correct. Using the FIFO method to value inventories when prices are rising will allocate more of the cost of goods available for sale to ending inventories (the most recent purchases, which are at higher costs, are assumed to remain in inventory) and less to cost of sales (the oldest purchases, which are at lower costs, are assumed to be sold first). © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 335. Solutions 317 37 C is correct. Karp’s inventory under FIFO equals Karp’s inventory under LIFO plus the LIFO reserve. Therefore, as of 31 December 2018, Karp’s inventory under FIFO equals: Inventory (FIFO method) = Inventory (LIFO method) + LIFO reserve = $620 million + 155 million = $775 million 38 B is correct. Karp’s cost of goods sold (COGS) under FIFO equals Karp’s cost of goods sold under LIFO minus the increase in the LIFO reserve. Therefore, for the year ended 31 December 2018, Karp’s cost of goods sold under FIFO equals: COGS (FIFO method) = COGS (LIFO method) – Increase in LIFO reserve = $2,211 million – (155 million – 117 million) = $2,173 million 39 A is correct. Karp’s net income (NI) under FIFO equals Karp’s net income under LIFO plus the after- tax increase in the LIFO reserve. For the year ended 31 December 2018, Karp’s net income under FIFO equals: NI (FIFO method) = NI (LIFO method) + Increase in LIFO reserve × (1 – Tax rate) = $247 million + 38 million × (1 – 20%) = $277.4 million Therefore, the increase in net income is: Increase in NI = NI (FIFO method) – NI (LIFO method) = $277 million – 247 million = $30.4 million 40 B is correct. Karp’s retained earnings (RE) under FIFO equals Karp’s retained earnings under LIFO plus the after- tax LIFO reserve. Therefore, for the year ended 31 December 2018, Karp’s retained earnings under FIFO equals: RE (FIFO method) = RE (LIFO method) + LIFO reserve × (1 – Tax rate) = $787 million + 155 million × (1 – 20%) = $911 million Therefore, the increase in retained earnings is: Increase in RE = RE (FIFO method) – RE (LIFO method) = $911 million – 787 million = $124 million 41 A is correct. The cash ratio (cash and cash equivalents ÷ current liabilities) would be lower because cash would have been less under FIFO. Karp’s income before taxes would have been higher under FIFO, and consequently taxes paid by Karp would have also been higher and cash would have been lower. There is no impact on current liabilities. Both Karp’s current ratio and gross profit margin would have been higher if FIFO had been used. The current ratio would have been higher because inventory under FIFO increases by a larger amount than the cash decreases for taxes paid. Because the cost of goods sold under FIFO is lower than under LIFO, the gross profit margin would have been higher. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 336. Reading 21 ■ Inventories 318 42 B is correct. If Karp had used FIFO instead of LIFO, the debt- to- equity ratio would have decreased. No change in debt would have occurred, but sharehold- ers’ equity would have increased as a result of higher retained earnings. 43 B is correct. Crux’s adjusted inventory turnover ratio must be computed using cost of goods sold (COGS) under FIFO and excluding charges for increases in valuation allowances. COGS (adjusted) = COGS (LIFO method) – Charges included in cost of goods sold for inventory write- downs – Change in LIFO reserve = $3,120 million – 13 million – (55 million – 72 million) = $3,124 million Note: Minus the change in LIFO reserve is equivalent to plus the decrease in LIFO reserve. The adjusted inventory turnover ratio is computed using average inventory under FIFO. Ending inventory (FIFO) = Ending inventory (LIFO) + LIFO reserve Ending inventory 2018 (FIFO) = $480 + 55 = $535 Ending inventory 2017 (FIFO) = $465 + 72 = $537 Average inventory = ($535 + 537)/2 = $536 Therefore, adjusted inventory turnover ratio equals: Inventory turnover ratio = COGS/Average inventory = $3,124/$536 = 5.83 44 B is correct. Rolby’s adjusted net profit margin must be computed using net income (NI) under FIFO and excluding charges for increases in valuation allowances. NI (adjusted) = NI (FIFO method) + Charges, included in cost of goods sold for inventory write- downs, after tax = $327 million + 15 million × (1 – 30%) = $337.5 million Therefore, adjusted net profit margin equals: Net profit margin = NI/Revenues = $337.5/$5,442 = 6.20% 45 A is correct. Mikko’s adjusted debt- to- equity ratio is lower because the debt (numerator) is unchanged and the adjusted shareholders’ equity (denominator) is higher. The adjusted shareholders’ equity corresponds to shareholders’ equity under FIFO, excluding charges for increases in valuation allowances. Therefore, adjusted shareholders’ equity is higher than reported (unadjusted) shareholders’ equity. 46 C is correct. Mikko’s and Crux’s gross margin ratios would better reflect the current gross margin of the industry than Rolby because both use LIFO. LIFO recognizes as cost of goods sold the cost of the most recently purchased units, therefore, it better reflects replacement cost. However, Mikko’s gross margin ratio best reflects the current gross margin of the industry because Crux’s LIFO reserve is decreasing. This could reflect a LIFO liquidation by Crux which would distort gross profit margin. 47 B is correct. The FIFO method shows a higher gross profit margin than the LIFO method in an inflationary scenario, because FIFO allocates to cost of goods sold the cost of the oldest units available for sale. In an inflationary envi- ronment, these units are the ones with the lowest cost. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 337. Solutions 319 48 A is correct. An inventory write- down increases cost of sales and reduces profit and reduces the carrying value of inventory and assets. This has a nega- tive effect on profitability and solvency ratios. However, activity ratios appear positively affected by a write- down because the asset base, whether total assets or inventory (denominator), is reduced. The numerator, sales, in total asset turnover is unchanged, and the numerator, cost of sales, in inventory turnover is increased. Thus, turnover ratios are higher and appear more favorable as the result of the write- down. 49 B is correct. Finished goods least accurately reflect current prices because some of the finished goods are valued under the “last- in, first- out” (“LIFO”) basis. The costs of the newest units available for sale are allocated to cost of goods sold, leaving the oldest units (at lower costs) in inventory. ZP values raw materials and work in process using the weighted average cost method. While not fully reflecting current prices, some inflationary effect will be included in the inven- tory values. 50 C is correct. FIFO inventory = Reported inventory + LIFO reserve = ¥608,572 + 10,120 = ¥618,692. The LIFO reserve is disclosed in Note 2 of the notes to con- solidated financial statements. 51 A is correct. The inventory turnover ratio would be lower. The average inven- tory would be higher under FIFO and cost of products sold would be lower by the increase in LIFO reserve. LIFO is not permitted under IFRS. Inventory turnover ratio = Cost of products sold ÷ Average inventory 2018 inventory turnover ratio as reported = 10.63 = ¥5,822,805/[(608,572 + 486,465)/2]. 2018 inventory turnover ratio adjusted to FIFO as necessary = 10.34 = [¥5,822,805 – (19,660 – 10,120)]/[(608,572 + 10,120 + 486,465 + 19,660)/2]. 52 A is correct. No LIFO liquidation occurred during 2018; the LIFO reserve increased from ¥10,120 million in 2008 to ¥19,660 million in 2018. Management stated in the MDA that the decrease in inventories reflected the impacts of decreased sales volumes and fluctuations in foreign currency translation rates. 53 C is correct. Finished goods and raw materials inventories are lower in 2018 when compared to 2017. Reduced levels of inventory typically indicate an antic- ipated business contraction. 54 B is correct. The decrease in LIFO inventory in 2018 would typically indicate that more inventory units were sold than produced or purchased. Accordingly, one would expect a liquidation of some of the older LIFO layers and the LIFO reserve to decrease. In actuality, the LIFO reserve increased from ¥10,120 mil- lion in 2017 to ¥19,660 million in 2018. This is not to be expected and is likely caused by the increase in prices of raw materials, other production materials, and parts of foreign currencies as noted in the MDA. An analyst should seek to confirm this explanation. 55 B is correct. If prices have been decreasing, write- downs under FIFO are least likely to have a significant effect because the inventory is valued at closer to the new, lower prices. Typically, inventories valued using LIFO are less likely to incur inventory write- downs than inventories valued using weighted average cost or FIFO. Under LIFO, the oldest costs are reflected in the inventory carry- ing value on the balance sheet. Given increasing inventory costs, the inventory carrying values under the LIFO method are already conservatively presented at the oldest and lowest costs. Thus, it is far less likely that inventory write- downs will occur under LIFO; and if a write- down does occur, it is likely to be of a lesser magnitude. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 338. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 339. Long-Lived Assets by Elaine Henry, PhD, CFA, and Elizabeth A. Gordon, PhD, MBA, CPA Elaine Henry, PhD, CFA, is at Stevens Institute of Technology (USA). Elizabeth A. Gordon, PhD, MBA, CPA, is at Temple University (USA). LEARNING OUTCOMES Mastery The candidate should be able to: a. identify and contrast costs that are capitalised and costs that are expensed in the period in which they are incurred; b. compare the financial reporting of the following types of intangible assets: purchased, internally developed, acquired in a business combination; c. explain and evaluate how capitalising versus expensing costs in the period in which they are incurred affects financial statements and ratios; d. describe the different depreciation methods for property, plant, and equipment and calculate depreciation expense; e. describe how the choice of depreciation method and assumptions concerning useful life and residual value affect depreciation expense, financial statements, and ratios; f. describe the different amortisation methods for intangible assets with finite lives and calculate amortisation expense; g. describe how the choice of amortisation method and assumptions concerning useful life and residual value affect amortisation expense, financial statements, and ratios; h. describe the revaluation model; i. explain the impairment of property, plant, and equipment and intangible assets; j. explain the derecognition of property, plant, and equipment and intangible assets; k. explain and evaluate how impairment, revaluation, and derecognition of property, plant, and equipment and intangible assets affect financial statements and ratios; (continued) R E A D I N G 22 © 2019 CFA Institute. All rights reserved. Note: Changes in accounting standards as well as new rulings and/or pronouncements issued after the publication of the readings on financial reporting and analysis may cause some of the information in these readings to become dated. Candidates are not responsible for anything that occurs after the readings were published. In addition, candidates are expected to be familiar with the analytical frameworks contained in the readings, as well as the implications of alternative accounting methods for financial analysis and valuation discussed in the readings. Candidates are also responsible for the content of accounting standards, but not for the actual reference numbers. Finally, candidates should be aware that certain ratios may be defined and calculated differently. When alternative ratio definitions exist and no specific definition is given, candidates should use the ratio definitions emphasized in the readings. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 340. Reading 22 ■ Long-Lived Assets 322 LEARNING OUTCOMES Mastery The candidate should be able to: l. describe the financial statement presentation of and disclosures relating to property, plant, and equipment and intangible assets; m. analyze and interpret financial statement disclosures regarding property, plant, and equipment and intangible assets; n. compare the financial reporting of investment property with that of property, plant, and equipment. INTRODUCTION ACQUISITION OF PROPERTY, PLANT AND EQUIPMENT a identify and contrast costs that are capitalised and costs that are expensed in the period in which they are incurred; 1.1 Introduction Long-lived assets, also referred to as non- current assets or long- term assets, are assets that are expected to provide economic benefits over a future period of time, typically greater than one year.1 Long- lived assets may be tangible, intangible, or financial assets. Examples of long- lived tangible assets, typically referred to as property, plant, and equipment and sometimes as fixed assets, include land, buildings, furniture and fixtures, machinery and equipment, and vehicles; examples of long- lived intangible assets (assets lacking physical substance) include patents and trademarks; and examples of long- lived financial assets include investments in equity or debt securities issued by other entities. The scope of this reading is limited to long- lived tangible and intangible assets (hereafter, referred to for simplicity as long- lived assets). The first issue in accounting for a long- lived asset is determining its cost at acqui- sition. The second issue is how to allocate the cost to expense over time. The costs of most long- lived assets are capitalised and then allocated as expenses in the profit or loss (income) statement over the period of time during which they are expected to provide economic benefits. The two main types of long- lived assets with costs that are typically not allocated over time are land, which is not depreciated, and those intan- gible assets with indefinite useful lives. Additional issues that arise are the treatment of subsequent costs incurred related to the asset, the use of the cost model versus the revaluation model, unexpected declines in the value of the asset, classification of the asset with respect to intent (for example, held for use or held for sale), and the derecognition of the asset. This reading is organised as follows. Sections 1–5 describe and illustrate account- ing for the acquisition of long- lived assets, with particular attention to the impact of capitalizing versus expensing expenditures. Sections 6–7 describe the allocation of the costs of long- lived assets over their useful lives. Section 8 discusses the revalu- ation model that is based on changes in the fair value of an asset. Section 9 covers the concepts of impairment (unexpected decline in the value of an asset). Section 10 describes accounting for the derecognition of long- lived assets. Sections 11–12 describe 1 1 In some industries, inventory is held longer than one year but is nonetheless reported as a current asset. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 341. Introduction Acquisition of Property, Plant and Equipment 323 financial statement presentation, disclosures, and analysis of long- lived assets. Section 13 discusses differences in financial reporting of investment property compared with property, plant, and equipment. A summary is followed by practice problems. 1.2 Acquisition of Long- Lived Assets Upon acquisition, property, plant, and equipment (tangible assets with an economic life of longer than one year and intended to be held for the company’s own use) are recorded on the balance sheet at cost, which is typically the same as their fair value.2 Accounting for an intangible asset depends on how the asset is acquired. If several assets are acquired as part of a group, the purchase price is allocated to each asset on the basis of its fair value. An asset’s cost potentially includes expenditures additional to the purchase price. A key concept in accounting for expenditures related to long- lived assets is whether and when such expenditures are capitalised (i.e., included in the asset shown on the balance sheet) versus expensed (i.e., treated as an expense of the period on the income statement). After examining the specific treatment of certain expenditures, we will consider the general financial statement impact of capitalising versus expensing and two analytical issues related to the decision—namely, the effects on an individual company’s trend analysis and on comparability across companies. 