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from (continued front flap) well as concise learning outcome statements and summary chapter overviews. THOMAS R. ROBINSON, CFA, is Managing Director, Education Division of CFA Institute, where he leads and develops the teams responsible for producing and delivering educational content and examinations to candidates, members, and other investment professionals encompassing the CFA Program, CIPM Program, Lifelong Learning, Private Wealth, Publications, and Conferences. HENNIE van GREUNING, CFA, is a Senior Advisor at the World Bank. His World Bank publication on I nternational Financial Reporting Standards has appeared in four editions. Mr. van Greuning has also coauthored Analyzing and Managing Banking Risk. ELAINE HENRY, CFA, is an Assistant Professor of Accounting at the University of Miami, where she teaches courses in accounting, nancial statement analysis, and valuation. After working in corporate nance at Lehman Brothers, strategy consulting at McKinsey & Company, and corporate banking at Citibank, she obtained a PhD from Rutgers University where she majored in accounting and minored in nance. MICHAEL A. BROIHAHN, CFA, is an Associate Professor of Accounting and the Director of Graduate Programs at Barry University in Miami, Florida. His teaching and research interests encompass nancial accounting, auditing, and professional ethics. He currently serves CFA Institute in a number of capacities. Jacket Design: Loretta Leiva Jacket Illustration: Getty Images PRAISE FOR INTERNATIONAL FINANCIAL STATEMENT ANALYSIS International Financial Statement Analysis is arriving on the scene at the right time with a new and useful orientation and comprehensive coverage. It should be an important and valuable resource. GARY JOHN PREVITS, E. Mandell de Windt Professor, Case Western Reserve University This text is the basis for analyzing and interpreting nancial statements of companies around the globe and appeals to both the student and seasoned investor. It is an essential read and reference book for the global investor in search of alpha. CHRIS SENYEK, CFA, CPA, Managing DirectorAccounting & Tax Policy Research, ISI Group, Inc. This text is a valuable addition to the nancial statement analysis literature with its emphasis on nancial reporting from an IFRS perspective, while highlighting major differences between IFRS and U.S. GAAP throughout. With IFRS rapid global adoption, it provides a nancial statement analysis foundation for analysts globally who will be comparing IFRS and U.S. GAAP nancial statements in the coming years as convergence continues. The authors integration of the IFRS framework throughout the text is particularly noteworthy, since it is the rst source of guidance that professionals utilize when applying IFRS in practice. DAVID R. CAMPBELL SR., Professor of Accounting, Drexel University Dont forget to pick up the I nternational Financial Statement Analysis Workbook . A companion study guide that mirrors this text chapter by chapter. International Financial International Financial Statement Analysis Statement Analysis Straightforward and accessible, International Financial Statement Analysis provides you with the continuity of topic coverage that is so critical to the learning process. Filled with in-depth insights and expert advice, this practical guide offers a detailed look at how nancial statement analysis can be understood in a global context and applied around the world. Robinson van Greuning Henry Broihahn $95.00 USA/$105.00 CAN INTERNATIONAL FINANCIAL STATEMENT ANALYSIS T he process of nancial statement analysis allows you to gain important insights into the true nancial condition of a company. With it, realistic valuations can be made for investment, lending, or merger and acquisition purposes. While this discipline has increased in complexity especially on an international levelthere are ways to deal with the practical challenges youll face. As part of the CFA Institute Investment Series, I nternational Financial Statement Analysis has been designed to help you effectively evaluate nancial statements in todays volatile markets and uncertain global economy. With I nternational Financial Statement Analysis, the distinguished team of Thomas Robinson, Hennie van Greuning, Elaine Henry, and Michael Broihahntogether with a number of experienced contributorsprovides you with complete coverage of the most important issues in this eld. Written with both the established and aspiring nancial professional in mind, this book will help you understand the mechanics of the accounting process, which is the foundation for nancial reporting; comprehend the differences and similarities in income statements, balance sheets, and cash ow statements around the globe; and assess the implications for securities valuation of any nancial statement element or transaction. Youll also discover how different nancial analysis techniques such as ratio analysis and common-size nancial statementscan provide valuable clues into a companys operations and risk characteristics. Along the way, youll also become familiar with many other essential aspects of this discipline, including the importance of income tax accounting and reporting, the difculty of measuring the value of employee compensation, and the impact of foreign exchange rates on the nancial statements of a multinational corporation. And to enhance your understanding of the tools and techniques presented here, dont forget to pick up the I nternational Financial Statement Analysis Workbook. This companion guide contains carefully constructed problems with detailed solutions as (continued on back flap) ffirs.indd ffirs.indd i 9/17/08 12:47:45 PM INTERNATIONAL FINANCIAL STATEMENT ANALYSIS ffirs.indd i 9/17/08 12:47:45 PM CFA Institute is the premier association for investment professionals around the world, with over 95,000 members in 134 countries. Since 1963 the organization has developed and administered the renowned Chartered Financial Analyst Program. With a rich history of leading the investment profession, CFA Institute has set the highest standards in ethics, education, and professional excellence within the global investment community, and is the foremost authority on investment profession conduct and practice. Each book in the CFA Institute Investment Series is geared toward industry practitioners, along with graduate-level nance students, and covers the most important topics in the industry. The authors of these cutting-edge books are themselves industry professionals and academics and bring their wealth of knowledge and expertise to this series. ffirs.indd ii 9/17/08 12:47:46 PM INTERNATIONAL FINANCIAL STATEMENT ANALYSIS Thomas R. Robinson, CFA Hennie van Greuning, CFA Elaine Henry, CFA Michael A. Broihahn, CFA John Wiley & Sons, Inc. ffirs.indd iii 9/17/08 12:47:46 PM Copyright 2009 by CFA Institute. All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 750-4470, or on the web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions. Limit of Liability/Disclaimer of Warranty: While the publisher and authors have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specically disclaim any implied warranties of merchantability or tness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of prot or any other commercial damages, including but not limited to special, incidental, consequential, or other damages. For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762-2974, outside the United States at (317) 572-3993, or fax (317) 572-4002. Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. For more information about Wiley products, visit our web site at www.wiley.com. Library of Congress Cataloging-in-Publication Data: International nancial statement analysis / Thomas R. Robinson . . . [et al.]. p. cm.(CFA Institute investment series) Includes index. ISBN 978-0-470-28766-8 (cloth) 1. Financial statements. 2. International business enterprisesAccounting. HF5681.B2I5788 2008 657'.3dc22 I. Robinson, Thomas R. 2008014644 Printed in the United States of America 10 9 8 7 6 5 4 3 2 1 ffirs.indd iv 9/17/08 12:47:47 PM CONTENTS Foreword Preface Acknowledgments Introduction CHAPTER 1 Financial Statement Analysis: An Introduction Learning Outcomes 1. Introduction 2. Scope of Financial Statement Analysis 3. Major Financial Statements and Other Information Sources 3.1. Financial Statements and Supplementary Information 3.2. Other Sources of Information 4. Financial Statement Analysis Framework 4.1. Articulate the Purpose and Context of Analysis 4.2. Collect Data 4.3. Process Data 4.4. Analyze/Interpret the Processed Data 4.5. Develop and Communicate Conclusions/Recommendations 4.6. Follow Up 5. Summary Practice Problems CHAPTER 2 Financial Reporting Mechanics Learning Outcomes 1. Introduction 2. The Classication of Business Activities 3. Accounts and Financial Statements 3.1. Financial Statement Elements and Accounts 3.2. Accounting Equations xvii xix xxiii xxv 1 1 2 2 5 6 16 18 19 20 21 21 21 22 22 23 25 25 26 26 27 28 30 v ftoc.indd v 9/17/08 12:48:13 PM vi Contents 4. The Accounting Process 4.1. An Illustration 4.2. The Accounting Records 4.3. Financial Statements 5. Accruals and Valuation Adjustments 5.1. Accruals 5.2. Valuation Adjustments 6. Accounting Systems 6.1. Flow of Information in an Accounting System 6.2. Debits and Credits 7. Using Financial Statements in Security Analysis 7.1. The Use of Judgment in Accounts and Entries 7.2. Misrepresentations 8. Summary Practice Problems Appendix 2A: A Debit/Credit Accounting System CHAPTER 3 Financial Reporting Standards Learning Outcomes 1. Introduction 2. The Objective of Financial Reporting 3. Financial Reporting Standard-Setting Bodies and Regulatory Authorities 3.1. International Accounting Standards Board 3.2. International Organization of Securities Commissions 3.3. Capital Markets Regulation in Europe 3.4. Capital Markets Regulation in the United States 4. Convergence of Global Financial Reporting Standards 5. The International Financial Reporting Standards Framework 5.1. Objective of Financial Statements 5.2. Qualitative Characteristics of Financial Statements 5.3. Constraints on Financial Statements 5.4. The Elements of Financial Statements 5.5. General Requirements for Financial Statements 6. Comparison of IFRS with Alternative Reporting Systems 6.1. U.S. GAAP 6.2. Implications of Other Reporting Systems 6.3. Reconciliation of Financials Prepared According to Different Standards 7. Effective Financial Reporting 7.1. Characteristics of an Effective Financial Reporting Framework 7.2. Barriers to a Single Coherent Framework 8. Monitoring Developments in Financial Reporting Standards 8.1. New Products or Types of Transactions 8.2. Evolving Standards and the Role of CFA Institute 8.3. Company Disclosures 9. Summary Practice Problems ftoc.indd vi 36 36 36 50 52 52 54 55 55 55 57 57 58 59 59 62 79 79 80 80 82 83 83 84 85 87 89 89 91 92 92 94 98 98 99 101 102 102 102 104 104 105 106 109 110 9/17/08 12:48:14 PM Contents CHAPTER 4 Understanding the Income Statement Learning Outcomes 1. Introduction 2. Components and Format of the Income Statement 3. Revenue Recognition 3.1. General Principles 3.2. Revenue Recognition in Special Cases 3.3. Implications for Financial Analysis 4. Expense Recognition 4.1. General Principles 4.2. Issues in Expense Recognition 4.3. Implications for Financial Analysis 5. Nonrecurring Items and Nonoperating Items 5.1. Discontinued Operations 5.2. Extraordinary Items 5.3. Unusual or Infrequent Items 5.4. Changes in Accounting Standards 5.5. Nonoperating Items: Investing and Financing Activities 6. Earnings Per Share 6.1. Simple versus Complex Capital Structure 6.2. Basic EPS 6.3. Diluted EPS 7. Analysis of the Income Statement 7.1. Common-Size Analysis of the Income Statement 7.2. Income Statement Ratios 8. Comprehensive Income 9. Summary Practice Problems CHAPTER 5 Understanding the Balance Sheet Learning Outcomes 1. Introduction 2. Components and Format of the Balance Sheet 2.1. Structure and Components of the Balance Sheet 2.2. Format of the Balance Sheet 3. Measurement Bases of Assets and Liabilities 3.1. Current Assets 3.2. Current Liabilities 3.3. Tangible Assets 3.4. Intangible Assets 3.5. Financial Instruments: Financial Assets and Financial Liabilities 4. Equity 4.1. Components of Equity 4.2. Statement of Changes in Shareholders Equity ftoc.indd vii vii 113 113 114 114 118 119 121 128 129 130 134 139 139 140 140 141 142 143 144 144 145 146 152 152 154 157 160 161 165 165 166 166 167 170 177 181 184 187 187 192 194 194 196 9/17/08 12:48:15 PM viii 5. Uses and Analysis of the Balance Sheet 5.1. Common-Size Analysis of the Balance Sheet 5.2. Balance Sheet Ratios 6. Summary Practice Problems CHAPTER 6 Understanding the Cash Flow Statement Learning Outcomes 1. Introduction 2. Components and Format of the Cash Flow Statement 2.1. Classication of Cash Flows and Noncash Activities 2.2. A Summary of Differences between IFRS and U.S. GAAP 2.3. Direct and Indirect Cash Flow Formats for Reporting Operating Cash Flow 3. The Cash Flow Statement: Linkages and Preparation 3.1. Linkages of the Cash Flow Statement with the Income Statement and Balance Sheet 3.2. Steps in Preparing the Cash Flow Statement 3.3. Conversion of Cash Flows from the Indirect to the Direct Method 4. Cash Flow Statement Analysis 4.1. Evaluation of the Sources and Uses of Cash 4.2. Common-Size Analysis of the Statement of Cash Flows 4.3. Free Cash Flow to the Firm and Free Cash Flow to Equity 4.4. Cash Flow Ratios 5. Summary Practice Problems CHAPTER 7 Financial Analysis Techniques Learning Outcomes 1. Introduction 2. The Financial Analysis Process 2.1. The Objectives of the Financial Analysis Process 2.2. Distinguishing between Computations and Analysis 3. Analysis Tools and Techniques 3.1. Ratios 3.2. Common-Size Analysis 3.3. The Use of Graphs