Review of Financial Reporting & Analysis

1. Review of Financial Reporting & Analysis Prof. Phil Drake

2. CFA Exam Weights

3. Our Approach Tonight • We have only two hours. • Giddy up • The emphasis is on review. • You should know this material, but not at the depth you need to understand. • Assume you know how the financial statements articulate. • Focus on the balance sheet, then the income statement … you are on your own for the rest.

4. Asset Definition • Probable future economic benefit • Obtained or controlled by the entity • As a result of past transactions Current vs. Non-Current - based on year or operating cycle, which ever is longer.

5. Cash and Cash Equivalents • Cash, of course. • Equivalents include money market instruments such as ST CDs, high quality commercial paper, Treasuries, money market funds that mature in three months or less. • Typically reported at fair value. Amortized cost is permitted, but infrequently selected.

6. Investments in Debt Securities Three Categories • Held to Maturity • Requires ability and intent • Available for Sale • Cash Management • Trading • Intent to sell in the near term

7. Accounting for Debt Securities Accounting & Valuation • Held to Maturity • Interest revenue, gain/loss on sale • Reported on balance sheet at amortized cost • Available for Sale • Interest revenue, gain/loss on sale • Fair value … with Unrealized Holding G/L to Comprehensive Income (i.e., equity) • Trading • Interest Revenue, gain/loss on sale • Fair value … with Unrealized Holding G/L to Current Income (i.e., Income Statement, then Retained Earnings)

8. Investments in Equity Securities Accounting is based on level of influence • Minority, Passive (less than 20% ownership) • Fair Value Method • Minority, Active (20% - 50% ownership) • Equity Method • Majority, Active (more than 50% ownership) • Consolidation Method

9. Accounting for Equity Securities Accounting for Minority, Passive Investments • Readily Determinable Fair Values • Dividend Income, gain/loss on sale to Income Statement • Fair value … with unrealized holding gains/losses to current income • No Readily Determinable Fair Values • Dividend Income, gain/loss on sale to Income Statement • Report at cost, less impairment. The carrying amount should be subsequently adjusted for observable price changes with the unrealized holding gains/losses to current income

10. Accounting for Equity Securities Accounting for Minority, Active Investments Record purchase at cost. Single line acquisition If purchase price exceeds proportionate share of investee’s book value, identify fair values of underlying assets & liabilities. Recognize proportionate share of investee’s income as an increase in the Investment Recognize proportionate share of investee’s dividends as reduction in Investment

11. Valuation Passive Investments: Fair Value Method Annual Adjustment Unrealized Holding G/L in current income Significant Influence: Equity Method Annual Adjustment Proportional Share of Income = Income Proportional Share of income less Dividends = Investment Adjustment

12. Consolidations Basic Idea: The Parent company along with its Subsidiaries are a single economic unit. Combine the financial results for Parent & all Subsidiaries, then • Eliminate Intercompany Payables • Eliminate Intercompany Sales • Eliminate double-counting of Investment • Eliminate double-counting of Income

13. Consolidations – non-controlling Interests Non-controlling Interest - (aka Minority Interests) Occurs when the Parent does not own 100% of the subsidiary. The percentage of ownership not controlled by the Parent. For the Balance Sheet, Non-controlling Interests represent the percent of net assets (assets less liabilities of the subsidiary). Appears between Liabilities & Equities For the Income Statement, Non-controlling Interest is the percentage of subsidiary income held by the minority shareholders.

14. Consolidating Foreign Subsidiaries Companies often have international subsidiaries that must be consolidated with the Parent’s financial statements. Typically, the subsidiaries accounts are maintained with local currency (and, sometimes, local GAAP). The amounts on the foreign subsidiaries financial statements must be translated in U.S. dollars. To translate a foreign subsidiary’s financial statements into U.S. dollars, conversion is made with both Historical Exchange Rates (those which existed at the time a transaction occurred) and Current Exchange Rates (Exchange rates which exist as of the balance sheet date)

15. Consolidating Foreign Subsidiaries The use of different exchange rates means the resulting financial statements will not balance. To force the statements to balance, an account called “Translation Adjustment” is used. Two approaches are used depending on the independence of the subsidiary from the Parent company. • Self-contained: All-current method (local currency is functional) • Extension of US Parent: Monetary-Nonmonetary method (US dollar is functional currency) Subsidiaries in countries with hyperinflation (100+%) use the U.S. dollar as the functional currency.

16. Accounts Receivable Involves the application of two concepts – Definition of an Asset & Matching Definition of an asset: • Probable future economic benefit • Obtained or controlled by the entity • As a result of past transactions What is the cost of extending credit? • Bad debts.

