CFA L1 FRA notes

Financial reporting:​ “…provide financial information about the reporting entity that is useful to
existing and potential investors, lenders, and other creditors in making decisions about providing
resources to the entity…”
Balance sheet:​ also known as statement of financial position/condition; reports firm’s financial
position AT A POINT IN TIME
· Assets = resources controlled by firm
· Liabilities = amounts owed to lenders and creditors
· Owners’ Equity = residual interest in net assets of an entity (after deducting liabilities)
· Accounting equation: A = L + OE
· Expanded accounting equation: A = L + CC + ERE
o Also can be stated as A = L + CC +BRE + R – E - D
Statement of comprehensive income:​ reports all changes in equity except for shareholder
transactions (issuing stock, share repurchases, paying dividends)
Income statement:​ also known as statement of operations/profit and loss statement; reports on
firms’ financial performance OVER A PERIOD OF TIME
· Revenues = inflows from delivering or producing goods, rendering services, or other activities
related to firm’s core operations
· Expenses = outflows from delivering or producing goods or services related to firm’s core
operations
· Other income = gains that may or may not arise in the ordinary course of business
· ​Under IFRS, can be combined with Other Comprehensive Income statement and presented
as a single statement of comprehensive income
· ​Under U.S. GAAP, OCI can be reported in statement of shareholders’ equity
· Net income = revenue – expenses
o Expanded net income equation: NI = R – ordinary expenses + other income – other expenses +
gains - losses
Statement of changes in equity:​ reports amounts and sources of changes in equity investors’
investment in the firm OVER A PERIOD OF TIME
Statement of cash flows:​ reports company’s cash receipts and payments
· CFO: cash effects of transactions that involve the normal business of the firm
· CFI: cash flows resulting from acquisition or sale of PPE, subsidiary/segment, securities, and of
investments in other firms
· CFF: cash flows resulting from issuance or retirement of firm’s debt and equity and include
dividends paid to shareholders
Financial statement notes/footnotes:​ includes disclosures that provide further details about the
information summarized in the financial statement
· Basis of presentation such as fiscal period covered and inclusion of consolidated entities
· Information on accounting methods, assumptions, and estimates used by management
· Additional information on acquisitions, disposals, legal actions, employee benefit plans,
contingencies, commitments, significant customers, sales to related parties, and segments of the
firm
Management’s commentary/MD&A (analysis):​ discusses nature of business, past performance,
and future outlook (parts may be unaudited). SEC requires discussion of trends and significant
events and uncertainties that could affect firm’s liquidity, capital resources, and results of operations
· Effects of inflation and changing prices if material
· Impact of off-balance sheet obligations and contractual obligations
· Accounting policies requiring significant judgement by management
· Forward-looking expenditures and divestitures
Audits:​ provides REASONABLE assurance that the financial statement contain no material errors
· Unqualified/clean opinion: auditor believes the statements are free from material omissions and
errors
· Qualified opinion: statement make exceptions to accounting principles; exceptions must be
explained in audit report
· Adverse opinion: statements are not presented fairly or are materially nonconforming with
accounting standards
· Disclaimer of opinion: auditor is unable to express an opinion
Going concern:​ assumption that the firm will continue to operate for the foreseeable future
International Organization of Securities Commissions (IOSCO):​ 1.) protect investors, 2.) ensure
fairness, efficiency, and transparency of markets 3.) reduce systemic risk
Reports (all must be filed with the SEC):
· 8-K: reports events such as acquisitions and disposals of major assets or changes in
management/corporate governance (material events)
· 10-K: annual report (financial statements/info about business and management, ​AUDITED
· 10-Q: quarterly report (updated financial statements, disclosure of certain events (legal or changes
in accounting policies), ​UNaudited
· Proxy: issued to shareholders when an issue requires a shareholder vote
· S-1: registration statement filed prior to sale of new securities to public (​includes AUDITED
financial statements)
Flow of information
· Journal entries: record every transaction
· General journal: sorts by date
· General ledger: sorts by account
· Trial balance: shows balances in each account—account balances from adjusted trial balance
reported in financial statements
Qualitative characteristics
· Relevance: information in financial statements can influence users’ economic decisions or