as an Analytical Tool 3.4. Regression Analysis 4. Common Ratios Used in Financial Analysis 4.1. Interpretation and Context 4.2. Activity Ratios 4.3. Liquidity Ratios 4.4. Solvency Ratios ftoc.indd viii Contents 200 201 207 210 211 215 215 216 217 217 219 221 228 228 230 242 243 243 246 250 251 253 254 259 259 260 261 261 261 264 265 270 275 276 276 277 278 284 288 9/17/08 12:48:15 PM Contents ix 4.5. Protability Ratios 4.6. Integrated Financial Ratio Analysis 5. Equity Analysis 5.1. Valuation Ratios 5.2. Industry-Specic Ratios 5.3. Research on Ratios in Equity Analysis 6. Credit Analysis 6.1. The Credit Rating Process 6.2. Research on Ratios in Credit Analysis 7. Business and Geographic Segments 7.1. IAS 14 Requirements 7.2. Segment Ratios 8. Model Building and Forecasting 9. Summary Practice Problems 291 295 302 303 306 306 308 309 310 311 311 313 314 314 315 CHAPTER 8 International Standards Convergence 323 Learning Outcomes 1. Introduction 2. The IFRS Framework 2.1. Key Aspects of the IFRS Framework 2.2. Challenges in Financial Statement Preparation: Timing and Amounts 3. The Balance Sheet 3.1. Marketable Securities 3.2. Inventories 3.3. Property, Plant, and Equipment 3.4. Long-Term Investments 3.5. Goodwill 3.6. Intangible Assets Other than Goodwill 3.7. Provisions (Nonnancial Liabilities) 4. The Income Statement 4.1. Revenue Recognition: General 4.2. Revenue Recognition for Construction Contracts 4.3. Cost of Sales 4.4. Administrative Expenses (Including Employee Benets) 4.5. Depreciation Expenses 4.6. Finance Costs 4.7. Income Tax Expense 4.8. Nonrecurring Items 5. The Cash Flow Statement 6. Standard Setters Agenda for Convergence 7. Effect of Differences Between Accounting Standards 8. Summary Practice Problems ftoc.indd ix 323 324 325 325 326 326 327 329 329 330 331 335 336 336 336 337 337 337 337 338 338 339 339 340 341 344 345 9/17/08 12:48:16 PM x Contents CHAPTER 9 Financial Statement Analysis: Applications Learning Outcomes 1. Introduction 2. Application: Evaluating Past Financial Performance 3. Application: Projecting Future Financial Performance 3.1. Projecting Performance: An Input to Market-Based Valuation 3.2. Projecting Multiple-Period Performance 4. Application: Assessing Credit Risk 5. Application: Screening for Potential Equity Investments 6. Analyst Adjustments to Reported Financials 6.1. A Framework for Analyst Adjustments 6.2. Analyst Adjustments Related to Investments 6.3. Analyst Adjustments Related to Inventory 6.4. Analyst Adjustments Related to Property, Plant, and Equipment 6.5. Analyst Adjustments Related to Goodwill 6.6. Analyst Adjustments Related to Off-Balance-Sheet Financing 7. Summary Practice Problems CHAPTER 10 Inventories Learning Outcomes 1. Introduction 2. Inventory Cost and Inventory Accounting Methods 2.1. Determination of Inventory Cost 2.2. Declines in Inventory Value 2.3. Inventory Accounting Methods 2.4. Comparison of Inventory Accounting Methods 3. Financial Analysis of Inventories 3.1. Inventory Ratios 3.2. Financial Analysis Illustration 4. LIFO Accounting Method Under U.S. GAAP 4.1. The LIFO Method 4.2. LIFO Reserve 4.3. LIFO Liquidations 4.4. Inventory Financial Note Disclosures 5. Effects of Inventory Method Choice 5.1. Financial Statement Effects of Using LIFO 5.2. Inventory Method Changes 6. Summary Practice Problems 349 349 350 351 356 357 360 364 367 371 371 371 373 375 376 378 385 386 389 389 390 390 391 392 393 395 395 396 396 403 403 405 411 413 413 414 414 415 416 CHAPTER 11 Long-Lived Assets Learning Outcomes 1. Introduction ftoc.indd x 419 419 420 9/17/08 12:48:17 PM Contents 2. Accounting for the Acquisition of Long-Lived Tangible Assets 2.1. Accounting Standards Related to Capitalization of Expenditures 2.2. Costs Incurred at Acquisition 2.3. Capitalization of Interest Costs 3. Accounting for the Acquisition of Long-Lived Intangible Assets 3.1. Intangible Assets Purchased in Situations Other than Business Combinations 3.2. Intangible Assets Developed Internally 3.3. Intangible Assets Acquired in a Business Combination 4. Depreciating Long-Lived Tangible Assets 4.1. Depreciation Methods 4.2. Estimates Required for Depreciation Calculations 4.3. Using Fixed Asset Disclosures to Compare Companies Average Age of Depreciable Assets 5. Amortizing Intangible Assets with Finite Useful Lives 5.1. Amortizing Intangible Assets with Finite Useful Lives 5.2. Estimates Required for Amortization Calculations 6. Asset Retirement Obligations 7. Disposal of Long-Lived Operating Assets 7.1. Sale of Long-Lived Assets 7.2. Long-Lived Assets Disposed of Other than by a Sale 8. Impairment of Long-Lived Assets 8.1. Impairment of Long-Lived Tangible Assets Held for Use 8.2. Impairment of Intangible Assets with a Finite Life 8.3. Impairment of Goodwill and Other Intangibles with Indenite Lives 8.4. Impairment of Long-Lived Assets Held for Sale 8.5. Reversals of Impairments of Long-Lived Assets 8.6. Implications for Financial Statement Analysis 9. Revaluation of Long-Lived Assets 10. Summary Practice Problems CHAPTER 12 Income Taxes Learning Outcomes 1. Introduction 2. Differences Between Accounting Prot and Taxable Income 2.1. Current Tax Assets and Liabilities 2.2. Deferred Tax Assets and Liabilities 3. Determining the Tax Base of Assets and Liabilities 3.1. Determining the Tax Base of an Asset 3.2. Determining the Tax Base of a Liability 3.3 Changes in Income Tax Rates 4. Temporary and Permanent Differences Between Taxable and Accounting Prot 4.1. Taxable Temporary Differences 4.2. Deductible Temporary Differences 4.3. Examples of Taxable and Deductible Temporary Differences 4.4. Temporary Differences at Initial Recognition of Assets and Liabilities ftoc.indd xi xi 420 421 425 426 428 428 429 433 435 435 439 440 444 444 444 444 449 449 454 456 456 458 459 460 460 461 461 464 465 469 469 470 470 471 472 476 476 478 479 481 481 482 482 484 9/17/08 12:48:17 PM xii Contents 4.5. 4.6. Business Combinations and Deferred Taxes Investments in Subsidiaries, Branches, and Associates and Interests in Joint Ventures 5. Unused Tax Losses and Tax Credits 6. Recognition and Measurement of Current and Deferred Tax 6.1. Recognition of a Valuation Allowance 6.2. Recognition of Current and Deferred Tax Charged Directly to Equity 7. Presentation and Disclosure 8. Comparision of IFRS and U.S. GAAP 9. Summary Practice Problems CHAPTER 13 Long-Term Liabilities and Leases Learning Outcomes 1. Introduction 2. Bonds Payable 2.1. Accounting for Bond Issuance 2.2. Accounting for Bond Amortization, Interest Expense, and Interest Payments 2.3. Debt Extinguishment 2.4. Debt Covenants 2.5. Presentation and Disclosure of Long-Term Debt 2.6. Current Market Rates and Fair Values 3. Debt with Equity Features 3.1. Convertible Debt 3.2. Debt with Warrants 3.3. Financial Instruments with Characteristics of Both Debt and Equity 4. Leases 4.1. Advantages of Leasing 4.2. Finance (or Capital) Leases versus Operating Leases 5. Other Types of Off-Balance-Sheet Financing 5.1. Take-or-Pay and Throughput 5.2. Sale of Receivables 6. Summary Practice Problems CHAPTER 14 Employee Compensation: Postretirement and Share-Based Learning Outcomes 1. Introduction 2. Pensions and Other Postretirement Benets 2.1. Types of Postretirement Benet Plans and the Implications for Financial Reports 2.2. Measuring a Dened-Benet Pension Plans Liabilities 2.3. Measuring a Dened-Benet Pension Plans Periodic Costs ftoc.indd xii 485 485 486 486 487 487 490 496 499 500 505 505 506 506 506 512 515 516 517 519 519 519 522 524 527 527 527 545 545 547 549 550 555 555 556 556 556 559 560 9/17/08 12:48:18 PM Contents Financial Statement Reporting of Pension and Other Postretirement Benets 2.5. Evaluating Disclosures of Pension and Other Postretirement Benets 3. Share-Based Compensation 3.1. Stock Grants 3.2. Stock Options 3.3. Other Issues Related to Share-Based Compensation 4. Summary Practice Problems xiii 2.4. CHAPTER 15 Intercorporate Investments Learning Outcomes 1. Introduction 2. Basic Corporate Investment Categories 3. Minority Passive Investments 3.1. Held-to-Maturity Investments 3.2. Held-for-Trading Securities 3.3. Available-for-Sale Investments 3.4. Designated Fair Value 4. Minority Active Investments 4.1. Equity Method of Accounting: Basic Principles 4.2. Investment Costs that Exceed the Book Value of the Investee 4.3. Amortization of Excess Purchase Price 4.4. Impairment 4.5. Transactions with Associates 4.6. Disclosure 4.7. Issues for Analysts 5. Joint Ventures 6. Controlling Interest Investments 6.1. Pooling of Interests 6.2. Purchase Method 6.3. Impact of Pooling of Interests versus Purchase Method on Financial Statements: Date of Acquisition 6.4. Impact of Pooling of Interests versus Purchase Method on Financial Statements: Post-Acquisition 6.5. Consolidated Financial Statements 6.6. Financial Statement Presentation Subsequent to the Business Combination 6.7. Goodwill 6.8. Goodwill Impairment 6.9. Purchase Price Less than Fair Value (Bargain Purchase) 6.10. Additional Issues in Business Combinations that Impair Comparability 6.11. Proposed Joint Project of the IASB and FASB 7. Variable Interest and Special Purpose Entities 7.1. Illustration of an SPE for a Leased Asset 7.2. Securitization of Assets ftoc.indd xiii 561 574 589 591 591 594 595 596 605 605 605 606 608 608 608 608 609 612 612 615 616 618 618 621 621 622 624 624 626 630 630 632 636 638 638 640 640 640 642 643 644 9/17/08 12:48:18 PM xiv Contents 7.3. Qualifying Special Purpose Entities 7.4. Consolidated versus Nonconsolidated Securitization Transactions 8. Summary Practice Problems CHAPTER 16 Multinational Operations Learning Outcomes 1. Introduction 2. Foreign Currency Transactions 2.1. Foreign Currency Transaction Exposure to Foreign Exchange Risk 2.2. Analytical Issues 2.3. Disclosures Related to Foreign Currency Transaction Gains and Losses 3. Translation of Foreign Currency Financial Statements 3.1. Translation Conceptual Issues 3.2. Translation Methods 3.3. Illustration of Translation Methods (Excluding Hyperinationary Economies) 3.4. Translation Analytical Issues 3.5. Translation When a Foreign Subsidiary Operates in a Hyperinationary Economy 3.6. Companies Use Both Translation Methods at the Same Time 3.7. Disclosures Related to Translation Methods 4. Summary Practice Problems CHAPTER 17 Evaluating Financial Reporting Quality Learning Outcomes 1. Introduction 2. Discretion in Accounting Systems 2.1. Distinguishing Cash Basis from Accrual Basis Accounting 2.2. Placing Accounting Discretion in Context 2.3. Manipulation Incentives 2.4. Mechanisms Disciplining Management 3. Financial Reporting Quality: Denitions, Issues, and Aggregate Measures 3.1. Mean Reversion in Earnings 3.2. Measures of the Accrual Component of Earnings and Earnings Quality 3.3. Applying the Simple Measures of Earnings Quality 4. A Framework for Identifying Low-Quality Financial Reporting 4.1. Revenue Recognition Issues 4.2. Expense Recognition Issues 4.3. Balance Sheet Issues 4.4. Cash Flow Statement Issues 4.5. A Summary of Financial Reporting Quality Warning Signs ftoc.indd xiv 645 646 648 649 657 657 657 658 659 663 666 671 672 676 684 688 699 703 704 713 715 723 723 724 725 725 728 729 732 733 734 735 743 750 751 761 773 777 779 9/17/08 12:48:18 PM Contents xv 5. The Implications of Fair Value Reporting for Financial Reporting Quality: A Brief Discussion 6. Summary Practice Problems Glossary 789 References 803 About the Authors 807 About the CFA Program 811 Index ftoc.indd xv 782 782 783 813 9/17/08 12:48:19 PM ftoc.indd ftoc.indd xvi 9/17/08 12:48:19 PM FOREWORD I nvestors now routinely scour the globe looking for diversication and investment opportunities. At the same time they seek new and protable opportunities, the economies in which they invest directly benet from greater access to capital for development and growth, and from a lower and more competitive cost of capital. Because of the benets to cross-border investors and economies alike, the increasing globalisation of securities markets and capital is likely to be a dening hallmark of the twenty-rst century. Although globalisation has been gradually increasing for many years, the nal building blocksthe infrastructure necessary to ensure both free and unfettered movements of capital across borders and the investor protections required to support the owsare just now being put in place. They include cross-border stock exchanges, nancial institutions with global reach that can facilitate the efcient movement of capital from investors to companies, and the gradual development of cooperative arrangements among global regulators essential for the monitoring, oversight, and enforcement of consistent regulations and standards for investment. However, among the most critical and urgent of these changes is the development of a common nancial reporting standard, really a common language applicable and understandable across the globe, and the importance of a single, high-quality standard cannot be overstated. The effective functioning of capital markets and the economic benets that they could bring depend largely on the investors who participate in those markets. It is investors who must interpret nancial information, who evaluate the potential risks and rewards of investments, and who ultimately make investment decisions. In the absence of such a standard, the barriers to free movement of capital to those who most need it and can most efciently use it can be formidable. Investors, both large institutions and individuals, are required to invest large sums of resources to try to compensate, if they can do so at all. Their efforts must include not only understanding the language in which the nancial reports are prepared but also gaining expert knowledge in the local GAAP standards and their idiosyncrasies, as well as attempts to try to transform the various reporting systems into a consistent and comparable