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GROUP 5, Chapter 2 :Financial Reporting and Analysis, Receivables - Coggle…
GROUP 5
Chapter 1:Overview of Financial
Statement Analysis
Business Analysis
Trade creditor
Non-Trade creditor
Equity Analysis
Fundamental Analysis
Technical analysis / Charting
Accounting Analysis
Financial Analysis
Prospective Analysis
Dynamics of Business Activities
Investing
Activities
Planning
Activities
Financial
Activities
Financial Statements Reflect Business Activities
Balance Sheet
Income Statement
Statement of Shareholders' Equity
Statement of Cash Flows
Analysis Preview
Ratio Analysis
Valuation
Debt (Bond) Valuation
Equity Valuation
Residual Income Model
Free Cash Flow to Equity Model
Common-Size Analysis
6.Analyzing Operating Activities
Income Measurement
Concepts
Permanent Income
Also called sustainable earning power, or sustainable or normalized earnings
Estimate of stable average income that a company is expected to earn over its life
Reflects a long-term focus
Directly proportional to company value
Based on accrual accounting
Suffers from measurement error, arising because of accounting distortions
Economic Income
Includes both recurring and nonrecurring components rendering it less useful for forecasting future earnings potential.
Equals net cash flows + the change in the present value of future cash flows.
Accounting Income consists of
Permanent Component--the recurring component expected to persist indefinitely
Transitory Component--the transitory component not expected to persist
Value Irrelevant Component--value irrelevant components have no economic content; they are accounting distortions
Measurement
Revernues
Earned inflows or prospective inflows of cash from operations
Recognized inflows or prospective inflows of cash from non-operations
Expenses
Incurred outflows, prospective outflows, or allocations of past outflows of cash from operations
decreases in a company’s
net assets arising from
non-operations
Analysis
Operating versus non-operating
Operating income measure of company income as generated from operating activities
Three important aspects of operating income
Pertains only to income generated from operations
Focuses on income for the company, not simply for equity holders (means financing revenues and expenses are excluded)
Pertains only to ongoing business activities (i.e., results from discontinued operations is excluded)
Non-operating income--includes all components of net income excluded from operating income
Useful to separate non-operating components pertaining to financing and investing
Recurring versus non-recurring
Alternatives
• Net income—widely regarded as “bottom line” measure of income
• Comprehensive income--includes most changes to equity.
• Continuing income--excludes extraordinary items, cumulative effects of accounting changes, and the effects of discontinued operations from net income
• Core income--excludes all non-recurring items from net income
Non-Recurring Items
Extraordinary items
Unusual in nature
Infrequent in occurrence
Discontinued segments
Income statements for the current and prior two years are restated after excluding the effects of discontinued operations
Gains or losses from the discontinued operations are reported separately, net of tax
Accounting changes
Involves switch from one principle to another
Involves change in estimate underlying accounting
Special items
Transactions and events that are unusual or infrequent
Asset impairments
Restructuring charges
Restructuring charges
Revenue Recognition
Guilelines
Earning activities are substantially complete and no significant added effort is necessary
Risk of ownership is effectively passed to the buyer
Revenue, and related expense, are measured or estimated with accuracy
Revenue recognized normally
yields an increase in cash,
receivables or securities
Revenue transactions are at arm’s
length with independent parties
Transaction is not subject to revocation
Analysis
Importance for
Company valuation
Accounting-based contractual agreements
Management pressure to achieve income expectations
Management compensation linked to income
Valuation of stock options
Assess whether revenue reflects business reality
Assess risk of transactions
Assess risk of collectibility
Circumstances fueling questions about revenue recognition
Sale of assets or operations not producing cash flows to fund interest or dividends
Lack of equity capital
Existence of contingent liabilities
Deferred Charges
Research and development
High uncertainty of any potential benefits
Time period between R&D activities and determination of success
Intangible nature of most R&D activities
Difficulty in estimating future benefit period
Computer software costs
Prior to technological feasibility, costs are expensed