evaluation
· Faithful representation: information is complete, neutral, and free from error
Enhancing characteristics
· Comparability: statement presentations are consistent among firms and across time periods
· Verifiability: independent observers, using the same methods, obtain similar results
· Timeliness: information is available to decision makers before information is stale
· Understandability: users with basic knowledge of business and accounting should be able to
understand the information in the statements
Measurement base
· Historical cost: amount originally paid for asset
· Amortized cost: historical cost adjusted for depreciation, amortization, depletion, and impairment)
· Current cost: amount that would be paid today
· Realizable value: amount for which firm could sell the asset
· Fair value: amount at which two parties would exchange the asset
Classified balance sheet:​ shows current and noncurrent assets and liabilities
IFRS vs U.S. GAAP (I, X, A):
· FASB: comprehensive income = revenues, expenses, gains, losses, and comprehensive
income/IASB lists income and expenses as elements related to performance
· FASB defines assets as being a future economic benefit (probable)/IASB defines an asset as a
resource from which a future economic benefit is expected to flow
· FASB does NOT allow upward valuation of most assets
Coherent financial reporting framework
· Transparency, comprehensiveness, and consistency
Three approaches to standard setting:​ principles-based, rules-based, objectives-oriented/moving
towards OBJECTIVE-ORIENTED
Income statement presentation:
· ​Single-step:​ all revenues are grouped together and all expenses are grouped together
· ​Multi-step:​ includes gross profit
Gross profit:​ revenue – COGS
Operating profit:​ COGS – operating expenses (e.g SG and A, depreciation)
· ​Interest expense is an operating expense for a financial firm
Accrual accounting:​ revenue recognized when earned, expenses recognized when incurred (does
not necessarily coincide with the receipt or payment of cash)
Long-term contracts
· ​%-of-completion method (used under both IFRS and U.S. GAAP):​ revenue, expenses, and
profit recognized as work is performed
· total cost incurred/total expected cost of project
· ​What if outcome of project cannot be reliability measured?
o ​IFRS:​ revenue is recognized to the extent of contract costs, costs are expensed when incurred,
and profit is recognized at completion
o ​U.S. GAAP:​ All revenue, expenses, and profit are recognized only when the contract is complete
· ​Installment method:​ collectability cannot be reliably ESTIMATED
o Profit recognized as cash is collected
o Cash collected during the period x total expected profit as a % of sales (ex: sell land for $1,000,
original cost of $800, formula = [(1000-800)/1000] x collections = reported profit)
· ​Cost recovery method:​ collectability is highly UNCERTAIN
o Profit recognized only when cash collected exceeds costs incurred
Barter transaction:​ exchange of goods or services without cash
· ​U.S. GAAP:​ Revenue recognized at fair value only if firm has historically received cash payments
for such goods and services and can use historical experience to determine fair value. If not,
revenue recorded at carrying value
· ​IFRS:​ Revenue recorded at fair value; based on similar nonbarter transactions with unrelated
parties
Gross revenue reporting vs net revenue reporting:
· Gross = report sales revenue and COGS separately (ex: sell item for $5,000, receive $500
commission, report $5,000 in revenue $500 in profit, and $4,500 in expenses)
· Net = sales – cost (ex: using the above example, $500 in revenue and no expenses)
Inventory expense recognition
· Matching principle: expenses to generate revenue recognized in same period as revenue
· Period costs: costs expensed in period incurred because they cannot be directly tied to revenue
generation
· Specific identification: identify which items were sold and which items remain in inventory
· ​First-in, first-out (FIFO):​ first item purchased is assumed to be first item sold
· ​FIFO COGS =​ cost of inventory acquired first
· ​Ending inventory =​ cost of most recent purchase(s) used
· ​Last-in, first-out (LIFO):​ last item purchased assumed to be first item sold
· ​LIFO COGS =​ cost of inventory acquired last
· ​Ending inventory =​ cost of oldest purchase(s) used
· ​Under an inflationary environment LIFO = higher COGS, lower taxable income, lower income
taxes
· ​Weighted average cost (WAC) =​ makes no assumption about physical flow of inventory
· ​WAC COGS =​ cost of available goods/total units available; this average cost is used to determine
both COGS and ending inventory
Depreciation expense recognition
· ​Straight-line depreciation​: (cost – residual value)/useful life
o ​*SLD results in lower depreciation expense and higher net income in early years of asset’s
life (reversed in later years)
