Financial Reporting

How a company communicates its financial performance to stakeholders.
Think of it like a report card showing how well the business is doing.

Financial Analysis

Evaluating those statements to make economic decisions (investing, lending).
Think of it like reading the report card to decide if the student gets a scholarship.

Balance Sheet (“Snapshot”)

Shows financial position at a point in time.
Analogy: A photo of your bank account on a specific day.

• Assets – what the company owns
• Liabilities – what it owes
• Shareholders’ Equity – owners’ residual claim

Income Statement (“Movie of Performance”)

Shows profitability over a period of time.
Analogy: A video clip summarizing everything the company earned and spent.

• Starts with Sales/Revenue
• Subtract Operating Expenses
• Arrives at EBIT
  EBIT = Earnings Before Interest & Taxes

Statement of Cash Flows

Tracks actual cash movements over a period.
Analogy: Your bank transaction history, organized into categories.

3 Sections:

1. Operating Activities – cash from daily business
2. Investing Activities – buying/selling long-term assets
3. Financing Activities – borrowing, issuing stock, repaying debt

Each section includes both inflows and outflows.

Provide details not shown directly on statements:

• Accounting methods
• Assumptions & estimates
• Time period covered
• Acquisitions
• Major customers
• Geographic/business segments

Analogy: The footnotes of an exam — explains how answers were derived.

Management commentary on:

• Strategy
• Past performance
• Future expectations

Responsibility of management for:

• Accurate statements
• Proper internal control

Auditors provide an independent review of statements.

1. Unqualified Opinion
   “Everything looks good” — no material errors. (Most common)
2. Qualified Opinion
   “Mostly okay, but some issues.”
3. Adverse Opinion
   “Statements contain material errors or are non-compliant.”

Auditors may also discuss internal controls and key audit matters.

Primary Sources

• Quarterly Reports (10-Q) – typically unaudited
• Semi-Annual Reports – usually unaudited
• Proxy Statements – matters shareholders vote on
• Earnings Calls & Press Releases

Third-Party Sources

• Industry reports
• Analyst coverage
• Economic data

1. Define Purpose & Context
   • What questions are you answering? What resources and deadlines?
2. Collect Data
   • Financial statements, industry info, macroeconomic inputs.
3. Process Data
   • Ratios, charts, adjustments.
4. Analyze & Interpret
   • Compare trends, benchmark peers, identify strengths/weaknesses.
5. Develop & Communicate Conclusions
   • Prepare a report addressing Step 1.
6. Follow Up
   • Update analysis periodically or as new data appears.

Financial statements tell a story — balance sheet is the snapshot, income statement is the movie, cash flow statement is the cash diary.

Notes and MD&A provide context that numbers alone can’t show.

Audit opinions signal reliability — unqualified is what you want.

Analysis requires structure: purpose → data → processing → interpretation → conclusion → follow-up.

Financial analysis is not just numbers — it’s interpreting business reality.

Why Standards Exist

• Allow comparability across companies
• Allow flexibility so that different industries can still comply
• Ensure information is useful, consistent, and reliable

FASB

• Sets GAAP (U.S.)

IASB

• Sets IFRS (International)

Analogy: They are like the referees who decide the rules of the game.

• SEC — U.S.
• FCA — U.K.
• Most are part of IOSCO, which promotes global consistency
  (But IOSCO itself is not a regulator.)

Analogy: If standard-setters are referees, regulators are the league officials making sure everyone follows the rules.

Objective

Provide useful information to decision-makers.

Fundamental Qualitative Characteristics

1. Relevance

• Information influences decisions
• Has predictive and confirmatory (feedback) value
• Material information must be included
  Analogy: Only the meaningful parts of a story matter for understanding the plot.

2. Faithful Representation

Information must be:

• Complete
• Neutral
• Free from error
  Analogy: A map that accurately matches the territory.

Enhancing Qualitative Characteristics

1. Comparability — find similarities/differences
2. Verifiability — independent observers agree
3. Timeliness — information arrives before decisions are made
4. Understandability — clear to a knowledgeable user

1. Cost–Benefit Tradeoff

Benefits of better information must outweigh its costs.

2. Unquantifiable Information

Not everything can be measured numerically (e.g., brand reputation)

Going Concern

Company will operate in the foreseeable future.

Accrual Basis

Record transactions when they occur, not when cash is exchanged.

Reporting Elements:

• Balance Sheet
• Statement of Comprehensive Income
• Cash Flow Statement
• Statement of Changes in Equity
• Notes

General Features:

Fair Presentation

Same as faithful representation: complete, neutral, accurate.

Going Concern & Accrual Basis

Assumed unless otherwise disclosed.

Materiality & Aggregation

Group items but never misrepresent information.

No Offsetting

Cannot net expenses with revenue unless required by standards.

Reporting Frequency

At least annually.

Comparative Information

Show multiple periods.

Consistency of Presentation

Same classifications and layouts unless a justified change occurs.

Analysts must monitor:

• New transactions
• New products
• Actions of standard-setting bodies
• Company disclosures
• Accounting policy changes

Analogy: Analysts must stay updated like a mechanic tracking new car parts each year.

Standards allow global comparability and credibility.

Relevance + faithful representation form the foundation of useful reporting.

IFRS requires 5 core statements including notes.

Analysts must stay alert to changes in accounting policies and new standards.

“No offsetting” ensures transparency — companies can’t hide expenses by netting them.

Net Revenue

\text{Net Revenue} = \text{Revenue} - \text{Sales Returns and Allowances}

COGS (Cost of Goods Sold)

Direct costs of producing goods.

