Review for Analysis and Use of Financial Statements
Learning Outcome Statements (LOS) Aftercompleting this session, students should be able to: identify the groups (operating, investing and financing activities) into which business activities are categorized for financial reporting purposes and classify any business activity into the appropriate group. state fundamental principles for preparing financial statements as stated in IAS No.1
Categories of Business Activities Businesstransactions can be categorized as: Operating activities- the firm’s ordinary business. Investing activities- purchasing, selling and disposing of long-term assets. Financing activities- raising and repaying capital.
Fundamental Accounting Principles under IAS No.1 Thefundamental principles for preparing financial statements as stated in IAS No.1 include:
Learning Outcome Statements (LOS) Aftercompleting this session, students should be able to: explain the general principles of revenue recognition and accrual accounting. discuss the general principle of expense recognition and the implications of expense recognition principles for financial analysis.
Revenue Recognition and Accrual Accounting Under the accrual method of accounting, revenue is recognized when earned. Under accrual accounting, revenue is not necessarily earned when cash is received. In general, revenue should be recognized when: 1) There is evidence of arrangement between the buyer and the seller. 2) The product has been delivered or the service has been rendered. 3) The price is determined or determinable. 4) The seller is reasonably sure of collecting money. If a firm receives cash before revenue recognition is complete, the firm reports it as unearned revenue. Unearned revenue is reported on the balance sheet as a liability. The liability is reduced in the future as the revenue is earned.
Matching Principle and Implications for Financial Analysis Under the accrual method of accounting, expense recognition is based on the matching principle. Under the matching principle, expenses to generate revenue are recognized in the same period as the revenue. Not all expenses can be directly tied to revenue recognition. These costs are known as period costs. Period costs, such as administrative costs, are expensed in the period incurred. Like revenue recognition, expense recognition requires a number of estimates. Since estimates are involved, it is possible for firms to delay or accelerate the recognition of expenses. Delayed expense recognition increases current net income and is therefore more aggressive.
Learning Outcome Statements (LOS) Aftercompleting this session, students should be able to: illustrate accounting treatment for marketable securities including held-to-maturity securities, trading securities and available-for-sale securities list and explain the components of owners’ equity.
Marketable Securities Marketable investment securities are classified as either held-to-maturity, trading or available-for-sale. Held-to-maturity securities are debt securities acquired with the intent that they will be held to maturity. Held-to-maturity securities are reported on the balance sheet at amortized cost.Subsequent changes in the market value are ignored. Trading securities are debt and equity securities acquired with the intent to profit over the near term. They are reported on the balance sheet at fair value. Unrealized gains and losses that are changes in market value before the securities are sold are reported in the income statement. Available-for-sale securities are debt and equity securities that are not expected to be held to maturity or traded in the near term. They are reported on the balance sheet at fair value. However, any unrealized gains and losses are not recognized in the income statement but are reported in other comprehensive income as a part of owners’ equity. Dividend and interest income and realized gains and losses (actual gains or losses when the securities are sold) are recognized in the income statement for all three classifications of securities.
Investment Security Classifications: An Example Triple D Corporation purchased a 6 % bond, at par, for $1,000,000 at the beginning of the year. Interest rates have recently increased and the market value of the bond declined $20,000 Determine the bond’s effect on Triple D’s financial statements under each classification of securities.
Components of Owners’ Equity Owners’ equity is the residual interest in assets that remains after subtracting an entity’s liabilities. The Owners' Equity section of the balance sheet includescontributed capital, any minority (noncontrolling) interest, retained earnings, treasury stock and accumulated other comprehensive income. Contributed capital-the amount paid in by common and preferred shareholders. Minority (noncontrolling) interest- the portion of subsidiary that is not owned by the parent company. Retained earnings-the cumulative undistributed earnings of the firm since inception, the cumulative earnings that have not been paid out to shareholders as dividends. Treasury stock- common stock that the firm has repurchased. Treasury stock has no voting rights and does not receive dividends. Accumulated other comprehensive income-includes all changes to equity from sources other than net income and transactions with shareholders, such as issuing stock, reacquiring stock and paying dividends.