· ​Double declining balance method​: (1/n x 2)(cost) ​*n = useful life
o ​*DDB results in higher depreciation expense and lower net income in early years of asset’s
life
· ​*Amortize if asset is an intangible
· ​*Intangibles with indefinite lives (Goodwill) should be tested for impairment annually and
not amortized
o ​*If impaired, amount of impairment is expensed and recognized on income statement
Non-recurring items
· Discontinued operations: must be physically and operationally distinct from the rest of the firm
o Any income or loss is reported in income statement, net of tax, ​AFTER income from continuing
operations​ (no effect on income from continuing ops)
· Unusual or infrequent items: ​INCLUDED in income from continuing operations are reported
before tax
o Gains or losses from sale of assets or part of a business
o Impairments, write-offs, write-downs, restructuring costs
o ​*Allowed under U.S. GAAP, not allowed under IFRS
Change in accounting policies:​ applied retrospectively
Vertical common-size INCOME statement:​ expresses each category of the income statement as a
% of revenue. Eliminates the effects of size and allows for comparison of income statement items
over TIME (time-series) and ACROSS FIRMS (cross-sectional)
Effective tax rate:​ income tax expense expressed as a % of pretax income
Retained earnings:​ net income of firm is added to stockholders’ equity at end of each accounting
period. Transactions that affect income statement also affect stockholders’ equity
Comprehensive income:​ includes all changes in equity EXCEPT for owners contributions
(contributed capital) and distributions (NI + OCI)
Other comprehensive income:​ transactions NOT included in net income
· Foreign currency translation gains and losses
· Adjustments for minimum pension liability
· Unrealized gains and losses from cash flow hedging derivatives
· Unrealized gains and losses from available-for-sale securities (not expected to be held until
maturity or sold in the near term/reported at fair value)
Liquidity:​ firm’s ability to meet short-term obligations
Solvency:​ firm’s ability to meet long-term obligations
Classified balance sheet:​ report current and noncurrent assets and liabilities (required by BOTH
IFRS and U.S. GAAP)
Liquidity-based presentation:​ presents A and L in order of liquidity (not applicable to U.S. GAAP)
Current assets:​ cash and other assets that are likely to be converted into cash or used up within
one year or one operating cycle, whichever is greater
Current liabilities:​ obligations that will be satisfied within one year or one operating cycle, which is
greater
Types of current assets:​ cash and cash equivalents, marketable securities, accounts receivable,
and inventories
Other current assets:​ amounts that may not be material if shown separately (items combined into a
single amount)
· Could include prepaid expenses and deferred tax assets
Deferred tax assets:​ taxes payable > income tax expense recognized in income statement
· Expenses or losses recognized in income statement before they are tax deductible, or when
revenues or gains are taxable before they are recognized in income statement
Types of current liabilities:​ accounts payable, notes payable, current portion of long-term debt,
accrued liabilities (accrued expenses), taxes payable, unearned revenue
Cost model:​ PP&E reported at amortized cost (historical cost minus accumulated depreciation,
amortization, depletion, and impairment losses)
Revaluation model:​ PP&E reported at fair value minus any accumulated depreciation (changes in
fair value are reflected in shareholders’ equity)
Historical cost:​ includes purchase price + any cost necessary to get the asset ready for use
(delivery and installation for example
Impairment:​ carrying value > recoverable amount
· ​Recoverable amount:​ greater of fair value less any selling costs, or the asset’s value in use
(present value of asset’s future cash flows)
· If impaired, asset is written down to recoverable amount and loss is recognized on income
statement
Investment property under IFRS:​ reported at amortized cost (same as PP&E) or fair value
· Under fair value model, change in fair value reported in income statement
Items that should be expensed as incurred, regardless of U.S. GAAP or IFRS:
· Start-up and training costs
· Admin overhead
· Advertising and promotion costs
· Relocation and reorganization costs
· Termination costs
Goodwill:​ excess of purchase price over fair value of identifiable NET assets (A – L) acquired in a
business acquisition
· Internally generated goodwill is expensed as incurred
· Test for impairment annually (loss is recognized in income statement, does not affect cash flow)
Measuring financial assets:
· ​Held-to-maturity:​ measured at amortized cost and are assets that are acquired with the intent to
be held to maturity (ignore changes in market value)
· ​Trading securities:​ acquired with the intent to profit over the near term and are reported at fair