1.3 Property, Plant, and Equipment This section primarily discusses the accounting treatment for the acquisition of long- lived tangible assets (property, plant, and equipment) through purchase. Assets can be acquired by methods other than purchase.3 When an asset is exchanged for another asset, the asset acquired is recorded at fair value if reliable measures of fair value exist. Fair value is the fair value of the asset given up unless the fair value of the asset acquired is more clearly evident. If there is no reliable measure of fair value, the acquired asset is measured at the carrying amount of the asset given up. In this case, the carrying amount of the assets is unchanged, and no gain or loss is reported. Typically, accounting for the exchange involves removing the carrying amount of the asset given up, adding a fair value for the asset acquired, and reporting any difference between the carrying amount and the fair value as a gain or loss. A gain would be reported when the fair value used for the newly acquired asset exceeds the carrying amount of the asset given up. A loss would be reported when the fair value used for the newly acquired asset is less than the carrying amount of the asset given up. When property, plant, or equipment is purchased, the buyer records the asset at cost. In addition to the purchase price, the buyer also includes, as part of the cost of an asset, all the expenditures necessary to get the asset ready for its intended use. For example, freight costs borne by the purchaser to get the asset to the purchaser’s place of business and special installation and testing costs required to make the asset usable are included in the total cost of the asset. 2 Fair value is defined in International Financial Reporting Standards (IFRS) and under US generally accepted accounting principles (US GAAP) in the Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” [IFRS 13 and FASB ASC Topic 820] 3 IAS 16 Property, Plant and Equipment, paragraphs 24–26 [Measurement of Cost]; IAS 38 Intangible Assets, paragraphs 45–47 [Exchange of Assets]; and FASB ASC Section 845- 10- 30 [Nonmonetary Transactions – Overall – Initial Measurement]. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 342. Reading 22 ■ Long-Lived Assets 324 Subsequent expenditures related to long- lived assets are included as part of the recorded value of the assets on the balance sheet (i.e., capitalised) if they are expected to provide benefits beyond one year in the future and are expensed if they are not expected to provide benefits in future periods. Expenditures that extend the original life of the asset are typically capitalised. Example 1 illustrates the difference between costs that are capitalised and costs that are expensed in a period. EXAMPLE 1 Acquisition of PPE Assume a (hypothetical) company, Trofferini S.A., incurred the following expen- ditures to purchase a towel and tissue roll machine: €10,900 purchase price including taxes, €200 for delivery of the machine, €300 for installation and testing of the machine, and €100 to train staff on maintaining the machine. In addition, the company paid a construction team €350 to reinforce the factory floor and ceiling joists to accommodate the machine’s weight. The company also paid €1,500 to repair the factory roof (a repair expected to extend the useful life of the factory by five years) and €1,000 to have the exterior of the factory and adjoining offices repainted for maintenance reasons. The repainting neither extends the life of factory and offices nor improves their usability. 1 Which of these expenditures will be capitalised and which will be expensed? 2 How will the treatment of these expenditures affect the company’s finan- cial statements? Solution to 1: The company will capitalise as part of the cost of the machine all costs that are necessary to get the new machine ready for its intended use: €10,900 purchase price, €200 for delivery, €300 for installation and testing, and €350 to reinforce the factory floor and ceiling joists to accommodate the machine’s weight (which was necessary to use the machine and does not increase the value of the factory). The €100 to train staff is not necessary to get the asset ready for its intended use and will be expensed. The company will capitalise the expenditure of €1,500 to repair the factory roof because the repair is expected to extend the useful life of the factory. The company will expense the €1,000 to have the exterior of the factory and adjoin- ing offices repainted because the painting does not extend the life or alter the productive capacity of the buildings. Solution to 2: The costs related to the machine that are capitalised—€10,900 purchase price, €200 for delivery, €300 for installation and testing, and €350 to prepare the factory—will increase the carrying amount of the machine asset as shown on the balance sheet and will be included as investing cash outflows. The item related to the factory that is capitalised—the €1,500 roof repair—will increase the carrying amount of the factory asset as shown on the balance sheet and is an investing cash outflow. The expenditures of €100 to train staff and €1,000 to paint are expensed in the period and will reduce the amount of income reported on the company’s income statement (and thus reduce retained earnings on the balance sheet) and the operating cash flow. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 343. Introduction Acquisition of Property, Plant and Equipment 325 Example 1 describes capitalising versus expensing in the context of purchasing property, plant, and equipment. When a company constructs an asset (or acquires an asset that requires a long period of time to get ready for its intended use), bor- rowing costs incurred directly related to the construction are generally capitalised. Constructing a building, whether for sale (in which case, the building is classified as inventory) or for the company’s own use (in which case, the building is classified as a long- lived asset), typically requires a substantial amount of time. To finance construction, any borrowing costs incurred prior to the asset being ready for its intended use are capitalised as part of the cost of the asset. The company determines the interest rate to use on the basis of its existing borrowings or, if applicable, on a borrowing specifically incurred for constructing the asset. If a company takes out a loan specifically to construct a building, the interest cost on that loan during the time of construction would be capitalised as part of the building’s cost. Under IFRS, but not under US GAAP, income earned on temporarily investing the borrowed monies decreases the amount of borrowing costs eligible for capitalisation. Thus, a company’s interest costs for a period are included either on the balance sheet (to the extent they are capitalised as part of an asset) or on the income statement (to the extent they are expensed). If the interest expenditure is incurred in connec- tion with constructing an asset for the company’s own use, the capitalised interest appears on the balance sheet as a part of the relevant long- lived asset (i.e., property, plant, and equipment). The capitalised interest is expensed over time as the prop- erty is depreciated and is thus part of subsequent years’ depreciation expense rather than interest expense of the current period. If the interest expenditure is incurred in connection with constructing an asset to sell (for example, by a home builder), the capitalised interest appears on the company’s balance sheet as part of inventory. The capitalised interest is expensed as part of the cost of goods sold when the asset is sold. Interest payments made prior to completion of construction that are capitalised are classified as an investing cash outflow. Expensed interest may be classified as an operating or financing cash outflow under IFRS and is classified as an operating cash outflow under US GAAP. EXAMPLE 2 Capitalised Borrowing Costs BILDA S.A., a hypothetical company, borrows €1,000,000 at an interest rate of 10 percent per year on 1 January 2010 to finance the construction of a factory that will have a useful life of 40 years. Construction is completed after two years, during which time the company earns €20,000 by temporarily investing the loan proceeds. 1 What is the amount of interest that will be capitalised under IFRS, and how would that amount differ from the amount that would be capitalised under US GAAP? 2 Where will the capitalised borrowing cost appear on the company’s finan- cial statements? Solution to 1: The total amount of interest paid on the loan during construction is €200,000 (= €1,000,000 × 10% × 2 years). Under IFRS, the amount of borrowing cost eligible for capitalisation is reduced by the €20,000 interest income from temporarily investing the loan proceeds, so the amount to be capitalised is €180,000. Under US GAAP, the amount to be capitalised is €200,000. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 344. Reading 22 ■ Long-Lived Assets 326 Solution to 2: The capitalised borrowing costs will appear on the company’s balance sheet as a component of property, plant, and equipment. In the years prior to completion of construction, the interest paid will appear on the statement of cash flows as an investment activity. Over time, as the property is depreciated, the capitalised interest component is part of subsequent years’ depreciation expense on the company’s income statement. ACQUISITION OF INTANGIBLE ASSETS b compare the financial reporting of the following types of intangible assets: pur- chased, internally developed, acquired in a business combination; Intangible assets are assets lacking physical substance. Intangible assets include items that involve exclusive rights, such as patents, copyrights, trademarks, and franchises. Under IFRS, identifiable intangible assets must meet three definitional criteria. They must be (1) identifiable (either capable of being separated from the entity or aris- ing from contractual or legal rights), (2) under the control of the company, and (3) expected to generate future economic benefits. In addition, two recognition criteria must be met: (1) It is probable that the expected future economic benefits of the asset will flow to the company, and (2) the cost of the asset can be reliably measured. Goodwill, which is not considered an identifiable intangible asset,4 arises when one company purchases another and the acquisition price exceeds the fair value of the net identifiable assets (both the tangible assets and the identifiable intangible assets, minus liabilities) acquired. Accounting for an intangible asset depends on how it is acquired. The following sections describe accounting for intangible assets obtained in three ways: purchased in situations other than business combinations, developed internally, and acquired in business combinations. 2.1 Intangible Assets Purchased in Situations Other Than Business Combinations Intangible assets purchased in situations other than business combinations, such as buying a patent, are treated at acquisition the same as long- lived tangible assets; they are recorded at their fair value when acquired, which is assumed to be equivalent to the purchase price. If several intangible assets are acquired as part of a group, the purchase price is allocated to each asset on the basis of its fair value. In deciding how to treat individual intangible assets for analytical purposes, analysts are particularly aware that companies must use a substantial amount of judgment and numerous assumptions to determine the fair value of individual intangible assets. For analysis, therefore, understanding the types of intangible assets acquired can often be more useful than focusing on the values assigned to the individual assets. In other words, an analyst would typically be more interested in understanding what assets a company acquired (for example, franchise rights) than in the precise portion of the 2 4 The IFRS definition of an intangible asset as an “identifiable non- monetary asset without physical sub- stance” applies to intangible assets not specifically dealt with in standards other than IAS 38. The definition of intangible assets under US GAAP—“assets (other than financial assets) that lack physical substance”— includes goodwill in the definition of an intangible asset. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 345. Acquisition of Intangible Assets 327 purchase price a company allocated to each asset. Understanding the types of assets a company acquires can offer insights into the company’s strategic direction and future operating potential. 2.2 Intangible Assets Developed Internally In contrast with the treatment of construction costs of tangible assets, the costs to internally develop intangible assets are generally expensed when incurred. There are some situations, however, in which the costs incurred to internally develop an intangible asset are capitalised. The general analytical issues related to the capitalising- versus- expensing decision apply here—namely, comparability across companies and the effect on an individual company’s trend analysis. The general requirement that costs to internally develop intangible assets be expensed should be compared with capitalising the cost of acquiring intangible assets in situations other than business combinations. Because costs associated with internally developing intangible assets are usually expensed, a company that has internally devel- oped such intangible assets as patents, copyrights, or brands through expenditures on RD or advertising will recognise a lower amount of assets than a company that has obtained intangible assets through external purchase. In addition, on the statement of cash flows, costs of internally developing intangible assets are classified as operating cash outflows whereas costs of acquiring intangible assets are classified as investing cash outflows. Differences in strategy (developing versus acquiring intangible assets) can thus impact financial ratios. IFRS require that expenditures on research (or during the research phase of an internal project) be expensed rather than capitalised as an intangible asset.5 Research is defined as “original and planned investigation undertaken with the prospect of gaining new scientific or technical knowledge and understanding.”6 The “research phase of an internal project” refers to the period during which a company cannot demonstrate that an intangible asset is being created—for example, the search for alternative materials or systems to use in a production process. In contrast with the treatment of research- phase expenditures, IFRS allow companies to recognise an intangible asset arising from development expenditures (or the development phase of an internal project) if certain criteria are met, including a demonstration of the technical feasibility of completing the intangible asset and the intent to use or sell the asset. Development is defined as “the application of research findings or other knowledge to a plan or design for the production of new or substantially improved materials, devices, products, processes, systems or services before the start of commercial production or use.”7 Generally, US GAAP require that both research and development costs be expensed as incurred but require capitalisation of certain costs related to software development.8 Costs incurred to develop a software product for sale are expensed until the prod- uct’s technological feasibility is established and are capitalised thereafter. Similarly, companies expense costs related to the development of software for internal use until it is probable that the project will be completed and that the software will be used as intended. Thereafter, development costs are capitalised. The probability that the project will be completed is easier to demonstrate than is technological feasibility. The capitalised costs, related directly to developing software for sale or internal use, 5 IAS 38 Intangible Assets. 6 IAS 38 Intangible Assets, paragraph 8 [Definitions]. 7 IAS 38 Intangible Assets, paragraph 8 [Definitions]. 