Non-Cash Expenses

Expenses with no immediate cash outflow (e.g., depreciation, amortization).

By Nature

Grouped by type (e.g., total depreciation across departments).

By Function

Grouped by department (e.g., manufacturing, admin, selling).

Analogy:

• Nature: Sorting laundry by clothing type
• Function: Sorting laundry by whose room it goes into

Single-Step Income Statement

• Groups all revenues together
• Groups all expenses together
• Computes net income in one step

Multi-Step Income Statement

• More detailed
• Includes gross profit, operating income, and income from continuing ops

EBIT = Operating Income

Revenue is recognized when goods/services are transferred.

If goods delivered before payment → Accounts Receivable
If cash received before delivery → Unearned Revenue (Liability)

5 Steps

1. Identify the contract
2. Identify performance obligations
3. Determine transaction price
4. Allocate price to obligations
5. Recognize revenue as obligations are satisfied

Incremental contract acquisition costs → capitalized

Matching Principle

Match expenses to the revenue they helped generate.

Period Costs

Expensed when incurred (rent, utilities).

FIFO (First In, First Out)

Oldest inventory sold first.

LIFO (Last In, First Out)

Newest inventory sold first.

Weighted Average

Assign average cost to all units.

Specific Identification

Track each specific unit (e.g., jewelry).

Estimate in the same period as the sale.

Used for:

• Warranty liability
• Allowance for doubtful accounts

Earnings manipulation risk:

• Overestimate expenses → lower earnings
• Underestimate → boost earnings

Discontinued Operations

• Reported net of tax
• Shown separately from continuing operations

Unusual / Infrequent Items

• Still part of active operations
• Reported before tax

Retrospective Application

• For policy changes or error corrections
• Restate prior-period financials

Prospective Application

• For changes in estimates
• Apply going forward only

Operating

Day-to-day activities.

Non-Operating

Financing or investing activities.

Exception:
Financial firms treat interest income/expense as operating.

Basic EPS

Earnings available to common shareholders.

Exclude common dividends (already part of net income allocation).

\text{Basic EPS} =
\frac{\text{Net Income} - \text{Preferred Dividends}}
{\text{Weighted Average Number of Common Shares}}

Diluted EPS

Reflects potential dilution from:

• Convertible debt
• Convertible preferred shares
• Stock options

If diluted EPS > basic EPS, the securities are anti-dilutive, so diluted EPS = basic EPS.

Capital Structure

• Simple → No dilutive securities
• Complex → Has dilutive securities

If YE = December:

• Shares issued in January → × 12/12
• Issued in April → × 9/12
• Stock split → adjust all prior shares
• Repurchased in October → × 3/12

Each line as a % of revenue

Helps compare cross firms or time.

Gross Profit Margin

= Gross Profit / Revenue

Net Profit Margin

= Net Income / Revenue

“Margin” means divide by revenue.

Includes all changes in equity except owner transactions.

\text{Comprehensive Income} =
\text{Net Income} + \text{OCI}

OCI includes:

1. Unrealized AFS gains/losses
2. Unrealized hedge gains/losses
3. Foreign currency translation adjustments
4. Pension/retirement plan adjustments

Net Income – Dividends = Change in Retained Earnings
Ending RE flows into Equity on the Balance Sheet
Net increase in cash from CF statement updates Cash on the Balance Sheet

Income statements measure performance, not cash.

Revenue recognition hinges on performance obligations, not cash receipts.

Expense recognition follows matching for accuracy.

Inventory method choice affects profitability & taxes.

EPS gives insight into earnings available to common shareholders.

Discontinued operations = net of tax, everything else = pre-tax.

Comprehensive income captures all non-owner equity changes.

Solvency

Ability to meet long-term obligations.

Liquidity

Ability to meet short-term obligations.

Analogy:

• Solvency = can you pay your mortgage?
• Liquidity = can you pay your rent next month?

1. Mixed measurement methods (historical cost vs fair value)
2. Some values lack current relevance
3. Does not capture intangible factors (brand, human capital)

Classified Balance Sheet

Separates current vs non-current assets and liabilities.

Liquidity-Based Balance Sheet

Lists items by liquidity (common in banks).

Definitions

Non-Current Assets/Liabilities: longer than 1 year

Current Assets: sold/used within 1 year or operating cycle

Current Liabilities: settled within 1 year or operating cycle

Cash & Cash Equivalents

• MB: Amortized cost or fair value

Marketable Securities

1.Held for Trading (HFT)

• Measured at fair value
• Unrealized gains/losses → Income Statement

2.Available for Sale (AFS)

• Measured at fair value
• Unrealized gains/losses → OCI

3.Held to Maturity (HTM)

• Measured at amortized cost
• Unrealized gains/losses → ignored

Realized gains/losses → Income Statement for all three.

Accounts Receivable:

\small{\text{Net Receivables} = \text{Gross Receivables} - \text{Allowance for Doubtful Accounts}}

Allowance is a contra-asset.

Inventories

IFRS

Lower of cost or NRV

GAAP

• Same (lower of cost or NRV), unless LIFO/retail
• If LIFO/retail, use Lower of Cost or Market (LCM)
  Market = middle of:
  • Replacement cost
  • NRV
  • NRV – normal profit

Prepaid Expenses

Classified as current assets.

Accounts Payable

Notes Payable

Accrued Expenses (incurred but unpaid, e.g., wages)

Unearned Revenue (cash received before delivery)

Property, Plant & Equipment (PP&E)

Investment Property

Deferred Tax Assets

Intangibles

Goodwill

Long-term financial assets

Deferred tax liabilities

Long-term debt

Long-term financial liabilities

1. Contributed/Issued Capital

Shareholder contributions.

