Hervé Stolowy

12 January 2012

Financial Accounting and Statement Analysis

HEC MBA Program

Frequently Asked Questions and Additional Information

If you don’t find the relevant question, don’t hesitate to ask a question or make a comment:
Send an e-mail to your instructor:
capkun@hec.fr, hoos@hec.fr or stolowy@hec.fr

List of questions and comments

General questions

Question: Terms in French

Chapter 2: Introduction to financial statements

Question: Negative ending cash balance

Question: Meaning of “reserves”
Question: Retained earnings, bonus issue and stock price
Question: Recording of depreciation
Question: Income statement ratios
Question: Perpetual and periodic inventory systems for finished goods
Question: Busoni (Assignment 2.3) (increasing or decreasing order of liquidity)
Additional information: Corelli (Assignment 2.4)
Question: Corelli (Assignment 2.4)
Question: StoraEnso (Assignment 2.6) - 1
Question: StoraEnso (Assignment 2.6) - 2

Chapter 3: Financial statements presentation

Question: Classification by nature or by term in a vertical balance sheet

Question: Nokia’s Balance sheet (Assignment Nokia & others)
Question: Benetton’s Balance sheet (mid-term test)
Question: Telefonica’s income statement (mid-term test)

Chapter 5: Accounting principles and end-of-period adjustments

Question: No offsetting principle

Chapter 13: Financial fixed assets and business combinations

Question: Interest in earnings of equities

Chapter 14: Cash flow statement

Additional information: Pernod Ricard (Assignment 14.4) – Updated financial statements and
questions
Additional information: Procter & Gamble (Assignment 14.5) – Updated financial statements

Question: Reduction of share capital

Question: Direct method and change in inventory
Question: Change in the scope of consolidation
Question: Schedule of cash flow
Question: Share premium
Question: Minority interests
Question: Purchase of shares
Question: Dvorak Company (Review 14.1) – Purchase of fixed assets
Question: Dvorak Company (Review 14.1) – Sale of fixed assets
Question: Dvorak Company (Review 14.1) – Financial expenses and revenues
Question: Dvorak Company (Review 14.1) – Bank overdraft
Question: Mitsubishi Electric (Review 14.2) – Potential cash flow and deferred taxes
Question: Janacek Company (Assignment 14.2) – Provisions
Question: Janacek Company (Assignment 14.2) – Gain on sale of fixed assets
Question: Janacek Company (Assignment 14.2) – Accounts receivable
Question: Pernod Ricard (Assignment 14.4)

Chapter 15: Financial statement analysis

Question: Comparison of an income statement by nature and an income statement by function

Question: Ratios based on sales
Question: Bank overdraft (balance sheet analysis)
Question: Maintenance expense
Question: Ebitda
Question: Nokia & Ericsson (assignment 15.5) – Average collection period
 Questions, replies and additional information
General questions

Question: Terms in French

Reading “Les Echos” last week, I was confused by some French Accounting terms. Do you
happen to have a document which translates the main categories of the various accounting
documents into French?

Reply

You will find in the course web site a multilingual glossary (5 languages, including French).
Could you tell me if the terms you are looking for are not in the glossary?

Chapter 2: Introduction to financial statements

Question: Negative ending cash balance

Can a negative ending cash balance be shown in the balance sheet or does it have to be
matched by an equivalent overdraft on the liabilities side?

Reply

A negative ending cash balance is always displayed as a bank overdraft in the balance sheet
(within the liabilities).

Question: Meaning of “reserves”

In a financial statement, whenever we account for “Reserves”, is it assumed that its a “Cash
Reserve”? During the discussion in our group, there was some confusion if reserves can also
mean “money invested by a company”. We think “Reserves” and “money invested by a
company” are different as “Reserves is money that’s not even earning interest in the bank”.
Are we correct in this hypothesis? In the class, I remember you mentioning “Never to use
money from reserve for investment”. Please let us know.

Reply

It is difficult to explain in a few lines the concept of reserves. Have you read the book on
pages 65 (bottom) to 68? You have some elements there, which correspond to the course. As I
said, the account “reserves” represents a piece of paper where the company writes that it did
not distribute cash for dividends and, consequently avoided a cash payment (which represents
then a saving). As you can imagine, there is no cash in a piece of paper. So the idea of “cash
reserve” is strictly impossible.