17. Accounts Receivable Acct Rec. Allowance for Bad Debts What I can Collect Beg. Bal. Beg. Bal. Collections Bad Debt Expense Sales Write-Offs Write-Offs End Bal. End Bal. What I expect to Collect Net Account Receivable

18. Accounts Receivable Example Year 1 Sales $1,500,000 December 31, Year 1 Accounts Receivable $175,000 Allowance for Bad Debts (10,000) Accounts Receivable, net $165,000 Based on Analysis Goes to the Balance Sheet

19. Accounts Receivable Example December 31, Year 1 Bad Debt Expense $10,000 Allowance for Bad Debts $10,000 This entry applies the two important concepts: - matching expenses with the related revenues - recording the asset at its net realizable value (NRV)

20. Accounts Receivable Example Year 2 Sales $5,000,000 Identified and wrote-off as uncollectible $21,500 of accounts receivable. Allowance for Bad Debts $21,500 Accounts Receivable $21,500 Note, No impact of Net A/R

21. Accounts Receivable Example Year 2 December 31, Year 2 Accounts Receivable $330,000 Allowance for Bad Debts (25,000) Accounts Receivable, net $305,000 Based on Analysis Goes to the Balance Sheet

22. Accounts Receivable Example Allowance for Bad Debts December 31, Year 2 Bad Debt Expense $36,500 Allowance for Bad Debts $36,500 10,000 Beg. Balance Write-Offs 21,500 36,500 Bad Debt Exp. 25,000 End Balance

23. Inventory – Basic Approach Beg. Inventory + Purchases Cost of Goods Available for Sale Sold Not Sold Cost of Goods Sold (Income Statement) End. Inventory (Balance Sheet)

24. Inventory – Costing Methods Beg. Inventory 300 units @ $10 per unit Purchase 100 units @ $12 per unit Sale 200 units @ $30 per unit Purchase 600 units @ $14 per unit Purchase 200 units @ $15 per unit Sale 600 units @ $30 per unit End Inventory 400 units LIFO – Periodic Cost of Goods Sold $11,400 Ending Inventory $ 4,200 LIFO – Perpetual Cost of Goods Sold $10,800 Ending Inventory $ 4,800

25. Inventory – Costing Methods Ending Inventory FIFO Periodic $ 5,800 FIFO Perpetual 5,800 LIFO Periodic $ 4,200 LIFO Perpetual 4,800 W/A Periodic $ 5,200 W/A Perpetual 5,400 Cost of Goods Sold FIFO Periodic $ 9,800 FIFO Perpetual 9,800 LIFO Periodic $11,400 LIFO Perpetual 10,800 W/A Periodic $10,400 W/A Perpetual 10,200

26. Inventory – Valuation (LCM) • After determining FIFO/LIFO/W-A Ending Inventory, must compare to market valuation. • Follows the definition of an asset • Report on the balance sheet, the lower of cost or market. Write-downs of inventory from cost to market are included in cost of goods sold. • Can establish a reserve account for obsolesce.

27. Inventory – LIFO Layers As inventory levels increase, a LIFO layer is added. Can result in very old costs embedded in inventory. 15 units at $20 per unit 20 units at $17 per unit 40 units at $13 per unit 100 units at $10 per unit

28. Inventory – LIFO Liquidations Assume current costs are now $25 per unit. Delay purchases to “dip” into the LIFO layers … Instead of CGS at $25 per unit, now it is $20, then $17, then $13 and eventually, $10 per unit 15 units at $20 per unit 20 units at $17 per unit 40 units at $13 per unit 100 units at $10 per unit

29. Inventory – LIFO Liquidations LIFO Liquidations come at a very high cost – taxes!! LIFO Conformity rule states that if you use LIFO accounting for your tax return, you use it for your financial statements as well. It costs real money to dip into your LIFO Layers.

30. Inventory – Comparability • BIF + P – CGSF = EIF • BIL + P – CGSL = EIL • P = CGSL + EIL – BIL Substitute 3 into 1 • BIF + (CGSL + EIL – BIL) – CGSF = EIF Rearrange … CGSF = CGSL - [(EIF - EIL) – (BIF - BIL)] CGSF = CGSL – (LIFO ReserveE – LIFO ReserveB) CGSF = CGSL – Change in LIFO Reserve

31. Inventory – Comparability Assume rising inventory costs and stable or Increasing inventory levels.

32. Inventory - Summary Inventory Beg. Bal. Cost of Goods Sold Purchases Obsolescence End. Bal.

33. Long-Lived Assets – Major Issues Multi-period assets whose costs are matched to the revenues they help generate. • Smooths the impact on income (Asset) Capitalize Allocate Costs Expense Impairment Issues Based on the definition of an asset Great opportunities to shift expenses from one period to another.

34. Long-lived Assets Acc. Depreciation Long-lived Asset Beg. Bal. Beg. Bal. Disposals Disposals Depreciation Expense Acquisitions Impairments Impairments End Bal. End Bal.

