Financial Reporting

CA. Adithya Kiran F.C.A. C.F.A (U.S.A), CCO (IIBF).
I. FINANCIAL STATEMENT ANALYSIS: AN

INTRODUCTION
1. The objective of general-purpose financial reporting is:
 To provide financial information
 About the reporting entity
 That is useful to existing and potential investors, lenders and other
creditors
 Useful in making decisions about providing resources to the entity.
2. The role of financial statement analysis is to use the information in a company’s
financial statements, along with other relevant information, to make economic
decisions.
Analysts use FS data to evaluate:
 A company’s past performance; and
 Current financial position;
In order to form opinions about the company’s ability:
 To earn profits and generate cash flows in the future.
3. The income statement / statement of operations / profit and loss statement
reports on the financial performance of the firm over a period of time.
4. The statement of comprehensive income reports all changes in equity expect for
shareholder transactions.
5. Under IFRS the income statement can either be combined with other
comprehensive income or presented as a single statement of comprehensive
income or can be presented separately.
Under U.S. GAAP firms have an option to present comprehensive income
in the statement of shareholders equity.
6. The statement of changes in equity reports the amounts and sources (retained
earnings and shareholder transactions) of changes in equity investor’s
investment in the firm over a period of time.
7. Footnotes allow users to improve their assessments of the amount, timing and
uncertainty of the estimates reported in the financial statements.
YouTube: CA CFA ADITHYA KIRAN e-mail: eluruadithyakiran@yahoo.com

8. Management’s discussion and analysis (MD&A) section of the annual report

discusses a variety of issues some of which may be unaudited. SEC requires that
MD&A discuss:
a) Trends and identify significant events and uncertainties that affect the
firm’s liquidity, capital resources and results of operations.
b) Effects of inflation and changing prices if material.
c) Impact of off-balance sheet obligations and contractual obligations such as
purchase commitments.
d) Accounting policies that require significant judgment by management.
e) Forward-looking expenditures and divestitures.
9. The auditor examines the company’s accounting and internal control systems,
confirms assets and liabilities and generally tries to determine that there are no
material errors in the financial statements.
The standard auditor’s opinion contains three parts:
i. Whereas the financial statements are prepared by management and are its
responsibility, the auditor has performed an independent review.
ii. GAAS were followed, thus providing reasonable assurance that the FS
contain no ME’s.
iii. The auditor is satisfied that the statements were reported I/A accepted
accounting principles and that the principles chosen and estimates made
are reasonable.
Internal controls are the responsibility of the management. Auditor expresses an
opinion on them either separately or as the fourth element of the standard opinion.
The auditor’s opinion will contain an explanatory paragraph when a material loss is
probable but the amount cannot be reasonably estimated.
The auditor’s report must contain additional explanation when accounting methods
have not been used consistently between periods.
10. Besides the annual financial statements, an analyst should examine a

company’s quarterly or semiannual reports.
a) Form 8-K: report of events such as acquisitions and disposals of major assets
or changes in management or corporate governance.
b) Form 10-K: annual financial statements.

c) Form 10-Q: quarterly FS.

d) Proxy statements issued to shareholders when there are matters that require a
shareholder’s vote.
e) Corporate reports and press releases written by management and are often
viewed as public relations or sales material.
f) Pertinent information on economic conditions and the company’s industry to
be acquired from trade journals, statistical reporting services and government
agencies.
11. FS analysis framework consists of 6 steps:
a) State the objective and context - determine what questions the analysis seeks to
answer, the form in which this information needs to be presented, and what
resources and how much time available to perform the analysis.
b) Gather data.
c) Process the data- make appropriate adjustments to the FS, calculate ratios and
prepare exhibits such as graphs and common size balance sheets.
d) Analyze and interpret the data – decide what conclusions or recommendations the
information supports.
e) Report the conclusions or recommendations.
f) Update the analysis periodically.

II. FINANCIAL REPORTING MECHANICS

1) Financial statement elements are the major classifications of assets, liabilities,
owner’s equity, revenues and expenses.
2) Accounts are the specific records within each element where various transactions
are entered.
3) A company’s chart of accounts is a detailed list of the accounts that make up the
five financial statement elements and the line items presented in the financial
statements.
4) Contra accounts are used for entries that offset some part of the value of another
account.
Share repurchases that the company has made are represented in the contra
account called treasury stock.
5) Other comprehensive income includes changes resulting from foreign currency
translation, minimum pension liability adjustments, or unrealized gains and
losses on investments.
6) The Basic accounting equation: Assets = Liabilities + Owner’s equity.
7) Expanded accounting equation:
Assets = Liabilities + Contributed Capital + Beginning Retained Earnings + Rev – Exp - Div
Keeping the accounting equation in balance requires double-entry accounting.
8) Adjustments in preparing financial statements can be classified into two
categories viz., Accruals and Valuation Adjustments.
9) Accruals fall into 4 categories: Unearned revenue - Accrued revenue – Prepaid
Expenses – Accrued Expenses.
Accruals require an accounting entry when the earliest event occurs and require one or
more offsetting entries as the exchange is completed.
10) Valuation adjustments are accounting entries that update the asset values i.e.,
historical costs to reflect their current market values.

11) Information flows through an accounting system in four steps:

a) Journal entries record every transaction, showing which accounts are changed
and by what amounts. A listing of all the journal entries in order of their dates
is called the general journal.
b) The General Ledger sorts the entries in the general journal by account.
c) At the end of the accounting period an Initial Trial Balance is prepared that
shows the balances in each account. If any adjusting entries are needed, they
will be recorded and reflected in an Adjusted Trial Balance.
d) The account balances from the Adjusted Trial Balance are presented in the
financial statements.

III. FINANCIAL REPORTING STANDARDS

1. Need for Financial Reporting Standards (FRS).
 Given the variety and complexity of possible transactions and the estimates
and assumptions a firm must make when presenting its performance, financial
statements could potentially take any form if reporting standards did not exist.
Thus, FRS are needed to provide consistency by narrowing the range of
acceptable responses
 FRS ensures that transactions are reported by firms similarly. However, they
must remain flexible and allow discretion to management to properly describe
the economics of the firm.
 They provide inputs for valuation purposes.
2. Standard Setting Bodies are professional organizations of accountants and
auditors that establish FRS. Regulatory authorities are government agencies that
have the legal authority to enforce compliance with FRS.
3. The 3 objectives of Financial Market Regulation according to IOSCO are:
i. To protect investors;
ii. To ensure the fairness, efficiency, and transparency of markets; and
iii. To reduce systematic risk.
4. SEC required filings are as follows
Form No Purpose
S-1 Registration statement filed prior to the sale of new securities to the
public.
10-K Annual filing for US issuers
40-F Annual filing for Canadian Companies
20-F Annual filing for other foreign issuers in the U.S. Markets
10-Q Quarterly filing. These statements do not have to be audited.
6-K Semiannual financial statements for non U.S. Companies.
8-K Form to disclose material events
144 Notifying the SEC that a company wants to issue securities to certain
qualified buyers without registering the securities with SEC.
3,4 & 5 Involve beneficial ownership of securities by a company’s officers and
directors.