Question: Retained earnings, bonus issue and stock price

In class you said that Retained Earnings/Reserves can be converted to new shares as a “bonus
issue.” You said it only has a psychological effect. How does the market see this if a company
decides to convert Retained Earnings to new shares? How does it affect the stock price?
Reply

Your question is very interesting, but more relevant for the Corporate Finance course you will
have later in your program. You can however visit the following link:
http://economictimes.indiatimes.com/articleshow/1521568.cms

where you will find a very interesting discussion on the relationship between bonus issue and
stock price.

Question: Recording of depreciation

It is about depreciation. You told us that every transaction has at least 2 impacts on the
balance sheet, but concerning depreciation (which is considered as an “expense”), as I
understood, there is only one impact: it reduces the equipment value (so the assests). Should
not this be followed by a reduction of the shareholders equity?

Reply

The concept of depreciation is recorded with two impacts:

1 - Depreciation expense (in the income statement = represents a reduction in shareholders'

equity)
2 - Accumulated depreciation (which represents a reduction of assets).

You can see the double impact in one of the slides at the end of Chapter 2.

Question: Income statement ratios

At page 80, when looking at the different income statement ratios, I get the impression that
Net income, EBIT and income before interest and tax are all the same. When applied to case
2.4 that means that the net income is here represented by “operating profit”. Shouldn’t the net
income be equal to the “net profit for the period”?

Reply

You are right concerning the Earnings before interest and tax (EBIT) and Income before
interest and tax which represent exactly the same concept. However, these concepts are
different from the Net income. On page 80, the ambiguity stems from the fact that we wrote
(taking the example of the ROE): Net income/Average equity (or income before interest and
tax/Average equity). The “or” does not mean that the concepts are strictly alike but that there
are two alternative ways to compute the ROE. Both definitions will provide different (but
equivalent in terms of financial statement analysis) ratios.

(See the rest of the reply below).

Question: Perpetual and periodic inventory systems for finished goods

1/ We learned about periodic and perpetual systems for raw materials.

1.a/ What about "work in progress"? Could we use both systems for Work in Progress? Do
you have an exercise / an example to practice the "work in progress" notion?
1.b/ What about "finished products"? Through Schumann exercise we saw an accounting
method that could be qualified as "periodic". Could we use a "perpetual" method for Finished
products as well? Do you have an example?

Reply

Your question is totally relevant. I do not cover this issue on purpose, because it’s too
complex for beginners and not really useful for financial statement analysis. You have some
elements of explanations at the very end of the chapter 2. Tell me if you need more. (But I
don’t have specific materials, e.g., exercises on this issue).

Question: Busoni (Assignment 2.3) (increasing or decreasing order of liquidity)

In the exercise like Busoni one, where we need to show the impact of the events on the
financial statements with T accounts, do we need to follow an order of liquidity? If we follow
the order of the transactions as you give us, is it an error?

Reply

You can follow any order (increasing or decreasing). But you must be consistent within the
order chosen.

Additional information: Corelli (Assignment 2.4)

Following one group’s question, we would like to make clearer that the accounts should be
related to one column only (one ‘family’), because one account is only one part of a double
entry. (Exceptionally, one account in the list should be mentioned in two columns).

Question : Corelli (Assignment 2.4)

Regarding Assignment 2.3, there is one point I don’t understand: The “Financial Debt” is
related to “Liabilities” but the “Loan” is related to “Assets”. Since a loan is actually also a
financial debt, for what reason the two are related differently?

Reply

A “loan” can be received (then it’s a debt) or granted (it’s an asset). We should preferably use
the term “loan” in the second case only. If there is no specific information, we must assume
that the loan has been granted.

Question: StoraEnso (Assignment 2.6) - 1

When applied to case 2.4 that means that the net income is here represented by “operating
profit”. Shouldn’t the net income be equal to the “net profit for the period”

Reply
There is no ambiguity at this point. The “net income” is equal to the “Profit for the period”
and is totally different form the “Operating profit” (which is equivalent, in this case, to the
EBIT). (Once again, you will get used to these terminological differences. The most important
is to look at the content of the concept).