2. Retained Earnings

\text{Retained Earnings} = \text{Net Income} - \text{Dividends}

3. Treasury Shares

Repurchased shares.
Outstanding = Issued – Treasury

4. Par Value

Face value per share;
Amount raised = Par Value + Additional Paid-In Capital

5. Minority (Non-Controlling) Interest

If parent owns 60%, NCI = remaining 40%.

6. Preferred Shares

Priority claims and added privileges.

7. Accumulated OCI

Cumulative other comprehensive income.

Present each line item as a percentage of total assets.
Used to compare:

Liquidity & solvency analysis

Across companies

Across time

Liquidity Ratios

Current Ratio

\text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}}

Quick Ratio (Acid-Test)

\text{Quick Ratio} = 
\frac{\text{Cash + Marketable Securities + Receivables}}
{\text{Current Liabilities}}

Cash Ratio

\text{Cash Ratio} = 
\frac{\text{Cash + Marketable Securities}}
{\text{Current Liabilities}}

Higher = more liquid.

Solvency Ratios

Long-Term D/E

\text{Long-Term D/E} = 
\frac{\text{Long-Term Debt}}{\text{Total Equity}}

Total Debt Ratio

\text{Total Debt Ratio} =
\frac{\text{Total Debt}}{\text{Total Assets}}

Debt to Equity

\text{Debt to Equity} = 
\frac{\text{Total Debt}}{\text{Total Equity}}

Financial Leverage

\text{Financial Leverage} = 
\frac{\text{Average Total Assets}}{\text{Average Total Equity}}

Lower ratios = lower leverage = greater solvency.

• Balance Sheets show resources and obligations, not performance.
• Liquidity = short-term safety; solvency = long-term health.
• Marketable securities differ by measurement basis and where unrealized gains go.
• Inventory valuation differs under IFRS and GAAP (especially with LIFO).
• Equity includes contributions, retained earnings, treasury stock, OCI, minority interest.
• Liquidity and solvency ratios help analysts evaluate financial risk.

Do not appear on the cash flow statement:

Anything with no cash inflow/outflow

Exchanging non-monetary assets

Issuing stock to pay dividends

Starts with Net Income and converts to CFO by adjusting for:

• Non-cash items
  • D&A
    – Gains from investing/financing
  • Losses from investing/financing
• Working capital changes
  – Increase AR
  • Decrease inventory
  • Increase AP
    – Increase accrued liabilities

Key Rule:
Changes in:

Non-current liabilities & equity → CFF

Current assets & current liabilities → CFO

Non-current assets → CFI

Beginning AR + Sales – Cash Collections = Ending AR
Beginning AP + Purchases – Cash Paid = Ending AP
Beginning Inventory + Purchases – COGS = Ending Inventory
Beginning Cash + Cash Receipts – Cash Payments = Ending Cash

Two approaches:

1. Express each line as % of revenue
2. Express inflows as % of total inflows, outflows as % of total outflows

Used to compare firms and trends.

Free Cash Flow to the Firm (FCFF)

Cash available to both debt and equity holders.

Version 1 (Full expansion)

FCFF = NI + Non-Cash Charges + Interest(1–t) – Net Capital Expenditures – Working Capital Investment

Version 2 (Using CFO)

FCFF = CFO + Interest(1–t) – FC Inv

(CFO already accounts for non-cash items and working capital.)

Free Cash Flow to Equity (FCFE)

Cash available only to common shareholders.

Formula

FCFE = CFO – FC Inv + Net Borrowing

Where
Net Borrowing = Debt Issued – Debt Repaid

Relationship to FCFF

FCFE = FCFF – Interest(1–t) + Net Borrowing

Debt Coverage

Measures leverage and financial risk.

Interest Coverage

Ability to cover interest payments with CFO.

Reinvestment Ratio

Ability to purchase new assets using operating cash flows.

Debt Payment Ratio

Ability to repay debt using CFO.

Dividend Payment Ratio

Ability to pay dividends using CFO.

Investing & Financing Ratios

Evaluate sustainability of investment and financing activities.

• Cash flow statement tells where cash actually comes from and goes, not just accounting profit.
• GAAP and IFRS differ primarily in classification of interest & dividends.
• Indirect CFO adjusts NI for non-cash items and working capital changes.
• Free cash flow (FCFF & FCFE) is crucial for valuation.
• Strong liquidity and repayment capacity are captured through coverage ratios.

Ratio Analysis

• Evaluates past, current, and future performance
• Useful for comparisons across firms
• Helps assess efficiency, liquidity, solvency, and profitability
• Not meaningful in isolation
• Affected by different accounting policies

Analogy: Ratios are like vital signs for a business — helpful only when compared to history or peers.

Common-Size Analysis

• Converts all items to percentages
• Removes effect of company size
• Ideal for trend analysis and peer comparison

 Graphical Analysis

• Use charts to quickly identify trends or anomalies.

 Regression Analysis

• Useful for forecasting (e.g., sales vs advertising)
• Finds relationships between variables

1. Activity (Efficiency) Ratios
2. Liquidity Ratios
3. Solvency Ratios
4. Profitability Ratios
5. Valuation Ratios

Activity (Efficiency) Ratios

Higher turnover = more efficient use of assets.

Inventory Turnover:

How many times inventory is sold and replaced.
High = efficient; very high = may risk stockouts.