8 FASB ASC Section 350- 40- 25 [Intangibles—Goodwill and Other – Internal- Use Software – Recognition] and FASB ASC Section 985- 20- 25 [Software – Costs of Software to be Sold, Leased, or Marketed – Recognition] specify US GAAP accounting for software development costs for software for internal use and for software to be sold, respectively. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 346. Reading 22 ■ Long-Lived Assets 328 include the costs of employees who help build and test the software. The treatment of software development costs under US GAAP is similar to the treatment of all costs of internally developed intangible assets under IFRS. EXAMPLE 3 Software Development Costs Assume REH AG, a hypothetical company, incurs expenditures of €1,000 per month during the fiscal year ended 31 December 2019 to develop software for internal use. Under IFRS, the company must treat the expenditures as an expense until the software meets the criteria for recognition as an intangible asset, after which time the expenditures can be capitalised as an intangible asset. 1 What is the accounting impact of the company being able to demonstrate that the software met the criteria for recognition as an intangible asset on 1 February versus 1 December? 2 How would the treatment of expenditures differ if the company reported under US GAAP and it had established in 2018 that the project was likely to be completed and the software used to perform the function intended? Solution to 1: If the company is able to demonstrate that the software met the criteria for recognition as an intangible asset on 1 February, the company would recognise the €1,000 expended in January as an expense on the income statement for the fiscal year ended 31 December 2019. The other €11,000 of expenditures would be recognised as an intangible asset (on the balance sheet). Alternatively, if the company is not able to demonstrate that the software met the criteria for recog- nition as an intangible asset until 1 December, the company would recognise the €11,000 expended in January through November as an expense on the income statement for the fiscal year ended 31 December 2019, with the other €1,000 of expenditures recognised as an intangible asset. Solution to 2: Under US GAAP, the company would capitalise the entire €12,000 spent to develop software for internal use. 2.3 Intangible Assets Acquired in a Business Combination When one company acquires another company, the transaction is accounted for using the acquisition method of accounting.9 Under the acquisition method, the company identified as the acquirer allocates the purchase price to each asset acquired (and each liability assumed) on the basis of its fair value. If the purchase price exceeds the sum of the amounts that can be allocated to individual identifiable assets and liabilities, the excess is recorded as goodwill. Goodwill cannot be identified separately from the business as a whole. 9 Both IFRS and US GAAP require the use of the acquisition method in accounting for business combi- nations (IFRS 3 and FASB ASC Section 805). © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 347. Acquisition of Intangible Assets 329 Under IFRS, the acquired individual assets include identifiable intangible assets that meet the definitional and recognition criteria.10 Otherwise, if the item is acquired in a business combination and cannot be recognised as a tangible or identifiable intangible asset, it is recognised as goodwill. Under US GAAP, there are two criteria to judge whether an intangible asset acquired in a business combination should be recognised separately from goodwill: The asset must be either an item arising from contractual or legal rights or an item that can be separated from the acquired company. Examples of intangible assets treated separately from goodwill include the intangible assets previ- ously mentioned that involve exclusive rights (patents, copyrights, franchises, licenses), as well as such items as internet domain names and video and audiovisual materials. Exhibit 1 describes how AB InBev allocated the $103 billion purchase consideration in its 2016 acquisition of SABMiller Group. The combined company was renamed Anheuser- Busch InBev SA/NV. The majority of the intangible asset valuation relates to brands with indefinite life ($19.9 billion of the $20.0 billion total). Of $63.0 billion total assets acquired, assets to be divested were valued at $24.8 billion and assets to be held for were valued at $38.2 billion. In total, intangible assets represent 52 per- cent of the total assets to be held for use. In addition, $74.1 billion of goodwill was recognized in the transaction. Exhibit 1 Acquisition of Intangible Assets through a Business Combination Excerpt from the 2016 annual report of AB InBev: “On 10 October 2016, AB InBev announced the … successful com- pletion of the business combination with the former SABMiller Group (“SAB”). “The transaction resulted in 74.1 billion US dollar of goodwill pro- visionally allocated primarily to the businesses in Colombia, Ecuador, Peru, Australia, South Africa and other African, Asia Pacific and Latin American countries. The factors that contributed to the recognition of goodwill include the acquisition of an assembled workforce and the premiums paid for cost synergies expected to be achieved in SABMiller. Management’s assessment of the future economic benefits supporting recognition of this goodwill is in part based on expected savings through the implementation of AB InBev best practices such as, among others, a zero based budgeting program and initiatives that are expected to bring greater efficiency and standardization, generate cost savings and maximize purchasing power. Goodwill also arises due to the recognition of deferred tax liabilities in relation to the preliminary fair value adjustments on acquired intangible assets for which the amortization does not qualify as a tax deductible expense. None of the goodwill recognized is deductible for tax purposes. “The majority of the intangible asset valuation relates to brands with indefinite life, valued for a total amount of 19.9 billion US dollar. The valuation of the brands with indefinite life is based on a series of factors, including the brand history, the operating plan and the coun- tries in which the brands are sold. The fair value of brands was esti- mated by applying a combination of known valuation methodologies, such as the royalty relief and excess earnings valuation approaches. (continued) 10 As previously described, the definitional criteria are identifiability, control by the company, and expected future benefits. The recognition criteria are probable flows of the expected economic benefits to the company and measurability. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 348. Reading 22 ■ Long-Lived Assets 330 “The intangibles with an indefinite life mainly include the Castle and Carling brand families in Africa, the Aguila and Poker brand fam- ilies in Colombia, the Cristal and Pilsner brand families in Ecuador, and the Carlton brand family in Australia. “Assets held for sale were recognized in relation to the divestiture of SABMiller’s interests in the MillerCoors LLC joint venture and certain of SABMiller’s portfolio of Miller brands outside of the U.S. to Molson Coors Brewing company; the divestiture of SABMiller’s European premium brands to Asahi Group Holdings, Ltd and the divestiture of SABMiller’s interest in China Resources Snow Breweries Ltd. to China Resources Beer (Holdings) Co. Ltd. ….” [Excerpt] The following is a summary of the provisional allocation of AB InBev’s purchase price of SABMiller: Assets $ million Property, plant and equipment 9,060 Intangible assets 20,040 Investment in associates 4,386 Inventories 977 Trade and other receivables 1,257 Cash and cash equivalents 1,410 Assets held for sale 24,805 All other assets 1,087 Total assets 63,022 Total liabilities –27,769 Net identified assets and liabilities 35,253 Non-controlling interests –6,200 Goodwill on acquisition 74,083 Purchase consideration 103,136 Table is excerpted from the company’s 2016 Annual Report. Portions of detail are omitted, and subtotals are shown in italics. Source: AB InBev 2016 Annual Report, pp. 82- 85. CAPITALIZATION VERSUS EXPENSING: IMPACT ON FINANCIAL STATEMENTS AND RATIOS c explain and evaluate how capitalising versus expensing costs in the period in which they are incurred affects financial statements and ratios; This section discusses the implications for financial statements and ratios of capitalising versus expensing costs in the period in which they are incurred. We first summarize the general financial statement impact of capitalising versus expensing and two ana- lytical issues related to the decision—namely the effect on an individual company’s trend analysis and on comparability across companies. 3 Exhibit 1 (Continued) © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 349. Capitalization versus Expensing: Impact on Financial Statements and Ratios 331 In the period of the expenditure, an expenditure that is capitalised increases the amount of assets on the balance sheet and appears as an investing cash outflow on the statement of cash flows. After initial recognition, a company allocates the cap- italised amount over the asset’s useful life as depreciation or amortisation expense (except assets that are not depreciated, i.e., land, or amortised, e.g., intangible assets with indefinite lives). This expense reduces net income on the income statement and reduces the value of the asset on the balance sheet. Depreciation and amortisation are non- cash expenses and therefore, apart from their effect on taxable income and taxes payable, have no impact on the cash flow statement. In the section of the statement of cash flows that reconciles net income to operating cash flow, depreciation and amortisation expenses are added back to net income. Alternatively, an expenditure that is expensed reduces net income by the after- tax amount of the expenditure in the period it is made. No asset is recorded on the balance sheet and thus no depreciation or amortisation occurs in subsequent periods. The lower amount of net income is reflected in lower retained earnings on the balance sheet. An expenditure that is expensed appears as an operating cash outflow in the period it is made. There is no effect on the financial statements of subsequent periods. Example 4 illustrates the impact on the financial statements of capitalising versus expensing an expenditure. EXAMPLE 4 General Financial Statement Impact of Capitalising Versus Expensing Assume two identical (hypothetical) companies, CAP Inc. (CAP) and NOW Inc. (NOW), start with €1,000 cash and €1,000 common stock. Each year the companies recognise total revenues of €1,500 cash and make cash expenditures, excluding an equipment purchase, of €500. At the beginning of operations, each company pays €900 to purchase equipment. CAP estimates the equipment will have a useful life of three years and an estimated salvage value of €0 at the end of the three years. NOW estimates a much shorter useful life and expenses the equipment immediately. The companies have no other assets and make no other asset purchases during the three- year period. Assume the companies pay no dividends, earn zero interest on cash balances, have a tax rate of 30 percent, and use the same accounting method for financial and tax purposes. The left side of Exhibit 2 shows CAP’s financial statements; i.e., with the expenditure capitalised and depreciated at €300 per year based on the straight- line method of depreciation (€900 cost minus €0 salvage value equals €900, divided by a three- year life equals €300 per year). The right side of the exhibit shows NOW’s financial statements, with the entire €900 expenditure treated as an expense in the first year. All amounts are in euro. Exhibit 2 Capitalising versus Expensing CAP Inc. NOW Inc. Capitalise €900 as asset and depreciate Expense €900 immediately For Year 1 2 3 For Year 1 2 3 Revenue 1,500 1,500 1,500 Revenue 1,500 1,500 1,500 Cash expenses 500 500 500 Cash expenses 1,400 500 500 Depreciation 300 300 300 Depreciation 0 0 0 (continued) © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 350. Reading 22 ■ Long-Lived Assets 332 CAP Inc. NOW Inc. Capitalise €900 as asset and depreciate Expense €900 immediately For Year 1 2 3 For Year 1 2 3 Income before tax 700 700 700 Income before tax 100 1,000 1,000 Tax at 30% 210 210 210 Tax at 30% 30 300 300 Net income 490 490 490 Net income 70 700 700 Cash from operations 790 790 790 Cash from operations 70 700 700 Cash used in investing (900) 0 0 Cash used in investing 0 0 0 Total change in cash (110) 790 790 Total change in cash 70 700 700 As of Time 0 End of Year 1 End of Year2 End of Year 3 Time Time 0 End of Year 1 End of Year 2 End of Year 3 Cash 1,000 890 1,680 2,470 Cash 1,000 1,070 1,770 2,470 PP E (net) — 600 300 — PP E (net) — — — — Total Assets 1,000 1,490 1,980 2,470 Total Assets 1,000 1,070 1,770 2,470 Retained earnings 0 490 980 1,470 Retained earnings 0 70 770 1,470 Common stock 1,000 1,000 1,000 1,000 Common stock 1,000 1,000 1,000 1,000 Total share- holders’ equity 1,000 1,490 1,980 2,470 Total sharehold- ers’ equity 1,000 1,070 1,770 2,470 1 Which company reports higher net income over the three years? Total cash flow? Cash from operations? 2 Based on ROE and net profit margin, how does the profitability of the two companies compare? 3 Why does NOW report change in cash of €70 in Year 1, while CAP reports total change in cash of (€110)? Solution to 1: Neither company reports higher total net income or cash flow over the three years. The sum of net income over the three years is identical (€1,470 total) whether the €900 is capitalised or expensed. Also, the sum of the change in cash (€1,470 total) is identical under either scenario. CAP reports higher cash from operations by an amount of €900 because, under the capitalisation scenario, the €900 purchase is treated as an investing cash flow. Exhibit 2 (Continued) © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 351. Capitalization versus Expensing: Impact on Financial Statements and Ratios 333 Note: Because the companies use the same accounting method for both financial and taxable income, absent the assumption of zero interest on cash balances, expensing the €900 would have resulted in higher income and cash flow for NOW because the lower taxes paid in the first year (€30 versus €210) would have allowed NOW to earn interest income on the tax savings. Solution to 2: In general, Ending shareholders’ equity = Beginning shareholders’ equity + Net income + Other comprehensive income – Dividends + Net capital contribu- tions from shareholders. Because the companies in this example do not have other comprehensive income, did not pay dividends, and reported no capital contributions from shareholders, Ending retained earnings = Beginning retained earnings + Net income, and Ending shareholders’ equity = Beginning sharehold- ers’ equity + Net income. ROE is calculated as Net income divided by Average shareholders’ equity, and Net profit margin is calculated as Net income divided by Total revenue. For example, CAP had Year 1 ROE of 39 percent (€490/[(€1,000 + €1,490)/2]), and Year 1 net profit margin of 33 percent (€490/€1,500). CAP Inc. NOW Inc. Capitalise €900 as asset and depreciate Expense €900 immediately For year 1 2 3 For year 1 2 3 ROE 39% 28% 22% ROE 7% 49% 33% Net profit margin 33% 33% 33% Net profit margin 5% 47% 47% As shown, compared to expensing, capitalising results in higher profitabil- ity ratios (ROE and net profit margin) in the first year, and lower profitability ratios in subsequent years. For example, CAP’s Year 1 ROE of 39 percent was higher than NOW’s Year 1 ROE of 7 percent, but in Years 2 and 3, NOW reports superior profitability. Note also that NOW’s superior growth in net income between Year 1 and Year 2 is not attributable to superior performance compared to CAP but rather to the accounting decision to recognise the expense sooner than CAP. In general, all else equal, accounting decisions that result in recognising expenses sooner will give the appearance of greater subsequent growth. Comparison of the growth of the two companies’ net incomes without an awareness of the difference in accounting methods would be misleading. As a corollary, NOW’s income and profitability exhibit greater volatility across the three years, not because of more volatile performance but rather because of the different accounting decision. Solution to 3: NOW reports an increase in cash of €70 in Year 1, while CAP reports a decrease in cash of €110 because NOW’s taxes were €180 lower than CAP’s taxes (€30 versus €210). Note that this problem assumes the accounting method used by each com- pany for its tax purposes is identical to the accounting method used by the company for its financial reporting. In many countries, companies are allowed to use different depreciation methods for financial reporting and taxes, which may give rise to deferred taxes. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 352. Reading 22 ■ Long-Lived Assets 334 As shown, discretion regarding whether to expense or capitalise expenditures can impede comparability across companies. Example 4 assumes the companies purchase a single asset in one year. Because the sum of net income over the three- year period is identical whether the asset is capitalised or expensed, it illustrates that although capitalising results in higher profitability compared to expensing in the first year, it results in lower profitability in the subsequent years. Conversely, expensing results in lower profitability in the first year but higher profitability in later years, indicating a favorable trend. Similarly, shareholders’ equity for a company that capitalises the expenditure will be higher in the early years because the initially higher profits result in initially higher retained earnings. Example 4 assumes the companies purchase a single asset in one year and report identical amounts of total net income over the three- year period, so shareholders’ equity (and retained earnings) for the firm that expenses will be identical to shareholders’ equity (and retained earnings) for the capitalising firm at the end of the three- year period. Although Example 4 shows companies purchasing an asset only in the first year, if a company continues to purchase similar or increasing amounts of assets each year, the profitability- enhancing effect of capitalising continues if the amount of the expen- ditures in a period continues to be more than the depreciation expense. Example 5 illustrates this point. EXAMPLE 5 Impact of Capitalising Versus Expensing for Ongoing Purchases A company buys a £300 computer in Year 1 and capitalises the expenditure. The computer has a useful life of three years and an expected salvage value of £0, so the annual depreciation expense using the straight- line method is £100 per year. Compared to expensing the entire £300 immediately, the company’s pre- tax profit in Year 1 is £200 greater. 1 Assume that the company continues to buy an identical computer each year at the same price. If the company uses the same accounting treat- ment for each of the computers, when does the profit- enhancing effect of capitalising versus expensing end? 2 If the company buys another identical computer in Year 4, using the same accounting treatment as the prior years, what is the effect on Year 4 prof- its of capitalising versus expensing these expenditures? Solution to 1: The profit- enhancing effect of capitalising versus expensing would end in Year 3. In Year 3, the depreciation expense on each of the three computers bought in Years 1, 2, and 3 would total £300 (£100 + £100 + £100). Therefore, the total depreciation expense for Year 3 will be exactly equal to the capital expenditure in Year 3. The expense in Year 3 would be £300, regardless of whether the company capitalised or expensed the annual computer purchases. Solution to 2: There is no impact on Year 4 profits. As in the previous year, the depreciation expense on each of the three computers bought in Years 2, 3, and 4 would total £300 (£100 + £100 + £100). Therefore, the total depreciation expense for Year 4 © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 353. Capitalisation of Interest Costs 335 will be exactly equal to the capital expenditure in Year 4. Pre- tax profits would be reduced by £300, regardless of whether the company capitalised or expensed the annual computer purchases. Compared to expensing an expenditure, capitalising the expenditure typically results in greater amounts reported as cash from operations. Capitalised expenditures are typically treated as an investment cash outflow whereas expenses reduce operating cash flows. Because cash flow from operating activities is an important consideration in some valuation models, companies may try to maximise reported cash flow from operations by capitalising expenditures that should be expensed. Valuation models that use free cash flow will consider not only operating cash flows but also investing cash flows. Analysts should be alert to evidence of companies manipulating reported cash flow from operations by capitalising expenditures that should be expensed. In summary, holding all else constant, capitalising an expenditure enhances cur- rent profitability and increases reported cash flow from operations. The profitability- enhancing effect of capitalising continues so long as capital expenditures exceed the depreciation expense. Profitability- enhancing motivations for decisions to capitalise should be considered when analyzing performance. For example, a company may choose to capitalise more expenditures (within the allowable bounds of accounting standards) to achieve earnings targets for a given period. Expensing a cost in the period reduces current period profits but enhances future profitability and thus enhances the profit trend. Profit trend- enhancing motivations should also be considered when analyzing performance. If the company is in a reporting environment which requires identical accounting methods for financial reporting and taxes (unlike the United States, which permits companies to use depreciation methods for reporting purposes that differ from the depreciation method required by tax purposes), then expensing will have a more favorable cash flow impact because paying lower taxes in an earlier period creates an opportunity to earn interest income on the cash saved. In contrast with the relatively simple examples above, it is generally neither pos- sible nor desirable to identify individual instances involving discretion about whether to capitalise or expense expenditures. An analyst can, however, typically identify significant items of expenditure treated differently across companies. The items of expenditure giving rise to the most relevant differences across companies will vary by industry. This cross- industry variation is apparent in the following discussion of the capitalisation of expenditures. CAPITALISATION OF INTEREST COSTS c explain and evaluate how capitalising versus expensing costs in the period in which they are incurred affects financial statements and ratios; As noted above, companies generally must capitalise interest costs associated with acquiring or constructing an asset that requires a long period of time to get ready for its intended use.11 As a consequence of this accounting treatment, a company’s interest costs for a period can appear either on the balance sheet (to the extent they are capitalised) or on the income statement (to the extent they are expensed). 4 11 IAS 23 [Borrowing Costs] and FASB ASC Subtopic 835- 20 [Interest – Capitalization of Interest] specify respectively IFRS and US GAAP for capitalisation of interest costs. Although the standards are not com- pletely converged, the standards are in general agreement. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 354. Reading 22 ■ Long-Lived Assets 336 If the interest expenditure is incurred in connection with constructing an asset for the company’s own use, the capitalised interest appears on the balance sheet as a part of the relevant long- lived asset. The capitalised interest is expensed over time as the property is depreciated—and is thus part of depreciation expense rather than interest expense. If the interest expenditure is incurred in connection with constructing an asset to sell, for example by a real estate construction company, the capitalised interest appears on the company’s balance sheet as part of inventory. The capitalised interest is then expensed as part of the cost of sales when the asset is sold. The treatment of capitalised interest poses certain issues that analysts should consider. First, capitalised interest appears as part of investing cash outflows, whereas expensed interest typically reduces operating cash flow. US GAAP reporting com- panies are required to categorize interest in operating cash flow, and IFRS reporting companies can categorize interest in operating, investing, or financing cash flows. Although the treatment is consistent with accounting standards, an analyst may want to examine the impact on reported cash flows. Second, interest coverage ratios are solvency indicators measuring the extent to which a company’s earnings (or cash flow) in a period covered its interest costs. To provide a true picture of a company’s interest coverage, the entire amount of interest expenditure, both the capitalised portion and the expensed portion, should be used in calculating interest coverage ratios. Additionally, if a company is depreciating interest that it capitalised in a pre- vious period, income should be adjusted to eliminate the effect of that depreciation. Example 6 illustrates the calculations. EXAMPLE 6 Effect of Capitalised Interest Costs on Coverage Ratios and Cash Flow Melco Resorts Entertainment Limited (NASDAQ: MLCO), a Hong Kong SAR based casino company which is listed on the NASDAQ stock exchange and prepares financial reports under US GAAP, disclosed the following infor- mation in one of the footnotes to its 2017 financial statements: “Interest and amortization of deferred financing costs associated with major development and construction projects is capitalized and included in the cost of the project. …. Total interest expenses incurred amounted to $267,065, $252,600, and $253,168, of which $37,483, $29,033, and $134,838 were capitalized during the years ended December 31, 2017, 2016, and 2015, respectively. Amortization of deferred financing costs of $26,182, $48,345, and $38,511, net of amortization capitalized of nil, nil, and $5,458, were recorded during the years ended December 31, 2017, 2016, and 2015, respectively.” (Form 20- F filed 12 April 2018). Cash payments for deferred financing costs were reported in cash flows from financing activities. Exhibit 3 Melco Resorts Entertainment Limited Selected Data, as Reported (Dollars in thousands) 2017 2016 2015 EBIT (from income statement) 544,865 298,663 58,553 Interest expense (from income statement) 229,582 223,567 118,330 Capitalized interest (from footnote) 37,483 29,033 134,838 Amortization of deferred financing costs (from footnote) 26,182 48,345 38,511 © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 355. Capitalisation of Interest Costs 337 2017 2016 2015 Net cash provided by operating activities 1,162,500 1,158,128 522,026 Net cash from (used) in investing activities (410,226) 280,604 (469,656) Net cash from (used) in financing activities (1,046,041) (1,339,717) (29,688) Notes: EBIT represents “Income (Loss) Before Income Tax” plus “Interest expenses, net of capitalized interest” from the income statement. 1 Calculate and interpret Melco’s interest coverage ratio with and without capitalised interest. 2 Calculate Melco’s percentage change in operating cash flow from 2016 to 2017. Assuming the financial reporting does not affect reporting for income taxes, what were the effects of capitalised interest on operating and investing cash flows? Solution to 1: Interest coverage ratios with and without capitalised interest were as follows: For 2017 2.37 ($544,865 ÷ $229,582) without adjusting for capitalised interest; and 2.14 [($544,865 + $26,182) ÷ ($229,582 + $37,483)] including an adjustment to EBIT for depreciation of previously capitalised interest and an adjustment to interest expense for the amount of interest capitalised in 2017. For 2016 1.34 ($298,663÷ $223,567) without adjusting for capitalised interest; and 1.37 [($298,663 + $48,345) ÷ ($223,567 + $29,033)] including an adjustment to EBIT for depreciation of previously capitalised interest and an adjustment to interest expense for the amount of interest capitalised in 2016. For 2015 0.49 ($58,533÷ $118,330) without adjusting for capitalised interest; and 0.38 [($58,533 + $38,511) ÷ ($118,330+ $134,838)] including an adjustment to EBIT for depreciation of previously capitalised interest and an adjustment to interest expense for the amount of interest capitalised in 2015. The above calculations indicate that Melco’s interest coverage improved in 2017 compared to the previous two years. In both 2017 and 2015, the coverage ratio is lower when adjusted for capitalised interest. Solution to 2: If the interest had been expensed rather than capitalised, operating cash flows would have been lower in all three years. On an adjusted basis, but not an unad- justed basis, the company’s operating cash flow declined in 2017 compared to 2016. On an unadjusted basis, for 2017 compared with 2016, Melco’s operating cash flow increased by 0.4 percent in 2017 [($1,162,500 ÷ $1,158,128) – 1]. Including adjustments to expense all interest costs, Melco’s operating cash flow also decreased by 0.4 percent in 2017 {[$1,162,500 – $37,483) ÷ ($1,158,128 – $29,033)] – 1}. Exhibit 3 (Continued) © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 356. Reading 22 ■ Long-Lived Assets 338 If the interest had been expensed rather than capitalised, financing cash flows would have been higher in all three years. The treatment of capitalised interest raises issues for consideration by an analyst. First, capitalised interest appears as part of investing cash outflows, whereas expensed interest reduces operating or financing cash flow under IFRS and operating cash flow under US GAAP. An analyst may want to examine the impact on reported cash flows of interest expenditures when comparing companies. Second, interest coverage ratios are solvency indicators measuring the extent to which a company’s earnings (or cash flow) in a period covered its interest costs. To provide a true picture of a company’s interest coverage, the entire amount of interest, both the capitalised portion and the expensed portion, should be used in calculating interest coverage ratios. Generally, including capitalised interest in the calculation of interest coverage ratios provides a better assessment of a company’s solvency. In assigning credit ratings, rating agencies include capitalised interest in coverage ratios. For example, Standard Poor’s calculates the EBIT interest coverage ratio as EBIT divided by gross interest (defined as interest prior to deductions for capitalised interest or interest income). Maintaining a minimum interest coverage ratio is a financial covenant often included in lending agreements, e.g., bank loans and bond indentures. The definition of the coverage ratio can be found in the company’s credit agreement. The definition is relevant because treatment of capitalised interest in calculating coverage ratios would affect an assessment of how close a company’s actual ratios are to the levels specified by its financial covenants and thus the probability of breaching those covenants. CAPITALISATION OF INTEREST AND INTERNAL DEVELOPMENT COSTS c explain and evaluate how capitalising versus expensing costs in the period in which they are incurred affects financial statements and ratios; As noted above, accounting standards require companies to capitalise software devel- opment costs after a product’s feasibility is established. Despite this requirement, judgment in determining feasibility means that companies’ capitalisation practices may differ. For example, as illustrated in Exhibit 4, Microsoft judges product feasibility to be established very shortly before manufacturing begins and, therefore, effectively expenses—rather than capitalises—research and development costs. Exhibit 4 Disclosure on Software Development Costs Excerpt from Management’s Discussion and Analysis (MDA) of Microsoft Corporation, Application of Critical Accounting Policies, Research and Development Costs: “Costs incurred internally in researching and developing a computer software product are charged to expense until technological feasibility has been established for the product. Once technological feasibility is established, all software costs are capitalized until the product is available for general release to