Question: Stora Enso (Assignment 2.6) – 2

Question 1 of the assignment asks us to compute ratios for StoraEnso. One of these will be the
cash ratio. My question concerns the marketable securities of StoraEnso.

Can we consider the shares that StoraEnso has in associated companies to be readily
marketable? Also, “short-term investments” might include cash equivalents like bonds to be
redeemed within the year, but it is mixed with “receivables”. Can we consider “short term
investments and receivables” as a cash equivalent?

Reply

Short-term investments can reasonably be assimilated to cash and cash equivalents. When
their amount is mixed with receivables, it is necessary to refer to the notes and search for a
split between the two items. If no information is available, an assumption should be made.

Chapter 3: Financial statements presentation

Question: Classification by nature or by term in a vertical balance sheet

In preparation for the midterm exam, I was looking at past tests and had a question regarding
classification of balance sheets as nature/term. I came across a vertical balance sheet where
the Assets were classified as Fixed (intangible assets, tangible, investments) and current
(receivables, inventory and cash). However the vertical balance sheet did not list financial and
operating liabilities instead listing current and non-current. The answer I saw for this was that
this was a balance sheet by “term” and not by “nature”. My question is does the classification
depend only on the way the liablities are mentioned? This seems to be like it’s “by nature” if
the assets are looked at, and “by term” if the liabilities are looked at. How does one decide? :

Reply

Your question is highly relevant. The distinction by nature/by term applies to both assets and
liabilities. However, in practice, assets are (almost) always classified in the same way,
whether by nature or by term. That’s why I said in class that you should concentrate on
liabilities because you can only see the difference (by nature vs. by term) with the liabilities.

Question: Nokia’s Balance sheet (Assignment Nokia & others)

Why Nokia’s Balance sheet is not horizontal but vertical instead?

Reply

The Nokia’s balance sheet is vertical because the assets are displayed above the liabilities, and
not on the left of the liabilities.
Question: Benetton’s Balance sheet (mid-term test)

Why is Benetton’ balance sheet horizontal?

Reply

Benetton’ balance sheet is horizontal because:

- the assets are displayed on a different page from the liabilities. (In a vertical format, assets
and liabilities always appear on the same page, one above the other).
- as a confirmation, we have the page numbers indicated.

Question: Telefonica’s income statement (mid-term test)

The income statement of Telefonica is horizontal. Does it mean that, therefore, no

classification can be made about expenses and degree of simplification? (referring to figure
3.6, Chapter 3).

Reply

The horizontal format is rarely found in practice. This is why, in Figure 3.6, this part of the
tree has not been developed. However, with a horizontal income statement, the distinctions
multiple step/single step and nature/function are possible.

In the case of Telefonica, we find sub-levels of income (e.g., operating income). This is a
multiple step format. The expenses are classified by nature (see the personnel expenses).

Chapter 5: Accounting principles and end-of-period adjustments

Question: No offsetting principle

In reference with the “no offsetting” accounting principles, in case of disputes, can one “play”
with the liability in favor of to compensate disputed receivables on a given supplier. “He is
not paying me so I do not pay him!” For example, A provides a service to B and B sells parts
(50 CU) to A independently of this service. B disputes the quality or completion of the service
(expectations were beyond actual service delivered) and refuses to pay the total amount
invoiced (30 CU remaining due). Can A also deduct in retaliation of the parts purchased,
“balancing” its financial statements independently of the contract content and the purchase
order (paying 20 CU of parts value)? Or is the dispute integrated under a provision? Does the
disputed amount influence the view, especially when cost to recover is higher than amount
itself?

Reply
Chapter 13: Financial fixed assets and business combinations

Question: Interest in earnings of equities

What is interest in earnings of equity company net of dividends?

Reply

Share of earnings of associates (affiliated companies).