Payables Turnover:

How often suppliers are paid.

• High → paying too quickly
• Low → possible liquidity issues

Receivables Turnover:

How fast customers pay cash.

Total Asset Turnover:

Efficiency of revenue generation from all assets.

Fixed Asset Turnover:

Efficiency of using fixed assets (PP&E).

Working Capital Turnover:

Revenue generated from net working capital.

Days Ratios:

Calculated as:

Days = (Number of Days) / Turnover Ratio  

When turnover ↑ → Days ↓

Days of Inventory (DOH)

If too high → obsolete inventory
If too low → stockouts risk

Days of Payables (DPO)

Days to pay suppliers.

Days of Sales Outstanding (DSO)

Time to collect cash from customers.

• High → slow customers
• Low → strict credit policy

Cash Conversion Cycle (CCC)

Measures how long cash is tied up in operations.

CCC = DOH + DSO

Net CCC = DOH + DSO – DPO

Liquidity Ratios

Measure ability to meet short-term obligations.

(See LM4 sheet contains formulas, so only conceptual repetition needed here.)

Breaks ROE into components:

Base Formula

Two-Step DuPont

ROE = ROA × Financial Leverage

Where
ROA = Net Income / Avg Assets
Financial Leverage = Avg Assets / Avg Equity

Three-Step DuPont

ROE = (Net Income / Revenue) ×
      (Revenue / Avg Assets) ×
      (Avg Assets / Avg Equity)

Where:

• Net Income / Revenue = Net Profit Margin
• Revenue / Avg Assets = Asset Turnover
• Avg Assets / Avg Equity = Financial Leverage

Equity Turnover

Revenue / Equity

P/E Ratio

EBITDA per Share

Price/Book

Price/Sales

Cash Flow per Share

Dividends per Share

Uses:

• Solvency ratios
• Liquidity ratios
• Business/geographic segment information

Lenders assess stability, leverage, and repayment ability.

A segment is reported if it contributes >10% of:

• Revenue
• Assets
• Income

Must differ in risk and return characteristics.

Ratio analysis is a core tool for equity and credit forecasting.

Ratios reveal trends, but only in context (industry, history).

Efficiency ratios show how well assets generate sales.

Days ratios translate turnover into clearer time-based measures.

CCC shows how long cash is tied up in operations.

DuPont breaks ROE into the drivers of profitability.

Segment reporting helps analysts understand different risk areas.

Capitalizing means adding costs to the balance sheet; expensing means immediately recognizing on the income statement. 

Expensed Costs (never capitalized)

• Abnormal waste
• Employee training
• Storage after production
• Shipping to customers
• Selling, G&A expenses

Capitalized Costs

Capitalized = “added to inventory value and expensed later through COGS”

• Purchase price of inventory
• Direct conversion costs (labor + materials)
• Storage during production
• Delivery of asset to production site

💡 CFA Tip: Capitalized items inflate current assets & earnings (because expenses are deferred). Expensed items reduce current net income.

1. Specific Identification

• Tracks the exact unit sold
• Used for unique, high-value items (jewelry, cars)

2. FIFO (First-In, First-Out)

• Earliest purchases → COGS
• Ending inventory equals most recent purchases

3. LIFO (Last-In, First-Out)

• Most recent purchases → COGS
• Ending inventory reflects older costs

4. Weighted Average

• All units receive same average cost

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Key understanding:

• FIFO better reflects current inventory value (balance sheet).
• LIFO better reflects current costs in COGS (income statement).

Weighted Average

Always falls between FIFO and LIFO.

Occurs when a firm sells more inventory than it purchases → older low-cost inventory becomes COGS.

Effects in rising prices:

• Artificially low COGS
• Artificially high gross profit + net income
• Not sustainable
  CFA risk: Earnings manipulation red flag.

LIFO Reserve

Difference between FIFO and LIFO inventory values.
FIFO Inventory = LIFO Inventory + LIFO Reserve

Decreases during LIFO liquidation.

LIFO → FIFO Conversions (CFA must-memorize)

During rising prices:

• FIFO Inventory > LIFO
• FIFO COGS < LIFO
• FIFO NI > LIFO
• FIFO Retained Earnings > LIFO

Key Formulas

\text{FIFO Inventory} = \text{LIFO Inventory} + \text{LIFO Reserve}

\text{FIFO COGS} = \text{LIFO COGS} - \Delta \text{LIFO Reserve}

\text{FIFO NI} = \text{LIFO NI} + \Delta \text{LIFO Reserve} \times (1 - t)

\text{FIFO RE} = \text{LIFO RE} + \text{LIFO Reserve} \times (1 - t)

Important:

• Balance sheet items → use LIFO Reserve
• Income statement items → use Change in LIFO Reserve (ΔLR)

IFRS

Inventory reported at lower of cost or NRV (NRV = Selling Price − Costs to sell).
Write-ups allowed (but only up to the original cost).

US GAAP

• For FIFO or Weighted Avg: Lower of cost or NRV.
• For LIFO / Retail method: Lower of cost or market
  • Market = middle value of:
    • Replacement cost
    • NRV
    • NRV − Normal profit margin

No reversals allowed under GAAP.

Inventory Write-Downs

Write-downs:

• Increase COGS
• Reduce inventory on balance sheet
• Decrease assets & net income

Changing Methods

• Weighted Avg → FIFO: Retrospective change
• Any → LIFO: Prospective change
• IFRS: must show information becomes more reliable
• GAAP: only needs justification

Analytical Insight

If raw materials & WIP grow faster than finished goods:
→ Firm expects higher demand.