value (unrealized gains and losses recognized in income statement)
· ​Available-for-securities:​ not expected to be held to maturity or traded in near term and are
reported at fair value (unrealized gains and losses go to OCI, not the income statement)
· ​*Any dividend and interest income, as well as realized gains and losses, are all recognized
in the income statement for all three measurements
Deferred tax liability:​ income tax expense in income statement > taxes payable (TEMPORARY
differences)
· Expenses or losses are tax deductible before they are recognized in income statement
· Revenues or gains recognized in income statement before they are taxable
Owners’ equity:​ residual interest in assets that remains after subtracting an entity’s liabilities
· Includes contributed capital, pfd stock, treasury stock, retained earnings, non-controlling interest,
and accumulated OCI
Comprehensive income vs accumulated other comprehensive income:​ the former includes net
income and OCI and is an income measure over a period of time. The latter does not include net
income and is a component of shareholders’ equity at a POINT in time
Vertical common-size balance sheet:​ expresses each item on the balance sheet as a % of total
assets
U.S. GAAP cash flow classifications
· ​CFO Inflows
o Cash collected from customers
o Interest and dividends received
o Sale proceeds from trading securities
· ​CFO outflows
o Cash paid to employees and suppliers
o Cash paid for other expenses
o Acquisition of trading securities
o Interest paid
o Taxes paid
· ​CFI inflows
o Sales proceeds from fixed assets
o Sale proceeds from debt and equity investments
o Principal received from loans made to others
· ​CFI outflows
o Acquisition of fixed assets
o Acquisition of debt and equity investments
o Loans made to others
· ​CFF inflows
o Principal amounts of debt issued
o Proceeds from issuing stock
· ​CFF outflows
o Principal paid on debt
o Payments to reacquire stock
o Dividends paid to shareholders
Noncash transactions:​ must be disclosed in either a footnote or supplemental schedule to the cash
flow statement
Methods of presenting cash flows
o ​Direct:​ converts an accrual-bases income statement into a cash-basis income statement.
Presents firm’s operating cash receipts and payments and provides more information than indirect
method
o Cash collected from customers
o Cash used in production of goods and services
o Cash operating expenses
o Cash paid for interest
o Cash paid for taxes
o ​*IGNORE NONCASH CHARGES WITH DIRECT METHOD
o ​Indirect:​ net income is converted to CFO by making adjustments for transactions that affect net
income but are NON-cash transactions (depreciation and amortization, gains and losses, changes in
balance sheet accounts resulting from accrual accounting events. Focuses on the differences in net
income and CFO (link to income statement when forecasting future CFO)
o ​BEGIN WITH NET INCOME
o Subtract gains or add losses resulting from CFF or CFI activites
o Add back all noncash charges to income (depreciation and amortization)
o Subtract all noncash components of revenue
o Add or subtract changes to balance sheet operating accounts
§ Increases in operating asset accounts are subtracted
§ Decreases in operating asset accounts added
§ Increases in operating liability accounts are added
§ Decreases in operating liability accounts are subtracted
o ​*Both methods are allowed under both U.S. GAAP and IFRS, but direct method is the
preferred method (rarely used by firms, though)
Common-size cash flow statement:​ express each line item as a % of revenue OR express each
inflow as a % of total inflows and outflows as a % of total outflows
Horizontal common-size balance sheet/income statement:​ divisor = first-year values (good for
identifying trends)
Three methods of examining the variability of financial outcomes
· ​Sensitivity analysis:​ based on “what if” questions
· ​Scenario analysis:​ based on specific scenarios and will yield a range of values for financial
statement items
· ​Simulation:​ technique in which probability distributions for key variables are selected and a
computer is used to generate a distribution of values for outcomes based on repeated random
selection
Inventory costs that are capitalized:
· Purchase costs less trade discounts and rebates
· Conversion costs including labor and overhead
· Other costs necessary to bring inventory to its present location and condition
Inventory costs that are expensed:
· Abnormal waste of materials, labor, or overhead
· Storage costs (unless required as part of production)
· Administrative overhead
· Selling costs
FIFO vs LIFO in an inflationary environment:​ Under FIFO, COGS will be understated and results
in earnings being overstated, equaling higher income taxes, which decreases cash flow. Under
LIFO, COGS will be higher and earnings will be lower, equaling lower income taxes, which increases
cash flow.
