Notes - Summary Financial Statement Analysis PDF

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Week 1 Why FS are important    

Without adequate info, investors cannot properly judge the opportunities and risks of investment alternatives FS are the first and often the best source of info about a company’s past performance, current health, and prospects for the future FS and accompanying disclosures provide info about a company’s economic wealth and changes in that wealth FS can be used for various purposes o Analytical tool o Management report card o Early warning signal o Basis for prediction o Measure of accountability

Accounting is not an exact science    

Some financial statement items (i.e. cash) are measured with a high degree of precision and reliability Many items (i.e. product warranty liabilities) are judgemental and uncertain in their measurement because they are derived from estimates of future events Investors and others should not accept the numbers in FS at face value FS readers must o Understand financial reporting standards o Recognise that management can shape info o Distinguish between reliable and judgemental info

Economics of accounting info 

The FS of business enterprises serve two key functions o Info asymmetry  Provide a way for company management to transfer info about business activities to people outside the company o Contract efficiency  FS info is often included in contracts between the company and other parties

Demand for ad supply of accounting info  

FS are demanded because of their value as a source of info about company performance, financial condition and resource stewardship The supply of FS is guided by the costs of producing and disseminating it and the benefits it will provide to the company

Users of FS 

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Shareholders and investors o Investment decisions o Proxy contests Managers and employees o Performance assessment o Compensation contracts Lenders and suppliers o Lending decisions o Covenant compliance Customers o Seller’s health o Repeat purchases

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o Warranties and support Govt and regulators o Mandatory reporting o Taxing authorities o Regulated industries

Fundamental concepts of financial reporting  

Financial reporting is governed by principles and rules known as ‘generally accepted accounting principles’ (GAAP) that evolve over time as business conditions change There’s virtually no standard that the FASB has ever written that is free from judgement in its application

Primary characteristics 

Relevant info o Helps users form more accurate predictions about the future or it allows them to better understand how past economic events have affected the business

Predictive value The info improves the decision maker’s ability to forecast the future outcome of past or present events 

Materiality Omission or misstatement of the info could influence the decisions that financial statement user make about a specific reporting entity

Neutrality Info cannot be selected to favour one set of interested parties over another

Free from material error Some minimum level of accuracy is also necessary for an estimate to be a faithful representation of an economic event

Faithful representation

Completeness Financial info can be false or misleading if important facts are omitted 

Confirmatory value The info confirms or alters the decision maker’s earlier beliefs

Materiality o Depends on both quantitative (the amount of the misstatement) and qualitative (the possible impact of the misstatement) considerations

Qualitative characteristics 

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Comparability o Allows analysts to identify real economic similarities in and differences between underlying economic events because those similarities or differences are not obscured by accounting methods or disclosure practices Verifiability

Means that independent measurers should get similar results when using the same yardstick; financial info that lacks verifiability is less reliable for decision purposes Timeliness o Refers to info that is available to decision makers while it is still fresh and capable of influencing their decisions Understandability o The characteristics of info that enables users to comprehend its meaning o

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Summary  

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FS are an important source of info about a company, its economic growth, and its prospects FS help improve decisions making and make it possible to monitor managers activities o Equity investors use FS to form opinions about the value of a company and its stock o Creditors use statement info to gauge a company’s ability to repay its debts and to check whether the company is complying with loan covenants o Analysts use FS as the basis for recommendations to investors and creditors o Auditors use FS to help design more effective audits Investors, creditors and other interested parties demand FS because the info useful

Week 2 Under accrual accounting 

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Revenues are recorded (recognised) when the seller has performed a service or conveys an asset to the buyer which entitles the seller to the benefits represented by the revenues, and the value to be received for that service or asset is reasonably assured and can be measured with a high degree of reliability Expenses are expired costs or assets that are used up in producing those produce revenues o Expenses recognition is tied to revenue recognition- commonly referred to as the ‘matching principle’ o Expenses are recorded in the same accounting period in which the related revenues are recognised

Cash flow vs accrual income measurement 

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Accrual accounting decouples measured earrings (i.e. revenues minus expenses) from the amount of cash generated from operations o Accrual accounting revenues generally don’t correspond to cash receipts for the period, not do accrual expenses always correspond to cash outlays for the period o Accrual accounting can produce large discrepancies between measured earnings and the amount of cash generated from operations (cash-basis earnings) Accrual accounting better matches economic benefit with economic effort, thereby producing a measure of operating performance- accrual earnings- that provides a more realistic picture of past economic activities Many believe that accrual accounting numbers also provide a better basis for predicting future performance of an enterprise

Articulation of IS and Balance sheet 

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Two things happen when income is recognised in the FS o 1) owners equity is increased by the amount of the income o 2) net assets (that is, gross assets minus gross liabilities) are increased by an identical amount Thus there are two identical ways of thinking about income recognition Net asset valuation and income determination are interrelated

A critical accouting questions 

At what point is it appropriate to recognise that a firm’s net assets have increased in value and this recognise income?