format for the comparison of various investment opportunities with the limited patchwork of information available. The attractiveness of a single, high-quality standard is immediately apparent. Although accounting standards are written with these global investors in mind, historically they have varied widely across borders because of the existence of differing accounting and enforcement regimes. Our goal at the International Accounting Standards Board (IASB) is to develop accounting principles that will span borders and require a company, whether in New York, London, Tokyo, Mumbai, or Shanghai, to report a transaction in the same way. In this way, we aim to enable investors and other decision makers to make informed judgements and to allocate capital efciently, wherever they are based. The establishment of a single set of high-quality accounting standards used throughout the worlds capital markets would greatly assist in the analysis and comparison of nancial xvii fbetw.indd fbetw.indd xvii 9/17/08 12:48:46 PM xviii Foreword information. For investors, the good news is that within just seven years of the IASBs establishment, International Financial Reporting Standards (IFRSs) are now permitted or required by over 100 countries around the world, with the remaining major economies following a path toward convergence and adoption. The adoption of IFRSs, combined with rigorous audits and effective enforcement regimes, should serve as the basis of a sound nancial reporting infrastructure for increasingly integrated capital markets. However, despite this excellent progress, much work remains to be done before the dream of globally integrated nancial markets with a single nancial reporting system becomes reality. First, nancial statement preparers worldwide must have the tools they need to understand and be able to apply IFRSs correctly and uniformly, regardless of the jurisdiction or the regulatory regime. Second, auditors in all countries and of all companies that choose to apply IFRSs must have the tools to gain the technical competence they need to perform audits of nancial statements prepared according to the standards and to be able to demonstrate that knowledge through formal coursework in university curricula as well as rigorous examinations. Third, investors must have the necessary tools to gain the expert knowledge of IFRSs required to understand, analyze, and interpret nancial statements prepared according to IFRSs. Unfortunately, the rapid developments in nancial markets, regulation, and standard setting at the global level have not been accompanied by ground-level development of the learning tools essential to support the market infrastructure. Specically, until now, the textbooks and other in-depth instructional materials suitable for use in the global environment have not been developed. Development necessarily takes a long time and requires substantial investment of resources. Thus, we welcome the resolve and commitment of CFA Institute to do its part to enhance and support the globalization of nancial markets by developing this text for the use of one of the core nancial reporting constituencies worldwide, investors. Importantly, this text bridges the current changes under way in nancial reporting by presenting the information investors need in both IFRSs, the emerging global standard, and U.S. GAAP, the system still currently in use in the worlds largest nancial market. As more countries adopt IFRSs, the remaining national systems in place will gradually disappear. Thus, this text will provide the information most investors will require to analyze nancial reports of companies regardless of the country of the reporting company or the reporting regime in use in that country. The U.S. standard setter, the Financial Accounting Standards Board (FASB), and the IASB have formally committed to work toward convergence in all major respects of their respective standard systems within the next several years. Thus, in a relatively short time, the last remaining signicant differences in the systems will be removed. CFA Institute is committed to following the progress in standards development and convergence with regularly scheduled updates in this text so that it will remain current and an invaluable resource for the global investment profession. The IASBs emphasis on serving the needs of capital providers is why IFRSs have been developed with signicant input from the global investment community and why we at the IASB greatly appreciate the support and encouragement offered by CFA Institute. It is also why I am delighted to have been asked to introduce this rst nancial analysis text in the CFA Institute Investment Series. CFA Institute rightly sets the bar very high to become a CFA charterholder, and this publication has an important role to play in assisting current and aspiring investment professionals to achieve the highest standards of ethics, integrity, education, and professional excellence. Sir David Tweedie, Chairman International Accounting Standards Board fbetw.indd fbetw.indd xviii 9/17/08 12:48:47 PM P REFACE I nternational Financial Statement Analysis is a practically oriented introduction to nancial statement analysis. Each chapter covers one major area of nancial statement analysis and is written by highly credentialed experts. By taking a global perspective on accounting standards, with a focus on International Financial Reporting Standards (IFRS), and by selecting a broad range of companies for illustration, the book well equips the reader for practice in todays global marketplace. The book adopts a structured presentation style, clearly explaining and illustrating each major concept, tool, or technique as it is introduced. Technical terms are dened in their rst major occurrence, and terminology is used consistently across the chapters. No prior accounting background is assumed of the reader. In more detail, chapter coverage is as follows: Chapter 1, Financial Statement Analysis: An Introduction, provides an integrative perspective on nancial statement analysis and a foundation for the entire book. After motivating the uses of nancial statement analysis, the chapter discusses the key nancial statements and other information sources relevant to nancial analysis. The chapter concludes by presenting a framework for conducting any nancial statement analysis. Chapter 2, Financial Reporting Mechanics, explains how accounting systems record a companys transactions with suppliers, customers, employees, capital suppliers, and taxing authorities and how those transactions are eventually summarized in nancial statements. Understanding nancial reporting mechanics enables an analyst to understand the interrelationships of nancial accounts and statements and, therefore, to better assess a companys nancial performance. Chapter 3, Financial Reporting Standards, introduces the accounting standard-setting and regulatory contexts within which companies prepare their nancial statements. The chapter explains the conceptual framework behind the preparation of nancial statements, focusing on IFRS. Understanding that framework will help the reader evaluate the securities valuation implications of any nancial statement element or transaction. Chapter 4, Understanding the Income Statement, explains the income statement, which summarizes an entitys revenue and expenses over a stated time period. The chapter explains revenue and expense recognition principles, the interpretation of income statement elements, and the calculation of earnings per share. The chapter illustrates a range of tools for analyzing and interpreting the income statement. Chapter 5, Understanding the Balance Sheet, explains the balance sheet, which presents the nancial position of a company at a point in time. The information in this chapter should help the reader to better assess a companys ability to meet debt obligations, generate future cash ows, and make distributions to owners. The chapter explains the balance sheets components, alternative formats, and the measurement bases of assets and liabilities. Tools relevant for analyzing and interpreting the balance sheet are illustrated. xix fpref.indd fpref.indd xix 9/24/08 9:37:26 AM xx Preface Chapter 6, Understanding the Cash Flow Statement, explains the cash ow statement, which summarizes cash receipts and disbursements over a stated time period. After presenting the components and alternative formats of the cash ow statement in detail, the chapter offers clear discussions of the linkages of the cash ow statement with the income statement and balance sheet and of the steps in cash ow statement preparation. The chapter also introduces cash ow statement analysis and interpretation. This chapter completes the overview of the most important nancial statements. Chapter 7, Financial Analysis Techniques, builds on the prior chapters to present a comprehensive overview of the techniques used by analysts to evaluate the performance and nancial condition of a company. The chapter illustrates the use of ratio analysis, commonsize nancial statements, decomposition (DuPont) analysis, and analyst adjustments to reported nancials. The use of nancial statement analysis by both equity analysts and credit analysts is illustrated. Chapter 8, International Standards Convergence, provides an overview of a very important development in accounting: the planned convergence of IFRS and U.S. generally accepted accounting principles (U.S. GAAP). The chapter also illustrates some typical analyst adjustments used to facilitate valid comparisons of nancials prepared according to IFRS with nancials prepared according to U.S. GAAP. Chapter 9, Financial Statement Analysis: Applications, consolidates and extends skills and knowledge from earlier chapters by illustrating four major applications of nancial statement analysis: evaluating past nancial performance, projecting future nancial performance, assessing credit risk, and screening for potential equity investments. An overview of analyst adjustments to reported nancials often used in such applications concludes the chapter. Chapter 10, Inventories, begins a series of chapters that take a more detailed look at important accounting topics than was possible in the chapters covering the major nancial statements. For merchandising and manufacturing companies, inventory is an important asset, and inventory cost ow is a major determinant of net income. This chapter presents the major issues associated with accounting for and analyzing inventories. Chapter 11, Long-Lived Assets, presents such important topics related to long-lived (noncurrent) assets as accounting for tangible and intangible assets; depreciation of tangible assets; amortization of intangible assets with nite useful lives; accounting for asset retirement obligations; accounting for the disposal of long-lived operating assets; impairment of long-lived assets; and asset revaluation. Chapter 12, Income Taxes, explains the issues that arise because of potential differences between the accounting used for reporting income taxes and the accounting used for preparing a companys nancial statements. Chapter 13, Long-Term Liabilities and Leases, discusses accounting for debt, debt with equity features, leases, and off-balance-sheet liabilities. Chapter 14, Employee Compensation: Postretirement and Share-Based, explains such issues as accounting for dened-benet pensions and executive stock options. These means of compensation are complex, but need to be understood by analysts because they can have substantial effects on a companys actual nancial position and performance. Chapter 15, Intercorporate Investments, provides an overview of the accountingrelated issues arising from the investments companies make in other companies. The chapter covers the classication of intercorporate investments and for each type explains the accounting issues relevant to the analyst. Chapter 16, Multinational Operations, presents two major topics: the accounting for foreign currency-denominated transactions that arise in international trade and the fpref.indd fpref.indd xx 9/24/08 9:37:28 AM Preface xxi translation of foreign currency nancial statements of overseas subsidiaries into the parent companys currency for the purpose of preparing consolidated nancial statements. Chapter 17, Evaluating Financial Reporting Quality, deals with evaluating the accuracy with which a companys reported nancials reect its operating performance and their usefulness for forecasting future cash ows. Besides illustrating a generally applicable framework for evaluating nancial reporting quality, the chapter introduces concepts and techniques being used in leading investment management rms to interpret reported nancial results. fpref.indd fpref.indd xxi 9/24/08 9:37:28 AM fpref.indd fpref.indd xxii 9/24/08 9:37:29 AM A CKNOWLEDGMENTS We would like to thank the many individuals who played a role in producing this book. Robert R. Johnson, CFA, Managing Director of the Education Division at CFA Institute, originally saw the need for specialized curriculum materials and initiated their development. We appreciate his support. Dennis W. McLeavey, CFA, initiated the project and John D. Stowe, CFA, oversaw its nal development during their respective terms as Head of Curriculum Development. Jerald E. Pinto, CFA, had primary responsibility for the delivery of the rst nine chapters and the chapter on nancial reporting quality, while Christopher B. Wiese, CFA, oversaw organization, writing, and editing of the other chapters. Individual manuscript reviews were provided by Evan Ashcraft, CFA; Donna Bernachi, CFA; Sean D. Carr; Harold Evensky; Philip Fanara, CFA; Jane Farris, CFA; Jacques Gagne, CFA; Mui Cheng Heng, CFA; David Jessop; Lisa Joublanc, CFA; Swee Sum Lam, CFA; Asjeet Lamba, CFA; Barbara MacLeod, CFA; Rebecca McEnally, CFA; Lewis