An Assignment

On
The So Far Learnings of Financial Statement Analysis and Evaluation

Prepared For:
Md. Sajib Hossain
Assistant Professor
Department of Finance
University of Dhaka

Prepared By:
Md. Samiul Islam
ID No:23-196
BBA 23​rd​ Batch, B Section
Department of Finance
University of Dhaka

Date of Submission: 7​ ​July, 2020

Long Lived Assets:
Capitalization vs Expensing:
When an asset is expected to provide benefits for only the current period, its cost is expensed on
the income statement rather than capitalize for the period. If an asset is expensed to give benefits
over multiple periods, it is capitalized.

Financial Reporting of Different Types of Intangible Asset:

The cost of a purchased finite lived intangible asset is amortized over its useful life. Indefinite
lived intangible assets are not amortized, but are tested for impairment at least annually. The cost
of internally developed intangible assets is expensed.
Under IFRS, research costs are expensed but development costs may be capitalized. Under U.S.
GAAP both research and development costs are expensed as incurred, excepted in the case of
software created for sales for others.
The acquisition method is used to account for assets acquired in a business combination. The
purchase price is allocated to the fair value of identifiable assets of the acquired firm less its
liabilities. Any excess of the purchase price above the fair value of the acquired firm’s net assests
is recorded as goodwill, an unidentifiable intangible asset that cannot be separated from the
business itself.

Capitalizing vs Expensing Costs Incurred affecting Financial Statements and Ratios:

Compared to expensing the asset cost, capitalization results in:
● Lower expense and higher net income in the period of acquisition, higher expense and
lower net income in each of the remaining years of asset’s life.
● Higher assets and equity
● Higher ROE and ROA in the initial period
● Lower debt to assets and debt to equity ratios

In the early years of an assets life accelerated depreciation results in higher depreciation
expenses, lower net income and lower ROA and ROE compare to straight line
depreciation.
Firms can reduce depreciation and increase net income by using longer useful lives and
higher salvage values.
Revaluation Model:
Under IFRS firms have the option to revalue assets based on their fair value. On the other hand
US GAAP dost not permit that.
The impact of revaluation on the income depends on whether the initial revaluation resulted in a
gain or loss. If the initial revaluation resulted in a loss, the initial loss would be recognized in the
income statement and any subsequent gain would be recognized in the income statement only to
the extent of previously reported loss.
Impairment:
Under IFRS an asset is impaired when its carrying value exceeds the recoverable amount.The
recoverable amount is the greater of value less selling costs and the value in use. If impaired, the
asset is written down to the recoverable amount. Loss recoveries are permitted.
Under US GAAP, an asset is impaired if its carrying value is greater than the assets undiscounted
future cash flows. If impaired, the asset is written down to fair value.
Asset impairments result in losses in the income statements. It has no impact on cash flowas they
have no tax.
When long lived asset is sold, the difference between the sale proceeds and the carrying
value of the asset is reported as a gain or loss in the income statement.
When a long lived asset is abandoned, the carrying value is removed from the balance
sheet and a loss is recognized in that amount.

Long Lived Liabilities:

When a bond is issued assets and liabilities both initially increase by the bond proceeds.
A premium bond is reported on the balance sheet at a value greater than its face value. As the
premium is amortized the book value of the bond liability will decrease until it reaches its face
value at maturity.
A discount bond is reported on the balance sheet at less than its face value. As the discount is
amortized, the book value of the bond liability will increase until it reaches its face value at
maturity.
When bonds are redeemed before maturity, a gain or loss is recognized equal to the difference
between the redemption price and the carrying value of the bond liability at the reacquisition
date.

Under IFRS except for short term leases, a lessee reports an asset and a liability on its balance
sheet, both equal to the present value of the promised lease payments. The interest portion of
each lease payment is reported as interest expense, while the principle repayment portion of each
payment reduces the lese liability. For short term leases, rent expense is reported on the income
statement and no balance sheet entries are required.

Under US GAAP, a lease is classified as a finance lease if the benefits and risks of ownership
have been substantially transferred to the lessee, or as an operating lease otherwise. Reporting for
a finance lease is the same as under IFRS. For an operating lease, the entire lease payment is
recorded as a lease expense while the principal portion reduces the lease liability.

Under IFRS there are two lease classification for lessors, finance leases and operating lease.
With a financial lease, the lessor removes the leased asset from its balance sheet and adds a lease
receivable asset. The lessor reports the interest portion of the lease payments as income. For
operating lease, the lessor reports lease payments as income and depreciation and other costs as
expenses.

Under US GAAP, lessor classifications for leases are sales type, direct financing, or operating. A
lease is sales type if it meets the transfer of ownership criteria and collection of the lease
payments is probable. A lease is direct financing if the transfer of ownership criteria are not met,
a third party guarantees the residual value and the lease payments plus the residual value at least
equal to the fair value of the asset. A lease that is neither sales type nor direct financing is an
operating lease.
Financial Reporting Quality:
Financial reporting quality refers to the characteristics of a firm’s financial statements. High
quality financial reporting adheres to generally accepted accounting principles and is decision
useful in term of relevance and faithful representations.
Quality of reported results refers to the level and sustainability of a firm’s earnings, cash flows
and balance sheet items. High quality earnings are enough to provide the firm’s investors with an
adequate return and are endurable in future periods.