CFA Reminder

Inventory choice affects:

• Liquidity ratios
• Profitability
• Leverage
• Cash flow
  Analysts often adjust statements to compare peers consistently.

• FIFO gives the best balance sheet representation; LIFO gives the best income statement representation.
• LIFO reserve adjustments are required for comparability.
• In inflation, FIFO makes you “look richer”; LIFO makes you “pay less tax.”
• LIFO liquidation artificially boosts profits → earnings quality issue.
• IFRS prohibits LIFO; GAAP allows it.
• Write-down reversals: allowed under IFRS, prohibited under GAAP.
• Always adjust financial statements for analytical consistency before peer comparisons.
• Inventory accounting affects nearly every key ratio (profitability, liquidity, leverage).

You can either:

• Expense immediately → hits the income statement today
• Capitalize → put it on the balance sheet and expense gradually (dep/amort)

Analogy:

Expensing = eating the whole cost “meal” today.
Capitalizing = spreading that meal into multiple small leftovers over time.

Capitalized Interest

Interest incurred during construction must be capitalized (not expensed).

Analogy:

It’s like building a house: the interest you pay during construction becomes part of the house’s cost

If Purchased or Acquired in Business Combination

→ Record at fair value

If Developed Internally

IFRS

• Expense research
• Capitalize development

GAAP

• Expense both research and development

Analogy:

Research = exploring ideas → cost that may lead nowhere → always expense.
Development = building something real → can be capitalized.

Software Development Rules

For Sale

Both IFRS & GAAP:
Capitalize after technical feasibility is established.
Before that → expense.

For Internal Use

• IFRS: Capitalize when feasible
• GAAP: Capitalize all development after preliminary stage

Analogy:

Before feasibility = “rough sketches in your notebook.” → expense.
After feasibility = “blueprints ready; building begins.” → capitalize.

Analogy:

Capitalizing is like taking a loan from the future. You look richer today but must pay with depreciation later.

Straight-Line

\text{Depreciation}_{SL} = \frac{\text{Cost} - \text{Salvage}}{\text{Useful Life}}

Analogy:

Like eating a chocolate bar equally every day.

Double Declining Balance (DDB)

\text{Depreciation}_{DDB} = \left(\frac{2}{\text{Useful Life}}\right)
\times \text{Beginning Book Value}

Never depreciates below salvage.

Analogy:

Eating a big chunk of the chocolate at the start, smaller pieces later.

Units of Production

\text{Depreciation}_{UoP} =
\frac{\text{Cost} - \text{Salvage}}{\text{Total Units}}
\times \text{Units Produced}

Analogy:

The asset “ages” only when you use it — like car tires wearing out based on miles driven.

Intangibles with Finite Lives

• Examples: Patents, copyrights
• Amortized just like depreciation (SL, DDB)

Analogy:

A patent is like a limited-time movie ticket — expires eventually.

GAAP

• Always uses cost model (historical cost – accumulated depreciation).

IFRS

• Can choose cost model or revaluation model.
  

Revaluation Model Rules

• Gains → revaluation surplus (equity), skip the income statement
• Losses → reduce surplus first, then hit income statement
• Gains after losses reverse income statement losses first
  LM8 – Long Lived Assets

Analogy:

Think of a revaluation surplus like a “piggy bank”.

• Gains fill the piggy bank.
• Losses empty it before affecting the income statement.

Impairment Testing

If impaired:

• Asset written down
• Loss goes to the income statement

Effects

• Assets ↓
• Expenses ↑
• Net income ↓
• ROE & ROA ↓
• Future depreciation ↓ → future income ↑
  LM8 – Long Lived Assets

Analogy:

Impairment is waking up to realize your car is worth less than you thought — you recognize the loss today, but future insurance costs drop.

Derecognition of Assets

Occurs when PP&E is removed from balance sheet.
Three methods:

1. Sale – Gain/Loss = Sale price – Carrying Value

2. Abandonment – Loss = Carrying Value

3. Exchange – Remove old asset; new asset recorded; difference → gain/loss

Analogy:

Like getting rid of an old laptop:

• Sell it
• Throw it away
• Trade it in

\text{Total Useful Life} =
\frac{\text{Historical Cost}}{\text{Annual Depreciation}}

\text{Average Age} =
\frac{\text{Accumulated Depreciation}}{\text{Annual Depreciation}}

\text{Remaining Useful Life} =
\frac{\text{Net Book Value}}{\text{Annual Depreciation}}

Analogy:

It’s like reading the “age” of a car based on miles driven vs expected mileage

• Property held for rent or appreciation
• Uses revaluation model
• Gains & losses go directly to income statement, not equity

Analogy:

An investment property is like a rental condo — each time its value changes, you recognize it as income or loss immediately.

• Capitalization smooths net income and boosts early-year profitability.
• IFRS offers more flexibility (revaluation, capitalization of development).
• Impairments decrease current income but improve future income.
• Double Declining Balance shifts expenses forward → lower NI early.
• Investment property treatment under IFRS is unique (all FV changes in IS).
• Always analyze PP&E turnover, age, and remaining useful life for valuation insights.
• Revaluation surplus behaves like a “buffer” before gains/losses hit income.

Why Income Tax Expense ≠ Taxes Payable

Financial statements and tax returns often recognize revenue/expense at different times → temporary differences.
This creates:

• Deferred Tax Liability (DTL)
• Deferred Tax Asset (DTA)

Analogy:

Think of it like paying rent on different schedules:

• Accounting books pay monthly
• Tax rules pay quarterly
  The mismatch creates temporary “prepaid or owed” amounts.