· LIFO ending inventory = earliest costs (less than current cost in an inflationary environment)
· FIFO ending inventory = recent costs
Periodic inventory system vs perpetual inventory system:​ inventory values and COGS
determined at end of accounting period (purchases added to beginning inventory to arrive at COGS
available for sale) vs values are updated continuously (inventory purchased and sold is recorded
directly in inventory when transaction(s) occur)
· ​*For specific identification and FIFO, ending inventory values and COGS are the same
whether a periodic or perpetual system is used
FIFO vs LIFO when prices are increasing and inventories are stable or increasing
· ​FIFO COGS:​ lower
· ​FIFO tax:​ higher
· ​FIFO ending inventory:​ higher
· ​FIFO gross profit:​ higher
· ​FIFO net income:​ higher
· ​LIFO COGS:​ higher
· ​LIFO tax:​ lower
· ​LIFO ending inventory:​ lower
· ​LIFO gross profit:​ lower
· ​LIFO net income:​ lower
· ​*Regardless of whether or not prices are rising or falling, FIFO will provide the most useful
measure of ending inventory due to ending inventory being made up of the most RECENT
purchases
Converting LIFO to FIFO:
· Add LIFO reserve to LIFO inventory
· Subtract change in LIFO reserve from COGS
· Decrease cash by LIFO reserve x tax rate
· Increase equity/retained earnings by LIFO reserve x (1 – tax rate)
Effects on ratios (assuming increasing prices)
· ​Profitability:​ LIFO = higher COGS = lower earnings = lower profitability ratios
· ​Liquidity:​ LIFO = lower inventory value = lower current ratio = lower working capital
· ​Activity:​ LIFO = higher COGS = higher inventory turnover = lower days of inventory on hand
· ​Solvency:​ LIFO = lower inventory = lower total assets = lower stockholders’ equity = higher debt
ratio and higher debt-to-equity ratio
LIFO liquidation:​ Occurs when a LIFO firms’ inventory quantities are declining, which results in
higher profit margins and higher income taxes (inflates operating margins/not sustainable)—LIFO
liquidations can be used to artificially inflate earnings (can be caused by strikes or material
shortages or decline in customer demand)
Net realizable value:​ expected sales price less estimated selling costs and completion costs
· ​*If net realizable value is less than balance sheet value (book value), item is written down to
net realizable value and loss is recognized in the income statement. If there is a subsequent
recovery in value, the item can be written up by no more than what it was written down for.