Costs in extractive industries
Full‑cost
Successful efforts
Miscellaneous (Other)
Employee Benefits
Increase in employee benefits supplementary to salaries and wages
Employee Stock Options
Enhanced employee performance
Align employee and company incentives
Viewed as means to riches
Tool to attract talented and enterprising workers
Do not have direct cash flow effects
Do not require the recording of costs
Interest Costs
Defined
Compensation for use of money
Excess cash paid beyond the money (principal) borrowed
Rate
Determined by risk characteristics of borrower
Expense
Determined by interest rate, principal, and time
Analysis
Interest on convertible debt is controversial by ignoring the cost of conversion privilege
Diluted earnings per share uses number of shares issuable in event of conversion of convertible debt
Analysts view interest as a period cost—not capitalizable
Changes in a company borrowing rate, not explained by market trends, reveal changes in risk
Income Taxes
Temporary Income Tax Differences
Differences that are temporary in nature
Expected to reverse in the future
Mainly like timing differences between tax and GAAP accounting
Accounted for using deferred tax adjustments
Income Tax Accounting
Identify types and amounts of temporary differences and the nature and amount of each type of operating loss and tax credit carryforward
Measure total deferred tax liability for taxable temporary differences
Compute total deferred tax asset for deductible temporary differences and operating loss carryforwards
Measure deferred tax assets for each type of tax credit carryforward
Income Tax Analysis
Financial Statement Adjustments
Present Valuing Deferred Tax Assets and Liabilities
Forecasting Future Income and Cash Flows
Analyzing Permanent and Temporary Differences
Earnings Management and Earnings Quality
Chapter 3: Analyzing Financing Activities
Leases
Leasing Facts
Lease
MLP – minimum lease payments
Lease Accounting and Reporting
Capital Lease Accounting
Operating Lease Accounting
Lease Disclosure and Off-Balance-Sheet Financing
Effects of Lease Accounting
Postretirement Benefits
Pension benefits
Pension Basics
Pension Plan Categories
Focus of Pension Analysis
Other Postretirement Employee Benefits (OPEB)
Features of OPEB Accounting
OPEB Accounting Terminology
Analyzing Postretirement Benefits
Pension Accounting Requirements
Recognized Status on the Balance Sheet
Recognized Pension Cost
Articulation of Balance Sheet and Income Statement Effects
Liabilities
Noncurrent (Long-Term) Liabilities
Analyzing Liabilities
Restrictions
Ability and flexibility
Terms of indebtedness
Obligations
Dilutive conversion features
Prohibitions
Current (short-term) Liabilities
Contingencies and Commitments
Contingencies
Contingent liabilities
Contingent assets
Analyzing Contingencies
Sources of useful information:
Useful analyses
Commitments
Basics of Commitments
Analyzing Commitments
Sources of useful information:
Useful analyses
Off-Balance-Sheet Financing
Basics of Off-Balance-Sheet Financing
Analysis of Off-Balance-Sheet Financing
SPEs
Benefits of SPEs
Shareholders’ Equity
Basics of Equity Financing
Equity
Equity Analysis
Equity Classes
Capital stock
Sources of increases in capital stock outstanding:
Sources of decreases in capital stock outstanding:
Components of Capital Stock
Contributed (or Paid-In) Capital
Treasury Stock (or buybacks)
Classification of Capital Stock
Preferred Stock
Common Stock
Basics of Retained Earnings
Retained Earnings
Cash and Stock Dividends
Prior Period Adjustments
Appropriations of Retained Earnings
Restrictions (or Covenants) on Retained Earnings
Spin-Offs and Split-Offs
Chapter 4: Analyzing Investing Activities
Current Asset Introduction
Cash, Cash Equivalents and Liquidity
Cash Equivelent
Short-term, highly liquid investments
Readily convertible to cash
Close to maturity date and not sensitive to interest rate changes.
Cash
Currency, coins and amounts on deposit in bank accounts, checking accounts, and some savings accounts.
Prepaid
Prepaid Expense
advance payments for services or goods not yet received that extend beyond the current accounting period
Analysis
noncurrent prepaids sometimes are included among prepaid expenses classified as current--when their magnitude is large, they warrant scrutin
advance payments for services or goods not yet received that extend beyond the current accounting period
Classification
Current Asset
Resources or claims to resources used within one year
Non-Current Asset
Resources or claims to resources used beyond one year
Inventories
Methods
LIFO
Liquidations
inventories in separate cost pools.
inventory quantities reduce, each cost layer is matched against current selling prices
periods of rising prices, dipping into lower cost layers can inflate profits.