Randolph, CFA; Raymond D. Rath, CFA; Sanjiv Sabherwal; Zouheir Tamim El Jarkass; William A. Trent, CFA; Lavone Whitmer, CFA; and Geoffrey Whittington. End-of-chapter problems and solutions were written by William A. Trent, CFA. We thank all of them for their excellent and detailed work. Nicole Robbins of CFA Institute and Sophia Battaglia provided copyediting that substantially contributed to the books readability. Wanda Lauziere of CFA Institute expertly served as project manager for the books production. xxiii flast.indd flast.indd xxiii 9/17/08 12:50:41 PM flast.indd flast.indd xxiv 9/17/08 12:50:42 PM I NTRODUCTION C FA Institute is pleased to provide you with this Investment Series covering major areas in the eld of investments. These texts are thoroughly grounded in the highly regarded CFA Program Candidate Body of Knowledge that serves as the anchor for the three levels of the CFA Program. Currently, nearly 200,000 aspiring investment professionals are devoting hundreds of hours each to master this material, as well as other elements of the Candidate Body of Knowledge, to obtain the coveted CFA charter. We provide these materials for the same reason we have been chartering investment professionals for over 40 years: to lead the investment profession globally by setting the highest standards of ethics, education, and professional excellence. H ISTORY This book series draws on the rich history and origins of CFA Institute. In the 1940s, a handful of societies for investment professionals developed around common interests in the evolving investment industry. At that time, the idea of purchasing common stock as an investmentas opposed to pure speculationwas still a relatively new concept for the general public. Just 10 years before, the U.S. Securities and Exchange Commission had been formed to help referee a playing eld marked by robber barons and stock market panics. In January 1945, a fundamental analysisdriven professor and practitioner from Columbia University and Graham-Newman Corporation wrote an article in the precursor of todays CFA Institute Financial Analysts Journal, making the case that people who research and manage portfolios should have some sort of credential to demonstrate competence and ethical behavior. This person was none other than Benjamin Graham, the father of security analysis and future mentor to well-known modern investor Warren Buffett. Creating such a credential took 16 years. By 1963, 284 brave soulsall over the age of 45took an exam and successfully launched the CFA credential. What many do not fully understand is that this effort was driven by a desire to create professional standards for practitioners dedicated to serving individual investors. In so doing, a fairer and more productive capital market would result. Most professionsincluding medicine, law, and accountinghave certain hallmark characteristics that help to attract serious individuals and motivate them to devote energy to their lifes work. First, there must be a body of knowledge. Second, there need to be entry requirements, such as those required to achieve the CFA credential. Third, there must be a commitment to continuing education. Finally, a profession must serve a purpose beyond ones individual interests. By properly conducting ones affairs and putting client interests rst, the investment professional encourages general participation in the incredibly productive global xxv flast.indd flast.indd xxv 9/17/08 12:50:42 PM xxvi Introduction capital markets. This encourages the investing public to part with their hard-earned savings for redeployment in the fair and productive pursuit of appropriate returns. As C. Stewart Sheppard, founding executive director of the Institute of Chartered Financial Analysts, said: Society demands more from a profession and its members than it does from a professional craftsman in trade, arts, or business. In return for status, prestige, and autonomy, a profession extends a public warranty that it has established and maintains conditions of entry, standards of fair practice, disciplinary procedures, and continuing education for its particular constituency. Much is expected from members of a profession, but over time, more is given. The Standards for Educational and Psychological Testing, put forth by the American Psychological Association, the American Educational Research Association, and the National Council on Measurement in Education, state that the validity of professional credentialing examinations should be demonstrated primarily by verifying that the content of the examination accurately represents professional practice. In addition, a practice analysis study, which conrms the knowledge and skills required for the competent professional, should be the basis for establishing content validity. For more than 40 years, hundreds upon hundreds of practitioners and academics have served on CFA Institute curriculum committees, sifting through and winnowing out all the many investment concepts and ideas to create a body of investment knowledge and the CFA curriculum. One of the hallmarks of curriculum development at CFA Institute is its extensive use of practitioners in all phases of the process. CFA Institute has followed a formal practice analysis process since 1995. Most recently, the effort involves special practice analysis forums held at 20 locations around the world. Results of the forums were put forth to 70,000 CFA charterholders for verication and conrmation. In 2007, CFA Institute moved to implement a continuous practice analysis by making use of a collaborative web-based site and wiki technology. This will open the process to thousands more charterholders and signicantly reduce the lag effect of concepts and techniques moving from practice to the Candidate Body of Knowledge. What this means for the reader is that the concepts highlighted in these texts were selected by practitioners who fully understand the skills and knowledge necessary for success. We are pleased to put this extensive effort to work for the benet of the readers of the Investment Series. B ENEFITS This series will prove useful to those contemplating entry into the extremely competitive eld of investment management, as well as those seeking a means of keeping ones knowledge fresh and up to date. Regardless of its use, this series was designed to be both user friendly and highly relevant. Each chapter within the series includes extensive references for those who would like to dig deeper into a given concept. The workbooks provide a summary of each chapters key points to help organize your thoughts, as well as sample questions and answers to test yourself on your progress. I believe that the general public seriously underestimates the disciplined processes needed for the best investment rms and individuals to prosper. This material will help you better understand the investment eld. For those new to the industry, the essential concepts that flast.indd xxvi 9/17/08 12:50:42 PM Introduction xxvii any investment professional needs to master are presented in a time-tested fashion. These texts lay the basic groundwork for many of the processes that successful rms use on a dayto-day basis. Without this base level of understanding and an appreciation for how the capital markets work, it becomes challenging to nd competitive success. Furthermore, the concepts herein provide a true sense of the kind of work that is to be found managing portfolios, doing research, or pursuing related endeavors. The investment profession, despite its relatively lucrative compensation, is not for everyone. It takes a special kind of individual fundamentally to understand and absorb the teachings from this body of work and then apply it in practice. In fact, most individuals who enter the eld do not survive in the long run. The aspiring professional should think long and hard about whether this is the right eld. There is no better way to make such a critical decision than by reading and evaluating the classic works of the profession. The more experienced professional understands that the nature of the capital markets requires a commitment to continuous learning. Markets evolve as quickly as smart minds can nd new ways to create exposure, attract capital, or manage risk. A number of the concepts in these texts did not exist a decade or two ago when many were starting out in the business. Hedge funds, derivatives, alternative investment concepts, and behavioral nance are just a few examples of the new applications and concepts that have altered the capital markets in recent years. As markets invent and reinvent themselves, a best-in-class foundation investment series is of great value. Investment professionals must continuously hone their skills and knowledge if they are to compete with the young talent that constantly emerges. In fact, as we talk to major employers about their training needs, we are often told that one of the biggest challenges they face is how to help the experienced professional keep up with the recent graduates. This series can be part of that Register to View AnswerONVENTIONAL WISDOM It doesnt take long for the astute investment professional to realize two common characteristics of markets. First, prices are set by conventional wisdom, as a function of the many variables in the market. Truth in markets is, at its essence, what the market believes it is and how it assesses pricing credits or debits based on those beliefs. Second, inasmuch as conventional wisdom is a product of the evolution of general theory and learning, by denition conventional wisdom is often wrong or at the least subject to material change. When I rst entered this industry in the mid-1970s, conventional wisdom held that the concepts examined in these texts were a bit too academic for use in the competitive marketplace. What were considered to be the best investment rms of the time were led by men who had an eclectic style, an intuitive sense of markets, and a great track record. In the rough-and-tumble world of the practitioner, some of these concepts were considered to be of no use. Could conventional wisdom have been more wrong? During the years of my tenure in the profession, the practitioner investment management rms that evolved successfully were full of determined, intelligent, intellectually curious investment professionals who endeavored to apply these concepts in a serious and disciplined manner. Today, the best rms are run by those who carefully form investment hypotheses and test them rigorously in the marketplace, whether it be in a quant strategy, comparative shopping for stocks within an industry, or hedge fund strategies. Their goal is to create investment flast.indd xxvii 9/17/08 12:50:43 PM xxviii Introduction processes that can be replicated with some statistical reliability. I believe those who embraced the so-called academic side of the learning equation have been much more successful as realworld investment managers. T HE TEXTS One of the most prominent texts over the years in the investment management industry has been Maginn and Tuttles Managing Investment Portfolios: A Dynamic Process. The third edition updates key concepts from the 1990 second edition. Some of the more experienced members of our community own the prior two editions and will add the third edition to their library. Not only does this seminal work take the concepts from the other readings and put them in a portfolio context, but it also updates the concepts of alternative investments, performance presentation standards, portfolio execution and, very importantly, managing individual investor portfolios. Focusing attention away from institutional portfolios, and toward the individual investor, makes this edition an important and timely work. Quantitative Investment Analysis focuses on some key tools that are needed for todays professional investor. In addition to classic time value of money, discounted cash ow applications, and probability material, there are two aspects that can be of value over traditional thinking. The rst involves the chapters dealing with correlation and regression that ultimately gure into the formation of hypotheses for purposes of testing. This gets to a critical skill that many professionals are challenged by: the ability to distinguish useful information from the overwhelming quantity of available data. For most investment researchers and managers, their analysis is not solely the result of newly created data and tests that they perform. Rather, they synthesize and analyze primary research done by others. Without a rigorous manner by which to understand quality research, you cannot understand good research, nor do you have a basis on which to evaluate less rigorous research. What is often put forth in the applied world as good quantitative research frequently lacks rigor and validity. Second, the last chapter of Quantitative Investment Analysis on portfolio concepts takes the reader beyond the traditional capital asset pricing model (CAPM) type of tools and into the more practical world of multifactor models and arbitrage pricing theory. This chapter also helps address the concerns of those who thought the text had a CAPM bias. Equity Asset Valuation is a particularly cogent and important resource for anyone involved in estimating the value of securities and understanding security pricing. A well-informed professional knows that the common forms of equity valuationdividend discount modeling, free cash ow modeling, price/earnings models, and residual income modelscan all be reconciled to one another under certain assumptions. With a deep understanding of the underlying assumptions, the professional investor can better understand what other investors assume when calculating their valuation estimates. In my prior life as the head of an equity investment team, this knowledge gave us an edge over other investors. Fixed