35. Long-lived Assets – Acquisitions Acquisition Cost – All the costs necessary to ready the asset for its intended use. Specialized machinery for a manufacturer. Invoice price Taxes Delivery charges Speeding ticket during delivery Installation costs (including repouring floor) Repair work for damage during installation Setup costs (labor and materials)

36. Long-lived Assets – Depreciation Depreciation – Allocating the cost of the asset over the period of benefit. Accounting depreciation ≠ Economic Depreciation Depreciable amount = Acquisition Cost less Residual Value Cost - $1,000,000 Residual Value - $250,000 Depreciable Amount - $750,000 The amount to be expensed over the estimated useful life of the asset.

37. Long-lived Assets – Depreciation Methods Straight-Line: Simple and most pervasive. Other methods: Sum-of-the-years digits Units of production Declining balance MACRS (tax return only) Depreciation Expense Book Value

38. Long-lived Assets – Betterments vs. Repairs Betterment – Costs incurred after the asset has been placed in service. A betterment extends the asset’s useful life, increases the asset’s productive capacity, or increases the asset’s productive efficiency. Capitalize costs incurred. Repairs – No increase in economic benefit or increased service potential. Expense costs as incurred.

39. Long-lived Assets – Disposals & Exchanges Disposal – Compare the asset’s book value to the value received from the sale. The difference is either a gain or loss. Exchange – One productive asset (e.g., inventory) for another asset (e.g., equipment). General rule: The new asset is recorded as the Fair market value (FMV) of the asset exchanged. Exceptions for exchanges of similar assets or where FMV is not ascertainable.

40. Long-lived Assets – Change in market Value Revaluation – Not with U.S. GAAP. However, IFRS and other countries allow revaluation up to market value. Impairments – Decline in market value of an asset. There are different kinds of tests for different kinds of long-lived assets.

41. Long-lived Assets – Acquired Intangibles Acquired Business Tangible Assets Identifiable Intangibles Other Balance Sheet Marketing related Customer related Technology related Contract related • Trademarks • Trade names • Marketing materials • Style guide (unique color, shape or package design) • Mastheads • Domain names • Distributor relationships • Retailer relationships • Order or production backlog • Contractual and non-contractual customer relationships • Trade secrets, such as secret formulas, processes or recipes • Patented and un-patented technology • Computer software • Databases • Supply contracts • Advertising, management & service contracts • Licensing & royalty agreements • Lease agreements • Construction permits • Franchise agreements • Non-compete agreements

42. Goodwill Goodwill arises when the purchase price paid for another business exceeds the fair market value of the acquired net assets of that business. $10 million $1 million - Goodwill $1 million - Identifiable Intangibles $3 million - Excess net asset FMV over BV $5 million - Net asset book value Allocation Consideration transferred

43. Long-lived Assets – Intangibles Amortization Depends on the type of intangible asset it is. • Limited Life intangible assets • Amortize straight-line over estimated economic life. • Indefinitive Life intangible assets • Assets that the firm intends to maintain for an unknown period of time. • No amortization. • Goodwill • No amortization.

44. Long-lived Assets – Impairments Property, Plant & Equipment and Limited Life Intangible Assets (Category 1) Two Step Impairment Test: Step one: Compare future estimated undiscounted cash flows to book value. If cash flows are less than book value, the asset is impaired. Step two: Write the asset down to either fair market value (FMV) or discounted future cash flows & recognize the impairment loss.

45. Long-lived Assets – Impairments Indefinite-Life Intangible Assets (other than Goodwill) (Category 2) One Step Impairment Test: Step one: Write the asset down to either fair market value (FMV) or discounted future cash flows if below book value.

46. Long-lived Assets – Impairments Goodwill (Category 3) Two Step Impairment Test: Step one: Compare the fair value of the reporting unit to its book value including goodwill If fair value is below book value, then go to step two. Step two: Determine the implied fair value of goodwill by comparing the fair value of the reporting to the fair value of net identifiable assets. Write goodwill down if needed.

47. Long-lived Assets – Impairments The FASB added a new Step Zero for Intangibles and Goodwill. • Step zero is an optional, qualitative assessment. • If determined that it is more likely than not (i.e., a greater than 50% likelihood) that the fair value of a reporting unit exceeds its carrying value, then no further work required.

48. Liabilities – Major Issues Fixed Payment Dates & Amts. Fixed Payment Amts, Est. Dates Est. Date & Amount Advances & Unexecuted Agreements Mutually Executed Contracts Contingent Obligations Note Payable Interest Pay. Bonds Pay. Accounts Pay. Taxes Pay. Warranties Payable Rental Fees Subscriptions Insurance Purchase Employment Commitments Pending Lawsuits Off BS Instruments Generally Not Recognized as Accounting Liability Recognized as Accounting Liabilities

49. Liabilities – Basic Definition Probable future economic sacrifice, The obligation belongs to the firm, and Is the result of past transactions. Parallels the definition of an asset.

50. Liabilities – Current • Accounts payable • Wages, salaries, and other payroll items • Short-term notes and Interest payable • Warranties – Matching concept. • Estimate the warranty liability at the time of sale and record the expense. • Reduce the liability based on actual costs incurred.