5. Barriers to convergence of accounting standards:

 Different standard-setting bodies and regulatory authorities of different
countries can and do disagree on the best treatment of a particular item or issue.
 Political pressures that regulatory body’s face from business groups and others
who will be affected by changes in reporting standards.
6. IASB framework:
 Details the qualitative characteristics of FS (Relevance and Faithful representation).
 Specifies the required reporting elements.
 Notes certain constraints and assumptions that are involved in FS preparation.
7. FS are relevant if the information contained in them can:

 Influence user’s economic decisions; or
 Affect user’s evaluations of past events; or
 Affect user’s forecasts of future events.
To be relevant, information should have predictive value, confirmatory value (Confirm
prior expectations)
8. Information that is faithfully representative is complete, neutral (absence of bias),

and free from error.
Four characteristics that enhance relevance and faithful representation are
comparability, verifiability, timeliness and understandability.
Comparability: FS Presentation should be consistent among firms and across times.
Verifiability: Independent observers, using the same methods, obtain same results.
Timeliness: Information is available to decision makers before it becomes stale.
Understandability: Users with a basic knowledge of business and accounting and
who make a reasonable effort to study the FS should be able to readily understand
the information the statements present. Useful information should not be omitted
just because it is complicated.
9. The elements of FS are grouping of assets, liabilities and equity (for measuring
financial position) and income and expenses (for measuring performance).
An item should be recognized in its FS element if a future economic benefit from
the item (flowing to or from the firm) is probable and the item’s value or cost can
be measured reliably.
The amounts at which items are reported in the FS elements depend on their
measurement base. MB includes historical cost, amortized cost (HC-

depreciation, amortization, depletion and impairment), current cost, realizable

value, present value and fair value.
10. Constraints involved in FS preparation:
o The benefit that users gain from the information should be greater than the cost
of presenting it.
o Non-quantifiable information about a company (its reputation, brand loyalty,
capacity for innovation) cannot be captured directly in FS.
11. Two important underlying assumptions of FS are accrual accounting and going
concern.
12. The required FS are: BS – SCI – CFS – SCOE – Exp notes
13. Features for preparing FS are:

 Faithful presentation of transactions and event according to the standard.
 Consistency in presentation and classification.
 Materiality – implies that FS should be free of misstatement of omissions.
 Aggregation of similar items and separation of dissimilar items.
 No offsetting of assets against liabilities or income against expenses unless a
specific standard permits or requires it.
 Reporting frequency must be at least annually.
14. The structure and content of FS:
 Classified balance sheet showing current and noncurrent assets and liabilities.
 Minimum information is required on the face of each FS and in the notes.
 Comparative information for prior periods should be included unless a specific
standard states otherwise.
15. Frameworks of FASB and IASB differ in following respects:
a) The IASB framework lists income and expenses as elements related to
performance, while the FASB framework includes revenues, expenses, gains,
losses and comprehensive income.
b) The FASB defines an asset a future economic benefit, whereas the IASB defines it
as a resource from which a future economic benefit is expected to flow. Also, the
FASB uses the word probable in its definition of assets and liabilities.

c) FASB does not allow upward valuation of most assets.

d) IFRS is a principle-based approach, while US GAAP is rule based. The common
conceptual framework is moving toward an objectives-oriented approach.
Firms that list their shares in the US but do not use either IFRS or US GAAP are
required to reconcile their FS with US GAAP. For IFRS firms listing their shares in the
US, reconciliation is not required.
16. A coherent FR framework is one that fits together logically. Such a framework
should be transparent, comprehensive and consistent.
Barriers to creating a coherent FRF include issues related to valuation, standard
setting and measurement.
17. An analyst should be aware of new products and innovations in the financial
markets that generate new types of transactions. These might not fall nearly into
the existing FRS. The analyst can use the FRF as a guide for evaluating what
affects new P/I might have on the FS.
18. Management can:

 Discuss the impact of adopting a new standard ;
 Conclude that the standard does not apply ;
 Conclude that the standard will not affect the FS materially ; or
 State that they are still evaluating the effects of new standards.
Management cannot say that it has chosen not to implement the new standard.

IV. UNDERSTANDING INCOME STATEMENTS

1. Investors examine a firm’s income statement for valuation purposes while lenders
examine the same to evaluate the firm’s ability to pay its debt.
2. Revenue less adjustments for estimated returns and allowances is known as net
revenue. Sales is just one component of revenue.
3. Expenses are grouped together by their nature or function. Grouping expenses by
function is sometimes referred to as the cost of sales method. Expenses can be
presented as negative numbers or parentheses can be used to signify expenses.
4. Net income = (revenue – ordinary expenses) + (other income – other expense) +
(gains – losses). Net income is sometimes referred to as earnings or the bottom
line.
5. Minority interest is subtracted in arriving at net income because the parent is
reporting all of the subsidiary’s revenue and expense.
6. A firm can present its income statement using a single-step or multi-step format.
7. By using the accrual method of accounting firms can manipulate net income.
8. According to IASB revenues is recognized from the sale of goods when:
a) The risk and reward of ownership is transferred.
b) There is no continuing control or management over the goods sold.
c) Revenue can be reliably measured.
d) There is a probable flow of economic benefits.
e) The cost can be reliably measured.
For services rendered, revenue is recognized when:
i. The amount of revenue can be reliably measured.
ii. There is a probable flow of economic benefits.
iii. The stage of completion can be measured.
iv. The cost incurred and the cost of completion can be reliably measured.
9. According FASB revenue is recognized when:
a) Realized or realizable; and
b) Earned.
c) There is an evidence of an arrangement between the buyer and seller.
d) The product has been delivered or the service has been rendered.
e) The price is determined or determinable.
f) The seller is reasonably sure of collecting money.

10. When the outcome of a long-term contract can be reliably estimated, the
percentage of completion method (% of costs incurred to total estimated costs) is
used under IFRS and US GAAP.
11. When the outcome cannot be reliably measured:
 Under IFRS revenue is recognized to the extent of costs incurred, costs are expensed
when incurred, and profit is recognized only at completion.
 Under US GAAP completed contract method is used.
If loss is expected, the loss must be recognized immediately under IFRS & US GAAP.
12. Percentage of completion method is:
 More aggressive since revenue is reported sooner than completed contract
method.
 Is more subjective because it involves cost estimates.
 Provides smoother earnings and results in better matching of revenue and
expenses over time.
13. In case of installment sales, under U.S. GAAP, if collectability is:
a. Certain – revenue is recognized at the time of sale using the normal revenue
recognition criteria.
b. Cannot be reliably measured – Installment method is used wherein profit is equal
to cash collected during the period multiplied by the total expected profit as a
percentage of sales.
c. Highly uncertain – Cost recovery method is used which recognizes profits when
cash collected exceeds costs incurred.
Under IFRS if the outcome:
i. Can be reliably measured – The discounted PV of the installment payments is
recognized at the time of sale. The difference between the installment payments
and the discounted PV is recognized as interest over time.
ii. Cannot be reliably estimated – revenue recognition is similar to cost recovery
method.
14. According to U.S. GAAP revenue from barter transaction can be recognized at FV
only if the firm has historically received cash payments for such goods and services
and can use this historical experience to determine FV. Otherwise, the revenue is
recorded at the carrying value of the asset surrendered.
15. Under IFRS revenue from barter transactions must be based on the FV of revenue
from similar non-barter transactions with unrelated parties.