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Step 1: revenue is recognised when an entity satisfies its contractual obligation to provide goods and services to a customer Step 2: the matching principle associates expired costs (expenses) with the revenue recognised in a period

Expense recognition  

Once revenue for a period has been determined, the next step in determining income is to accumulate and record the costs associated with generating the revenue There are two types of costs associated with generating revenue o Traceable costs are easily traced to the revenue earned o Period costs are also clearly important in generating revenue, but their contribution to a specific sale is difficult, if not impossible, to quantify

Traceable costs  

Matching process: traceable costs are recognised in expense in the same period as the corresponding revenue is recognised Product costs o Costs of physically producing a good o Often constitute a large portion of the traceable costs o Also include manufacturing overhead (factor maintenance, insurance, depreciation etc)  It is difficult to associate overhead costs with specific units of production  Generally allocated to inventory costs (and this expensed as part of COGS) on some rational basis

Income statement format and classification   

Virtually all decision models in modern corporate finance are based on expected future cash flows Financial reporting seeks to satisfy users needs by providing financial info in a format that gives usres reliable and representative baseline numbers for generating their own forecasts of future cash flows The income statement separates earning into two components o Continuing operations  “Sustainable’ or likely to be repeated in future reporting periods o Discontinued operations- ‘transitory’

Unusual or infrequently occurring items   

Gains or losses (usually losses) that arise from a firm’s continuing operations, but that are not typical, recurring costs Reported as separate line items in the continuing operations section of the IS Examples o Write-downs or write-offs of receivables, inventory, equipment leased to others, and intangibles o Gains or losses from the exchange or translation of foreign currencies o Gains or losses frm the sale or abandonment of PPE o Special one time charges from corporate restructuring o Gains or losses from the sale of investments o Losses from floods, fires or other disasters

Discontinued operations   

Transactions related to certain operations the firm intends to discontinue or has already discontinued are separated from other income statement items Discontinued operations will not generated future operating cash flows Classification on IS o The operating results of discontinued operations are excluded from continuing operations in the current period when the decision to discontinue was made o In addition, they are excluded from continuing operations in any prior years for which comparative data are provided o Net income for those prior years are the same as originally reported; the amounts removed from continuing operations are reclassified to discontinued operations

Reporting accounting changes 

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Consistency o Means using the same accounting methods to describe similar economic events from period to period o Enhances decisions usefulness by allowing users to identify trends or turning points in a company’s performance over time Changing accounting methods o Firms sometimes voluntarily switch accounting methods or revise estimates because the alternative method or estimate better reflects the firms underlying economics o Accounting standards-setting bodies frequently issue new standards requiring companies to change accounting methods (mandatory) When firms change accounting methods, it raises questions about transition methods

Summary

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Key differences between cash and accrual income measurement o In most instances, accrual-basis revenues don’t equal cash receipts and accrual expenses don’t equal cash disbursements o The principles that govern revenue and expense recognition under accrual accounting are designed to alleviate the mismatching of effort and accomplishment that occur under cashbasis accounting o The matching principle determines how and when the assets that are used up in generating the revenue or that expire with the passage of time are expensed o Relative to current operating cash flows, accrual earning’s generally provide a more useful measurement of firm performance and serve as a more useful benchmark for predicting future cash flows

Week 3 Revenue recognition AASB 15    

The main issue in accounting for revenue is in determining when the revenue is to be recognised AASB 15 will apply to all contracts with customers, except for contracts covered by other standards, such as leases, insurance and financial instruments AASB stipulates how and when revenue is recorded, requiring entities to provide users of FS with more info and reporting disclosure Its core principle is revenue recognition for the transfer of goods or services, at a value that reflects the consideration to which the entity expects to the entitled, in return for meeting performance obligations

Five-stage model     

1) whether a contract exists 2) the explicit and implicit promises in the contract to deliver goods and/or services to a customer 3) the transaction price payable by the customer 4) how to allocate the transaction price to the goods and services 5) when to recognise revenue based on when ‘control’ over the good or service transfers to a customer

Step 1       

All of the following conditions must be met before a firm to account for a contract with a customer Al parties to the contract have approved the contract and are legally obligated to perform their obligations under the contract Each party’s rights regarding the goods or services being exchanged can be identified Payment terms can be identified The contract has commercial substance Collection is probable If neither party has yet performed under the contract and both parties have the right to cancel the contract without penalty, then for the purposes of the revenue recognition standard, no contract exists