Gain is recognized in income statement
Inventory disclosures:​ founds in financial statement footnotes
· Cost flow method (LIFO, FIFO, WAC, etc…)
· Total carrying value of inventory
· COGS
· Inventory writedowns
· Reversal of any writedowns (includes discussion of circumstances around reversal) ​*This applies
to IFRS only as you cannot write up inventory under U.S. GAAP
· Carrying values of inventory pledged as collateral
Inventory changes:​ Change is made retrospectively
Capitalizing vs expensing:​ recorded as an asset on the balance sheet at cost vs an expense on
the income statement
Identifiable intangible asset:​ can be separated from firm or arise from contractual or legal right,
controlled by firm, expected to provide future economic benefit
Unidentifiable intangible asset:​ once that cannot be purchased separately and may have an
indefinite life (goodwill)
Effects of capitalizing vs expensing
· ​Net income (capitalize):​ Report higher net income in first year, lower in subsequent years
(capitalized expenditure allocated to income statement through depreciation expense)
· ​Net income (expense):​ Lower in first year (reduced by after-tax amount of expenditure), higher in
later years
· ​Shareholders’ equity (capitalize):​ Higher retained earnings and shareholders’ equity due to
higher assets, reduced in later years
· ​Shareholders’ equity (expense):​ Lower retained earnings and shareholders’ equity will reflect
entire reduction in net income in period of expenditure
· ​CFO (capitalize):​ Higher CFO and lower CFI (total cash flow will be the same)
· ​CFO (expense):​ Lower CFO and higher CFI
· ​Financial ratios (capitalize):​ Higher assets and higher equity = lower debt-to-assets and lower
debt-to-equity, higher RoA and RoE (RoA and RoE will be lower in subsequent years due to net
income being reduced by depreciation expense), higher interest coverage (EBIT/interest expense);
interest expense is lower
· ​Financial ratios (expense):​ RoA and RoE will be lower in first year, higher in later years
Capitalize vs expensing
Capitalize​ ​Expense
Total assets ​Higher​ ​Lower
Shareholders’ equity ​Higher​ ​Lower
Net income (first year) ​Higher​ ​Lower
CFO ​Higher​ ​Lower
Interest coverage (first year) ​Higher​ ​Lower
Income variability ​Lower​ ​Higher
Net income (subsequent years) ​Lower​ ​Higher
CFI ​Lower​ ​Higher
Debt ratio and Debt-to-equity ​Lower​ ​Higher
Interest coverage (subsequent years) ​Lower​ ​Higher
Carrying/book value:​ net value of an asset or liability on the balance sheet (for PP&E, carrying
value = historical cost – accumulated depreciation)
Historical cost:​ original purchase price of asset including installation and transportation costs
Useful lives
Longer useful life​ ​Shorter useful life
Decreases annual depreciation Increases annual depreciation
Increases reported net income Reduces reported net income
Salvage value
Higher salvage value​ ​Lower salvage value
Decrease depreciation Increase depreciation
Increase net income Reduce net income
*Change in account estimate reported prospectively and put into effect in current period
When not to amortize an intangible asset:​ if it has an indefinite life and/or it can be renewed for a
MINIMAL cost
Leases
· ​Finance lease/capital lease:​ purchase of an asset that is financed with debt
o ​Lessee:​ add equal amounts to both assets and liabilities on balance sheet. Lessee will record
depreciation expense on asset and interest expense on liability
o ​*Interest expense =​ lease liability at beginning of period x interest rate
o ​*At inception of lease, lower of present value of future minimum lease payments or fair
value is recognized as an asset and as a liability on balance sheet
o ​*Under U.S. GAAP, interest expense (paid) is classified as CFO, whereas IFRS can be either
CFO or CFF
· ​Operating lease:​ no asset or liability is recognized by lessee and periodic lease payments are
recognized as rental expense in income statement (cash outflow from operating activities)
Impact of finance/capital lease vs operating lease (financial statements)