In a barter transaction, two parties exchange goods or services without cash

payment. A round-trip transaction involves the sale of goods to one party with the
simultaneous purchase of almost identical goods from the same party.
16. Under gross revenue reporting, the selling firm reports sales revenue and cost of
goods sold separately. Under net revenue reporting, only the difference in sales
and cost is reported. The following criteria must be met in order to use gross
revenue reporting under U.S. GAAP. The firm must:
a) Be the primary obligator under the contract.
b) Bear the inventory risk and credit risk.
c) Be able to choose its supplier.
d) Have reasonable latitude to establish the price.
Users of financial information must consider two points:
 How conservative are the firm’s revenue recognition policies ( recognizing
revenue sooner rather than later is more aggressive) ; and
 The extent to which the firm’s policies rely on judgment and estimates.
17. Expenses are decreases in economic benefits during the accounting period in the
form of outflows or depletion of assets or incurrence of liabilities that result in
decreases in equity other than those relating to distributions to equity participants.
18. Expenses which are not tied to revenue are known as period costs and are expensed
in the period incurred.
19. FIFO is appropriate for inventory that has a limited shelf life. LIFO is appropriate
for inventory that does not deteriorate with age. LIFO is allowable only in US
GAAP. Writing up of inventory is permitted only under IFRS. Under IFRS
inventory is reported at the lower of cost or NRV. Under U.S. GAAP at the lower of
cost or market value. MV is usually replacement cost. MC cannot exceed NRV and
cannot be less than (NRV- normal profit margin).
20. Depreciation is for tangible assets; depletion is for natural resources and
amortization is for intangible assets.
21. Accelerated depreciation speeds up the recognition of depreciation expense in a
systematic way to recognize more depreciation expense in the early years of the
asset’s life and less depreciation expense in the later years of its life.
22. Declining balance method (DB) does not explicitly use the asset’s residual value in
the calculations, but depreciation ends once the estimated residual value has been
reached. If the asset is expected to have no residual value, the DB method will never

fully depreciate it, so the DB method is typically changed to straight line at some
point in the asset’s life.
23. Double Declining Balance = [ (Cost – Accumulated depreciation) / useful life] / 2.
24. Intangible assets with indefinite lives are not amortized but are tested for
impairment at least annually.
25. Matching principle requires the firm to estimate bad debt expense in the period of
sale, rather than a later period.
26. Discontinued operations:
 Operation that management has decided to dispose of, but either has not yet done
so, or has disposed of in the current year after the operation has generated income
or losses.
 To be accounted for as a discontinued operation, the business – in terms of assets,
operations, and investing and financing activities – must be physically and
operationally distinct from the rest of the firm.
 The date when the company develops a formal plan for disposing of an operation is
referred to as the measurement date.
 The time between the measurement date and the actual disposal is referred to as the
phase out period.
 On the measurement date the company will accrue any estimated loss during the
phase out period and any estimated loss on the sale of the business. Any expected
gain on the disposal cannot be reported until after the sale is completed.
 Any income or loss from discontinued operations is reported separately in the
income statement, net of tax, after income from continuing operations. Any past
income statements presented must be restated, separating the income or loss from
the discontinued operations.
 Discontinued operations should be excluded when forecasting future earnings but
should be included when forecasting cash flows during the phase out period.
27. An item that is either unusual in nature or infrequent in occurrence but not both is
included in income from continuing operations and is reported before tax.
28. An extraordinary item is a material transaction or event that is both unusual and
infrequent in occurrence. They are reported separately in the income statement, net of
taxes, after income from continuing operations. IFRS does not allow extraordinary
items to be separated from operating results in the income statement.

An analyst may want to review them to determine whether some portion should be
included when forecasting future income. Some companies appear to be accident-prone
and have “extraordinary” losses every year or every few years.
29. Accounting changes:
 Include changes in accounting principles, changes in accounting estimates, and
prior-period adjustments.
 A change in accounting principle refers to change from one GAAP or IFRS
method to another. It requires retrospective applications. However change from
other method to LIFO under U.S.GAAP does not apply the change
retrospectively but use the carrying value of inventory as the first LIFO layer.
 Change in accounting estimate is the result of a change in management’s
judgment, usually due to new information. It is applied prospectively and does
not require the restatement of prior financial statements.
 A change from an incorrect accounting method to one that is acceptable under
GAAP or IFRS or the correction of an accounting error made in previous
financial statements is reported as prior-period adjustment. They usually involve
errors which should be reviewed carefully as the errors may indicate weaknesses
in the firm’s internal controls.
30. Operating and non-operating transactions are usually reported separately in the
income statements. For a non-financial firm, non-operating transactions may result
from investment income and financing expenses. An interest expense in independent
of firm’s operations as it is based on the firm’s capital structure.
31. Earning Per Share (EPS)
 Nonpublic companies are not required to report EPS data.
 EPS is reported only for shares of common stock.
 A stock split or stock dividend is applied to all shares outstanding prior to the
split or dividend and to the beginning of period weighted average shares.
 To compute Diluted EPS the numerator of EPS is adjusted in case of convertible
preferred stock and convertible bonds while no adjustment to the numerator is
required for dilutive stock options or warrants.
 Stock options and warrants are dilutive only when their exercise prices are less
than the average market price of the stock over the year. If they are dilutive,
treasury stock method is used to calculate the number of shares used in the
denominator. The treasury stock method assumes that the funds received by
the company from the exercise of the options would be used to hypothetically

purchase shares of the company’s common stock in the market at the average
market price.
 Net increase in common shares from the potential exercise of stock options or
warrants is calculated as [(AMP-EP) / AMP] / N where AMP is the average
market price, EP is the exercise price and N is the number of common shares
that the options and warrants can be converted into.
32. A vertical common-size income statement:
 Expresses each category of the income statement as a percentage of revenue.
Any sub-total found in the IS can be expressed as a percentage of revenue.
Expenses except tax can be presented as a percentage of revenue. Tax is
expressed as a percentage of pre-tax expense to reflect effective tax rate.
 Standardizes the IS by eliminating the effects of size.
 It facilitates time-series analysis and cross-sectional analysis.
 Common size analysis can also be used to examine a firm’s strategy.
33. Other comprehensive income includes transactions that are not included in net
income, such as:
a) Foreign currency translation gains and losses.
b) Adjustments for minimum pension liability.
c) Unrealized gains and losses from cash flow hedging derivatives.
d) Unrealized gains and losses from available for sale securities. AFS securities are
not expected to be held to maturity and reported in BLS at FV. The changes in
FV before sale of securities are known as unrealized gains and losses.
e) The changes in FV of long-lived assets reported under IFRS are included in
other comprehensive income.
Because firms have flexibility of including or excluding transactions from net income,
analysts must examine comprehensive income when comparing financial performance
with other firms.

V. UNDERSTANDING BALANCE SHEETS
1. The BS can be used to assess a firm’s :

 Liquidity – ability to meet short-term obligations.
 Solvency – ability to meet long-term obligations.
 Ability to make distributions to shareholders.
2. The BS elements (Assets, Liabilities & Equity) should not be interpreted as
market value or intrinsic value. The BS consists of a mixture of values
(Historical Cost, Amortized cost & Fair Value). Even if the BS was reported at
FV, the value may have changed since the BS date. There are a number of
assets and liabilities that do not appear on the BS but certainly have value.
3. Classified BS separates Noncurrent assets and liabilities from the current ones
and is permitted under IFRS & U.S. GAAP.
4. Liquidity-based BS presents assets and liabilities in the order of liquidity. It is
permitted only under IFRS. It is often used in banking industry.
5. Current assets include cash and other assets that will likely be converted into
cash or used up within one year or one operating cycle, whichever is greater.
6. A liability that meets any of the following criteria is considered current:
 Settlement is expected during the normal operating cycle.
 Settlement is expected within one year.
 Held primarily for trading purposes.
 There is not an unconditional right to defer settlement for more than one year.
7. Current assets reveal information about the operating activities of the firm.
Noncurrent assets provide information about the firm’s investing activities.
Noncurrent liabilities provide information about the firm’s long-term
financing activities.
8. Financial Assets.
a) Cash equivalents: Near enough to maturity that interest rate risk is
insignificant. Amortized cost or FV will result in same value.
b) Marketable securities.
c) Accounts receivables – reported at NRV, which is based on estimated
bad debt expense. Firms are required to disclose significant
concentrations of credit risk, including customer, geographic, and
industry concentrations.