Key Definitions

Tax Due

\text{Tax Due} = \text{Income Tax Expense} - \text{Taxes Payable}

Pre-Tax Income

• Accounting profit → Income statement
• Taxable income → Tax return

Deferred Tax Liability (DTL)

Occurs when: Income Tax Expense>Taxes Payable

Meaning: the company paid less tax now but will pay more later.
Caused by:

• Revenue recognized sooner in accounting
• Expenses recognized later in accounting

Analogy:

A DTL is a tax IOU — like deferring part of your rent to next month.

Deferred Tax Asset (DTA)

Occurs when: Income Tax Expense<Taxes Payable

Meaning: the firm paid more tax today than required → future benefit.
Often caused by:

• Higher expenses for accounting
• Lower revenue for accounting

Analogy:

A DTA is like prepaying your phone bill: you’ve paid early and will benefit later.

Temporary vs Permanent Differences

Only temporary differences create DTA/DTL. If difference is permanent, no deferred tax entries.

• Tax credits that directly reduce taxes → permanent difference

Analogy:

Temporary = “I’ll pay/receive later.”
Permanent = “Never reversing — forget about it.”

Tax Base of Assets & Liabilities

Tax Base of Asset

Value not yet recognized for tax depreciation.

DTL Formula

\text{DTL} = (\text{Carrying Value} - \text{Tax Base}) \times \text{Tax Rate}

If negative → it’s a DTA.

Tax Base of Liability

Amount not yet taxed on tax return.
For unearned revenue: tax base = 0

Analogy:

Tax base is what the government thinks your “remaining value” is for tax purposes.

Changes in Tax Rates

\text{Income Tax Expense}
  = \text{Taxes Payable}
  + \Delta \text{DTL}
  - \Delta \text{DTA}

If tax rate ↑ → both DTL and DTA ↑

Analogy:

Like changing the interest rate on a loan — the value of what you owe or are owed automatically adjusts.

Only record DTA/DTL if the difference will reverse

Permanent differences → do not create DTA/DTL

Valuation Allowance (VA) — GAAP Only

If it is more likely than not (>50%) that a DTA will not be realized → reduce the DTA using a valuation allowance.

Analogy:

A valuation allowance is like writing down a gift card you might never use.

IFRS vs GAAP Treatment

• GAAP:
  • Uses valuation allowance
  • Classifies DTA/DTL based on underlying asset/liability
• IFRS:
  • No valuation allowance
  • Reports net DTA
  • All DTA/DTL are non-current

Special Cases

DTL that is not expected to reverse → Record as equity, not as a liability

If DTA/DTL arises from equity transactions (e.g., revaluation surplus)
→ Record directly in equity

Depreciation Differences

Income statement might use SL while tax return uses DDB → creates temporary differences → DTA/DTL

Analogy:

Two people reading the same book at different speeds — but both finish eventually.

Disclosures (Must Report)

• DTAs & DTLs
• Valuation allowance & changes
• Tax loss carryforwards / credits
• Reconciliation of tax expense
• Classification differences (IFRS: all non-current; GAAP: depends on asset)

• DTA = future tax benefit; DTL = future tax obligation.
• Deferred taxes only arise from temporary differences.
• Permanent differences never reverse and never create deferred taxes.
• Valuation allowance reduces DTA when recovery is unlikely (GAAP only).
• Change in tax rates affects both DTA & DTL immediately.
• DTL that will not reverse → record as equity (rare but testable).
• IFRS vs GAAP differences (valuation allowance, classification) are heavily tested.
• Always reconcile tax expense using:Tax Expense=Taxes Payable+ΔDTL−ΔDTATax Expense=Taxes Payable+ΔDTL−ΔDTA

• Market rate (effective rate) determines the price investors will pay.
• Coupon rate is the stated interest rate on the bond.

Price Relationships

• Coupon = Market rate → Bond sells at par
• Coupon < Market rate → Bond sells at discount
• Coupon > Market rate → Bond sells at premium

Explanation:

Discounts/premiums occur because investors compare the bond’s coupon payments to what the market offers today.

Analogy:

If movie tickets cost $20 normally (market rate), but you are selling yours for $15 (coupon lower than market), people will pay more to match the “value,” making the bond sell at a discount.

Bond Carrying Behaviour

Premium Bond

• Carrying value decreases over time until it reaches face value.

Analogy:

Like slowly deflating a balloon — you start above par but come down each period.

Discount Bond

• Carrying value increases over time toward face value.

Analogy:

Like filling a balloon — you start below par and inflate toward face value.

Effective Interest Method

• Interest Expense is always based on the market rate at issuance and beginning carrying value.
• Coupon payment is based on face value × coupon rate.

Placements on Statements

• Interest Expense → Income Statement
• Coupon (cash paid) → CFO (GAAP), CFO or CFF (IFRS)
• Carrying Value → Balance Sheet

Amortization Formula

\text{Interest Expense}
  = \text{CV}_{\text{beg}}
  \times \text{Market Rate}

\text{Coupon Payment}
  = \text{Face Value} \times \text{Coupon Rate}

\text{Amortization Amount}
  = \text{Interest Expense} - \text{Coupon Payment}

• For discount bonds, amortization ↑ carrying value.
• For premium bonds, amortization ↓ carrying value.

Fair Value Reporting

IFRS & GAAP allow firms to measure bonds at fair value.
Changes in fair value come from:

1. Market interest rate changes → go to income statement
2. Credit spread changes → go to OCI

Added Explanation:

Credit risk is the issuer’s perceived default risk; market interest risk is external yield curve movement.