A spectrum for assessing financial reporting quality considers both the quality of a firm’s
financial statements and the quality of its earnings. One such spectrum, from highest quality to
lowest, is the following:
● Reporting is compliant with GAAP and decision useful earnings are sustainable and
adequate.
● Reporting is compliant and decision useful, but earnings quality is low.
● Reporting is compliant, but earnings quality is low and reporting choices and estimates
are biased.
● Reporting is compliant, but earnings are actively managed.
● Reporting is not compliant, but the numbers presented are biased on the company’s actual
economic activities.
● Reporting is not compliant and includes numbers that are fictitious or fraudulent.

Conservative and Aggressive Accounting:

Conservative accounting choices tend to decrease the company’s reported earnings and financial
position for the current period.
Aggressive accounting choices tend to increase reported earnings or improve the financial
position for the current period. Some managers employ conservative bias during periods when
earnings are above target and aggressive bias during poor periods of below target earnings to
artificially smooth earnings.

Managers may be motivated to report earnings that are greater than:

● Earnings guidance offered earlier by the management
● Consensus analyst expectations
● Those of the same period in the prior year.

Circumstances in which low quality, or even fraudulent, financial reporting is more probable are:
● The company has weak internal controls
● The board of directors provides inadequate oversight
● Applicable accounting standards provide a large range of acceptable accounting
treatments, provide for inconsequential penalties in the case of accounting fraud or both.

Accounting choices:
 ● Revenue recognition choices such as shipping terms (FOB shipping point versus FOB
destination), accelerating shipments (channel stuffing), and bill and hold transactions
● Estimates of reserves for uncollectible accounts or warranty expenses
● Valuation allowances on deferred tax assets
● Depreciation methods, estimates of useful lives and salvage values and recognition of
impairments
● Inventory cost flow methods
● Capitalization of expenses

Accounting warning signs:

● Revenue growth out of line with compatible firms
● Decreases over time turnover ratios
● Bill and hold, barter or related party transactions
● Net income not supported by operating cash flows
● Capitalization decisions, depreciation methods, useful lives, salvage values out of line
with comparable firms
● Frequent appearance of nonrecurring items

Applications of Financial Statement Analysis:

Trends in a company’s financial ratios and differences between its financial ratios and those of
its competitors or industry average ratios can reveal important aspects of its business strategy.

A company’s future income and cash flows can be projected by forecasting sales growth and
using estimates of profit margins and the increases in working capital and fixed assets necessary
to support the forecast sales growth.

One version of the three Cs includes: Character, Collateral and Capacity to repay. Credit rating
agencies are essentially weighted averages of several specific accounting ratios and business
characteristics.
● Scale and Diversification: Larger companies and those with a wider variety of product
lines and greater geographic diversification are better credit risks.
● Operational Efficiency: ROA, operating margins and EBITDA fall into this category.
Along with greater vertical diversification, high operating efficiency is associated with
better debt ratings.
● Margin Stability: Stability of the relevant profitability margins indicates a higher
profitability of repayment.
● Leverage: Ratios of operating earnings or some measures of free cash flow to interest
expense or total debt make up the most important part of the credit rating formula.

When companies use different accounting methods or estimates relating to areas such as
inventory accounting, depreciation, capitalization, and off-balance sheet financing, analysts must
adjust the financial statements for compatibility.

LIFO ending inventory can be adjusted to a FIFO basis by adding the LIFO reserve. LIFO cost
of goods sold can be adjusted to a FIFO basis by subtracting the change in the LIFO reserve.
When calculating solvency ratios, analysts should estimate the present value of operating lease
obligations and add it to the firm’s liabilities.

Free Cash Flow Valuation:

FCFF is the cash available to all of the firm’s investors, including stockholders and bondholders
after the firm buys and sells products, provides services, pays its cash operating expenses and
makes short and long term investments. FCFE is the cash available to common stock holders
after funding capital requirements, working capital needs and debt financing requirements.

The value of the firm is the present value of the expected future FCFF discounted at the WACC.
The value of the firm’s equity is the present value of the expected future FCFE discounted at the
required return on equity.

FCFE is easier where the capital structure is not volatile. If a company has negative FCFE and
significant debt outstanding, FCFE is generally the best choice.

Analysts prefer to use either FCFF or FCFE as a measure of value if:

● The firm does not pay dividend
● The firm pays dividends, but the dividends do not reflect the company’s long-term
profitability
● The analyst takes a control perspective

Formulas:
1. FCFF = Net income + Non cash charges + [Interest × (1 − tax rate)] – Fixed capital
investmen t– Working capital investment
2. FCFF = [EBIT × (1 − tax rate)] + Depreciation – Fixed capital investment – Working
capital investment
3. FCFF = [EBITDA × (1 − tax rate)] + (Dep × tax rate) − FCInv – WCInv
4. FCFF = Cash Flow from Operations + [Int × (1 − tax rate)] – FCInv
5. FCFE = FCFF − [Int × (1 − tax rate)] + net borrowing
6. FCFE = NI + NCC − FCInv − WCInv + net borrowing
7. FCFE = CFO − FCInv + net borrowing
8. V alue of the f irm = F CF F 1 /(W ACC − g )
9. V alue of equity = F CF E 1 /(r − g )

The single stage free cash flow models are useful for stable firms in mature industries. On the
other hand the assumptions for two and three stage free cash flow models are simply the
assumptions we make about the projected pattern of growth in free cash flow.