9. Current liabilities.
 Notes payables - obligations in the form of Promissory notes owed to
creditors and lenders and have maturity within one year.
 Current portion of long-term debt - Principal portion of debt due within
one year or operating cycle, whichever is greater.
 Accrued liabilities – expenses that have been recognized in the income
statement but are not yet contractually due.
 Unearned revenue – does not require a future cash flow like accounts
payable and also an indication of future growth as the revenue will
ultimately be recognized in the income statement.
10. Non-current Assets.

 Under IFRS PP&E can be reported using the cost model or the revaluation
model. Revaluation model is not permitted under U.S.GAAP.
 Under the cost model PPE is reported at Amortized cost (HC – AD/A/D –
Impairment losses).
 Impairment losses are recognized in the income statement. Loss recoveries are
allowed only under IFRS.
 Under revaluation model, PPE is reported at FV less AD. Changes in FV are
reflected in shareholder’s equity and may be recognized in the IS in certain
circumstances.
 Under IFRS investment property includes assets that generate rental income or
capital appreciation. They are reported at amortized cost or FV. Changes in FV
is recognized in the income statement.
 Identifiable intangible assets can be acquired separately or are the result of rights or
privileges conveyed to their owner. Unidentifiable intangible assets cannot be acquired
separately and may have an unlimited life.
 Revaluation model can be used for reporting UIIA under IFRS only when if there is an
active market for that asset exists.
 IA that is created internally is expensed under U.S. GAAP. Under IFRS costs incurred
during the development stage can be capitalized.
 Finite lived IA’s are amortized over their useful lives. IA’s with infinite lives are not
amortized but are tested for impairment at least annually.
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 Goodwill is the excess of purchase price over the FV of the identifiable net assets
acquired in business combinations.
 Acquirers pay G because the target:
 May have assets not reported on its BS.
 May have R&D assets that remain off BS because of current accounting standards.
 May have perceived synergies.
 G is only created through acquisition. Internally generated G is expensed as
incurred.
 Since G is not amortized, firms can manipulate net income upward by allocating
more of the acquisition price to G and less to identifiable assets. The result is less
depreciation and resulting in higher net income.
 Economic G derives from the expected future performance of the firm. Accounting G
is the result of past acquisitions.
 While computing ratios G should be eliminated from BS and the G impairment
should be eliminated from IS.
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 Financial instruments are contracts that give rise to both a financial asset of one entity and a
financial liability or equity instrument of another entity.
 FI are measured at HC (Unquoted equity investments and loans and receivables), amortized
cost (HTM securities) or FV (trading securities, AFS securities and derivatives).
 Amortized cost = Issue price – principal payments + amortized discount – amortized
premium – impairment losses. Subsequent changes in market value are ignored.
 Unrealized / Holding period gains and losses of trading securities are recognized in the IS.
 UG&L on AFS securities are reported in other comprehensive income as a part of

shareholder’s equity.
11. Owners’ equity.

 It includes contributed capital, perpetual preferred stock, treasury stock, retained
earnings, non-controlling interest and accumulated other comprehensive income.
 Outstanding shares = issued shares – treasury stock.
12. A vertical common-size BS expresses each item as a % of total assets. It can be used to
examine a firm’s strategy.

V. UNDERSTANDING CASH FLOW STATEMENTS
1. The cash flow statement provides information to assess the firm’s liquidity, solvency
and financial flexibility. An analyst can use the CFS to determine whether:
a) Regular operations generate enough cash to sustain the business.
b) Enough cash is generated to pay off existing debts as they mature.
c) Unexpected obligations can be met.
d) The firm can take advantage of new business opportunities as they arise.
e) The firm is likely to need additional financing.
2. Operating cash flows affect net income, investing activities affect long-term assets
and certain investments and financing activities affect firm’s capital structure.
3. Under U.S. GAAP cash from debt and equity investments (other than trading
securities) are reported as investing activities, while income from these investments
is reported as operating activity. Cash flows from borrowing are reported as
financing activity while interest paid on these borrowings is reported as operating
activity. However, dividend paid to shareholders is reported as financing activity.
IFRS allows flexibility in that dividend paid may be reported as operating activity/
financing activity while interest and dividend received may be reported as investing
activity/ operating activity.
Moreover, under US GAAP all taxes paid are reported as operating activities.
Under IFRS taxes paid are reported as operating activities unless the expense is
associated with an investing or financing transaction.
4. Non cash investing and financing activities must be disclosed in either a footnote or
supplemental schedule to the CFS.
5. The direct method converts an accrual basis income statement into a cash-basis
income statement.
6. Under the indirect method the starting point is the net income the bottom line of the
income statement. Under the direct method the starting point is the top of the income
statement (cash collections from customers).
7. While direct method presents operating cash receipts and payments separately,
indirect presents only the net result. The knowledge of past receipts and payments is
useful in estimating future operating cash flows. However, indirect method provides
a useful link to the income statement when forecasting future operating cash flows.

8. Under US GAAP, a direct method presentation must also disclose the adjustments
necessary to reconcile net income to cash flow from operating activities. Moreover,
interest and taxes may be reported in CFS or disclosed in the footnotes.
9. Steps involved in calculating CFO under the indirect method are:
i. Begin with net income
ii. Subtract gains or Add losses that resulted from financing or investing
activities.
iii. Add back all non cash charges to income and subtract all non cash
components of revenue.
iv. Add or Subtract changes to BS operating accounts (i.e., Current Assets &
Current Liabilities).
CFO under direct method can be prepared using a combination of IS and a CFS under indirect
method.
10. Sources and uses of cash change as the firm moves through its life cycle. When a firm is
in the early stages of growth, it may experience negative operating cash flow as it uses
cash to finance increases in inventory and receivables. Over the long term, successful
firms must be able to generate operating cash flows that exceed capital expenditures and
provide a return to debt and equity holders.
11. An analyst should identify the major determinants of OCF’s. Positive OCF’s can be
generated by the firm’s earnings-related activities. Positive OCF’s can also be generated
by decreasing non-cash working capital such as liquidating inventory and receivables or
increasing payables, which are not sustainable.
12. A stable relationship of OCF and net income is an indication of quality earnings.
Earnings that significantly exceed OCF may be an indication of aggressive or improper
accounting choices.
13. Increasing capital expenditure, a use of cash, is an indication of growth. Selling capital
assets, a source of cash, may result in higher cash outflows in the future as older assets
are replaced.
14. While evaluating cash flows from financing activities, it has to be noted whether a firm
issued debt to reacquire stock or pay dividends.
15. Common-size CFS presents each item as a % of revenue and is useful in identifying
trends and forecasting future cash flows. Alternatively, each inflow can be expressed as
a % of total cash inflows and each outflow can be expressed as a % of total outflows.