Weighted Avergae
FIFO
Definitions
Expensing
Treat as period cost
Capitalizing
Treat as product cost
Inventories
Goods held for sale, or goods acquired for sale
Analyzing
Process
Deferred tax payable + [LIFO reserve x Tax rate]
Retained earnings + [LIFO reserve x (1-Tax rate)]
Reported LIFO Inventory + LIFO reserve
LIFO Reverse
amount by which current cost exceeds reported cost of LIFO inventories
Long-Lived Asset
resources that are used to generate revenues (or reduce costs) in the long run
Capitalization
process of deferring a cost that is incurred in the current period
Allocation
process of periodically expensing a deferred cost (asset) to one or more future expected benefit periods
determined by benefit period, salvage value, and allocation method
Impairment
process of writing down asset value when its expected (undiscounted) cash flows are less than its carrying (book) value
Plant Assets & Natural Resources
Plant Assets
Tangible
Actively Used in Operations
Expected to Benefit Future Periods
Property, Plant and Equipment
Valuation analysis
Limitations
Balance sheets do not purport to reflect market values
Not especially relevant in assessing replacement values
Not comparable across companies
Not particularly useful in measuring opportunity costs
Collection of expenditures reflecting different purchasing power
Depreciation methods
Double-Declining-Balance
Activity (Units-of-Production)
Natural Resources
Natural resources (wasting assets)—rights to extract or consume natural resources
Depletion
Unit depletion rate
Total depletion cost for a period
Analyzing Depreciation and Depletion
Average age
Average remaining life
Average total life span
Average total life span
Intagible Assets
Often provide exclusive rights or privileges.
Useful life is often difficult to determine.
Useful life is often difficult to determine.
Noncurrent aasets without physical substances
Accounting
Record at cost, including purchase price, legal fees, and filing fees
Chapter 7: Cash Flow Analysis
Statement of Cash Flows
Relevance of Cash
Cash is the most liquid of assets.
Contrast: Accrual accounting and Cash basis accounting.
Statement of cash flows (SCF) helps address questions.
Reporting by Activities
Operating activities are the earning-related activities of a company.
Investing activities are means of acquiring and disposing of noncash assets.
Financing activities are means of contributing, withdrawing, and servicing funds to support business activities.
Constructing the Cash Flow Statement
Indirect Method
Direct Method
Steps in Constructing the Statement
Start with Net Income
Adjust Net Income for non-cash expenses and gains
Recognize cash inflows (outflows) from changes in current assets and liabilities
Sum to yield net cash flows from operations
Changes in long-term assets yield net cash flows from investing activities
Changes in long-term liabilities and equity accounts yield net cash flows from financing activities
Sum cash flows from operations, investing, and financing activities to yield net change in cash
Add net change in cash to the beginning cash balance to yield ending cash
Special Topics
Equity Method Investments
Acquisitions of Companies with Stock
Postretirement Benefit Costs
Securitization of Accounts Receivable
Analysis Implications of Cash Flows
Limitations in Cash Flow Reporting
Practice does not require separate disclosure of cash flows for extraordinary items or discontinued operations, but interest, dividends, and income taxes are classified as operating cash flows.
Interpreting Cash Flows and Net Income
An income statement records revenues when earned and expenses when incurred.
Cash flows from operations (CFO) is a broader view of operating activities than is net income.
Accounting accruals determining net income rely on estimates, deferrals, allocations, and valuations.
CFO exclude elements of revenues and expenses not currently affecting cash.
Analysis of Cash Flows
Inferences from Analysis of Cash Flows
Where management committed its resources
Where it reduced investments
Where additional cash was derived from
Where claims against the company were reduced
Disposition of earnings and the investment of discretionary cash flows
The size, composition, pattern, and stability of operating cash flows
Alternative Cash Flow Measures
Net income plus depreciation and amortization
EBITDA (earnings before interest, taxes, depreciation, and amortization)
Company and Economic Conditions
While both successful and unsuccessful companies can experience problems with cash flows from operations, the reasons are markedly different.
We must interpret changes in operating working capital items in light of economic circumstances.
Inflationary conditions add to the financial burdens of companies and challenges for analysis.