Issuance Costs

Bond liability on BS = Sales Proceeds − Issuance Costs

Analogy:

Like selling a house — closing costs reduce what you actually receive.

Companies can either:

• Wait until maturity to repay, or
• Redeem early (usually at a premium → loss)

Analogy:

Like breaking a phone contract early → expect a penalty fee.

Covenants protect the lender and restrict borrower behavior.

Affirmative Covenants (must do)

• Pay interest on time
• Follow regulations

Negative Covenants (must NOT do)

• No large acquisitions
• No excessive dividends
• Maintain max D/E ratio

Explanation:

These prevent the borrower from taking actions that increase default risk.

Presentation & Disclosures

What firms must disclose:

• Nature of liabilities
• Stated & effective rates
• Maturity schedule
• 5-year debt maturity table
• Call provisions
• Restrictions & collateral

Lessee Advantages

• Lower upfront costs
• Lower financing cost
• Less obsolescence risk

Lessor Advantages

• Interest income
• Increased usage of its products

Lease Types

Finance Lease (Lessee)

“Resembles ownership.”
Criteria (any one may qualify):

• Ownership transfers
• Lease term = majority of asset life
• PV of payments ≈ fair value
• Purchase option likely exercised
• Asset has no alternative use

Explanation:

Finance leases front-load interest expense and treat asset like a purchase.

Operating Lease (Lessee)

• Under GAAP only
• Payment separated into principal + interest
• ROU asset + Lease liability

Lease Accounting — Lessor

Operating Lease

• Keep asset on BS
• Depreciate asset
• Rent payments → revenue

Finance Lease

• Record lease receivable = PV of future payments
• Recognize gain/loss if carrying value ≠ lease receivable
• Principal reduces receivable

Defined Contribution Plan (DC)

• Employer contributes fixed amount
• Employee bears investment risk

Analogy:

Like your employer adding money into your personal investment account — you decide how it grows.

Defined Benefit Plan (DB)

• Employer promises future payments
• Firm bears investment risk

Analogy:

A DB plan is like a lifetime allowance — the company guarantees a future pension no matter what markets do.

Funded Status

Funded Status=Fair Value of Plan Assets−PV of Pension LiabilitiesFunded Status=Fair Value of Plan Assets−PV of Pension Liabilities

• If positive → Overfunded → Net pension asset
• If negative → Underfunded → Net pension liability

Changes affect:

• Income statement, or
• OCI

Leverage & Coverage Ratios

• Leverage ratios (e.g., D/E) → better when lower
• Coverage ratios (e.g., interest coverage) → better when higher

Added Explanation:

Leverage = reliance on debt
Coverage = ability to meet interest obligations

• Premium/discount amortization always leads carrying value → face value at maturity.
• Market rate at issuance is never changed when calculating interest expense.
• Fair value option sends market-rate changes to IS, credit changes to OCI.
• Finance vs operating lease distinctions affect profitability, leverage & cash flows.
• DB plans create major BS volatility → depends on funded status.
• Leverage ratios improve with lower debt; coverage improves with higher income.

Financial Reporting Quality

Reports are high-quality when they:

• Comply with GAAP/IFRS
• Provide information that is relevant, complete, neutral, transparent
• Help users make decisions

Quality of Reported Results

High-quality results when:

• Earnings are sustainable
• Earnings provide adequate return to investors

Analogy:

Financial reporting quality = “accuracy of the map.”
Reported results quality = “how good the destination actually is.”

Spectrum of Reporting Quality (Best → Worst)

1. GAAP-compliant, decision useful, sustainable earnings
2. GAAP, decision useful, unsustainable earnings
3. GAAP, biased choices (e.g., lower expenses than appropriate)
4. GAAP, earnings management
5. Not GAAP-compliant
6. Fictitious transactions (fraud)

Earnings management can still occur within GAAP.

Levels 1–3 are “legal but questionable,”
Level 4 is “manipulative but still within GAAP,”
5 & 6 are outright fraud.

Conservative Accounting

Produces lower current earnings, higher future earnings.
Tactics include:

• Higher depreciation (accelerated)
• Lower salvage value
• Shorter useful life
• Higher impairments
• Higher bad debt expense

Analogy:

Conservative accounting is like under-promising so future results look better.

Aggressive Accounting

Produces higher current earnings, lower future earnings.
Tactics include:

• Straight-line depreciation
• Higher salvage value
• Longer useful life
• Lower impairments
• Lower bad debt expense

Analogy:

Aggressive accounting is like overstating your fitness level—looks good today, unsustainable later.

Motivation / Intent

Intent must exist to manipulate results. Motivations:

• Hide poor performance
• Meet analyst expectations
• Maintain stock price
• Increase compensation

Opportunity

Occurs when environment weakens oversight:

• Weak internal controls
• Poor board supervision
• Flexible accounting standards

Rationalization

How management justifies manipulation:

• “It’ll reverse next quarter.”
• “Everyone does it.”
• “It helps long-term goals.”

Analogy:

Fraud triangle = diet cheating: temptation (motivation), chance (opportunity), excuses (rationalization).

Discipline Mechanisms

Used to maintain reporting quality:

• Market discipline: higher perceived risk → higher required returns
• Regulators (SEC, FCA)
• Auditors → provide assurance
• Debt covenants

Companies may use Non-GAAP metrics to show “core earnings.”
But must:

• Present comparable GAAP measure
• Explain why non-GAAP measure is useful
• Reconcile GAAP → non-GAAP

Added Explanation:

Non-GAAP numbers often exclude “non-recurring” items, but firms may abuse this to hide recurring losses.