VI. FINANCIAL ANALYSIS TECHNIQUES

1. Tools and techniques used to convert FS data into formats that facilitate analysis include:
 Ratio analysis.
 Common-size analysis.
 Graphical analysis.
 Regression analysis.
2. Ratios are often useful in identifying questions rather than answering questions directly.
They can be used to:
 Project future earnings and cash flow.
 Prepare pro forma FS.
 Evaluate a firm’s flexibility (the ability to grow and meet obligations even when
unexpected circumstances arise).
 Assess management’s performance.
 Evaluate changes in firm and industry over time.
 Compare the firm with industry competitors.
Limitations of ratios include:

 They are not useful when used in isolation. They must be viewed in relation to one another.
 Comparisons with other companies are made difficult by different accounting treatments.
 Difficult to find comparable industry ratios when analyzing companies that operate in
multiple industries.
 Determining the target value for a ratio is difficult, requiring some range of acceptable
values.
3. Horizontal common-size BS or IS presents each item as divided by first year values, which
are all standardized to 1.0.
4. Regression analysis can be used to identify relationships between variables. The results are
often used for forecasting.
5. Financial ratios are classified into:
a. Activity ratios.
b. Liquidity ratios.
c. Solvency ratios.
d. Profitability ratios.
e. Valuation ratios.

6. Activity ratios.
 They are also known as asset utilization ratios or operating efficiency ratios.
 They measure how efficiently the firm is managing its assets.
 They include:
i. Receivable turnover.
ii. Days of sales outstanding.
iii. Inventory turnover.
iv. Days of inventory on hand.
v. Payable’s turnover.
vi. Number of days of payables.
vii. Total asset turnover.
viii. Fixed asset turnover.
ix. Working capital turnover.
 An asset turnover ratio that is too high might imply:
 That the firm has too few assets for potential sales or that the asset base is outdated.
 That the firm will probably have to incur capital expenditures in the near future to
increase capacity to support growing revenues.
 Firms with more recently acquired assets will typically have lower fixed assets
turnover ratio.
 Large WCT ratio may indicate low WC. Low WC may result from payables exceeding
inventory and receivables, which is less informative about changes in the firm’s operating
efficiency.
7. Liquidity ratios include:
a. Current ratio. (a CR<1 indicates negative WC)
b. Quick ratio.
c. Cash ratio (more conservative liquidity measure).
d. Defensive interval ratio (the number of days of average cash expenditure the firm
could pay with its current liquid assets).
e. Cash conversion cycle.
8. Solvency ratios.
 These include debt ratios that are based on the BS and coverage ratios that are based
on the IS.
 These ratios include:
I. Debt-to-equity.
II. Debt-to-capital.
III. Debt-to-assets.
IV. Financial leverage.

V. Interest coverage.
VI. Fixed charge coverage ratio (meaningful measure for companies that lease a
large portion of their assets).
Analysts must consider the variability of cash flows when determining the reasonableness of the
ratios. Firms with stable cash flows are usually able to carry more debt.
9. Profitability ratios.
 They measure the overall performance of the firm relative to revenues, assets, equity
and capital.
 These ratios include:
A. Net profit margin (net income from continuing operations should be considered)
B. Gross profit margin (GP can be increased by raising prices or reducing costs.
However, the ability of raising prices may be limited by competition, while reducing
costs may not be sustainable).
C. Operating profit margin (EBIT may include some nonoperating items).
D. Pretax margin.
E. ROA.
F. Operating return on assets.
G. ROTC.
H. ROTE.
I. Return on Common equity.
10. DuPont Analysis.
 ROE = Asset Turnover  Net profit margin  leverage ratio
 ROE = ROA  leverage ratio.
 Leverage ratio is called the equity multiplier.
 ROE = EBIT Margin  Interest burden  Tax burden  Asset Turnover  Leverage ratio.
 A lower ratio indicates higher burden.
 When EBIT is replaced by operating earnings, the interest burden shows the effects of
nonoperating income as well as the effect of interest expenses.
 Generally high leverage will lead to high levels of ROE. However, as leverage rises, so does
the interest burden. Hence, the positive effects of leverage can be offset by the higher
interest payments that accompany more debt.

11. Valuation ratios – Equity analysis.

 Valuation ratios are used in analysis for investments in common equity.
 Per-share valuation measures include:
a. EPS.
b. CF per share.
c. EBIT per share.
d. EBITDA per share.
Per-share measures are not comparable because the number of outstanding shares differs among
firms.
 Sustainable growth rate is how fast the firm can grow without additional external equity
issues while holding the leverage constant.
 Net income per employee and sales per employee are used in analysis and valuation of
service and consulting companies.
 Growth in same store sales is used in restaurants and retail industries to indicate growth
without the effects of new locations that are taking customers from existing ones.
 Different industries have different levels of uncertainty. Comparing coefficients of
variation for a firm across time, or among firm and its peers, can aid the analyst in
assessing both the relative and absolute degree of risk a firm face.
12. Credit analysis.

 The ratios relevant for credit analysis include: interest coverage ratio, ROC, DTA ratios.
 Z-score is useful in predicting firm bankruptcies (a low score indicates high probability of
failure). This model was based on firm’s WC to assets, RE to assets, EBIT to assets, market
to book value of a share of stock, and revenues to assets.
13. Variability of financial outcomes.
 Three methods of examining the variability of financial outcomes around point estimates
are: sensitivity analysis, scenario analysis, and simulation.
 Sensitivity analysis is based on “what if” questions such as 3% increase in sales rather than
estimated 5%.
 Scenario analysis is based on specific scenarios (a specific set of outcomes for key variables)
and will also yield a range of values for FS items.
 Simulation is a 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 of values for the key variables.

VII. INVENTORIES
1. The costs included in inventory are similar under IFRS and US GAAP. These costs known
as product costs, are capitalized in the inventories account on the BS and include:
 Purchase costs less trade discounts and rebates.
 Conversion costs including labor and overhead.
 Other costs necessary to bring the inventory to its present location and condition.
By capitalizing inventory cost as an asset, expense recognition is delayed until the inventory is
sold and revenue is recognized.
Some costs are expensed in the period incurred. These costs, known as period costs, include:
 Abnormal waste of materials, labor, or overhead.
 Storage costs unless required as part of production.
 Administrative overhead.
 Selling costs.
2. Cost flow methods are known as cost flow assumption under US GAAP and cost flow
formula under IFRS. These are used to allocate inventory cost to the IS and BS.
Permissible methods under IFRS are: specific identification method, FIFO and weighted
average cost. Under US GAAP, LIFO method is also permitted.
A firm can use one or more of the inventory cost flow methods. However, the firm must
employ the same cost method for inventories of similar nature and use.
3. FIFO
 Ending inventory is based on the most recent purchases, arguably the best
approximation of current cost. Conversely COGS based on earliest purchases will be
less compared to current cost.
 Higher COGS (better approximation of current cost) under LIFO leads to lower
reported earnings and lower taxes and increased cash flows. It results in peculiar
situation where lower reported earnings are associated with higher cash flow from
operations. Ending inventory will be less than current cost.

4. Inventory recording systems.

 In a periodic inventory system, inventory values and COGS are determined at the end of the
accounting period.
 In a perpetual inventory system, those values are updated continuously. That is to say each
unit withdrawn will be matched with immediately preceding purchases.
 For the FIFO and specific identification methods, these values will be same under both
methods and differ for LIFO and weighted average. However, higher COGS and lower
ending inventory under LIFO still holds good irrespective of the method of recording
inventory.
5. In a period of changing prices and with stable or increasing inventory quantities, FIFO
provides the most useful measure of ending inventory in the BS, while LIFO produces a
better approximation of current cost in the IS.
6. All profitability measures will be affected by the choice of cost flow method. Any
profitability measure that includes COGS and current ratio will be lower under US
GAAP. Quick ratio is not affected by the choice of inventory method as it excludes
inventory. Inventory turnover ratio is also lower under LIFO with higher numerator
and lower denominator. LIFO results in lower assets and lower net income and lower
equity and higher debt-to-equity ratios. A written down may significantly affect
inventory turnover in current and future periods. Thus, comparison of ratios across time
may be an issue.
7. The written down or subsequent write-up, of inventory is usually accomplished through
the use of a valuation allowance account. It is a contra-asset account and is used to
separate the original cost of inventory from the carrying value of inventory.
8. Minimum market value under US GAAP is NRV minus normal profit margin and
maximum value will be NRV. Therefore the range permitted for market value is normal
profit margin.
9. Under LIFO ending inventory will be lower. Because cost is the basis for determining
whether impairment has occurred, LIFO firms are less likely to recognize inventory
write downs. Write-up of inventory is not permitted under US GAAP.
10. In certain industries (commodity like producers such as agricultural and mineral ores)
where reporting inventory at NRV is permitted (even if NRV is above historical cost)
any unrealized gains and losses from changing market prices are recognized in the IS. (If
active market exists, quoted market price is used or else recent market transactions are
used).