Specialized Cash Flow Ratios
Cash Flow Adequacy Ratio – Measure of a company’s ability to generate sufficient cash from operations to cover capital expenditures, investments in inventories, and cash dividends:
Three-year sum of cash from operations / Three-year sum of expenditures, inventory additions, and cash dividends
Cash Reinvestment Ratio – Measure of the percentage of investment in assets representing operating cash retained and reinvested in the company for both replacing assets and growth in operations:
Operating cash flow – Dividends / Gross plant + Investment + Other assets + Working capital
Chapter 2 :Financial Reporting and Analysis
Statutory Financial Reports
Form 10-K:Annual report
Form 10-Q: Quarterly report
Form 20-F: Registration statement or annual report by foreign issuers
Form 8-K:Current report
Regulation 14-A
Proxy statement
Prospectus
GAAP
Statements of Financial Accounting Standards (SFAS)
APB Opinions.
Accounting Research Bulletins (ARB).
AICPA pronouncements
EITF Bulletins.
Environmental Factors
Union, AICPA, Lender, Investor, Accountants,....
Financial accounting standards broad
Genarally Accepted Accounting Principles
Securities and Exchange Commission (SEC)
Independent, quasi-judicial government agency
Administer securities regulations & disclosures
Can modify & set GAAP, if necessary
Rarely directly challenges FASB
Major player in global accounting
International Financial Reporting Standards (IFRS)
Set by International Accounting Standards Board
Not currently accepted in U.S.
SEC under pressure to accept IAS
Managers of Companies
Primary responsibility for fair & accurate reports
Applies accounting to reflect business activities
Managerial discretion is necessary in accounting
Major lobbyist on GAAP
Auditing
SEC requires Audit Report
Check Auditor quality & independence
Corporate Governance
Board of directors oversight
Audit committee of the board
Internal Auditor
Internal Users
Managers
Officers
Internal Auditors
Sales Managers
Budget Officers
Controller
External Users
Lenders
Shareholders
Governments
Labor Unions
External Auditors
Customers
Alternative information sources
Economic, Industry & Company News
Voluntary Disclosure
Information Intermediaries
Desirable Qualities of Accounting Information
Relevance
Reliability
Financial Accounting
Important Accounting Principles
Historical Cost
Accrual Accounting
Materiality
Conservatism
Relevance of Accounting Information
Limitations of Accounting Information
Timeliness
Frequency
Forward Looking
Accruals-The Cornerstone
Illustration - Case Facts
Case Illustration – Cash Accounting
Net income = Operating cash flow + Accurals
Case Illustration – Accrual Accounting
Foundations of Accrual Accounting
Relation between Cash Flows and Accruals
Short-Term and Long-Term Accruals
Accruals and Cash Flows - Myths
Accruals and Cash Flows - Truths
Economic concepts of income
Measures changes in Shareholders wealth.
Cash flows + Present value of expected future cash flows.
Useful when the objective of analysis is determining the exact return to the shareholder for the period.
Less useful for forecasting future earnings potential.
Accounting concept of income
Based on the concept of accrual accounting
Main purpose is income measurement
Two main processes
Expense
Matching
Accounting Vs Economic income
Alternative income concepts
Historical cost
Transaction basis
Conservatism
Earnings management
Fair value accounting
Advantages & Disadvantages
Advantages
Reflects current information.
Consistent measurement criteria.
Comparability
No conservative bias
More useful for equity analysis
Disadvantages
Lower objectivity
Susceptibility to manipulation. Use of Level 3 inputs.
Lack of conservatism.
Excessive income volatility.
Implications for Analysis
Focus on the balance sheet.
Restating income.
Analyzing use of inputs.
Analyzing financial liabilities.
Accounting Analysis
Demand for Accounting Analysis
Sources of Accounting Distortions
Analysis Objectives
Earnings Management – Frequent Source of Distortion
Earnings Management – Motivations
Earnings Management – Mechanics
Process of Accounting Analysis
Auditing And Financial Statement Analysis
Receivables
amounts due from others
from the loaning of money
from the sale of goods or services
Analyzing
Collection Risk
Determining competitors’ receivables
Examining customer concentration
Investigating the age pattern
Determining portion
Analyzing adequacy of allowances
Authencity of Receivables
Review
Return policies
contingencies on receivable
Credit policy
Securitization
when a company sells all or a portion of its receivables to a third party
Recourse
guarantee of collectibility
With
Sale of receivables does not effectively transfer risk of ownership
seller must record both an asset and a compensating liability for the amount factored
Without
seller removes the receivables from the balance sheet
Account Receivable
oral promises of indebtedness due from customers
Note Receivable
formal written promises of indebtedness due from others
Evaluation
Net realizable value
total amount of receivables less an allowance for uncollectible accounts