Income Analysis has been at the forefront of new concepts in recent years, and this particular text offers some of the most recent material for the seasoned professional who is not a xed-income specialist. The application of option and derivative technology to the once staid province of xed income has helped contribute to an explosion of thought in this area. Not only are professionals challenged to stay up to speed with credit derivatives, swaptions, collateralized mortgage securities, mortgage-backed securities, and other vehicles, but this flast.indd xxviii 9/17/08 12:50:43 PM Introduction xxix explosion of thought also puts a strain on the worlds central banks to provide sufcient oversight. Armed with a thorough grasp of the new exposures, the professional investor is much better able to anticipate and understand the challenges our central bankers and markets face. Corporate Finance: A Practical Approach is a solid foundation for those looking to achieve lasting business growth. In todays competitive business environment, companies must nd innovative ways to enable rapid and sustainable growth. This text equips readers with the foundational knowledge and tools for making smart business decisions and formulating strategies to maximize company value. It covers everything from managing relationships between stakeholders to evaluating mergers and acquisitions bids as well as the companies behind them. Through extensive use of real-world examples, readers will gain critical perspective into interpreting corporate nancial data, evaluating projects, and allocating funds in ways that increase corporate value. Readers will gain insights into the tools and strategies employed in modern corporate nancial management. International Financial Statement Analysis is designed to address the ever-increasing need for investment professionals and students to think about nancial statement analysis from a global perspective. The text is a practically oriented introduction to nancial statement analysis that is distinguished by its combination of a true international orientation, a structured presentation style, and abundant illustrations and tools covering concepts as they are introduced in the text. The authors cover this discipline comprehensively and with an eye to ensuring the readers success at all levels in the complex world of nancial statement analysis. I hope you nd this new series helpful in your efforts to grow your investment knowledge, whether you are a relatively new entrant or an experienced veteran ethically bound to keep up-to-date in the ever-changing market environment. CFA Institute, as a long-term committed participant of the investment profession and a not-for-prot association, is pleased to give you this opportunity. Jeff Diermeier, CFA President and Chief Executive Ofcer CFA Institute October 2008 flast.indd xxix 9/17/08 12:50:44 PM flast.indd flast.indd xxx 9/17/08 12:50:44 PM CHAPTER 1 F INANCIAL STATEMENT ANALYSIS: AN INTRODUCTION Thomas R. Robinson, CFA CFA Institute Charlottesville, Virginia Hennie van Greuning, CFA World Bank Washington, DC Elaine Henry, CFA University of Miami Miami, Florida Michael A. Broihahn, CFA Barry University Miami, Florida L EARNING OUTCOMES After completing this chapter, you will be able to do the following: Discuss the roles of nancial reporting and nancial statement analysis. Discuss the roles of the key nancial statements (income statement, balance sheet, cash ow statement, and statement of changes in owners equity) in evaluating a companys performance and nancial position. 1 c01.indd 1 9/17/08 11:22:55 AM 2 International Financial Statement Analysis Discuss the importance of nancial statement notes and supplementary information (including disclosures of accounting methods, estimates, and assumptions) and managements discussion and analysis. Discuss the objective of audits of nancial statements, the types of audit reports, and the importance of effective internal controls. Identify and explain information sources besides annual nancial statements and supplementary information that analysts use in nancial statement analysis. Describe the steps in the nancial statement analysis framework. 1 . INTRODUCTION Analysts are employed in a number of functional areas. Commonly, analysts evaluate an investment in some type of security that has characteristics of equity (representing an ownership position) or debt (representing a lending position). In arriving at investment decisions or recommendations, analysts need to evaluate the performance, nancial position, and value of the company issuing the securities. Company nancial reports, which include nancial statements and other data, provide the information necessary to evaluate the company and its securities. Consequently, the analyst must have a rm understanding of the information provided in each companys nancial reports, including the nancial notes and other forms of supplementary information. This chapter is organized as follows: Section 2 discusses the scope of nancial statement analysis. Section 3 describes the sources of information used in nancial statement analysis, including the primary nancial statements (income statement, balance sheet, and cash ow statement). Section 4 provides a framework for guiding the nancial statement analysis process, and section 5 summarizes the key points of the chapter. Practice problems in the CFA Institute multiple-choice format conclude the chapter. 2 . SCOPE OF FINANCIAL STATEMENT ANALYSIS The role of nancial reporting by companies is to provide information about their performance, nancial position, and changes in nancial position that is useful to a wide range of users in making economic decisions.1 The role of nancial statement analysis is to take nancial reports prepared by companies, combined with other information, to evaluate the past, current, and prospective performance and nancial position of a company for the purpose of making investment, credit, and other economic decisions. In evaluating nancial reports, analysts typically have an economic decision in mind. Examples include the following: Evaluating an equity investment for inclusion in a portfolio. Evaluating a merger or acquisition candidate. Evaluating a subsidiary or operating division of a parent company. 1 See paragraph 12 of the Framework for the Preparation and Presentation of Financial Statements, originally published by the International Accounting Standards Committee in 1989 and then adopted by the International Accounting Standards Board in 2001. c01.indd 2 9/17/08 11:22:57 AM Chapter 1 Financial Statement Analysis: An Introduction 3 Deciding whether to make a venture capital or other private equity investment. Determining the creditworthiness of a company that has made a loan request. Extending credit to a customer. Examining compliance with debt covenants or other contractual arrangements. Assigning a debt rating to a company or bond issue. Valuing a security for making an investment recommendation to others. Forecasting future net income and cash ow. There are certain themes in nancial analysis. In general, analysts seek to examine the performance and nancial position of companies as well as forecast future performance and nancial position. Analysts are also concerned about factors that affect risks to the companys future performance and nancial position. An examination of performance can include an assessment of a companys protability (the ability to earn a prot from delivering goods and services) and its cash owgenerating ability (the ability to produce cash receipts in excess of cash disbursements). Prot and cash ow are not equivalent. Prot represents the excess of the prices at which goods or services are sold over all the costs of providing those goods and services (regardless of when cash is received or paid). Example 1-1 illustrates the distinction between prot and cash ow. EXAMPLE 1-1 Prot versus Cash Flow Sennett Designs (SD) sells imported furniture on a retail basis. SD began operations during December 2006 and sold furniture for cash of 250,000. The furniture that was sold by SD was delivered by the supplier during December, but the supplier has granted SD credit terms, according to which payment is not due until January 2007. SD is obligated to pay 220,000 in January for the furniture it sold during December. 1. How much is SDs prot for December 2006 if no other transactions occurred? 2. How much is SDs cash ow for December 2006? Solution to 1. SDs prot for December 2006 is the excess of the sales price (250,000) over the cost of the goods that were sold (220,000), or 30,000. Solution to 2. The December 2006 cash ow is 250,000. Although protability is important, so is the ability to generate positive cash ow. Cash ow is important because, ultimately, cash is needed to pay employees, suppliers, and others to continue as a going concern. A company that generates positive cash ow from operations has more exibility in funding needed investments and taking advantage of attractive business opportunities than an otherwise comparable company without positive cash ow. Additionally, cash ow is the source of returns to providers of capital. Therefore, the expected magnitude of future cash ows is important in valuing corporate securities and in determining the companys ability to meet its obligations. The ability to meet short-term obligations is generally referred to as liquidity, and the ability to meet long-term obligations is generally referred to as solvency. However, as shown in Example 1-1, cash ow in a given period is not c01.indd c01.indd 3 9/17/08 11:22:57 AM 4 International Financial Statement Analysis a complete measure of performance in that period; for example, a company may be obligated to make future cash payments as a result of a transaction generating positive cash ow in the current period. As noted earlier, prots reect the ability of a company to deliver goods and services at prices in excess of the costs of delivering the goods and services. Prots also provide useful information about future (and past) cash ows. If the transaction of Example 1-1 were repeated year after year, the long-term average annual cash ow of SD would be 30,000, its annual prot. Many analysts not only evaluate past protability but also forecast future protability. Exhibit 1-1 shows how news media coverage of corporate earnings announcements places corporate results in the context of analysts expectations. Furthermore, analysts frequently use earnings in valuation, for example, when they value shares of a company on the basis of the price-to-earnings ratio (P/E) in relation to peer companies P/Es or when they use a present value model of valuation that is based on forecasted future earnings. Analysts are also interested in the current nancial position of a company. The nancial position can be measured by comparing the resources controlled by the company in relation to the claims against those resources. An example of a resource is cash. In Example 1-1, if no other transactions occur, the company should have cash on 31 December 2006 of 250,000. EXHIBIT 1-1 An Earnings Release and Analyst Reaction Panel A. Excerpt from Apple Earnings Release Apple Reports Third-Quarter Results Posts Second-Highest Quarterly Revenue and Earnings in Companys History CUPERTINO, CaliforniaJuly 19, 2006Apple today announced nancial results for its scal 2006 third quarter ended July 1, 2006. The Company posted revenue of $4.37 billion and a net quarterly prot of $472 million, or $0.54 per diluted share. These results compare to revenue of $3.52 billion and a net prot of $320 million, or $0.37 per diluted share, in the year-ago quarter. Gross margin was 30.3 percent, up from 29.7 percent in the year-ago quarter. International sales accounted for 39 percent of the quarters revenue. Apple shipped 1,327,000 Macintosh computers and 8,111,000 iPods during the quarter, representing 12 percent growth in Macs and 32 percent growth in iPods over the year-ago quarter. . . . Panel B. Excerpt from CNET News.com Report Mac Sales Up 12 Percent as Apple Prots Soar by Tom Krazit Apple Computers third-quarter revenue fell a little short of expectations, but protability was far higher than expected and Mac sales increased at a healthy clip. . . . Net income was $472 million, or 54 cents per share, an improvement of 48 percent compared with last years results of $320 million in net income and 37 cents per share. Analysts surveyed by Thomson First Call had been expecting Apple to report $4.4 billion in revenue and earn 44 cents per share. . . . The outlook for the next period will probably disappoint some investors. The company predicted fourth-quarter revenue would be about $4.5 billion to $4.6 billion, less than the $4.9 billion analysts had been expecting. Apple executives will hold a conference call later Wednesday to discuss results. Sources: www.apple.com/pr/library/2006/jul/19results.html, http://news.com.com/Mac+sales+up+12+ percent+as+Apple+prots+soar/2100-1047_3-6096116.html. c01.indd 4 9/17/08 11:23:01 AM Chapter 1 Financial Statement Analysis: An Introduction 5 EXHIBIT 1-2 Grupo Imsa Press Release Dated 18 January 2005 Standard & Poors and Fitch Upgrade Grupo Imsas Credit Rating MONTERREY, Mexico: Grupo Imsa (NYSE: IMY) (BMV: IMSA) announces that Standard & Poors has recently upgraded the Companys local currency corporate credit rating from BBB to BBB and its national scale rating from mxAA to mxAA+. Fitch Mexico also increased Grupo Imsas domestic rating from AA(mex) to AA+(mex). These rating upgrades reect the positive results of Grupo Imsas main businesses and the strengthening of its nancial position, combined with the Companys geographic diversication, market leadership, state-of-the-art technology and high operational efciency. Mr. Marcelo Canales, Grupo Imsas CFO, explained: Grupo Imsa follows a policy of