Learning Outcome Statements (LOS) Aftercompleting this session, students should be able to: compare and contrast cash flows from operating, investing and financing activities. classify cash flow items as relating to cash flows from operating, investing and financing activities, given a description of the items. analyze and interpret a cash flow statement. illustrate the statement of cash flow presentation.
Cash Flows from Operating, Investing and Financing Activities Items on the cash flow statement come from two sources: 1) income statement items and 2) change in balance sheet accounts. A firm’s cash receipts and payments are classified on the cash flow statement as either operating, investing or financing activities. Cash flow from operating activities (CFO), sometimes referred to as “cash flow from operations" or “operating cash flow," consists of the inflows and outflows of cash resulting from transactions related to a firm’s normal operation. Cash flow from investing activities (CFI)consists of the inflows and outflows of cash resulting from the acquisition or disposal of long-term assets and certain investments. Cash flow from financing activities (CFF)consists of the inflows and outflows of cash resulting from transactions affecting the firm’s capital structure.
Direct and Indirect Methods of Cash Flow Statement There are two methods of presenting the cash flow statement: the direct method and the indirect method. The difference between the two methods relates to the presentation ofcash flow from operating activities. The presentation of cash flows from investing activities and financing activities is exactly the same under both methods. Under the direct method, each line item of the accrual-based income statement is converted into cash receipts or cash payments. Under the indirect method, net income is converted to operating cash flow by making adjustments for transactions that affect net income but are not cash transactions. The adjustments include eliminating noncash expenses (e.g., depreciation and amortization), nonoperating items (e.g., gains and losses) and changes in balance sheet accounts resulting from accrual accounting events.
Direct Method of Presenting Operating Cash Flow Seagraves Supply Company Operating Cash Flow-Direct Method For the Year ended December 31, 20xx Notice the similarities of the direct method cash flow presentation and an income statement. The direct method begins with cash inflows from customers and then deduct cash outflows for purchases, operating expenses, interest and taxes.
Indirect Method of Presenting Operating Cash Flow Seagraves Supply Company Operating Cash Flow-Indirect Method For the Year ended December 31, 20xx
Learning Outcome Statements (LOS) Aftercompleting this session, students should be able to: describe the limitations of ratio analysis. calculate, classify and interpret activity, liquidity, solvency, and profitability ratios. demonstrate the application of and interpret changes in the component parts of the DuPont analysis (the decomposition of return on equity). calculate the sustainable growth rate for a company.
Limitations of Ratio Analysis • Financial ratios are not useful when viewed in isolation. They are • valid only whencompared to those of other firms or to the • company’s historical performance. • Comparisons with other companies are made more difficult due to • different accounting treatments across firms. • It is difficult to find comparable industry ratios when analyzing • companies that operate in multiple industries. • Conclusions cannot be made from viewing one set of ratios. All • ratios must be viewed relative to one another.
Decomposition of ROE Using the DuPont Analysis • The DuPont system of analysis is an approach that can be used to analyze return on equity (ROE). • The DuPont System can be expressed in the so-called “three-part approach”. • For the original approach, ROE could be expressed as: Net Income Equity = • We can also expand the ROE formula above into the following formula: • ROE= Net IncomeX Net SalesX Total Assets • Net SalesTotal AssetsTotal Equity ROE = Net Profit MarginX Total Assets Turnover X Leverage Ratio
Decomposition of ROE: An Example StarterInc. has maintained a stable and relatively high ROE of approximately 18 % over the last three years. Use traditional DuPont analysis to decompose this ROE into its three components and comment on trends in company performance. Answer: ROE 20X3: 21.5/119 = 18.1 % 20X4: 22.3/124 = 18.0 % 20X5: 21.9/126 = 17.4 %
Decomposition of ROE: An Example(Cont) Answer: ROE 20X3: (21.5/305) x (305/230) x (230/119) = 7.0 % x 1.33 x 1.93 = 18.1 % 20X4: (22.3/350) x (350/290) x (290/124) = 6.4 % x 1.21 x 2.34 = 18.0 % 20X5: (21.9/410) x (410/350) x (350/126) = 5.3 % x 1.17 x 2.78 = 17.4 % • While the ROE has dropped only slightly, both the total assets turnover and the net profit margin have declined. • The effects of declining net margins and assets turnover on ROE have been offset by a significant increase in leverage. The company has become more risky due to increased debt financing.