11. Inventory disclosures under IFRS and US GAAP.

a) The cost flow method used.
b) Carrying value of inventory by classification.
c) Carrying values reported at FV less selling costs.
d) Write downs and write-up’s, including a discussion of the circumstances of the
reversal.
e) Carrying value of inventories pledged as collateral.
12. Inventory changes.

 Changes in cost flow methods are made retrospectively, and the cumulative effect
of change is reported as an adjustment to the beginning retained earnings of the
earliest year presented.
 When a firm changes from LIFO to another cost flow method, the change is
applied prospectively. In such case carrying value is used as the first layer of
inventory under LIFO.
 Under IFRS, the firm must demonstrate that the change will provide reliable and
more relevant information. Under US GAAP, the firm must explain why the
change is preferable.
13. Inventory turnover that is too low (i.e., higher ending inventory):
 Implies slow-selling or obsolete products.
 Results in higher storage costs.
 Cash tied-up, that might be used more effectively.
 In case of luxury goods, low turnover may be coupled with high gross profit
margin.
 Lower turnover and lower gross profit margin may indicate that the firm has
reduced its prices to sell its inventory.
High turnover ratio:
 Results in loss of potential sales.
 May indicate inventory write downs.
High turnover together with slower growth may be an indication of inadequate
inventory quantities. Alternatively, sales growth at or above the industry average
supports the condition that high inventory turnover reflects greater efficiency.

VIII. LONG-LIVED ASSETS

A. Capitalizing Versus Expensing
1. An expenditure that is expected to provide a future economic benefit over multiple
accounting periods is capitalized. However, if the future economic benefit is unlikely or
highly uncertain, the expenditure is expensed in the period incurred.
2. Allocation of capitalized expenditure to the IS through depreciation expense, reduces the
variability of net income by spreading the expense over multiple periods.
3. The choice between capitalizing costs and expensing them will affect cash flows from
operations, cash flows from investing, and numerous financial ratios.
4. Total assets are greater with capitalization resulting in higher equity and liabilities are
unaffected.
5. Capitalizing expenditure will result in higher operating cash flow compared to expensing.
Assuming no differences in tax treatment, total cash flows will be the same. If the tax
treatment is changed to match the financial reporting treatment of the expenditure,
expensing will result in higher operating cash flow in the first year because of the tax
savings.
6. Debt-to-assets ratio and the debt-to-equity ratios are lower with capitalization due to higher
asset and equity base (larger denominator). It also results in higher ROE & ROA because of
higher earnings.
7. For an expensing firm, net income is higher in subsequent years and assets and equity are
lower as no asset is capitalized and also no depreciation expense in the subsequent years as
the entire expenditure is recognized in the first year itself.
Immediately recognizing expenditure gives the appearance of growth after the first year.
B. Construction Interest.
 Interest on the construction costs of assets constructed for own use or for resale, is
capitalized. Interest on general corporate debt in excess of project construction costs is
expensed.
 If no construction debt is outstanding, the interest rate is based on existing unrelated
borrowings.
 Under IFRS income earned by temporarily investing borrowed funds reduces the interest
that is eligible for capitalization. There is no such reduction of capitalized interest under
US GAAP.

 Capitalized interest is reported in the CFS as an outflow from investing activities, while
interest expense is reported as an outflow from operating activities.
 Capitalization of interest results in lower interest expense and higher interest coverage ratio.
C. Intangible Assets
 Under IFRS, an identifiable intangible asset must be:
i. Capable of being separated from the firm or arise from a contractual or legal right.
ii. Controlled by the firm.
iii. Expected to provide future economic benefits.
iv. Assets’ cost must be readily measurable.
 An unidentifiable intangible asset is one that cannot be purchased separately and may have
an indefinite life. Goodwill is said to an unidentifiable asset that cannot be separated from
the business itself.
 G/w created in business combination is capitalized while internally generated G/w is
expensed.
 Accounting for an IA depends on whether the asset was:
 Created internally;
 Purchased externally; or
 Acquired in a business combination.
 Under IFRS research costs are expensed while development costs are capitalized. Under US
GAAP both R&D costs are expensed expect software development expense.
 Costs incurred to develop software for sale to others are expensed as incurred until the
product’s technological feasibility has been established, after which costs are capitalized
under both IFRS and US GAAP.
 Under IFRS, treatment is same whether the software is developed for sale or for a firm’s
own use. Under US GAAP, all R&D costs are capitalized when a firm develops software for
its own use.
 If the intangible asset is purchased as part of a group, the total purchase price is allocated to
each asset on the basis of its FV. For analytical purposes, an analyst is usually more
interested in the type of asset acquired rather than the value assigned on the balance sheet.
For example, recently acquired franchise rights may provide insight into the firm’s future
operating performance. In this case, the allocation of cost is not as important.
 Estimating useful life for an IA is complicated by many legal, regulatory, contractual,
competitive, and economic factors that may limit the use of IA.
 Goodwill is an example of Unidentifiable IA with indefinite life. Trade mark is an example
of identifiable IA with indefinite life.

D. Depreciation
 The analyst must decide whether the reported depreciation expense is more or less than
economic depreciation, which is the actual decline in the value of the asset over the period.
E.g., video rental stores.
 Salvage value is not used in computing depreciation under DDB. However, once the
carrying value of the asset reaches the salvage value, no additional depreciation expense is
recognized.
 The unit of production method applied to natural resources is referred to as depletion.
 Calculating the depreciation expense requires estimating an asset’s useful life and its
salvage value. Firm’s can manipulate depreciation expense, and therefore net income, by
increasing or decreasing either of these estimates. A change in any of the estimates is
applied prospectively.
 Estimates are also involved when a manufacturing firm allocates depreciation expense
between COGS and SG&A. While the allocation does not affect a firm’s operating margin, it
affects the firm’s gross margin and operating expenses.
 IFRS requires firms to depreciate the components of an asset separately, thereby requiring
useful life estimates for each component. Component depreciation is allowed under US
GAAP but is not mandated.
E. Revaluation
 Under US GAAP long-lived assets are reported at depreciated cost. There is no fair value
alternative for asset reporting.
 IFRS permits revaluation resulting in long-lived assets to be reported at FV’s as long as
active markets exist for the assets so that their FV can be reliably estimated. Same treatment
must be used for similar assets.
 An increase in the assets value above HC is reported as a component of shareholder’s
equity in an account called revaluation surplus.
 Revaluing asset upward results in greater total assets, greater shareholder’s equity, higher
depreciation expense and lower profitability in periods after revaluation.
F. Impairment
 Under IFRS, firms must annually assess whether events or circumstances indicate an
impairment of an asset’s value has occurred. Under US GAAP, an asset is tested for
impairment only when E&C indicate that the firm may not be able to recover the carrying
value through future use.