Chapter 14: Cash flow statement

Additional information: Pernod Ricard (Assignment 14.4) – Updated financial

statements and questions

- Since the initial writing of this case study, we updated the cash flow statement with the
annual report 2000, 2001 and 2002. We provide in the course website an excel file with
the updated cash flow statement.
- The format adopted over the period is consistent with the last year’s (2002) format.
- The format has been significantly changed in 2002. Some of the questions raised for the
original case study are no more valid. When necessary, we also provide (in italics) an
update of the question.
- We suggest to start the study of the Pernod Ricard cash flow statement with a comparison
of the two formats.

Please find below the list of questions.

1. What does the “cash flow” (“cash flow from operations” in the 2002 version) item in the
operating activities represent?

2. Which method is used for computing the cash flow from operating activities?

3. What does the “change in working capital need” (“increase (decrease) in working capital
requirement” in the 2002 version) item in the operating activities represent?

3a. In the 2002 version, which concept is “missing” after the “increase (decrease) in working
capital requirement”?

3b. In the 2002 version, which unusual concept is disclosed after the “Cash flow from
operations”?

3c. In the 2002 version, which common concept are not disclosed?

4. How does the statement balance? Is this the traditional method of balancing a cash flow
statement?

5. With the help of the note accompanying the cash flow statement, restate the final part of
the statement in order to balance it with cash and cash equivalents. (Marketable securities
are assumed to be a cash equivalent).

Additional information: Procter & Gamble (Assignment 14.5) – Updated financial

statements

Since the initial writing of this case study, we updated the cash flow statement with the annual
report 2000, 2001 and 2002. We provide in the course website an excel file with the updated
cash flow statement.

Question: reduction of share capital

Page 537 of the book (1st edition)

Where in the balance sheet can I find Payment on reduction of share capital (repayment of
shares)?

Reply

You don’t find it explicitly. A note is necessary. However, if, in an assignment, there is a
decrease in share capital, it can be assumed that there was a repayment (although other
explanations are possible).

Question: Direct method and change in inventory

In page 541 (1st edition) you explain how the direct method works. I’m not sure I understand
why changes in inventory are taken into account to get the cost of merchandise sold. For cash
flow purposes, it seems to me that purchases should just be adjusted with the change in
accounts payable.

In my opinion, the change in inventory affects the income statement since sometimes you
record purchases but you don’t consume all of them and you have to adjust. But I don’t see
the meaning here since it doesn’t involve cash payments.

Reply

Your question is highly relevant. There are two hypotheses, depending on the format.

1 – Format by function

The cost of goods sold is disclosed. The direct method will work this way.

Cost of goods sold

Less Change (ending minus beginning) in inventories (in the working capital need)
Plus Change (ending minus beginning) in accounts payable (in the working capital need).
= Cash paid to suppliers

2 – Format by nature (let’s take a simple example with merchandise only)

“Purchases” and “Change in inventories of merchandise” are disclosed.

There are two methods of computations:

Purchases
+ Change in inventories of merchandise
= “Cost of merchandise sold”
Less Change in inventories (in the working capital need)
Plus Change in accounts payable (in the working capital need).
= Cash paid to suppliers

You all notice that the change in inventories is added then subtracted. A shorter method can
then be used:
Purchases
+ Change in inventories of merchandise
= “Cost of merchandise sold”
Less Change in inventories (in the working capital need)
Plus Change in accounts payable (in the working capital need).
= Cash paid to suppliers

In other words:

Purchases
Plus Change in accounts payable (in the working capital need).
= Cash paid to suppliers

Question: Change in the scope of consolidation

What does it mean by “effective change in the scope of consolidation”?

Reply

I guess you mean “effect of changes in the scope of consolidation”. This line represents the
impact of the acquisition of a subsidiary on the cash flow statement. Usually it is equal to the
cost of acquisition (minus the cash found in the subsidiary).

Question: Schedule of cash flow

Why do we need a schedule of cash flow?

Reply

A schedule of cash flow is not a standardized term. It simply means the detail of the
computation of the cash flow.

Question: Share premium

What is share premium?

Reply

The share premium is the difference between the issuance price of a share and the nominal
value (par value). See more details in Chapter 11.

Question: Minority interests

Why is “minority interests” considered a non-cash item to be included in the operating

activities using the indirect method?

Reply
Minority interests represent the share of earnings of subsidiaries belonging to minority
shareholders. It has reduced the net income but it is not a real cash expense. It is then
considered as a non-cash expense.