Inflating Revenue

• Recognize revenue early
• Increase accounts receivable
• Alter shipping terms (bill-and-hold)

Expense Manipulation

• Decrease bad debt / warranty estimates
• Lower valuation allowance
• Capitalize vs. expense decisions

Inventory Methods

• Favor FIFO in rising prices → COGS ↓, earnings ↑

Cash Flow Manipulation

• Delay paying suppliers → A/P ↑ → CFO ↑ artificially
• Capitalize interest → moves cash outflow to CFI, artificially boosting CFO

Analogy:

Manipulating CFO is like hiding credit card bills to make your bank account look healthier.

Revenue & Cash Flow

• Sudden change in revenue recognition
• Higher revenue not matched by receivables
• NI growing faster than CFO
• Asset turnover patterns out of line

Inventory & Depreciation

• Inventory rising faster than sales
• Capitalizing unusual items
• Inventory turnover ↓
• LIFO liquidation (boosts income)

Other Red Flags

• 4th quarter results far different from other quarters
• Related-party transactions
• Non-recurring items used repeatedly
• Heavy reliance on non-GAAP measures

Analogy:

Warning signs are like engine warning lights—one by itself might be fine, but multiple together mean trouble

• High financial reporting quality ≠ high earnings quality → they are distinct.
• Many forms of earnings management are GAAP-compliant.
• Aggressive accounting boosts short-term earnings but harms future sustainability.
• CFO patterns are often the strongest indicator of manipulation.
• Non-GAAP measures require reconciliation and can hide recurring costs.
• Inventory and receivables ratios are powerful red flags in exams.
• Fraud triangle is foundational: motivation, opportunity, rationalization.

Financial statement analysis focuses on understanding how a company performed historically and whether performance is sustainable.

Use of Ratios

Ratios help analysts:

• Identify trends over time
• Measure profitability, liquidity, solvency, and efficiency
• Compare performance across firms
• Understand a firm’s strategy

Added Explanation:

Profitability tells how efficiently the company turns revenue into income.
Liquidity tells whether short-term obligations can be met.
Solvency tells whether long-term obligations can be met.
Efficiency tells how well assets generate revenue.

Analogy:

Ratios are like a health check-up: blood pressure (liquidity), lung capacity (solvency), heart health (profitability), and metabolism (efficiency).

Strategy Interpretation via Ratios

If a firm has lower gross margins, it may be pursuing a low-cost strategy rather than differentiation.

Analogy:

Think Walmart (low margin, high volume) vs. Apple (high margin, differentiated brand).

Analysts often:

• Express each line item as a percentage of revenues (common-size forecasting)
• Hold these percentages steady or adjust based on expectations
• Make assumptions about:
  • Working capital changes
  • Future capital expenditures (CAPEX)
  • Dividend policy

Added Explanation:

Forecasting models often begin with sales projections, then use margins & ratios to estimate future profitability.

Analogy:

Forecasting is like planning a trip: estimate fuel needed (working capital), maintenance (CAPEX), and how much you can spend on stops (dividends).

Credit analysis determines whether a company can meet interest and principal payments on time.

Key Categories:

1. Size & Scale – larger firms often more stable
2. Operating Efficiency & Earnings Sustainability – consistent profitability
3. Financial Leverage – debt levels & debt-related ratios
4. Liquidity – ability to meet short-term obligations

Banks and bondholders rely heavily on coverage ratios like interest coverage and debt/EBITDA.

Analogy:

• Lending money to a company is like lending to a friend:
• Do they manage cash well? (liquidity)
• Do they earn regularly? (profitability)
• Do they already owe others money? (leverage)

Analysts screen stocks using attribute filters:

Common Screening Filters

• Low P/E
• Low D/E
• Dividend-paying
• High earnings growth
• Low P/B for value investors

Investor Styles

• Growth investors → seek high earnings & high growth
• Value investors → want cheap metrics (low P/E, low P/B)

Analogy:

Growth investors shop for fast-growing startups; value investors shop for undervalued hidden gems.

Analysts often adjust statements to improve comparability.

Inventory & Depreciation Adjustments

• Compare firms with different salvage value assumptions
• Adjust useful life differences
• Convert FIFO to LIFO or vice-versa for consistency

FIFO vs. LIFO shifts income between periods; analysts adjust to compare companies properly.

Securities Classifications

• Available-for-sale (AFS) unrealized gains/losses → OCI
• Held-for-trading (HFT) unrealized gains/losses → Income Statement

Analogy:

HFT is like day-trading — gains/losses hit earnings right away.
AFS is like holding a long-term investment — changes appear in equity until sold.

Goodwill Adjustments

• Analysts often exclude goodwill when calculating ratios → use tangible assets only
• Goodwill impairments hit the income statement
• If impairment is reversed for analysis, adjust accordingly

Analogy:

Goodwill = “brand premium.” Since it can vanish suddenly via impairments, analysts often strip it out.

Goodwill distortions often require adjustments for ROA, ROE, asset turnover.

Ratio analysis is foundational for assessing historical performance.

Forecasts often begin with revenue projections and stable ratios.

Credit analysis relies heavily on coverage and liquidity ratios.

Equity investors differ in what they screen for (value vs. growth).

Comparable analysis requires adjusting accounting differences (FIFO/LIFO, useful lives).

Unrealized gains/losses differ by classification (OCI vs. IS).