Collectability vs price concessions  

If a firm believes it will not ultimately receive the full, stated contract price, judgement may be necessary to determine if the shortfall is due to a collectability problem or a price concession For example: o A hospital immediately treats an uninsured patient in the emergency room; later, the hospital determines the patient is uninsured and does not expect to collect in full. o Initially, the hospital cannot determine that the patient is committed to perform its obligation; therefore, no revenue may yet be recognized. o The hospital will reassess whether a contract can be identified as circumstances change. o Suppose subsequently the hospital determines that based on similar situations in the past, it expects the patient to pay $1,000 to settle the bill of $10,000. o A contract has been identified and the transaction price is $1,000, the amount the hospital expects to be entitled to collect.

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The $9,000 is considered a discount or a price concession, not a failure to collect, because the patient never agreed to pay $10,000.

Consideration received before a contract exists  

Sometimes a payments is received before a contract an be identified When that is the case, revenue may be recognised when o 1) the consideration is non-refundable and o 2) any one of the following events has occurred  There are no remaining obligations to transfer goods or services to the customer  The contract has been terminated  The entity has transferred the goods or services to which the consideration received relates, and it has no further obligation to transfer goods or services

Step 2: identify the performance obligations in the contract 

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Two criteria that must both be met for a good or service to be distinct o The customer can benefit from the good or service on its own or in conjunction with other readily available resources o The entity’s promise to transfer the good or service to the customer is separately identifiable in the contract A warranty is considered a separate performance obligation if o The customer has the option t purchase the warranty separately; or o The warranty provides services beyond what is required to assure the product is free of defects at the time of sale

Step 3: determine the transaction price 

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The transaction price o The amount of consideration the firm expects to be entitled to receive o Excludes amounts collected on behalf of 3rd parties, such as for sales tax Non-cash consideration is to be valued at fair value The transaction price may have both fixed and variable components

Assessing whether the firm is a principal or an agent 

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For transactions involving more than two parties, a firm may need to determine whether it is an o Principal (providing goods or services) - A firm is considered a principal if it obtains control of the goods or services and then transfers that control to another party. o Agent (facilitating the sale of goods or services by another party). The principal–agent determination affects whether a firm recognizes revenue on a gross or a net basis. o A principal recognizes revenue for the gross amount paid by the customer and reports as an expense its cost of goods sold. A principal may not recognize revenue until the goods or services promised to the end customer have been transferred. o An agent reports revenue only for the net amount retained (e.g., its commission). An agent may recognize revenue when its performance obligation to the principal is satisfied

Step 4: allocate the transaction price to the performance obligations in the contract 

The allocation of the transaction price should be based on the stand-alone prices for the goods and services comprising each performance obligation

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Stand-alone prices are straightforward when the goods and services in the contract are also sold separately; otherwise, estimates must be made using a o Adjusted market approach o Expected cost plus margin approach o Residual approach

Step 5: recognise revenue when (or as) the entity satisfies a performance obligation  

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A performance obligation is considered satisfied when control over the goods and services that comprise the performance obligation is transferred to the customer Control has transferred when o The customer has a legal obligation to pay the firm o The customer has legal title (in the case of goods) o The customer has physical possession (in the case of goods) o The customer is subject to the risks and rewards generally associated with ownership o The customer has indicated its acceptance of the goods and services These are indicators of control; no single item above is decisive Alternatively, control over the asset (the goods or services provided to the customer) may transfer to the customer over time o That is, the performance obligation is satisfied over time

Licenses  

Some transactions involving intellectual property represent a sale of intellectual property, whereas others represent licenses The approach t be used for revenue recognition depends on whether the transaction is considered a sale or a license o If the transaction represents a ale, then it is treated like any other ale and the 5-step model is applied to determine the point in time that sales revenue may be recognised o If the transaction is a license, then revenue recognition may be entirely at the inception of the license or over time during the period of the license, depending on the circumstances

Consignment arrangements 

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A consignment arrangement exists when a firm delivers goods to another party but retains control over them o The purpose of the arrangement is typically to facilitate a sale to a 3 rd party Indicators that a consignment agreement exists are as follows o The firm transferring possession of the product still controls it until some event occurs, such as the sale of the product to a 3rd party o The firm transferring possession of the product has the right to require the product to be returned or transferred elsewhere o The entity that has received the product is not obligated to pay for it (unless it is sold)

Bill-and-hold arrangements  

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A bill-and-hold arrangement exists when the firm bills a customer for goods but retains physic...