Determination Sustainable Growth Rate • Thesustainable growth rateis how fast a firm can grow without additional external equity issues while holding leverage constant. • Sustainable growth rate (g) could be calculated using the following formula: • g = Retention Rate (RR) x ROE • where Retention Rate (RR) = 1- dividend payout ratio • Dividend Payout Ratio = Dividend per Share/EPS Ex: Calculation of Sustainable Growth Rate Please calculate the sustainable growth rate of each company.
Determination Sustainable Growth Rate (Cont) RR = 1-dividend payout ratio RRA = 1- (1.50/3.00) = 1-0.50 = 0.50 RRB = 1- (1.00/4.00) = 1-0.25 = 0.75 RRC = 1- (2.00/5.00) = 1-0.40 = 0.60 g = RR x ROE gA = 0.50 x 14 % = 7 % gB = 0.75 x 12 % = 9 % gC = 0.60 x 10 % = 6 %
Learning Outcome Statements (LOS) Aftercompleting this session, students should be able to: determine whether a debt security or equity security should be classified as held to maturity, available for sale or as trading security. compute the effect of debt-security and equity-security classification on financial statements and financial ratios. determine, given various ownership and/or control levels and relevant accounting standards, whether the cost method, the equity method or the consolidation method should be used. compute and compare the effects of using the cost method, the equity method and the consolidation method on a company’s financial statements and financial ratios.
Categories of Intercorporate Investments Intercorporate investments are categorized as either: (1) Investments in financial assets (when the investing firm has no significant control over the operations of the investee firm) (2) Investments in associates (when the investing firm has significant influence over the operations of the investee firm, but not control (3) Business combinations (when the investing firm has control over the operations of the investee firm). Percentage of ownership (or voting control) is typically used to determine the appropriate category for financial reporting purposes. However, the ownership percentage is only a guideline. Ultimately, the category is based on the investor’s ability to influence or control the investee.
Categories of Financial Assets An ownership interest of less than 20 % is usually considered a passive investment. In this case, the investor cannot significantly influence or control the investee. Investments in financial assets could be classified as: 1) Held-to-maturity 2) Available-for-sale 3) Held-for-trading Debt securities held-to-maturity are securities that a company has the positive intent and ability to hold to maturity. These securities are carried at amortized cost and cannot be sold prior to its maturity except under unusual circumstances. This classification applies only to debt securities. It does not apply to equity investments. Debt and equity securities available-for-sale may be sold to address the liquidity and other needs of a company. They are carried at fair market value on the balance sheet. Debt and equity trading securities are securities acquired for the purpose of selling them in the near term. They are measured at fair market value and are listed as current assets on the balance sheet.
Financial Statement Effects of Investment Security Classification
Example: Investment in Financial Assets At the beginning of the year, Midland Corporation purchased a 9 %bond with a fair value of $100,000. The bond was issued for $96,209 to yield 10 %. The coupon payments are made annually at year-end. The fair value of the bond at the end of the year is $98,500. Determine the impact on Midland’s balance sheet and income statement if the bond investment is classified as held-to-maturity, held-for-trading and available-for-sale. Held-to-Maturity • The balance sheet value is based on amortized cost. At year-end, Midland recognizes interest revenue of $9,621 ($96,209 beginning bond investment x 10 % market rate at issuance). • The interest revenue includes the coupon payment of $9,000 ($100,000 face value x 9 % coupon rate) and the amortized discount of $621 ($9,621 interest revenue-$9,000 coupon payment). • At year-end, the bond is reported on the balance sheet at $96,830 ($96,209 beginning bond investment +$621 amortized discount).