Finance/capital lease​ ​Operating lease
Assets ​Higher​ ​Lower
Liabilities ​Higher​ ​Lower
Net income (later years) ​Higher​ ​Lower
EBIT (operating income) ​Higher​ ​Lower
CFO ​Higher​ ​Lower
Total net income ​Same​ ​Same
Total cash flow ​Same​ ​Same
Net income (early years) ​Lower​ ​Higher
CFF ​Lower​ ​Higher
Impact of finance/capital lease vs operating lease (Ratios)
Finance/capital lease​ ​Operating lease
Current ratio (CA/CL) ​Lower​ ​Higher
Working capital (CA – CL) ​Lower​ ​Higher
Asset turnover (revenue/TA) ​Lower​ ​Higher
Return on assets (NI/TA) ​Lower​ ​Higher
Return on equity (NI/SE) ​Lower​ ​Higher
Debt/assets ​Higher​ ​Lower
Debt/equity ​Higher​ ​Lower
Lease reported by lessor
· ​Finance/capital lease:​ sale = to present value of lease payments, and COGS = to carrying value
of asset. Asset is removed from balance sheet and lease receivable, = to present value of lease
payments, is created
o Lessor recognizes interest income over term of lease (equal to lease receivable at beginning of
period x interest rate)
o Interest revenue reported as inflow from CFO and principal reduction reported as inflow from CFI
· ​Operating lease:​ lessor recognizes lease payment as rental income (keep asset on balance sheet
and recognize depreciation expense)
Benefits of leasing
· Conserves cash
· Asset can be returned to the lessor
· Can provide more flexibility than other forms of financing as agreement can be negotiated to better
suit needs of each party
· Entering into an operating lease does not result in a balance sheet liability (reported leverage ratios
are lower compared to borrowing funds)
· Allows lessee to deduct depreciation expense and interest expense for tax purposes
Sales-type lease:​ present value of lease payments > carrying value of asset
· Lessor sold asset for present value of lease payments and provided loan to buyer in same amount
· Lessor recognizes sale = to PV of lease payments and COGS = to carrying value of asset
· Asset removed from balance sheet and lease receivable is created
· Interest portion = lease receivable at beginning of period x lease interest rate
· Cash flow statement: interest portion of lease payment is reported as an inflow (CFO) and principal
reduction treated as an inflow (CFI)
Direct financing lease:​ present value of lease payments = carrying value of asset
· No gross profit is recognized by lessor at inception
· Lessor removes asset from b balance sheet and creates a lease receivable in same amount
Deferred tax liability:​ income tax expense > taxes payable, or, pretax income (income statement) >
taxable income (tax return)
· Revenues recognized in income statement before being included on tax return
· Expenses are tax deductible before being recognized in income statement
· Expected to reverse and result in future cash OUTFLOWS when taxes are paid
Deferred tax asset:​ taxes payable > income tax expense, or, taxable income (tax return) > pretax
income (income statement)
· Revenues taxable before being recognized in income statement
· Expenses are recognized in income statement before being tax deductible
· Tax loss carryforwards reduce future taxable income (future tax savings vs future cash outflows as
with a DTL)
· DTAs must be reduced by a valuation allowance if it is more likely than not (50%) that some or all
of a DTA will not be realized (decreases net balance sheet DTA, increasing income tax expense and
decreasing net income)
*DTLs and DTAs are created by TEMPRORARY differences
*An increase/decrease in the tax rate will increase/decrease DTLs and DTAs
Permanent tax difference:​ does not result in DTLs or DTAs and are not expected to reverse (can
be caused by revenue that is not taxable, expenses that are not deductible, or tax credits that result
in a direct reduction of taxes)
Measuring bonds
· ​When issued at par:
o assets and liabilities increase by bond proceeds
o interest expense for period is = to coupon payment (income statement)
o proceeds reported as inflow (CFF) and coupon payments reported as an outflow (CFO under U.S.