maintaining a solid nancial position that ensures the Companys continuity for the benet of our employees, shareholders and creditors. We take our nancial commitments very seriously, as can be seen from the fact that during our 70 years of existence we have always complied with our nancial obligations. The change in rating also reects the strength of our business model and its capacity to generate cash. Mr. Canales added: These upgrades in credit rating should translate into a better valuation of our debt to reect Grupo Imsas new nancial reality. Grupo Imsa, a holding company, dates back to 1936 and is today one of Mexicos leading diversied industrial companies, operating in three core businesses: steel processed products; steel and plastic construction products; and aluminum and other related products. With manufacturing and distribution facilities in Mexico, the United States, Europe and throughout Central and South America, Grupo Imsa currently exports to all ve continents. Grupo Imsas shares trade on the Mexican Stock Exchange (IMSA) and, in the United States, on the NYSE (IMY). This document contains forward-looking statements relating to Grupo Imsas future performance or its current expectations or beliefs, including statements regarding the intent, belief or current expectations of the Company and its management. Investors are cautioned that any such forward-looking statements are not guarantees of future performance and involve a number of risks and uncertainties pertaining to the industries in which the Company participates. Grupo Imsa does not intend, and does not assume any obligation, to update these forward-looking statements. Source: Business Wire, 18 January 2005. This cash can be used by the company to pay the obligation to the supplier (a claim against the company) and may also be used to make distributions to the owner (who also has a claim against the company for any prots that have been earned). Financial position is particularly important in credit analysis, as depicted in Exhibit 1-2. In conducting a nancial analysis of a company, the analyst will regularly refer to the companys nancial statements, nancial notes and supplementary schedules, and a variety of other information sources. The next section introduces the major nancial statements and most commonly used information sources. 3 . MAJOR FINANCIAL STATEMENTS AND OTHER INFORMATION SOURCES In order to perform an equity or credit analysis of a company, an analyst must collect a great deal of information. The nature of the information will vary based on the individual task but will typically include information about the economy, industry, and company as well as information about comparable peer companies. Much of this information will come from outside c01.indd 5 9/17/08 11:23:01 AM 6 International Financial Statement Analysis the company, such as economic statistics, industry reports, trade publications, and databases containing information on competitors. The company itself provides some of the core information for analysis in its nancial reports, press releases, and conference calls and webcasts. Companies prepare nancial reports to report to investors and creditors on nancial performance and nancial strength at regular intervals (annually, semiannually, and/ or quarterly). Financial reports include nancial statements and supplemental information necessary to assess the performance and nancial position of the company. Financial statements are the end results of an accounting record-keeping process that records the economic activities of a company. They summarize this information for use by investors, creditors, analysts, and others interested in a companys performance and nancial position. In order to provide some assurances as to the information provided in the nancial statements and related notes, the nancial statements are audited by independent accountants, who express an opinion on whether the nancial statements fairly portray the companys performance and nancial position. 3.1. Financial Statements and Supplementary Information The key nancial statements that are the focus of analysis are the income statement, balance sheet, statement of cash ows, and statement of changes in owners equity. The income statement and statement of cash ows portray different aspects of a companys performance over a period of time. The balance sheet portrays the companys nancial position at a given point in time. The statement of changes in owners equity provides additional information regarding the changes in a companys nancial position. In addition to the nancial statements, a company provides other information in its nancial reports that is useful to the nancial analyst. As part of his or her analysis, the nancial analyst should read and assess this additional information, which includes: Notes to the nancial statements (also known as footnotes) and supplementary schedules. Managements discussion and analysis (MD&A). The external auditors report(s). The following sections illustrate the major nancial statements. 3.1.1. Income Statement The income statement presents information on the nancial results of a companys business activities over a period of time. The income statement communicates how much revenue the company generated during a period and what costs it incurred in connection with generating that revenue. Net income (revenue minus all costs) on the income statement is often referred to as the bottom line because of its proximity to the bottom of the income statement.2 Income statements are reported on a consolidated basis, meaning that they include the revenues and expenses of afliated companies under the control of the parent (reporting) company. The income statement is sometimes referred to as a statement of operations or prot and loss (P&L) statement. The basic equation underlying the income statement is Revenue Expenses Net income. In Exhibit 1-3, the income statement is presented with the most recent year in the rst column and the earliest year in the last column. Although this is a common presentation, 2 Net income is also referred to as net earnings or net prot. In the event that costs exceed revenues, it is referred to as net loss. c01.indd 6 9/17/08 11:23:02 AM Chapter 1 7 Financial Statement Analysis: An Introduction EXHIBIT 1-3 Wal-Mart Consolidated Statements of Income (in millions except per share data) Fiscal years ended 31 January 2005 2004 2003 $285,222 $256,329 $229,616 2,767 2,352 1,961 287,989 258,681 231,577 219,793 198,747 178,299 Operating, selling, general, and administrative expenses 51,105 44,909 39,983 Operating Income Interest 17,091 15,025 13,295 Debt 934 729 799 Capital lease 253 267 260 (201) (164) (132) 986 832 927 16,105 14,193 12,368 5,326 4,941 3,883 Revenues Net sales Other income, net Costs and Expenses Cost of sales Interest income Interest, net Income from continuing operations before income taxes and minority interest Provision for Income Taxes Current Deferred Total Income from continuing operations before minority interest 263 177 474 5,589 5,118 4,357 10,516 9,075 8,011 Minority interest Income from continuing operations Income from discontinued operations, net of tax Net Income (249) 10,267 (214) 8,861 (193) 7,818 193 137 $ 10,267 $ 9,054 $ 7,955 $ 2.41 $ 2.03 $ 1.77 Basic Net Income per Common Share Income from continuing operations Income from discontinued operations Basic net income per common share 0.05 0.03 $ 2.41 $ 2.08 $ 1.80 $ 2.41 $ 2.03 $ 1.76 0.04 0.03 $ 2.41 $ 2.07 $ 1.79 4,259 4,363 4,430 Diluted Net Income per Common Share Income from continuing operations Income from discontinued operations Diluted net income per common share Weighted Average Number of Common Shares Basic Diluted c01.indd 7 4,266 4,373 4,446 Dividends per Common Share $ 0.52 $ 0.36 $ 0.30 9/17/08 11:23:02 AM 8 International Financial Statement Analysis analysts should be careful when reading an income statement because in other cases, the years may be listed from most distant to most recent. Exhibit 1-3 shows that Wal-Marts total revenue for the scal year ended 31 January 2005 was (in millions) $287,989. Wal-Mart then subtracted its operating costs and expenses to arrive at an operating income (prot) of $17,091. Operating income reects a companys prots from its usual business activities, before deducting interest expense or taxes. Operating income is thus often referred to as EBIT, or earnings before interest and taxes. Operating income reects the companys underlying performance independent of the use of nancial leverage. WalMarts total interest cost (net of the interest income that was earned from investments) for 2005 was $986; its earnings before taxes was, therefore, $16,105. Total income tax expense for 2005 was $5,589, and the minority interest expense (income earned by the minority shareholders from Wal-Mart subsidiary companies) was $249. After deducting these nal expenses, Wal-Marts net income for scal 2005 was $10,267. Companies present their basic and diluted earnings per share on the face of the income statement. Earnings per share represents the net income divided by the number of shares of stock outstanding during the period. Basic earnings per share uses the weighted average number of common shares that were actually outstanding during the period, whereas diluted earnings per share uses diluted sharesthe number of shares that would be outstanding if potentially dilutive claims on common shares (e.g., stock options) were exercised by their holders. Wal-Marts basic earning per share for 2005 was $2.41 ($10,267 net income 4,259 basic shares outstanding). Likewise, Wal-Marts diluted earnings per share for 2005 was also $2.41 ($10,267 net income 4,266 diluted shares). An analyst examining the income statement might note that Wal-Mart was protable in each year and that revenue, operating income, net income, and earnings per shareall measures of protabilityincreased over the three-year period. The analyst might formulate questions related to protability, such as the following: Is the growth in revenue related to an increase in units sold, an increase in prices, or some combination? After adjusting for growth in the number of stores, is the company still more protable over time? How does the company compare with other companies in the industry? Answering such questions requires the analyst to gather, analyze, and interpret facts from a number of sources, including the income statement. The chapter on understanding the income statement will explain the income statement in greater detail. The next section illustrates the balance sheet, the second major nancial statement. 3.1.2. Balance Sheet The balance sheet (also known as the statement of nancial position or statement of nancial condition) presents a companys current nancial position by disclosing resources the company controls (assets) and what it owes (liabilities) at a specic point in time. Owners equity represents the excess of assets over liabilities. This amount is attributable to the owners or shareholders of the business; it is the residual interest in the assets of an entity after deducting its liabilities. The three parts of the balance sheet are formulated in an accounting relationship known as the accounting equation: Assets Liabilities Owners equity (that is, the total amount for assets must balance to the combined total amounts for liabilities and owners equity). Alternatively, the three parts of the balance sheet c01.indd 8 9/17/08 11:23:03 AM Chapter 1 9 Financial Statement Analysis: An Introduction of the accounting relationship may be formulated as Assets Liabilities Owners equity. Depending on the form of the organization, owners equity also goes by several alternative titles, such as partners capital or shareholders equity. Exhibit 1-4 presents Wal-Marts consolidated balance sheets for the scal years ended 31 January 2004 and 2005. EXHIBIT 1-4 Wal-Mart Consolidated Balance Sheets (in millions except per-share data) Fiscal Years Ended 31 January 2005 2004 Assets Current assets: Cash and cash equivalents $ 5,488 $ 5,199 Receivables 1,715 1,254 Inventories 29,447 26,612 1,841 1,356 38,491 34,421 Land 14,472 12,699 Buildings and improvements 46,582 40,192 Fixtures and equipment 21,461 17,934 1,530 1,269 Property and equipment, at cost 84,045 72,094 Less accumulated depreciation 18,637 15,684 65,408 56,410 Property under capital lease 4,997 4,286 Less accumulated amortization 1,838 1,673 Prepaid expenses and other Total current assets Property and equipment, at cost: Transportation equipment Property and equipment, net Property under capital lease: Property under capital lease, net 3,159 2,613 10,803 9,882 2,362 2,079 $120,223 $105,405 Commercial paper $ 3,812 $ 3,267 Accounts payable 21,671 19,425 Accrued liabilities Goodwill Other assets and deferred charges Total assets Liabilities and shareholders equity Current liabilities: 12,155 10,671 Accrued income taxes 1,281 1,377 Long-term debt due within one year 3,759 2,904 Obligations under capital leases due within one year Total current liabilities c01.indd 9 210 42,888 196 37,840 (Continued ) 9/17/08 11:23:03 AM 10 International Financial Statement Analysis EXHIBIT 1-4 Continued Fiscal Years Ended 31 January 2005 2004 $20,087 $17,102 Long-term obligations under capital leases 3,582 2,997 Deferred income taxes and other 2,947 2,359 Minority interest 1,323 1,484 Long-term debt: Shareholders equity: Preferred stock ($0.10 par value; 100 shares authorized, none issued) Common stock ($0.10 par value; 11,000 shares authorized, 4,234 and 4,311 issued and outstanding in 2005 and 2004, respectively) Capital in excess of par value Other accumulated comprehensive income Retained earnings Total shareholders equity Total Liabilities and Shareholders Equity 423 431 2,425 2,135 2,694 851 43,854 40,206 49,396 43,623 $120,223 $105,405 On 31 January 2005, Wal-Marts total resources or assets were $120,223 (in millions). Shareholders equity (in millions) was $49,396. Although Wal-Mart does not give a total amount for all the balance sheet liabilities, it may be determined from the accounting relationship as Total assets Total shareholders equity or $120,223 $49,396 $70,827.3 Using the balance sheet and applying nancial statement analysis, the analyst will be able to answer such questions as: Has the companys liquidity (ability to meet short-term obligations) improved? Is the company solvent (does it have sufcient resources to cover its obligations)? What is the companys nancial position relative to the industry? The chapter on understanding the balance sheet will cover the analysis of the balance sheet in more depth. The next section illustrates the cash ow statement. 