Question: Purchase of shares

I just want to make sure I did understand well the classification principle: When investing in
another company through buying a quantity of shares, this operation should be classified in
investing activities, and the dividends of this investments in operation CF?

Reply

Totally correct.

Question: Dvorak Company (Review 14.1) – Purchase of fixed assets

Based on the solution provided, there is:

Purchase of fixed assets -4,000

Cash paid on purchase of fixed assets -3,750

I see the above as repetition in a way. The way I interpret it is that the total purchase of fixed
assets is 4,000 CU, of which 3,750 CU is paid in cash and the rest is in the form of payables.
Hence, if there is 2 lines, there is a repetition. Had I understood this wrongly? How should
this be interpreted?

Reply

There is no repetition. The cash amount is integrated in the computation of the cash flow. The
other figure (purchase) is a simple indication of the determination of the cash movement.

Question: Dvorak Company (Review 14.1) – Sale of fixed assets

The sale price of the fixed assets is 450 whereas the book value of sold items (which I assume
is the fixed assets) is only 250, so there is a gain on sale of fixed assets, right? If there is a
gain, shouldn’t I +200? The solution was to -200.

Reply

A gain is subtracted from the profit (because it has increased the profit).

Question: Dvorak Company (Review 14.1) – Financial expenses and revenues

In review 14.1, financial expenses and revenues are kept in operating activities? Usually,
when granting a loan, are the revenues from such a loan classified in the operating CF
(considering a normal company and not a bank)?

Reply
There are several possibilities (see table 14.14). The best solution is to include all the
elements related to the income statement in the operating cash flow.

Question: Dvorak Company (Review 14.1) – Bank overdraft

There are two methods as to how to perceive an overdraft when preparing the cash flow (as
seen in R14.1: the 750 CU was either incorporated in financing activities or considered as
negative cash). Which one would you want us to use in the exam?

Reply

You can choose.

Question: Mitsubishi Electric (Review 14.2) – Potential cash flow and deferred taxes

When determining the potential cash flow, you don’t just add/subtract non-cash
expenses/income but also the account “deferred tax income”.

That account is not a non-cash expense nor a non-cash income. I thought it could be there
because it has taken a part when determining the firm’s profit since the company is not going
to pay what has been recorded as "income tax expense" but that account minus the "deferred
tax income" account. Therefore, you should add this amount to the net income as the company
is not really paying what has been entered as income tax expense.

However, in the Mitsubishi case, it is included with a negative sign, which decreases the net
income, this meaning that the income tax expense for the year is even higher.

Reply

Your question arises from the fact that we have not studied the deferred taxation. I would
suggest to refer to chapter 6. To simplify, a deferred income tax expense is the difference
between the income tax expense computed on the basis of the taxable income (= the income
tax which will be really paid) and a “fictitious” income tax expense computed on the basis of
an “economic” income (which is less related to tax regulation).

The deferred income tax you found in the cash flow statement is the same amount you will
find in the income statement (see below the last line).

As you will understand from your reading of chapter 6, deferred income tax expense can be
positive or negative (depending on the difference between the taxable income and the
“economic” income). In the present case, the deferred income tax is positive in 2000 and 1999
and negative in 1998. (Be careful, a positive deferred income tax is reported with a negative
sign, because the expenses have a positive sign… Sorry for that).

To answer more directly the question, I should say that the deferred income tax expense is a
non cash expense, because it is by construction a fiction. (Only the income tax expense –
“current income tax expense” in the case of Mitsubishi) is a cash expense.

As the deferred tax expense is a non cash expense, it should be added back to the net income
(if it has reduced the net income) or subtracted from the net income (if it has increased the
profit). In our case, the deferred tax expense has increased the net income in 2000 (see above).
It should be then subtracted (hence the negative sign).

Question: Janacek Company (Assignment 14.2) - Provisions

On no 2. Reconciliation Statement:

Is it correct to take provisions from the previous year? If so, why is this when you take
depreciation from the previous year?

Reply

You do not take the depreciation expense from the previous year but the depreciation expense
from the current. (You adjust the net income of year X2 with the depreciation expense of the
same year). The same explanation applies to provisions. (The only difference is that you do
not integrate provisions linked to current asset).