 Under IFRS, the impairment loss to the extent of the same recognized earlier can be
reversed. Under US GAAP loss recoveries are not permitted.
 Under US GAAP undiscounted cash flows are used to test the impairment. If found an asset
impaired, the same is calculated using discounted cash flows if the FV of the asset is not
known.
 If a firm reclassifies a long-lived asset from held for use to held for sale, the asset is no
longer depreciated or amortized but tested for impairment. For LLA’s HFS, the loss can be
reversed both under IFRS and US GAAP.
G. Disclosures relating to PPE.

 Under IFRS the firms must disclose:
1. Basis for measurement.
2. Useful lives or depreciation rate.
3. Gross CV and AD.
4. Reconciliation of beginning and ending CV’s.
5. Title restrictions and assets pledged as collateral.
6. Agreements to acquire PPE in future.
7. The revaluation date.
8. How FV is determined.
9. CV using HC in case of revaluation.
10. Whether the useful lives of IA’s are finite or indefinite.
11. Amount of IL’s and reversals.
12. Circumstances that caused the IL or reversal.
 Under US GAAP the firms must disclose:
a. Depreciation expense.
b. Balances and AD of major classes of assets by nature and function.
c. General description of depreciation methods used.
d. An estimate of amortization expense of IA’s for the next five years.
e. A description of the impaired asset.
f. Circumstances that caused the impairment.
g. How FV was determined.
h. The amount of IL.

H. Investment property
 Under IFRS, property that a firm owns for the purpose of collecting rental income,
earning capital appreciation, or both, is classified as investment property. US GAAP does
not distinguish between IP from other kinds of LLA’s.
 For IP, revaluation above HC is recognized as a gain on the IS.
 Firms that use the cost model must disclose the FV of IP.
 Transfers to or from IP:
Transfer from Transfer to FS treatment
Owner occupied IP Treat as revaluation: recognize
Gain only if it reverses
Previously recognized loss.
Inventory IP Recognize G/L if FV is
Different from CV.
IP Owner occupied or FV of asset at date of
Inventory Transfer will be its cost under
New classification.

IX. INCOME TAXES

1. Tax Return Terminology:
a. Taxable Income- Income subjected to tax based on the tax return.
b. Taxes Payable- The tax liability on the BS caused by taxable income. This is also
known as current tax expense.
c. Income tax paid – The actual cash flow for income taxes including payments or
refunds from other years.
d. Tax loss carry forward - A current or past loss that can be used to reduce taxable
income (thus, taxes payable) in the future.
e. Tax base of an asset is the amount that will be deductible for tax purposes in future
periods.
f. Tax base of a liability is the carrying amount of the liability less any amounts that will
be deductible for tax purposes in the future. With respect to payments from customers
received in advance of providing the goods and services, the tax base of such a liability
is the carrying amount less any amount of the revenue that will not be taxable in
future.
An analyst shall not only evaluate the difference between the tax base for tax
purposes and carrying amount of accounting records, but the relevance of that
difference on future profits and losses and thus by implication future taxes.
2. Financial Reporting Terminology:

i. Accounting profit – EBT based on FAS. As such accounting profit does not include a
provision for income tax expense.
ii. Income tax expense – Expense recognized in the IS that includes taxes payable and
changes in DTA/L.
iii. Valuation allowance – Reduction of DTA based on the likelihood that assets will not
be realized.
3. Classification of Deferred Tax Asset /Liability.
 Under IFRS, DTA/L’s are always classified as noncurrent.
 Under U.S. GAAP, DTA/L’s are classified as current and noncurrent based on the
classification of the underlying asset or liability.

4. Criteria for recognizing DTA/L:

a) If at all it is doubtful that whether future economic benefits will be realized from a
temporary difference, the TD will not lead to the creation of a DTA/L.
b) If a DTA/L resulted in the past, but the criteria of economic benefits is not met on the
current balance sheet date, then under IFRS, an existing DTA/L related to the item
will be reversed. Under U.S. GAAP, a valuation allowance is established.
Both IFRS and U.S. GAAP prescribes the balance sheet liability method of recognition of
deferred tax. It focuses on recognition of a DTA/L if there is a temporary difference between
the carrying amount and tax base of balance sheet items.
The net change in deferred tax during a reporting period is the difference between the
balance of the DTA/L for the current period and the balance of the previous year.
5. Differences between the treatment of an accounting item for tax reporting and for FR can
occur when:
 There are differences in the timing of recognition.
 Assets/Liabilities have different carrying values and tax bases.
 Tax losses from prior periods may offset future taxable income.
 The deductibility of gains and losses of assets and liabilities may vary for accounting
and income tax purposes.
 Adjustments of reported financial data from prior years might not be recognized
equally for accounting and tax purposes or might be recognized in different periods.
6. When the income tax rate changes, the BS values of DTA/DTL must be changed to reflect to
new rate because the new rate is the rate expected to be in force when the associated
reversals occur. This change also affects income tax expense in the current period.
7. The statutory tax rate and the firm’s effective tax rate differ due to permanent differences
and also when the firm is operating in more than one tax jurisdiction and also due to tax
holidays in some countries.
Reported effective tax rate = Income tax expense / Pretax income (Accounting profit)
8. Temporary differences can be:
 Taxable TD’s that result in a taxable amount in a future period when determining the
taxable profit as the balance sheet item is recovered or settled. TTD’s result in a DTL:
a. When the carrying amount of an asset > tax base.
b. When the tax base of the liability > Carrying amount.
 Deductible TD’s result in a reduction or deduction of taxable income in a future
period when the balance sheet item is recovered or settled. They result in DTA when:
a. The tax base of asset > Carrying Amount.

b. The carrying amount of the liability > Tax base.

The recognition of a DTA is only allowed to the extent there is a reasonable expectation of future
profits against which the asset or liability (that gave rise to the DTA) can be recovered or settled.
To determine the probability of sufficient future profits for utilization, one must consider the
following:
i. Sufficient TTD’s must exist that are related to the same tax authority and the same
taxable entity; and
ii. The taxable temporary differences that are expected to reverse in the same periods as
expected for the reversal of the DTD’s.
 TD’s can also result from the choice of inventory cost-flow method. In US if LIFO is used for
accounting purposes, then it should only be used for tax purposes too resulting in no TD.
9. Although DTA or DTL is expected to reverse in future, they are not discounted to present
value.
10. Valuation Allowance Account.
 Used only for DTA’s
 Contra account used to reduce BS value of DTA when it is more likely than not that some or
all of the DTA will not be realized.
 Increasing the VA will decrease DTA, increase income tax expense and decrease net income.
 If a company has order backlogs or existing contracts which are expected to generate future
taxable income, a VA might be necessary.
 If a company has cumulative losses over the past few years or a history of inability to use
tax loss carry forwards, then the company would need to use a VA to reflect the likelihood
that a DTA will never be realized.
 Management can manipulate earnings by changing VA as decrease in VA increases
earnings.
11. Unused tax losses and tax credits: when assessing the probability that sufficient taxable
profit will be generated in the future, the following criteria can serve as a guide:
a. A DTA as a result of losses and tax credits is only recognized to the extent of the
available TTD’s.
b. Assess the probability that the entity will in fact generate future taxable profits
before the unused tax losses or credits expire pursuant to tax rules regarding the
carry forward of the unused tax losses.
c. Determine whether the past tax losses were as a result of specific circumstances that