GAAP or either CFO or CFF under IFRS)
o Repayment at maturity = cash outflow (CFF)
· ​Premium bonds and discount bonds:​ book value decreased until it reaches face value at
maturity/book value increased until it reaches face value at maturity
Effective interest rate method:​ interest expense is = to book value of bond liability at beginning of
period x bond’s yield at issuance
· ​Premium bond:​ interest expense will decrease over time (interest expense < coupon payment)
o interest expense – coupon payment = amortization of premium (interest expense – coupon
payment = amortization of premium)
· ​Discount bond:​ interest expense will increase over time (interest expense > coupon payment)
o interest expense – coupon payment = amortization of discount
Bond redeemed prior to maturity:​ gain or loss is recognized by subtracting the redemption price
from the book value of bond at reacquisition date
· Reacquired cost > carrying value = loss to the firm
· Reacquired cost < carrying value = gain to the firm
Debt covenants
· ​Affirmative:​ borrower makes promises to do certain things (make timely payments, maintain
certain ratios, maintain collateral)
· ​Negative:​ borrower promises to refrain from certain actions (increasing dividends, repurchasing
shares, issuing more debt, engaging in merger and acquisitions)
· ​Technical default:​ bondholders demand immediate payback of principal if firm violates a covenant
Disclosures on long-term debt in footnotes
· Nature of liabilities
· Maturity dates
· Stated and effective interest rate
· Call provisions and conversion privileges
· Restrictions imposed by creditors
· Assets pledged as security
· Amount of debt maturing in each of the next FIVE years
DCP vs DBP
· ​DCB =​ employer promises to pay employee specific amount after retirement (pension)
o ​*If fair value of plan assets > estimated pension obligation = overfunded = net pension
asset
o ​*If fair value of plan assets < estimated pension obligation = underfunded = net pension
liability
· ​DCP =​ employer makes no promise to pay employee specific amount at retirement—firm
contributes a sum of money each period to employee’s retirement account (401(k))
o ​*Pension expense = employer’s contribution; no future obligation to report on balance
sheet as liability
Financial reporting quality
· Decision-useful financial reporting = relevance and faithful representation
o Relevant = ​material
o Faithful representation encompasses ​completeness, neutrality, and the absence of errors
· Quality of earnings = how sustainable? Temporary increases from events such as changes in the
exchange rate or liquidating a portion of inventory are not sustainable and are not of good quality.
Higher earnings from greater efficiency or increasing market share are sustainable and are of good
quality
· ​Order of quality:
o Compliant with GAAP and decision useful; earnings are sustainable and adequate
o Compliant with GAAP and decision useful; earnings are not sustainable or not adequate
o Compliant with GAAP; earnings are not sustainable or not adequate, and estimates are biased
o Compliant with GAAP; amount of earnings is actively managed
o NOT compliant with GAAP; #s presented are based on company’s actual economic activities
o NOT compliant with GAAP; #s are fictious or fraudulent
· ​Conservative accounting vs aggressive accounting:​ the former DECREASES earnings and
financial position for current period, the latter INCREASES reported earnings and financial position
o Conservative accounting will tend to increase future earnings
o Aggressive accounting will tend to decrease future earnings
o ​*Earnings smoothing occurs when adjusted accrued liabilities are based on management
estimates
Aggressive​ ​Conservative
Capitalizing current period costs Expensing current period costs
Longer useful lives Shorter useful lives
Higher salvage values Lower salvage values
Straight-line depreciation Accelerated depreciation
Delayed recognition of impairments Early recognition of impairments
Less accrual of reserves for bad debt More accrual of reserves for bad debt
Smaller valuation allowances on deferred tax assets Larger valuation allowances on DTA
Why employ aggressive accounting methods?​ To beat a benchmark # for EPS, beat prior year’s
EPS, beat consensus analyst expectations, beat earnings guidance previously offered up by
management, avoid violating debt covenants if highly levered
Conditions conducive to low-quality reporting:​ weak internal controls, inadequate oversight from
board of directors, or applicable accounting standards provide a large range of acceptable
accounting treatments, a lack of penalties in case of fraud, or both
Rationalization​: management says they’ll fix it later or give themselves some kind of justification as
to why it was okay to manage earnings
Credit ratings
· ​Three Cs​: character, collateral, and capacity
· ​Character​ ​=​ management’s reputation and firm’s history of debt repayment
· ​Collateral =​ ability to pledge collateral
· ​Capacity =​ ability to repay
Specific metrics considered in a credit rating
· ​Scale and diversification:​ larger companies and those with a wider variety of products and
greater geographic diversification
· ​Operational efficiency:​ operating RoA, operating margins, EBITDA margins, high operating
efficiency
· ​Margin stability:​ stability of relevant profitability margins

· ​Leverage:​ ratios of operating earnings, EBITDA, or some measure of free cash flow to interest
expense or total debt