Example: Investment in Financial Assets Held-for-Trading • The balance sheet value is based on fair value of $98,500. • Interest revenue of $9,000 ($100,000 x 9 % coupon rate) is recognized in the income statement. • An unrealized gain of $2,291 ($98,500 fair value-$96,209 beginning bond investment) is also recognized in the income statement. Available-for-Sale • The balance sheet value is based on fair value of $98,500. • Interest revenue of $9,000 ($100,000 x 9 % coupon rate) is recognized in the income statement. • An unrealized gain of $2,291 ($98,500 fair value-$96,209 beginning bond investment) is reported in stockholders’ equity as a component of other comprehensive income.
Investments in Associates Investment ownership of between 20 % and 50 % is usuallyconsidered influential. Influential investments are accounted for using the equity method. Under the equity method, the initial investment is recorded at cost and reported on the balance sheet as a noncurrent asset. In subsequent periods, the proportionate share of the investee’s earnings increases the investment account on the investor’s balance sheet and is recognized in the investor’s income statement.Dividends received from the investee are treated as a return of capital and thus, reduce the investment account. Unlike investments in financial assets, dividends received from the investee are not recognized in the investor’s income statement. If the investee reports a loss, the investor’s proportionate share of the loss reduces the investment account and also lower earnings in the investor’s income statement.
Example: Implementing the Equity Method Assume the following: December 31, 20X5, Company P (the investor) invests $1,000 in return for 30 % of the common shares of Company S (the investee). During 20X6. Company S earns $400 and pays dividends of $100. During 20X7, Company S earns $600 and pays dividends of $150 Calculate the effects of the investment on Company P’s balance sheet, reported income and cash flow for 20X6 and 20X7. 20X6 • Under the equity method for 20X6, Company P will: • Recognize $120 ($400 x 30 %) in the income statement from its proportionate share of the net income of Company S. • Increase its investment account on the balance sheet by $120 to $1,120, reflecting its proportionate share of the net assets of Company S. • Receive $30 ($100 x 30 %) in cash dividends from Company S and reduce its investment in Company S by that amount to reflect the decline in the net assets of Company S due to the dividend payments. • At the end of 20X6, the carrying value of Company S on Company P’s balance sheet will be $1,090 ($1,000+$120-$30).
Example: Implementing the Equity Method (Cont) 20X7 • Under the equity method for 20X7, Company P will: • Recognize $180 ($600 x 30 %) in the income statement from its proportionate share of the net income of Company S. • Increase its investment account on the balance sheet by $180 to $1,270, reflecting its proportionate share of the net assets of Company S. • Receive $45 ($150 x 30 %) in cash dividends from Company S and reduce its investment in Company S by that amount to reflect the decline in the net assets of Company S due to the dividend payments. • At the end of 20X7, the carrying value of Company S on Company P’s balance sheet will be $1,225 ($1,090+$180-$45).
Consolidated Method Direct or indirect ownership of more than 50 % of the voting shares requires the parent to use consolidated reporting. Consolidated reporting results in two firms being presented as one economic entity, even though the firms may be separate legal entities. All income of the affiliate (less any minority interests) is reported on the parent’s income statement. There are two exceptions: (1) if control is temporary or (2) if barriers to control exist such as governmental intervention, bankruptcy, civil order, or if a nonconvertible currency is involved. These exceptions exist to accommodate situations where the parent cannot use the subsidiaries’ assets or control its actions.