are unlikely to be repeated; and

d. Discover if tax planning opportunities are available to the entity that will result in
future profits. These may include changes in tax legislation that is phased in over
more than one financial period to the benefit of the entity.
12. DTL:
a) A DTL will not be recognized at the initial recognition of goodwill. Any impairment of
goodwill for accounting purposes, to the extent that it is related to the goodwill at initial
recognition, should not result in any deferred taxation. Any future differences between the
carrying amount and tax base as a result of amortization and the deductibility of a portion
of goodwill constitute a temporary difference for which provision should be made.
b) Results from accelerated depreciation methods used for tax reporting purposes which
defer tax payments. The analyst should consider the firm’s growth rate and capital
spending levels when determining whether the difference will actually reverse.
c) Gain on sale of asset would reverse the DTL as the WDV for tax purposes is lower
resulting in higher tax payments.
d) If DTL’s are not expected to reverse in future, they will be classified as equity or else
classified as liability.
13. DTA:
 Impairments results in DTA since the write down is recognized immediately in the IS, but the
deduction on the tax return is generally not allowed until the asset is sold or disposed of.
 Restructuring expenses results in DTA as they are recognized in IS when restructuring is
announced but not deducted for tax purposes until actually paid.
 Post-employment benefits and deferred compensation and warranty expenses results in
DTA.
 Taxes payable higher than tax expense results in DTA.
 Delayed recognition of expense results in DTA.
 Recognizing an expense for accounting purpose and capitalizing the same for tax purposes
results in DTA due to amortization expense in subsequent periods.
 A deferred tax adjustment is made to stockholders’ equity to reflect the future tax impact of
unrealized gains or losses on AFS marketable securities that are taken directly to equity. No
DTL is added to the BS for the future tax liability when gains/losses are realized.

14. Recognition and Measurement of Current Tax and Deferred Tax:

a. Current taxes are based on the tax rates prevailing at the balance sheet date. Deferred taxes
should be measured at the tax rate that is expected to apply when the asset is realized or
the liability settled.
b. There may be different forms of tax such as income tax, capital gains tax and dividend
distribution tax etc. It would be prudent to use the tax rate and the tax base that is
consistent with how an asset or liability is expected the tax base will be recovered or
settled.
c. Deferred taxes should be recognized on the income statement unless:
 Taxes or deferred taxes charged directly to equity, or
 A possible provision for deferred taxes relates to a business combination.
d. The carrying amounts may change even though there may have been no change in
temporary differences during the period evaluated. This can result from:
i. Change in tax rates.
ii. Reassessments of the recoverability of deferred tax assets; or
iii. Changes in the expectations for how an asset will be recovered and what influences
the DTA/L.
e. All unrecognized DTA/L’s must be reassessed at the BLS date and measured against the
criteria of probable future economic benefits. If such a DTA is likely to be recovered, the
same may be recognized.
15. Examples of deferred taxes that should be taken directly to equity:
 Revaluation of PPE. Only the portion of the difference between the tax base and
carrying amount that is not a result of the revaluation is recognized as giving rise to
a DTL. The effect of the revaluation surplus and the associated tax effects are
accounted for in equity. The revaluation surplus is reduced by the tax provision
associated with the excess of FV over the carrying value. At the end of each year, an
amount equal to the depreciation as a result of the revaluation minus the deferred
tax effect will be transferred from the revaluation reserve to retained earnings.
 Long-term investments at FV.
 Changes in accounting policies.
 Errors corrected against the opening balance of retained earnings.
 Initial recognition of an equity component related to complex financial instruments.
 Exchange rate differences arising from the currency translation procedures for
foreign operations.
 Deferred taxes related to a business combination.

16. Disclosures in FS:

 Companies are required to disclose details of the sources of the TD’s that cause the DTA
and DTL reported on the BS.
 DTL, DTA, VA, net change in VA.
 Unrecognized DTL for undistributed earnings of subsidiaries and JV’s.
 Reconciliation of reported tax expense and the tax expense based on the SR.
Understanding the differences in these two tax amounts will enable the analyst to better
estimate future earnings and cash flow. In analyzing trends in tax rates, it is important to
only include reconciliation items that are continuous in nature rather than those that are
sporadic. The more volatile the special items the more difficult for the analyst to forecast
the ETR for the foreseeable future without additional information. This volatility also
reduces comparability with other firms.
 Tax loss carry forwards and credits.
17. Comparison between US GAAP and IFRS.
Distinguishing feature US GAAP IFRS

a) Revaluation of fixed Not applicable, no revaluation Deferred taxes are recognized in
assets and IA. allowed. equity.
b) Undistributed profit No DTs for foreign subsidiaries DT’s are recognized unless the
from an investment in a or JV’s that meet the indefinite parent or venture or investor is able
subsidiary or JV. reversal criterion to control the distribution of sharing
c) Undistributed profit DTs are recognized for TD’s of profit and its probable that the
from an investment TD’s will not reverse in the future.
associate.
d) DA recognition Recognized in full and then Recognized if probable that
reduced if more likely than not sufficient taxable profit will be
that it will not be realized. available to recover the asset.
e) Tax rates used to Enacted tax rates only Enacted or substantially enacted tax
measure DT’s rate.
f) Presentation of DT’s Classified as current or Netted and classified as noncurrent.
on the BS. noncurrent based on the
classification of the underlying
asset or liability. DTA and DTL
are not netted off.
g) Goodwill DTA/L is not recognized for un A deferred tax account is not
amortizable goodwill. recognized for goodwill arising in a
business combination. IAS-12 does
not allow the creation of a DTA
arising from negative goodwill.

h) Exemption No exemption provided An exemption is provided for the

(deferred tax is not initial recognition of an asset or
provided on the liability in a transaction that:
temporary i. Is not a business combination;
difference) and
ii. Affects neither accounting
profit nor taxable profit at the
time of the transaction.
i) Tax losses and tax DTA creation is allowed DTA creation is allowed
credits

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Financial Reporting

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CA. Adithya Kiran F.C.A. C.F.A (U.S.A), CCO (IIBF).

I. FINANCIAL STATEMENT ANALYSIS: AN

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8. Management’s discussion and analysis (MD&A) section of the annual report

10. Besides the annual financial statements, an analyst should examine a

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c) Form 10-Q: quarterly FS.

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II. FINANCIAL REPORTING MECHANICS

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11) Information flows through an accounting system in four steps:

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III. FINANCIAL REPORTING STANDARDS

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5. Barriers to convergence of accounting standards:

7. FS are relevant if the information contained in them can:

8. Information that is faithfully representative is complete, neutral (absence of bias),

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depreciation, amortization, depletion and impairment), current cost, realizable

12. The required FS are: BS – SCI – CFS – SCOE – Exp notes

13. Features for preparing FS are:

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c) FASB does not allow upward valuation of most assets.

18. Management can:

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IV. UNDERSTANDING INCOME STATEMENTS

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In a barter transaction, two parties exchange goods or services without cash

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V. UNDERSTANDING BALANCE SHEETS

1. The BS can be used to assess a firm’s :

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10. Non-current Assets.

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 UG&L on AFS securities are reported in other comprehensive income as a part of

11. Owners’ equity.

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V. UNDERSTANDING CASH FLOW STATEMENTS

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VI. FINANCIAL ANALYSIS TECHNIQUES

Limitations of ratios include:

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11. Valuation ratios – Equity analysis.

12. Credit analysis.

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4. Inventory recording systems.

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11. Inventory disclosures under IFRS and US GAAP.

12. Inventory changes.

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VIII. LONG-LIVED ASSETS

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G. Disclosures relating to PPE.