3.1.3. Cash Flow Statement Although the income statement and balance sheet provide a measure of a companys success in terms of performance and nancial position, cash ow is also vital to a companys long-term success. Disclosing the sources and uses of cash helps creditors, investors, and other statement users evaluate the companys liquidity, solvency, and nancial exibility. Financial exibility is the ability to react and adapt to nancial adversities and opportunities. The cash ow statement classies all company cash ows into operating, investing, 3 Note that this computation includes an amount labeled minority interest in liabilities. Minority interest represents ownership in a subsidiary company by others (not the parent company). Accounting rule makers are currently considering reclassifying this amount as part of owners equity. c01.indd 10 9/17/08 11:23:04 AM Chapter 1 11 Financial Statement Analysis: An Introduction and nancing activity cash ows. Operating activities involve transactions that enter into the determination of net income and are primarily activities that comprise the day-to-day business functions of a company. Investing activities are those activities associated with the acquisition and disposal of long-term assets, such as equipment. Financing activities are those activities related to obtaining or repaying capital to be used in the business. Exhibit 1-5 presents Wal-Marts consolidated statement of cash ows for the scal years ended 31 January 2003, 2004, and 2005. EXHIBIT 1-5 Wal-Mart Consolidated Statements of Cash Flows (in millions) Fiscal Years Ended 31 January 2005 2004 2003 $ 10,267 $ 8,861 $ 7,818 Cash Flows from Operating Activities Income from continuing operations Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 4,405 3,852 3,364 Deferred income taxes 263 177 474 Other operating activities 378 173 685 (304) 373 (159) Changes in certain assets and liabilities, net of effects of acquisitions: Decrease (increase) in accounts receivable (2,635) (1,973) (2,219) Increase in accounts payable Increase in inventories 1,694 2,587 1,748 Increase in accrued liabilities 976 1,896 1,212 15,044 15,946 12,923 50 82 15,044 15,996 13,005 Payments for property and equipment (12,893) (10,308) (9,245) Investment in international operations (315) (38) (749) 953 481 311 Net cash provided by operating activities of continuing operations Net cash provided by operating activities of discontinued operations Net cash provided by operating activities Cash Flows from Investing Activities Proceeds from the disposal of xed assets Proceeds from the sale of McLane Other investing activities Net cash used in investing activities of continuing operations Net cash used in investing activities discontinued operations Net cash used in investing activities 1,500 (96) (12,351) (12,351) 78 (73) (8,287) (9,756) (25) (83) (8,312) (9,839) Cash Flows from Financing Activities Increase in commercial paper Proceeds from issuance of long-term debt c01.indd 11 544 688 5,832 4,099 1,836 2,044 (Continued ) 9/17/08 11:23:05 AM 12 International Financial Statement Analysis EXHIBIT 1-5 Continued Fiscal Years Ended 31 January 2005 2004 2003 Purchase of company stock (4,549) (5,046) (3,383) Dividends paid (2,214) (1,569) (1,328) Payment of long-term debt (2,131) (3,541) (1,261) (204) (305) (216) Payment of capital lease obligations Other nancing activities Net cash used in nancing activities Effect of exchange rate changes on cash Net increase in cash and cash equivalents Cash and cash equivalents at beginning of year Cash and cash equivalents at end of year 113 (2,609) 111 (5,563) 205 320 (62) (2,370) (199) 289 2,441 597 5,199 2,758 2,161 $ 5,488 $ 5,199 $ 2,758 $ 5,593 $ 4,358 $ 4,539 1,163 1,024 1,085 377 252 381 Supplemental Disclosure of Cash Flow Information Income tax paid Interest paid Capital lease obligations incurred In the cash ows from operating activities section of Wal-Marts cash ow statement, the company reconciles its net income to net cash provided by operating activities. This emphasizes the different perspectives of the income statement and cash ow statement. Income is reported when earned, not necessarily when cash is received. The cash ow statement presents another aspect of performance: the ability of a company to generate cash ow from running its business. Ideally, the analyst would like to see that the primary source of cash ow is from operating activities (as opposed to investing or nancing activities). Note that Wal-Mart had a large amount of operating cash ow, which increased from 2003 to 2004 but decreased slightly in 2005. Although operating cash ow was high, an analyst might question why net income increased but operating cash ow decreased in 2005. The summation of the net cash ows from operating, investing, and nancing activities and the effect of exchange rates on cash equals the net change in cash during the scal year. For Wal-Mart, the summation of these four cash ow activities in 2005 was $289, which thus increased the companys cash from $5,199 on 31 January 2004 (beginning cash balance) to $5,488 on 31 January 2005 (ending cash balance). Note that these beginning and ending cash balances agree with the cash reported on Wal-Marts balance sheets in Exhibit 1-4. The cash ow statement will be treated in more depth in the chapter on understanding the cash ow statement. 3.1.4. Statement of Changes in Owners Equity The income statement, balance sheet, and cash ow statements represent the primary nancial statements used to assess a companys performance and nancial position. A fourth nancial statement is also available, variously called a statement of changes in owners equity, statement of shareholders equity, or statement of retained earnings. This statement primarily serves to report changes in the owners investment in the business over time and assists the analyst in understanding the changes in nancial position reected on the balance sheet. c01.indd 12 9/17/08 11:23:05 AM Chapter 1 Financial Statement Analysis: An Introduction 13 3.1.5. Financial Notes and Supplementary Schedules Financial notes and supplementary schedules are an integral part of the nancial statements. By way of example, the nancial notes and supplemental schedules provide explanatory information about the following: Business acquisitions and disposals Commitments and contingencies Legal proceedings Stock option and other employee benet plans Related-party transactions Signicant customers Subsequent events Business and geographic segments Quarterly nancial data Additionally, the footnotes contain information about the methods and assumptions used to prepare the financial statements. Comparability of financial statements is a critical requirement for objective financial analysis. Financial statement comparability occurs when information is measured and reported in a similar manner over time and for different companies. Comparability allows the analyst to identify and analyze the real economic substance differences and similarities between companies. The International Accounting Standards Board based in London sets forth standards under which international financial statements should be prepared. These are referred to as International Financial Reporting Standards (IFRS). Similarly, the Financial Accounting Standards Board (FASB) in the United States sets forth standards (called statements of financial accounting standards) that constitute the key part of the body of principles known as generally accepted accounting principles (U.S. GAAP). These two organizations are working to make their standards similar, but there are key differences. When comparing a U.S. company with a European company, an analyst must understand differences in these standards, which can relate, for example, to the period in which to report revenue. Even within each of these sets of standards there can be choices for management to make that can reduce comparability between companies. Both IFRS and U.S. GAAP allow the use of alternative accounting methods to measure company nancial performance and nancial condition where there are differences in economic environments between companies. Additionally, some principles require the use of estimates and assumptions in measuring performance and nancial condition. This exibility is necessary because, ideally, a company will select those methods, estimates, and assumptions within the principles that fairly reect the unique economic environment of the companys business and industry. Although this exibility in accounting principles ostensibly meets the divergent needs of many businesses, it creates a problem for the analyst because comparability is lost when exibility occurs. For example, if a company acquires a piece of equipment to use in its operations, accounting standards require that the cost of the asset be reported as an expense in a systematic manner over the life of the equipment (estimating the process of the equipments wearing out). This allocation of the cost is known as depreciation. The standards permit a great deal of exibility, however, in determining the manner in which each years expense is determined. Two companies may acquire similar equipment but use different methods and assumptions to record the expense over time. Comparing the companies performance directly is then impaired by this difference. c01.indd 13 9/17/08 11:23:06 AM 14 International Financial Statement Analysis A companys accounting policies (methods, estimates, and assumptions) are generally presented in the notes to the nancial statements. A note containing a summary of signicant accounting policies reveals, for example, how the company recognizes its revenues and depreciates its capital assets. Analysts must be aware of the methods, estimates, and assumptions used by a company to determine if they are similar to those of other companies that are being used as benchmarks. If they are not similar, the analyst who understands accounting techniques can make adjustments to make the nancial statements more comparable. 3.1.6. Managements Discussion and Analysis Publicly held companies are often required to include in their nancial reports a section called Managements Discussion and Analysis (MD&A). In it, management must highlight any favorable or unfavorable trends and identify signicant events and uncertainties that affect the companys liquidity, capital resources, and results of operations. The MD&A must also provide information about the effects of ination, changing prices, or other material events and uncertainties that may cause the future operating results and nancial condition to materially depart from the current reported nancial information. Companies should also provide disclosure in the MD&A that discusses the critical accounting policies that require management to make subjective judgments and that have a signicant impact on reported nancial results. The MD&A section of a companys report provides a good starting place for understanding what is going on in the nancial statements. Nevertheless, it is only one input for the analyst in seeking an objective and independent perspective on a companys performance and prospects. 