Question: Janacek Company (Assignment 14.2) – Gain on sale of fixed assets

On no 2. Reconciliation Statement:

Do you calculate gain/loss on sale of fixed assets by subtracting the sales price from the book
value for the current year? I would intuitively have thought I should use the reverse, i.e.
Subtract book value from the sales price with the difference indicating my gain or loss?
Reply

The gain on sale is computed as follows: sales minus book value.

The gain on sale is then subtracted (because it has increased the net income) and a loss is
added back (because it has reduced the net income).

Question: Janacek Company (Assignment 14.2) – Accounts receivable

On no 2. Reconciliation Statement:

With respect to accounts receivable, I can see that the figure is negative of the difference
between the current and previous year on the balance sheet. I read that this is a negative
impact upon cash because it means that less customers have paid off their trade debt than new
customers have added to the trade balance but I don’t know if I written this down right or still
understand why the figure is negative. Can you help?

Reply

Your explanation is correct. You can put it another way. The change in accounts receivable
(ending less beginning) is positive. It means that we have more receivables at the end. The
impact of this evolution on cash is then negative.

Question: Pernod Ricard (Assignment 14.4)

I do not understand some parts of the restated cash flow statement in this instance. Eg. Why is
1998 cash provided by operating activities 196.8 not 196.7? Why is cash used in investment
activities 1999 -253.1 not -252.9? Why is the currency translation effect for 1999 -63.5 and
not -63.8?

Reply

The original version of the Pernod Ricard cash flow statement has some rounding problems.
Chapter 15: Financial statement analysis

Question: Comparison of an income statement by nature and an income statement by

function

If we want to compare two income statements, one by function and one by nature, is it true
that we can only compare some balances, isn’it? I mean, in an IS by function, since we don’t
have the EBITDA, will use only the balances at our disposal?

Reply

This is absolutely correct. If you have to compare an income statement by nature and an
income statement by function, you can only take the balances, which are common to both
statements.

Question: Ratios based on sales

In the ratios found in chapter 15 that are related to sales, do we divide by sales or by total
production when the information is available?

Reply

It is preferable to divide by sales.

Question: Bank overdraft (balance sheet analysis)

Can we have overdraft in the same time as Positive Cash in balance sheets? I’ve seen this in
assignment 15.4 (Club Med): does that refer to different bank accounts?

Reply

Yes it is not only possible but in reality compulsory (because of the non offsetting accounting
principle). That refers to different bank accounts.

Question: Maintenance expense

From the solution of review example 15.1 Maintenance seems to be considered as outsourced.
Sometimes, maintenance is done in-house. To avoid misunderstandings, would you mind
giving more details for such accounts in the exam.

Reply

If maintenance is not outsourced, it will not be reported in the income statement. (It would
probably be included in the salaries expense). In this case, the problem you mention does not
exist in practice. If maintenance it outsourced, it should be dealt with as external expenses.

Question: Ebitda

My doubt is about the differences of calculating the EBITDA. When calculate the EBITDA I
believe we should also consider the Other Operating activities, once its part of the normal
procedure of the company and therefore should be included in the EBITDA. The others
operating revenues are not Taxes, depreciation, amortization so why you do not consider it as
part of the EBITDA? Actually, I may be mistaken, but I prefer to consider the others operating
revenues as part of the EBITDA, once it is part of the operation of the company. But I know
that some people use the other way. Am I wrong?

Reply

Both solutions are possible. Traditionally, other operating revenues are not significant and
therefore not included in the EBITDA. (That’s why, in the income statement by nature, they
are disclosed in the operating income only). However, in some companies, this item is highly
important. In this case, I think you can include it in the EBITDA.

Question: Nokia & Ericsson (assignment 15.5) – Average collection period

In your solution to Nokia assignment, you computed average collection period using
receivables at end of year and not the average receivables (beginning + ending /2), while it is
stated in the ratio definitions as the average of the receivables? Is it a flexible definition? In
year 1999, it changes from 90 days to 78 days. What should we use in the exam?

Reply

Both solutions are acceptable.