customers. Judgment is required in determining when technological feasibility of a product is established. We have determined that technological feasibility for our software products is reached after all high- risk development issues have been 5 © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 357. Capitalisation of Interest and Internal Development Costs 339 resolved through coding and testing. Generally, this occurs shortly before the products are released to production. The amortization of these costs is included in cost of revenue over the estimated life of the products.” Source: Microsoft Corporation Annual Report on Form 10- K 2017, p. 45. Expensing rather than capitalising development costs results in lower net income in the current period. Expensing rather than capitalising will continue to result in lower net income so long as the amount of the current- period development expenses is higher than the amortisation expense that would have resulted from amortising prior periods’ capitalised development costs—the typical situation when a company’s development costs are increasing. On the statement of cash flows, expensing rather than capitalising development costs results in lower net operating cash flows and higher net investing cash flows. This is because the development costs are reflected as operating cash outflows rather than investing cash outflows. In comparing the financial performance of a company that expenses most or all software development costs, such as Microsoft, with another company that capitalises software development costs, adjustments can be made to make the two comparable. For the company that capitalises software development costs, an analyst can adjust (a) the income statement to include software development costs as an expense and to exclude amortisation of prior years’ software development costs; (b) the balance sheet to exclude capitalised software (decrease assets and equity); and (c) the statement of cash flows to decrease operating cash flows and decrease cash used in investing by the amount of the current period development costs. Any ratios that include income, long- lived assets, or cash flow from operations—such as return on equity—will also be affected. EXAMPLE 7 Software Development Costs You are working on a project involving the analysis of JHH Software, a (hypo- thetical) software development company that established technical feasibility for its first product in 2017. Part of your analysis involves computing certain market- based ratios, which you will use to compare JHH to another company that expenses all of its software development expenditures. Relevant data and excerpts from the company’s annual report are included in Exhibit 5. Exhibit 5 JHH SOFTWARE (Dollars in Thousands, Except Per- Share Amounts) CONSOLIDATED STATEMENT OF EARNINGS—abbreviated For year ended 31 December: 2018 2017 2016 Total revenue $91,424 $91,134 $96,293 Total operating expenses 78,107 78,908 85,624 Operating income 13,317 12,226 10,669 Provision for income taxes 3,825 4,232 3,172 (continued) Exhibit 4 (Continued) © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 358. Reading 22 ■ Long-Lived Assets 340 CONSOLIDATED STATEMENT OF EARNINGS—abbreviated For year ended 31 December: 2018 2017 2016 Net income $9,492 $7,994 $7,479 Earnings per share (EPS) $1.40 $0.82 $0.68 STATEMENT OF CASH FLOWS—abbreviated For year ended 31 December: 2018 2017 2016 Net cash provided by operating activities $15,007 $14,874 $15,266 Net cash used in investing activities* (11,549) (4,423) (5,346) Net cash used in financing activities (8,003) (7,936) (7,157) Net change in cash and cash equivalents ($4,545) $2,515 $2,763 *Includes software development expenses of and includes capital expenditures of ($6,000) ($4,000) ($2,000) ($2,000) ($1,600) ($1,200) Additional information: For year ended 31 December: 2018 2017 2016 Market value of outstanding debt 0 0 0 Amortisation of capitalised soft- ware development expenses ($2,000) ($667) 0 Depreciation expense ($2,200) ($1,440) ($1,320) Market price per share of com- mon stock $42 $26 $17 Shares of common stock out- standing (thousands) 6,780 9,765 10,999 Footnote disclosure of accounting policy for software development: Expenses that are related to the conceptual formulation and design of software products are expensed to research and development as incurred. The company capitalises expenses that are incurred to produce the finished product after technological feasibility has been established. 1 Compute the following ratios for JHH based on the reported financial statements for fiscal year ended 31 December 2018, with no adjustments. Next, determine the approximate impact on these ratios if the company had expensed rather than capitalised its investments in software. (Assume the financial reporting does not affect reporting for income taxes. There would be no change in the effective tax rate.) A P/E: Price/Earnings per share B P/CFO: Price/Operating cash flow per share Exhibit 5 (Continued) © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 359. Capitalisation of Interest and Internal Development Costs 341 C EV/EBITDA: Enterprise value/EBITDA, where enterprise value is defined as the total market value of all sources of a company’s financ- ing, including equity and debt, and EBITDA is earnings before inter- est, taxes, depreciation, and amortisation. 2 Interpret the changes in the ratios. Solution to 1: (Dollars are in thousands, except per- share amounts.) JHH’s 2019 ratios are presented in the following table: Ratios As reported As adjusted A P/E ratio 30.0 42.9 B P/CFO 19.0 31.6 C EV/EBITDA 16.3 24.7 A Based on the information as reported, the P/E ratio was 30.0 ($42 ÷ $1.40). Based on EPS adjusted to expense software development costs, the P/E ratio was 42.9 ($42 ÷ $0.98). ● ● Price: Assuming that the market value of the company’s equity is based on its fundamentals, the price per share is $42, regardless of a difference in accounting. ● ● EPS: As reported, EPS was $1.40. Adjusted EPS was $0.98. Expensing software development costs would have reduced JHH’s 2018 operating income by $6,000, but the company would have reported no amortisa- tion of prior years’ software costs, which would have increased oper- ating income by $2,000. The net change of $4,000 would have reduced operating income from the reported $13,317 to $9,317. The effective tax rate for 2018 ($3,825 ÷ $13,317) is 28.72%, and using this effective tax rate would give an adjusted net income of $6,641 [$9,317 × (1 – 0.2872)], compared to $9,492 before the adjustment. The EPS would therefore be reduced from the reported $1.40 to $0.98 (adjusted net income of $6,641 divided by 6,780 shares). B Based on information as reported, the P/CFO was 19.0 ($42 ÷ $2.21). Based on CFO adjusted to expense software development costs, the P/ CFO was 31.6 ($42 ÷ $1.33). ● ● Price: Assuming that the market value of the company’s equity is based on its fundamentals, the price per share is $42, regardless of a difference in accounting. ● ● CFO per share, as reported, was $2.21 (total operating cash flows $15,007 ÷ 6,780 shares). ● ● CFO per share, as adjusted, was $1.33. The company’s $6,000 expen- diture on software development costs was reported as a cash outflow from investing activities, so expensing those costs would reduce cash from operating activities by $6,000, from the reported $15,007 to $9,007. Dividing adjusted total operating cash flow of $9,007 by 6,780 shares results in cash flow per share of $1.33. C Based on information as reported, the EV/EBITDA was 16.3 ($284,760 ÷ $17,517). Based on EBITDA adjusted to expense software development costs, the EV/EBITDA was 24.7 ($284,760 ÷ $11,517). © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 360. Reading 22 ■ Long-Lived Assets 342 ● ● Enterprise Value: Enterprise value is the sum of the market value of the company’s equity and debt. JHH has no debt, and therefore the enterprise value is equal to the market value of its equity. The market value of its equity is $284,760 ($42 per share × 6,780 shares). ● ● EBITDA, as reported, was $17,517 (earnings before interest and taxes of $13,317 plus $2,200 depreciation plus $2,000 amortisation). ● ● EBITDA, adjusted for expensing software development costs by the inclusion of $6,000 development expense and the exclusion of $2,000 amortisation of prior expense, would be $11,517 (earnings before interest and taxes of $9,317 plus $2,200 depreciation plus $0 amortisation). Solution to 2: Expensing software development costs would decrease historical profits, oper- ating cash flow, and EBITDA, and would thus increase all market multiples. So JHH’s stock would appear more expensive if it expensed rather than capitalised the software development costs. If the unadjusted market- based ratios were used in the comparison of JHH to its competitor that expenses all software development expenditures, then JHH might appear to be under- priced when the difference is solely related to accounting factors. JHH’s adjusted market- based ratios provide a better basis for comparison. For the company in Example 7, current period software development expenditures exceed the amortisation of prior periods’ capitalised software development expendi- tures. As a result, expensing rather than capitalising software development costs would have the effect of lowering income. If, however, software development expenditures slowed such that current expenditures were lower than the amortisation of prior periods’ capitalised software development expenditures, then expensing software development costs would have the effect of increasing income relative to capitalising it. This section illustrated how decisions about capitalising versus expensing impact financial statements and ratios. Earlier expensing lowers current profits but enhances trends, whereas capitalising now and expensing later enhances current profits. Having described the accounting for acquisition of long- lived assets, we now turn to the topic of measuring long- lived assets in subsequent periods. DEPRECIATION OF LONG-LIVED ASSETS: METHODS AND CALCULATION d describe the different depreciation methods for property, plant, and equipment and calculate depreciation expense; e describe how the choice of depreciation method and assumptions concerning useful life and residual value affect depreciation expense, financial statements, and ratios; k explain and evaluate how impairment, revaluation, and derecognition of prop- erty, plant, and equipment and intangible assets affect financial statements and ratios; 6 © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 361. Depreciation of Long-Lived Assets: Methods and Calculation 343 Under the cost model of reporting long- lived assets, which is permitted under IFRS and required under US GAAP, the capitalised costs of long- lived tangible assets (other than land, which is not depreciated) and intangible assets with finite useful lives are allocated to subsequent periods as depreciation and amortisation expenses. Depreciation and amortisation are effectively the same concept, with the term depreciation referring to the process of allocating tangible assets’ costs and the term amortisation referring to the process of allocating intangible assets’ costs.12 The alternative model of reporting long- lived assets is the revaluation model, which is permitted under IFRS but not under US GAAP. Under the revaluation model, a company reports the long- lived asset at fair value rather than at acquisition cost (historical cost) less accumulated depreciation or amortisation, as in the cost model. An asset’s carrying amount is the amount at which the asset is reported on the balance sheet. Under the cost model, at any point in time, the carrying amount (also called carrying value or net book value) of a long- lived asset is equal to its historical cost minus the amount of depreciation or amortisation that has been accumulated since the asset’s purchase (assuming that the asset has not been impaired, a topic which will be addressed in Section 9). Companies may present on the balance sheet the total net amount of property, plant, and equipment and the total net amount of intangible assets. However, more detail is disclosed in the notes to financial state- ments. The details disclosed typically include the acquisition costs, the depreciation and amortisation expenses, the accumulated depreciation and amortisation amounts, the depreciation and amortisation methods used, and information on the assumptions used to depreciate and amortise long- lived assets. 6.1 Depreciation Methods and Calculation of Depreciation Expense Depreciation methods include the straight-line method, in which the cost of an asset is allocated to expense evenly over its useful life; accelerated methods, in which the allocation of cost is greater in earlier years; and the units-of-production method, in which the allocation of cost corresponds to the actual use of an asset in a particular period. The choice of depreciation method affects the amounts reported on the financial statements, including the amounts for reported assets and operating and net income. This, in turn, affects a variety of financial ratios, including fixed asset turnover, total asset turnover, operating profit margin, operating return on assets, and return on assets. Using the straight- line method, depreciation expense is calculated as depreciable cost divided by estimated useful life and is the same for each period. Depreciable cost is the historical cost of the tangible asset minus the estimated residual (salvage) value.13 A commonly used accelerated method is the declining balance method, in which the amount of depreciation expense for a period is calculated as some per- centage of the carrying amount (i.e., cost net of accumulated depreciation at the beginning of the period). When an accelerated method is used, depreciable cost is not used to calculate the depreciation expense but the carrying amount should not be reduced below the estimated residual value. In the units- of- production method, the amount of depreciation expense for a period is based on the proportion of the asset’s production during the period compared with the total estimated productive capacity of the asset over its useful life. The depreciation expense is calculated as depreciable 12 Depletion is the term applied to a similar concept for natural resources; costs associated with those resources are allocated to a period on the basis of the usage or extraction of those resources. 13 The residual value is the estimated amount that an entity will obtain from disposal of the asset at the end of its useful life. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 362. Reading 22 ■ Long-Lived Assets 344 cost times production in the period divided by estimated productive capacity over the life of the asset. Equivalently, the company may estimate a depreciation cost per unit (depreciable cost divided by estimated productive capacity) and calculate depreciation expense as depreciation cost per unit times production in the period. Regardless of the depreciation method used, the carrying amount of the asset is not reduced below the estimated residual value. Example 8 provides an example of these depreciation methods. EXAMPLE 8 Alternative Depreciation Methods You are analyzing three hypothetical companies: EVEN- LI Co., SOONER Inc., and AZUSED Co. At the beginning of Year 1, each company buys an identical piece of box manufacturing equipment for $2,300 and has the same assumptions about useful life, estimated residual value, and productive capacity. The annual production of each company is the same, but each company uses a different method of depreciation. As disclosed in each company’s notes to the financial statements, each company’s depreciation method, assumptions, and production are as follows: Depreciation method ■ ■ EVEN- LI Co.: straight- line method ■ ■ SOONER Inc.: double- declining balance method (the rate applied to the carrying amount is double the depreciation rate for the straight- line method) ■ ■ AZUSED Co.: units- of- production method Assumptions and production ■ ■ Estimated residual value: $100 ■ ■ Estimated useful life: 4 years ■ ■ Total estimated productive capacity: 800 boxes ■ ■ Production in each of the four years: 200 boxes in the first year, 300 in the second year, 200 in the third year, and 100 in the fourth year 1 Using the following template for each company, record its beginning and ending net book value (carrying amount), end- of- year accumulated depreciation, and annual depreciation expense for the box manufacturing equipment. Template: Beginning Net Book Value Depreciation Expense Accumulated Depreciation Ending Net Book Value Year 1 Year 2 Year 3 Year 4 2 Explain the significant differences in the timing of the recognition of the depreciation expense. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 363. Depreciation of Long-Lived Assets: Methods and Calculation 345 3 For each company, assume that sales, earnings before interest, taxes, depreciation, and amortization, and assets other than the box manufac- turing equipment are as shown in the following table. Calculate the total asset turnover ratio, the operating profit margin, and the operating return on assets for each company for each of the four years. Discuss the ratios, comparing results within and across companies. Sales Earnings before Interest, Taxes, Depreciation, and Amortization Carrying Amount of Total Assets, Excluding the Box Manufacturing Equipment, at Year End* Year 1 $300,000 $36,000 $30,000 Year 2 320,000 38,400 32,000 Year 3 340,000 40,800 34,000 Year 4 360,000 43,200 36,000 * Assume that total assets at the beginning of Year 1, including the box manufacturing equipment, had a value of $30,300. Assume that depreciation expense on assets other than the box manufacturing equipment totaled $1,000 per year. Solution to 1: For each company, the following information applies: Beginning net book value in Year 1 equals the purchase price of $2,300; accumulated year-end depreciation equals the balance from the previous year plus the current year’s depreciation expense; ending net book value (carrying amount) equals original cost minus accumulated year- end depreciation (which is the same as beginning net book value minus depreciation expense); and beginning net book value in Years 2, 3, and 4 equals the ending net book value of the prior year. The following text and filled- in templates describe how depreciation expense is calculated for each company. EVEN- LI Co. uses the straight- line method, so depreciation expense in each year equals $550, which is calculated as ($2,300 original cost – $100 residual value)/4 years. The net book value at the end of Year 4 is the estimated residual value of $100. EVEN-LI Co. Beginning Net Book Value Depreciation Expense Accumulated Year-End Depreciation Ending Net Book Value Year 1 $2,300 $550 $550 $1,750 Year 2 1,750 550 1,100 1,200 Year 3 1,200 550 1,650 650 Year 4 650 550 2,200 100 SOONER Inc. uses the double- declining balance method. The depreciation rate for the double- declining balance method is double the depreciation rate for the straight- line method. The depreciation rate under the straight- line method is 25 percent (100 percent divided by 4 years). Thus, the depreciation rate for the double- declining balance method is 50 percent (2 times 25 percent). The depreciation expense for the first year is $1,150 (50 percent of $2,300). Note that under this method, the depreciation rate of 50 percent is applied to the carrying amount (net book value) of the asset, without adjustment for expected residual value. Because the carrying amount of the asset is not depreciated below its © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 364. Reading 22 ■ Long-Lived Assets 346 estimated residual value, however, the depreciation expense in the final year of depreciation decreases the ending net book value (carrying amount) to the estimated residual value. SOONER Inc. Beginning Net Book Value Depreciation Expense Accumulated Year-End Depreciation Ending Net Book Value Year 1 $2,300 $1,150 $1,150 $1,150 Year 2 1,150 575 1,725 575 Year 3 575 288 2,013 287 Year 4 287 187 2,200 100 Another common approach (not required in this question) is to use an accelerated method, such as the double- declining method, for some period (a year or more) and then to change to the straight- line method for the remaining life of the asset. If SOONER had used the double- declining method for the first year and then switched to the straight- line method for Years 2, 3, and 4, the depreciation expense would be $350 [($1,150 – $100 estimated residual value)/3 years] a year for Years 2, 3, and 4. The results for SOONER under this alternative approach are shown below. SOONER Inc. Beginning Net Book Value Depreciation Expense Accumulated Year-End Depreciation Ending Net Book Value Year 1 $2,300 $1,150 $1,150 $1,150 Year 2 1,150 350 1,500 800 Year 3 800 350 1,850 450 Year 4 450 350 2,200 100 AZUSED Co. uses the units- of- production method. Dividing the equipment’s total depreciable cost by its total productive capacity gives a cost per unit of $2.75, calculated as ($2,300 original cost – $100 residual value)/800. The depreciation expense recognised each year is the number of units produced times $2.75. For Year 1, the amount of depreciation expense is $550 (200 units times $2.75). For Year 2, the amount is $825 (300 units times $2.75). For Year 3, the amount is $550. For Year 4, the amount is $275. AZUSED Co. Beginning Net Book Value Depreciation Expense Accumulated Year-End Depreciation Ending Net Book Value Year 1 $2,300 $550 $550 $1,750 Year 2 1,750 825 1,375 925 Year 3 925 550 1,925 375 Year 4 375 275 2,200 100 Solution to 2: All three methods result in the same total amount of accumulated depreciation over the life of the equipment. The significant differences are simply in the timing of the recognition of the depreciation expense. The straight- line method recognises the expense evenly, the accelerated method recognises most of the expense in the first year, and the units- of- production method recognises the expense on the basis of production (or use of the asset). Under all three methods, the ending net book value is $100. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 365. Depreciation of Long-Lived Assets: Methods and Calculation 347 Solution to 3: Total asset turnover ratio = Total revenue ÷ Average total assets Operating profit margin = Earnings before interest and taxes ÷ Total revenue Operating return on assets = Earnings before interest and taxes ÷ Average total assets Ratios are shown in the table below, and details of the calculations for Years 1 and 2 are described after discussion of the ratios. EVEN-LI Co. SOONER Inc. AZUSED Co. Ratio* AT PM (%) ROA (%) AT PM (%) ROA (%) AT PM (%) ROA (%) Year 1 9.67 11.48 111.04 9.76 11.28 110.17 9.67 11.48 111.04 Year 2 9.85 11.52 113.47 10.04 11.51 115.57 9.90 11.43 113.10 Year 3 10.02 11.54 115.70 10.17 11.62 118.21 10.10 11.54 116.64 Year 4 10.18 11.57 117.74 10.23 11.67 119.42 10.22 11.65 118.98 * AT = Total asset turnover ratio. PM = Operating profit margin. ROA = Operating return on assets. For all companies, the asset turnover ratio increased over time because sales grew at a faster rate than that of the assets. SOONER had consistently higher asset turnover ratios than the other two companies, however, because higher depreciation expense in the earlier periods decreased its average total assets. In addition, the higher depreciation in earlier periods resulted in SOONER having lower operating profit margin and operating ROA in the first year and higher operating profit margin and operating ROA in the later periods. SOONER appears to be more efficiently run, on the basis of its higher asset turnover and greater increases in profit margin and ROA over time; however, these comparisons reflect differences in the companies’ choice of depreciation method. In addition, an analyst might question the sustainability of the extremely high ROAs for all three companies because such high profitability levels would probably attract new competitors, which would likely put downward pressure on the ratios. EVEN-LI Co. Year 1: Total asset turnover ratio = 300,000/[(30,300 + 30,000 + 1,750)/2] = 300,000/31,025 = 9.67 Operating profit margin = (36,000 – 1,000 – 550)/300,000 = 34,450/300,000 = 11.48% Operating ROA = 34,450/31,025 = 111.04% Year 2: Total asset turnover ratio = 320,000/[(30,000 + 1,750 + 32,000 + 1,200)/2] = 320,000/32,475 = 9.85 Operating profit margin = (38,400 – 1,000 – 550)/320,000 = 36,850/320,000 = 11.52% Operating ROA = 36,850/32,475 = 113.47% © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 366. Reading 22 ■ Long-Lived Assets 348 SOONER Inc. Year 1: Total asset turnover ratio = 300,000/[(30,300 + 30,000 + 1,150)/2] = 300,000/30,725 = 9.76 Operating profit margin = (36,000 – 1,000 – 1,150)/300,000 = 33,850/300,000 = 11.28% Operating ROA = 33,850/30,725 = 110.17% Year 2: Total asset turnover ratio = 320,000/[(30,000 + 1,150 + 32,000 + 575)/2] = 320,000/31,862.50 = 10.04 Operating profit margin = (38,400 – 1,000 – 575)/320,000 = 36,825/320,000 = 11.51% Operating ROA = 36,825/31,862.50 = 115.57% AZUSED Co. Year 1: Total asset turnover ratio = 300,000/[(30,300 + 30,000 + 1,750)/2] = 300,000/31,025 = 9.67 Operating profit margin = (36,000 – 1,000 – 550)/300,000 = 34,450/300,000 = 11.48% Operating ROA = 34,450/31,025 = 111.04% Year 2: Total asset turnover ratio = 320,000/[(30,000 + 1,750 + 32,000 + 925)/2] = 320,000/32,337.50 = 9.90 Operating profit margin = (38,400 – 1,000 – 825)/320,000 = 36,575/320,000 = 11.43% Operating ROA = 36,575/32,337.50 = 113.10% In many countries, a company must use the same depreciation methods for both financial and tax reporting. In other countries, including the United States, a company need not use the same depreciation method for financial reporting and taxes. As a result of using different depreciation methods for financial and tax reporting, pre- tax income on the income statement and taxable income on the tax return may differ. Thus, the amount of tax expense computed on the basis of pre- tax income and the amount of taxes actually owed on the basis of taxable income may differ. Although these differences eventually reverse because the total depreciation is the same regardless of the timing of its recognition in financial statements versus on tax returns, during the period of the difference, the balance sheet will show what is known as deferred taxes. For instance, if a company uses straight- line depreciation for financial reporting and an accelerated depreciation method for tax purposes, the company’s financial statements will report lower depreciation expense and higher pre- tax income in the first year, compared with the amount of depreciation expense and taxable income in its tax reporting. (Compare the depreciation expense in Year 1 for EVEN- LI Co. and SOONER Inc. in the previous example.) Tax expense calculated on the basis of the financial statements’ pre- tax income will be higher than taxes payable on the basis of taxable income; the difference between the two amounts represents a deferred tax © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 367. Depreciation of Long-Lived Assets: Methods and Calculation 349 liability. The deferred tax liability will be reduced as the difference reverses (i.e., when depreciation for financial reporting is higher than the depreciation for tax purposes) and the income tax is paid. Significant estimates required for calculating depreciation include the useful life of the asset (or its total lifetime productive capacity) and its expected residual value at the end of that useful life. A longer useful life and higher expected residual value decrease the amount of annual depreciation expense relative to a shorter useful life and lower expected residual value. Companies should review their estimates periodically to ensure they remain reasonable. IFRS require companies to review estimates annually. Although no significant differences exist between IFRS and US GAAP with respect to the definition of depreciation and the acceptable depreciation methods, IFRS require companies to use a component method of depreciation.14 Companies are required to separately depreciate the significant components of an asset (parts of an item with a cost that is significant in relation to the total cost and/or with different useful lives) and thus require additional estimates for the various components. For instance, it may be appropriate to depreciate separately the engine, frame, and interior furnishings of an aircraft. Under US GAAP, the component method of depreciation is allowed but is seldom used in practice.15 The following example illustrates depreciating compo- nents of an asset. EXAMPLE 9 Illustration of Depreciating Components of an Asset CUTITUP Co., a hypothetical company, purchases a milling machine, a type of machine used for shaping metal, at a total cost of $10,000. $2,000 was esti- mated to represent the cost of the rotating cutter, a significant component of the machine. The company expects the machine to have a useful life of eight years and a residual value of $3,000 and that the rotating cutter will need to be replaced every two years. Assume the entire residual value is attributable to the milling machine itself, and assume the company uses straight- line depreciation for all assets. 1 How much depreciation expense would the company report in Year 1 if it uses the component method of depreciation, and how much depreciation expense would the company report in Year 1 if it does not use the compo- nent method? 2 Assuming a new cutter with an estimated two- year useful life is purchased at the end of Year 2 for $2,000, what depreciation expenses would the company report in Year 3 if it uses the component method and if it does not use the component method? 3 Assuming replacement of the cutter every two years at a price of $2,000, what is the total depreciation expense over the eight years if the com- pany uses the component method compared with the total depreciation expense if the company does not use the component method? 4 How many different items must the company estimate in the first year to compute depreciation expense for the milling machine if it uses the com- ponent method, and how does this compare with what would be required if it does not use the component method? 14 IAS 16 Property, Plant and Equipment, paragraphs 43–47 [Depreciation]. 15 According to KPMG’s IFRS Compared to US GAAP, December 2017, kpmg.com. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 368. Reading 22 ■ Long-Lived Assets 350 Solution to 1: Depreciation expense in Year 1 under the component method would be $1,625. For the portion of the machine excluding the cutter, the depreciable base is total cost minus the cost attributable to the cutter minus the estimated residual value = $10,000 – $2,000 – $3,000 = $5,000. Depreciation expense for the machine excluding the cutter in the first year equals $625 (depreciable cost divided by the useful life of the machine = $5,000/8 years). For the cutter, the depreciation expense equals $1,000 (depreciable cost divided by the useful life of the cutter = $2,000/2 years). Thus, the total depreciation expense for Year 1 under the component method is $1,625 (the sum of the depreciation expenses of the two components = $625 + $1,000). Depreciation expense in Year 2 would also be $1,625. If the company does not use the component method, depreciation expense in Year 1 is $875 (the depreciable cost of the total milling machine divided by its useful life = [$10,000 – $3,000]/8 years). Depreciation expense in Year 2 would also be $875. Solution to 2: Assuming that at the end of Year 2, the company purchases a new cutter for $2,000 with an estimated two- year life, under the component method, the depreciation expense in Year 3 will remain at $1,625. If the company does not use the component method and purchases a new cutter with an estimated two- year life for $2,000 at the end of Year 2, the depreciation expense in Year 3 will be $1,875 [$875 + ($2,000/2) = $875 + $1,000]. Solution to 3: Over the eight years, assuming replacement of the cutters every two years at a price of $2,000, the total depreciation expense will be $13,000 [$1,625 × 8 years] when the component method is used. When the component method is not used, the total depreciation expense will also be $13,000 [$875 × 2 years + $1,875 × 6 years]. This amount equals the total expenditures of $16,000 [$10,000 + 3 cutters × $2,000] less the residual value of $3,000. Solution to 4: The following table summarizes the estimates required in the first year to compute depreciation expense if the company does or does not use the component method: Estimate Required using component method? Required if not using component method? Useful life of milling machine Yes Yes Residual value of milling machine Yes Yes Portion of machine cost attributable to cutter Yes No Portion of residual value attributable to cutter Yes No Useful life of cutter Yes No Total depreciation expense may be allocated between the cost of sales and other expenses. Within the income statement, depreciation expense of assets used in production is usually allocated to the cost of sales, and the depreciation expense of assets not used in production may be allocated to some other expense category. For © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 369. Amortisation of Long-Lived Assets: Methods and Calculation 351 instance, depreciation expense may be allocated to selling, general, and administrative expenses if depreciable assets are used in those functional areas. Notes to the financial statements sometimes disclose information regarding which income statement line items include depreciation expense, although the exact amount of detail disclosed by individual companies varies. AMORTISATION OF LONG-LIVED ASSETS: METHODS AND CALCULATION f describe the different amortisation methods for intangible assets with finite lives and calculate amortisation expense; g describe how the choice of amortisation method and assumptions concerning useful life and residual value affect amortisation expense, financial statements, and ratios; k explain and evaluate how impairment, revaluation, and derecognition of prop- erty, plant, and equipment and intangible assets affect financial statements and ratios; Amortisation is similar in concept to depreciation. The term amortisation applies to intangible assets, and the term depreciation applies to tangible assets. Both terms refer to the process of allocating the cost of an asset over the asset’s useful life. Only those intangible assets assumed to have finite useful lives are amortised over their useful lives, following the pattern in which the benefits are used up. Acceptable amortisation methods are the same as the methods acceptable for depreciation. Assets assumed to have an indefinite useful life (in other words, without a finite useful life) are not amortised. An intangible asset is considered to have an indefinite useful life when there is “no foreseeable limit to the period over which the asset is expected to generate net cash inflows” for the company.16 Intangible assets with finite useful lives include an acquired customer list expected to provide benefits to a direct- mail marketing company for two to three years, an acquired patent or copyright with a specific expiration date, an acquired license with a specific expiration date and no right to renew the license, and an acquired trade- mark for a product that a company plans to phase out over a specific number of years. Examples of intangible assets with indefinite useful lives include an acquired license that, although it has a specific expiration date, can be renewed at little or no cost and an acquired trademark that, although it has a specific expiration, can be renewed at a minimal cost and relates to a product that a company plans to continue selling for the foreseeable future. As with depreciation for a tangible asset, the calculation of amortisation for an intangible asset requires the original amount at which the intangible asset is recognised and estimates of the length of its useful life and its residual value at the end of its useful life. Useful lives are estimated on the basis of the expected use of the asset, considering any factors that may limit the life of the asset, such as legal, regulatory, contractual, competitive, or economic factors. 7 16 IAS 38 Intangible Assets, paragraph 88. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 370. Reading 22 ■ Long-Lived Assets 352 EXAMPLE 10 Amortisation Expense IAS 38 Intangible Assets provides illustrative examples regarding the accounting for intangible assets, including the following: A direct- mail marketing company acquires a customer list and expects that it will be able to derive benefit from the information on the list for at least one year, but no more than three years. The customer list would be amortised over management’s best estimate of its useful life, say 18 months. Although the direct- mail marketing company may intend to add customer names and other information to the list in the future, the expected benefits of the acquired customer list relate only to the customers on that list at the date it was acquired. In this example, in what ways would management’s decisions and estimates affect the company’s financial statements? Solution: Because the acquired customer list is expected to generate future economic benefits for a period greater than one year, the cost of the list should be capital- ised and not expensed. The acquired customer list is determined to not have an indefinite life and must be amortised. Management must estimate the useful life of the customer list and must select an amortisation method. In this example, the list appears to have no residual value. Both the amortisation method and the estimated useful life affect the amount of the amortisation expense in each period. A shorter estimated useful life, compared with a longer estimated useful life, results in a higher amortisation expense each year over a shorter period, but the total accumulated amortisation expense over the life of the intangible asset is unaffected by the estimate of the useful life. Similarly, the total accumulated amortisation expense over the life of the intangible asset is unaffected by the choice of amortisation method. The amortisation expense per period depends on the amortisation method. If the straight- line method is used, the amortisation expense is the same for each year of useful life. If an accelerated method is used, the amortisation expense will be higher in earlier years. THE REVALUATION MODEL h describe the revaluation model; k explain and evaluate how impairment, revaluation, and derecognition of prop- erty, plant, and equipment and intangible assets affect financial statements and ratios; The revaluation model is an alternative to the cost model for the periodic valuation and reporting of long- lived assets. IFRS permit the use of either the revaluation model or the cost model, but the revaluation model is not allowed under US GAAP. Revaluation changes the carrying amounts of classes of long- lived assets to fair value (the fair value must be measured reliably). Under the cost model, carrying amounts are historical costs less accumulated depreciation or amortisation. Under the reval- uation model, carrying amounts are the fair values at the date of revaluation less any subsequent accumulated depreciation or amortisation. 8 © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 371. The Revaluation Model 353 IFRS allow companies to value long- lived assets either under a cost model at his- torical cost minus accumulated depreciation or amortisation or under a revaluation model at fair value. In contrast, US accounting standards require that the cost model be used. A key difference between the two models is that the cost model allows only decreases in the values of long- lived assets compared with historical costs but the revaluation model may result in increases in the values of long- lived assets to amounts greater than historical costs. IFRS allow a company to use the cost model for some classes of assets and the revaluation model for others, but the company must apply the same model to all assets within a particular class of assets and must revalue all items within a class to avoid selective revaluation. Examples of different classes of assets include land, land and buildings, machinery, motor vehicles, furniture and fixtures, and office equipment. The revaluation model may be used for classes of intangible assets but only if an active market for the assets exists, because the revaluation model may only be used if the fair values of the assets can be measured reliably. For practical purposes, the revaluation model is rarely used for either tangible or intangible assets, but its use is especially rare for intangible assets. Under the revaluation model, whether an asset revaluation affects earnings depends on whether the revaluation initially increases or decreases an asset class’ carrying amount. If a revaluation initially decreases the carrying amount of the asset class, the decrease is recognised in profit or loss. Later, if the carrying amount of the asset class increases, the increase is recognised in profit or loss to the extent that it reverses a revaluation decrease of the same asset class previously recognised in profit or loss. Any increase in excess of the reversal amount will not be recognised in the income statement but will be recorded directly to equity in a revaluation surplus account. An upward revaluation is treated the same as the amount in excess of the reversal amount. In other words, if a revaluation initially increases the carrying amount of the asset class, the increase in the carrying amount of the asset class bypasses the income statement and goes directly to equity under the heading of revaluation surplus. Any subsequent decrease in the asset’s value first decreases the revaluation surplus and then goes to income. When an asset is retired or disposed of, any related amount of revaluation surplus included in equity is transferred directly to retained earnings. Asset revaluations offer several considerations for financial statement analyses. First, an increase in the carrying amount of depreciable long- lived assets increases total assets and shareholders’ equity, so asset revaluations that increase the carrying amount of an asset can be used to reduce reported leverage. Defining leverage as aver- age total assets divided by average shareholders’ equity, increasing both the numerator (assets) and denominator (equity) by the same amount leads to a decline in the ratio. (Mathematically, when a ratio is greater than one, as in this case, an increase in both the numerator and the denominator by the same amount leads to a decline in the ratio.) Therefore, the leverage motivation for the revaluation should be considered in analysis. For example, a company may revalue assets up if it is seeking new capital or approaching leverage limitations set by financial covenants. Second, assets revaluations that decrease the carrying amount of the assets reduce net income. In the year of the revaluation, profitability measures such as return on assets and return on equity decline. However, because total assets and shareholders’ equity are also lower, the company may appear more profitable in future years. Additionally, reversals of downward revaluations also go through income, thus increasing earnings. Managers can then opportunistically time the reversals to manage earnings and increase income. Third, asset revaluations that increase the carrying amount of an asset ini- tially increase depreciation expense, total assets, and shareholders’ equity. Therefore, profitability measures, such as return on assets and return on equity, would decline. Although upward asset revaluations also generally decrease income (through higher © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 372. Reading 22 ■ Long-Lived Assets 354 depreciation expense), the increase in the value of the long- lived asset is presumably based on increases in the operating capacity of the asset, which will likely be evidenced in increased future revenues. Finally, an analyst should consider who did the appraisal—i.e. an independent external appraiser or management—and how often revaluations are made. Appraisals of the fair value of long- lived assets involve considerable judgment and discretion. Presumably, appraisals of assets from independent external sources are more reliable. How often assets are revalued can provide an indicator of whether their reported value continues to be representative of their fair values. The next two examples illustrate revaluation of long- lived assets under IFRS. EXAMPLE 11 Revaluation Resulting in an Increase in Carrying Amount Followed by Subsequent Revaluation Resulting in a Decrease in Carrying Amount UPFIRST, a hypothetical manufacturing company, has elected to use the reval- uation model for its machinery. Assume for simplicity that the company owns a single machine, which it purchased for €10,000 on the first day of its fiscal period, and that the measurement date occurs simultaneously with the compa- ny’s fiscal period end. 1 At the end of the first fiscal period after acquisition, assume the fair value of the machine is determined to be €11,000. How will the company’s financial statements reflect the asset? 2 At the end of the second fiscal period after acquisition, assume the fair value of the machine is determined to be €7,500. How will the company’s financial statements reflect the asset? Solution to 1: At the end of the first fiscal period, the company’s balance sheet will show the asset at a value of €11,000. The €1,000 increase in the value of the asset will appear in other comprehensive income and be accumulated in equity under the heading of revaluation surplus. Solution to 2: At the end of the second fiscal period, the company’s balance sheet will show the asset at a value of €7,500. The total decrease in the carrying amount of the asset is €3,500 (€11,000 – €7,500). Of the €3,500 decrease, the first €1,000 will reduce the amount previously accumulated in equity under the heading of revaluation surplus. The other €2,500 will be shown as a loss on the income statement. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 373. The Revaluation Model 355 EXAMPLE 12 Revaluation Resulting in a Decrease in Asset’s Carrying Amount Followed by Subsequent Revaluation Resulting in an Increase in Asset’s Carrying Amount DOWNFIRST, a hypothetical manufacturing company, has elected to use the revaluation model for its machinery. Assume for simplicity that the company owns a single machine, which it purchased for €10,000 on the first day of its fiscal period, and that the measurement date occurs simultaneously with the company’s fiscal period end. 1 At the end of the first fiscal period after acquisition, assume the fair value of the machine is determined to be €7,500. How will the company’s finan- cial statements reflect the asset? 2 At the end of the second fiscal period after acquisition, assume the fair value of the machine is determined to be €11,000. How will the company’s financial statements reflect the asset? Solution to 1: At the end of the first fiscal period, the company’s balance sheet will show the asset at a value of €7,500. The €2,500 decrease in the value of the asset will appear as a loss on the company’s income statement. Solution to 2: At the end of the second fiscal period, the company’s balance sheet will show the asset at a value of €11,000. The total increase in the carrying amount of the asset is an increase of €3,500 (€11,000 – €7,500). Of the €3,500 increase, the first €2,500 reverses a previously reported loss and will be reported as a gain on the income statement. The other €1,000 will bypass profit or loss and be reported as other comprehensive income and be accumulated in equity under the heading of revaluation surplus. Exhibit 6 provides two examples of disclosures concerning the revaluation model. The first disclosure is an excerpt from the 2006 annual report of KPN, a Dutch tele- communications and multimedia company. The report was produced at a time during which any IFRS- reporting company with a US stock exchange listing was required to explain differences between its reporting under IFRS and its reporting if it had used US GAAP.17 One of these differences, as previously noted, is that US GAAP do not allow revaluation of fixed assets held for use. KPN’s disclosure states that the com- pany elected to report a class of fixed assets (cables) at fair value and explained that under US GAAP, using the cost model, the value of the asset class would have been €350 million lower. The second disclosure is an excerpt from the 2017 annual report of Avianca Holdings S.A., a Latin American airline that reports under IFRS and uses the revaluation model for one component of its fixed assets. 17 On 15 November 2007, the SEC approved rule amendments under which financial statements from foreign private issuers in the United States will be accepted without reconciliation to US GAAP if the finan- cial statements are prepared in accordance with IFRS as issued by the International Accounting Standards Board. The rule took effect for the 2007 fiscal year. As a result, companies such as KPN no longer need to provide reconciliations to US GAAP. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 374. Reading 22 ■ Long-Lived Assets 356 Exhibit 6 Impact of Revaluation 1 Excerpt from the annual report of Koninklijke KPN N.V. explaining certain differences between IFRS and US GAAP regarding “Deemed cost fixed assets”: KPN elected the exemption to revalue certain of its fixed assets upon the transition to IFRS to fair value and to use this fair value as their deemed cost. KPN applied the depreciated replacement cost method to determine this fair value. The revalued assets pertain to certain cables, which form part of property, plant equipment. Under US GAAP, this revaluation is not allowed and therefore results in a rec- onciling item. As a result, the value of these assets as of December 31, 2006 under US GAAP is EUR 350 million lower (2005: EUR 415 mil- lion; 2004: EUR 487 million) than under IFRS. Source: KPN’s Form 20- F, p. 168, filed 1 March 2007. 2 The 2017 annual report of Avianca Holdings S.A. and Subsidiaries shows $58.4 million of “Revaluation and Other Reserves” as a component of Equity on its balance sheet and $31.0 million in Other Comprehensive Income for the current year’s “Revaluation of Administrative Property”. The relevant footnote disclosure explains: “Administrative property in Bogota, Medellín, El Salvador, and San Jose is recorded at fair value less accumulated depreciation on build- ings and impairment losses recognized at the date of revaluation. Valuations are performed with sufficient frequency to ensure that the fair value of a revalued asset does not differ materially from its carrying amount. A revaluation reserve is recorded in other com- prehensive income and credited to the asset revaluation reserve in equity. However, to the extent that it reverses a revaluation deficit of the same asset previously recognized in profit or loss, the increase is recognized in profit and loss. A revaluation deficit is recognized in the income statement, except to the extent that it offsets an existing surplus on the same asset recognized in the asset revaluation reserve. Upon disposal, any revaluation reserve relating to the particular asset being sold is transferred to retained earnings. Source: AVIANCA HOLDINGS S.A. Form 20- F filed 01 May 2018. Clearly, the use of the revaluation model as opposed to the cost model can have a significant impact on the financial statements of companies. This has potential con- sequences for comparing financial performance using financial ratios of companies that use different models. IMPAIRMENT OF ASSETS i. explain the impairment of property, plant, and equipment and intangible assets; k. explain and evaluate how impairment, revaluation, and derecognition of prop- erty, plant, and equipment and intangible assets affect financial statements and ratios; 9 © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 375. Impairment of Assets 357 In contrast with depreciation and amortisation charges, which serve to allocate the depreciable cost of a long- lived asset over its useful life, impairment charges reflect an unanticipated decline in the value of an asset. Both IFRS and US GAAP require companies to write down the carrying amount of impaired assets. Impairment reversals for identifiable, long- lived assets are permitted under IFRS but typically not under US GAAP. An asset is considered to be impaired when its carrying amount exceeds its recoverable amount. Although IFRS and US GAAP define recoverability differently (as described below), in general, impairment losses are recognised when the asset’s carrying amount is not recoverable. The following paragraphs describe accounting for impairment for different categories of assets. 9.1 Impairment of Property, Plant, and Equipment Accounting standards do not require that property, plant, and equipment be tested annually for impairment. Rather, at the end of each reporting period (generally, a fiscal year), a company assesses whether there are indications of asset impairment. If there is no indication of impairment, the asset is not tested for impairment. If there is an indication of impairment, such as evidence of obsolescence, decline in demand for products, or technological advancements, the recoverable amount of the asset should be measured in order to test for impairment. For property, plant, and equipment, impairment losses are recognised when the asset’s carrying amount is not recoverable; the carrying amount is more than the recoverable amount. The amount of the impairment loss will reduce the carrying amount of the asset on the balance sheet and will reduce net income on the income statement. The impairment loss is a non- cash item and will not affect cash from operations. IFRS and US GAAP differ somewhat both in the guidelines for determining that impairment has occurred and in the measurement of an impairment loss. Under IAS 36, an impairment loss is measured as the excess of carrying amount over the recoverable amount of the asset. The recoverable amount of an asset is defined as “the higher of its fair value less costs to sell and its value in use.” Value in use is based on the present value of expected future cash flows. Under US GAAP, assessing recoverability is separate from measuring the impairment loss. The carrying amount of an asset “group” is considered not recoverable when it exceeds the undiscounted expected future cash flows of the group. If the asset’s carrying amount is considered not recoverable, the impairment loss is measured as the difference between the asset’s fair value and carrying amount. EXAMPLE 13 Impairment of Property, Plant, and Equipment Sussex, a hypothetical manufacturing company in the United Kingdom, has a machine it uses to produce a single product. The demand for the product has declined substantially since the introduction of a competing product. The company has assembled the following information with respect to the machine: © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 376. Reading 22 ■ Long-Lived Assets 358 Carrying amount £18,000 Undiscounted expected future cash flows £19,000 Present value of expected future cash flows £16,000 Fair value if sold £17,000 Costs to sell £2,000 1 Under IFRS, what would the company report for the machine? 2 Under US GAAP, what would the company report for the machine? Solution to 1: Under IFRS, the company would compare the carrying amount (£18,000) with the higher of its fair value less costs to sell (£15,000) and its value in use (£16,000). The carrying amount exceeds the value in use, the higher of the two amounts, by £2,000. The machine would be written down to the recoverable amount of £16,000, and a loss of £2,000 would be reported in the income statement. The carrying amount of the machine is now £16,000. A new depreciation schedule based on the carrying amount of £16,000 would be developed. Solution to 2: Under US GAAP, the carrying amount (£18,000) is compared with the undis- counted expected future cash flows (£19,000). The carrying amount is less than the undiscounted expected future cash flows, so the carrying amount is considered recoverable. The machine would continue to be carried at £18,000, and no loss would be reported. In Example 13, a write down in the value of a piece of property, plant, and equip- ment occurred under IFRS but not under US GAAP. In Example 14, a write down occurs under both IFRS and US GAAP. EXAMPLE 14 Impairment of Property, Plant, and Equipment Essex, a hypothetical manufacturing company, has a machine it uses to produce a single product. The demand for the product has declined substantially since the introduction of a competing product. The company has assembled the following information with respect to the machine: Carrying amount £18,000 Undiscounted expected future cash flows £16,000 Present value of expected future cash flows £14,000 Fair value if sold £10,000 Costs to sell £2,000 1 Under IFRS, what would the company report for the machine? 2 Under US GAAP, what would the company report for the machine? Solution to 1: Under IFRS, the company would compare the carrying amount (£18,000) with the higher of its fair value less costs to sell (£8,000) and its value in use (£14,000). The carrying amount exceeds the value in use, the higher of the two amounts, © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 377. Impairment of Assets 359 by £4,000. The machine would be written down to the recoverable amount of £14,000, and a loss of £4,000 would be reported in the income statement. The carrying amount of the machine is now £14,000. A new depreciation schedule based on the carrying amount of £14,000 would be developed. Solution to 2: Under US GAAP, the carrying amount (£18,000) is compared with the undis- counted expected future cash flows (£16,000). The carrying amount exceeds the undiscounted expected future cash flows, so the carrying amount is considered not recoverable. The machine would be written down to fair value of £10,000, and a loss of £8,000 would be reported in the income statement. The carrying amount of the machine is now £10,000. A new depreciation schedule based on the carrying amount of £10,000 would be developed. Example 14 shows that the write down to value in use under IFRS can be less than the write down to fair value under US GAAP. The difference in recognition of impairment losses is ultimately reflected in difference in book value of equity. 9.2 Impairment of Intangible Assets with a Finite Life Intangible assets with a finite life are amortised (carrying amount decreases over time) and may become impaired. As is the case with property, plant, and equipment, the assets are not tested annually for impairment. Instead, they are tested only when significant events suggest the need to test. The company assesses at the end of each reporting period whether a significant event suggesting the need to test for impairment has occurred. Examples of such events include a significant decrease in the market price or a significant adverse change in legal or economic factors. Impairment accounting for intangible assets with a finite life is essentially the same as for tangible assets; the amount of the impairment loss will reduce the carrying amount of the asset on the balance sheet and will reduce net income on the income statement. 9.3 Impairment of Intangibles with Indefinite Lives Intangible assets with indefinite lives are not amortised. Instead, they are carried on the balance sheet at historical cost but are tested at least annually for impairment. Impairment exists when the carrying amount exceeds its fair value. 9.4 Impairment of Long- Lived Assets Held for Sale A long- lived (non- current) asset is reclassified as held for sale rather than held for use when management’s intent is to sell it and its sale is highly probable. (Additionally, accounting standards require that the asset must be available for immediate sale in its present condition.)18 For instance, assume a building is no longer needed by a company and management’s intent is to sell it, if the transaction meets the accounting criteria, the building is reclassified from property, plant, and equipment to non-current assets held for sale. At the time of reclassification, assets previously held for use are tested for impairment. If the carrying amount at the time of reclassification exceeds the fair value less costs to sell, an impairment loss is recognised and the asset is written down to fair value less costs to sell. Long- lived assets held for sale cease to be depreciated or amortised. 18 IFRS 5 Non- current Assets Held for Sale and Discontinued Operations. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 378. Reading 22 ■ Long-Lived Assets 360 9.5 Reversals of Impairments of Long- Lived Assets After an asset has been deemed impaired and an impairment loss has been reported, the asset’s recoverable amount could potentially increase. For instance, a lawsuit appeal may successfully challenge a patent infringement by another company, with the result that a patent previously written down has a higher recoverable amount. IFRS permit impairment losses to be reversed if the recoverable amount of an asset increases regardless of whether the asset is classified as held for use or held for sale. Note that IFRS permit the reversal of impairment losses only. IFRS do not permit the revaluation to the recoverable amount if the recoverable amount exceeds the previ- ous carrying amount. Under US GAAP, the accounting for reversals of impairments depends on whether the asset is classified as held for use or held for sale.19 Under US GAAP, once an impairment loss has been recognised for assets held for use, it cannot be reversed. In other words, once the value of an asset held for use has been decreased by an impairment charge, it cannot be increased. For assets held for sale, if the fair value increases after an impairment loss, the loss can be reversed. DERECOGNITION j explain the derecognition of property, plant, and equipment and intangible assets; k explain and evaluate how impairment, revaluation, and derecognition of prop- erty, plant, and equipment and intangible assets affect financial statements and ratios; A company derecognises an asset (i.e., removes it from the financial statements) when the asset is disposed of or is expected to provide no future benefits from either use or disposal. A company may dispose of a long- lived operating asset by selling it, exchanging it, abandoning it, or distributing it to existing shareholders. As previously described, non- current assets that management intends to sell or to distribute to existing shareholders and which meet the accounting criteria (immediately available for sale in current condition and the sale is highly probable) are reclassified as non- current assets held for sale. 10.1 Sale of Long- Lived Assets The gain or loss on the sale of long- lived assets is computed as the sales proceeds minus the carrying amount of the asset at the time of sale. An asset’s carrying amount is typically the net book value (i.e., the historical cost minus accumulated depreciation), unless the asset’s carrying amount has been changed to reflect impairment and/or revaluation, as previously discussed. 10 19 FASB ASC Section 360- 10- 35 [Property, Plant, and Equipment – Overall – Subsequent Measurement]. © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution.
- 379. Derecognition 361 EXAMPLE 15 Calculation of Gain or Loss on the Sale of Long- Lived Assets Moussilauke Diners Inc., a hypothetical company, as a result of revamping its menus to focus on healthier food items, sells 450 used pizza ovens and reports a gain on the sale of $1.2 million. The ovens had a carrying amount of $1.9 million (original cost of $5.1 million less $3.2 million of accumulated depreciation). At what price did Moussilauke sell the ovens? A $0.7 million B $3.1 million C $6.3 million Solution: B is correct. The ovens had a carrying amount of $1.9 million, and Moussilauke recognised a gain of $1.2 million. Therefore, Moussilauke 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. A gain or loss on the sale of an asset is disclosed on the income statement, either as a component of other gains and losses or in a separate line item when the amount is material. A company typically discloses further detail about the sale in the man- agement discussion and analysis and/or financial statement footnotes. In addition, a statement of cash flows prepared using the indirect method adjusts net income to remove any gain or loss on the sale from operating cash flow and to include the amount of proceeds from the sale in cash from investing activities. Recall that the indirect method of the statement of cash flows begins with net income and makes all adjustments to arrive at cash from operations, including removal of gains or losses from non- operating activities. 10.2 Long- Lived Assets Disposed of Other Than by a Sale Long- lived assets to be disposed of other than by a sale (e.g., abandoned, exchanged for another asset, or distributed to owners in a spin- off) are classified as held for use until disposal or until they meet the criteria to be classified as held for sale or held for distribution.20 Thus, the long- lived assets continue to be depreciated and tested for impairment,