3.1.7. Auditor s Reports Financial statements presented in company annual nancial reports are often required to be audited (examined) by an independent accounting rm that then expresses an opinion on the nancial statements. Audits may be required by contractual arrangement, law, or regulation. Just as there are standards for preparing nancial statements, there are standards for auditing and for expressing the resulting auditors opinion. International standards for auditing have been developed by the International Auditing and Assurance Standards Board of the International Federation of Accountants. These standards have been adopted by many countries. Other countries, such as the United States, have developed their own standards. With the enactment of the SarbanesOxley Act in the United States, auditing standards are being promulgated by the Public Company Accounting Oversight Board (PCAOB). Under International Standard on Auditing 200: The objective of an audit of nancial statements is to enable the auditor to express an opinion whether the nancial statements are prepared, in all material respects, in accordance with an applicable nancial reporting framework.4 Publicly traded companies may also have requirements set by regulators or stock exchanges, such as appointing an independent audit committee of the board of directors to oversee the audit process. The audit process provides a basis for the independent auditor to express an audit opinion on the fairness of the nancial statements that were audited. Because audits are designed and conducted by using audit sampling techniques, independent auditors cannot express an opinion that provides absolute assurance about the accuracy or precision of the nancial statements. Instead, the independent audit report provides 4 International Federation of Accountants, Handbook of International Auditing, Assurance, and Ethics Pronouncements, 2006 edition, p. 230, available at www.ifac.org. c01.indd 14 9/17/08 11:23:06 AM Chapter 1 Financial Statement Analysis: An Introduction 15 reasonable assurance that the nancial statements are fairly presented, meaning that there is a high degree of probability that the audited nancial statements are free from material error, fraud, or illegal acts that have a direct effect on the nancial statements. The standard independent audit report for a publicly traded company normally has several paragraphs under both the international and U.S. auditing standards. The rst or introductory paragraph describes the nancial statements that were audited and the responsibilities of both management and the independent auditor. The second or scope paragraph describes the nature of the audit process and provides the basis for the auditors expression about reasonable assurance on the fairness of the nancial statements. The third or opinion paragraph expresses the auditors opinion on the fairness of the audited nancial statements. An unqualied audit opinion states that the nancial statements give a true and fair view (international) or are fairly presented (international and U.S.) in accordance with applicable accounting standards. This is often referred to as a clean opinion and is the one that analysts would like to see in a nancial report. There are several other types of opinions. A qualied audit opinion is one in which there is some limitation or exception to accounting standards. Exceptions are described in the audit report with additional explanatory paragraphs so that the analyst can determine the importance of the exception. An adverse audit opinion occurs when the nancial statements materially depart from accounting standards and are not fairly presented. An adverse opinion makes analysis of the nancial statements easy: Dont bother, because the companys nancial statements cannot be relied upon. Finally, a disclaimer of opinion occurs when, for some reason, the auditors are unable to issue an opinion. Exhibit 1-6 presents the independent auditors report for Wal-Mart. Note that Wal-Mart received a clean or unqualied audit opinion from Ernst & Young LLP for the companys scal year ended 31 January 2005. In the United States, under the Sarbanes-Oxley Act, the auditors must also express an opinion on the companys internal control systems. This information may be provided in a separate opinion or incorporated as a fourth paragraph in the opinion related to the nancial statements. The internal control system is the companys internal system that is designed, among other things, to ensure that the companys process for generating nancial reports is sound. Although management has always been responsible for maintaining effective internal control, the Sarbanes-Oxley Act greatly increases managements responsibility for demonstrating that the companys internal controls are effective. Publicly traded companies in the United States are now required by securities regulators to: Accept responsibility for the effectiveness of internal control. Evaluate the effectiveness of internal control using suitable control criteria. Support the evaluation with sufcient competent evidence. Provide a report on internal control. The Sarbanes-Oxley Act specically requires managements report on internal control to: State that it is managements responsibility to establish and maintain adequate internal control. Identify managements framework for evaluating internal control. Include managements assessment of the effectiveness of the companys internal control over nancial reporting as of the end of the most recent year, including a statement as to whether internal control over nancial reporting is effective. Include a statement that the companys auditors have issued an attestation report on managements assessment. Certify that the companys nancial statements are fairly presented. c01.indd 15 9/17/08 11:23:07 AM 16 International Financial Statement Analysis EXHIBIT 1-6 Wal-Marts Independent Audit Report Report of Independent Registered Accounting Firm WAL-MART The Board of Directors and Shareholders, Wal-Mart Stores, Inc. We have audited the accompanying consolidated balance sheets of Wal-Mart Stores, Inc. as of January 31, 2005 and 2004, and the related consolidated statements of income, shareholders equity and cash ows for each of the three years in the period ended January 31, 2005. These nancial statements are the responsibility of the companys management. Our responsibility is to express an opinion on these nancial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the nancial statements are free of material misstatement. An audit includes examining on a test basis, evidence supporting the amounts and disclosures in the nancial statements. An audit also includes assessing the accounting principles used and signicant estimates made by management, as well as evaluating the overall nancial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the nancial statements referred to above present fairly, in all material respects, the consolidated nancial position of Wal-Mart Stores, Inc. at January 31, 2005 and 2004, and the consolidated results of its operations and its cash ows for each of the three years in the period ended January 31, 2005, in conformity with U.S. generally accepted accounting principles. We also have audited, in accordance with the standards of the Public Accounting Oversight Board (United States), the effectiveness of Wal-Mart Stores, Inc.s internal control over nancial reporting as of January 31, 2005, based on criteria established in Internal Control Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Committee and our report dated March 25, 2005 expressed an unqualied opinion thereon. Ernst & Young LLP Rogers, Arkansas March 25, 2005 Source: 2005 Wal-Mart Stores, Inc. annual report. Exhibit 1-7 presents Wal-Mart managements report on internal control to its companys shareholders. Note that Wal-Mart has fully complied with each of the reporting criterion that were discussed in the preceding paragraph. Although these reports provide some assurances to analysts, they are not infallible. The analyst must always use a degree of healthy skepticism when analyzing nancial statements. 3.2. Other Sources of Information The information described in the previous section is generally provided to shareholders on an annual basis. Interim reports are also provided by the company either semiannually or quarterly. Interim reports generally present the four key nancial statements and footnotes but are not audited. These interim reports provide updated information on a companys performance and nancial position since the last annual period. Companies also prepare proxy statements for distribution to shareholders on matters that are to be put to a vote at the companys annual (or special) meeting of shareholders. The proxy statement typically provides useful information regarding management and director compensation and company stock performance and discloses any potential conicts of interest that may exist between management, c01.indd 16 9/17/08 11:23:07 AM Chapter 1 Financial Statement Analysis: An Introduction 17 EXHIBIT 1-7 Wal-Marts Report to Shareholders on Corporate Governance and Internal Control Managements Report to Our Shareholders WAL-MART Management of Wal-Mart Stores, Inc. (Wal-Mart) is responsible for the preparation, integrity and objectivity of Wal-Marts consolidated nancial statements and other nancial information contained in this Annual Report to Shareholders. Those consolidated nancial statements were prepared in conformity with accounting principles generally accepted in the United States. In preparing those consolidated nancial statements, Management was required to make certain estimates and judgments, which are based upon currently available information and Managements view of current conditions and circumstances. The Audit Committee of the Board of Directors, which consists solely of independent directors, oversees our process of reporting nancial information and the audit of our consolidated nancial statements. The Audit Committee stays informed of the nancial condition of Wal-Mart and regularly reviews Managements nancial policies and procedures, the independence of our independent auditors, our internal control and the objectivity of our nancial reporting. Both the independent nancial auditors and the internal auditors have free access to the Audit Committee and meet with the Audit Committee periodically, both with and without Management present. We have retained Ernst & Young LLP, an independent registered public accounting rm, to audit our consolidated nancial statements found in this annual report. We have made available to Ernst & Young LLP all of our nancial records and related data in connection with their audit of our consolidated nancial statements. We have led with the Securities and Exchange Commission the required certications related to our consolidated nancial statements as of and for the year ended January 31, 2005. These certications are attached as exhibits to our Annual Report on Form 10-K for the year ended January 31, 2005. Additionally, we have also provided to the New York Stock Exchange the required annual certication of our Chief Executive Ofcer regarding our compliance with the New York Stock Exchanges corporate governance listing standards. Report on Internal Control over Financial Reporting Management has responsibility for establishing and maintaining adequate internal control over nancial reporting. Internal control over nancial reporting is a process designed to provide reasonable assurance regarding the reliability of nancial reporting and the preparation of nancial statements for external reporting purposes in accordance with accounting principles generally accepted in the United States. Because of its inherent limitations, internal control over nancial reporting may not prevent or detect misstatements. Management has assessed the effectiveness of the companys internal control over nancial reporting as of January 31, 2005. In making its assessment, Management has utilized the criteria set forth by the Committee of Sponsoring Organizations (COSO) of the Treadway Commission in Internal ControlIntegrated Framework. Management concluded that based on its assessment, Wal-Marts internal control over nancial reporting was effective as of January 31, 2005. Managements assessment of the effectiveness of the companys internal control over nancial reporting as of January 31, 2005 has been audited by Ernst & Young LLP, an independent registered public accounting rm, as stated in their report which appears in this Annual Report to Shareholders. Evaluation of Disclosure Controls and Procedures We maintain disclosure controls and procedures designed to provide reasonable assurance that information, which is required to be timely disclosed, is accumulated and communicated to Management in a timely fashion. Management has assessed the effectiveness of these disclosure controls and procedures as of January 31, 2005 and determined that they were effective as of that date to provide reasonable assurance that information required to be disclosed by us in the reports we le or submit under the Securities Exchange Act of 1934, as amended, is accumulated and communicated to Management, as appropriate, to allow timely decisions regarding required disclosure and are effective to provide reasonable assurance that such information is recorded, processed, summarized and reported within the time periods specied by the SECs rules and forms. (Continued ) c01.indd 17 9/17/08 11:23:08 AM 18 International Financial Statement Analysis EXHIBIT 1-7 Continued Report on Ethical Standards Our company was founded on the belief that open communications and the highest standard of ethics are necessary to be successful. Our long-standing Open Door communication policy helps Management be aware of and address issues in a timely and effective manner. Through the open door policy all associates are encouraged to inform Management at the appropriate level when they are concerned about any matter pertaining to Wal-Mart. Wal-Mart has adopted a Statement of Ethics to guide our associates in the continued observance of high ethical standards such as honesty, integrity and compliance with the law in the conduct of Wal-Marts business. Familiarity and compliance with the Statement of Ethics is required of all associates who are part of Management. The company also maintains a separate Code of Ethics for our senior nancial ofcers. Wal-Mart also has in place a Related-Party Transaction Policy. This policy applies to all of Wal-Marts Ofcers and Directors and requires material related-party transactions to be reviewed by the Audit Committee. The Ofcers and Directors are required to report material related-party transactions to Wal-Mart. We maintain an ethics ofce which oversees and administers an ethics hotline. The ethics hotline provides a channel for associates to make condential and anonymous complaints regarding potential violations of our statement of ethics, including violations related to nancial or accounting matters. H. Lee Scott President and Chief Executive Ofcer Thomas M. Schoewe Executive Vice President and Chief Financial Ofcer Source: 2005 Wal-Mart Stores, Inc. annual report. the board, and shareholders. Companies also provide relevant current information on their web sites and in press releases and as part of conference calls. When performing nancial statement analysis, analysts should review all these company sources of information as well as information from external sources regarding the economy, the industry, the company, and peer (comparable) companies. Information on the economy, industry, and peer companies is useful in putting the companys nancial performance and position in perspective and in assessing the companys future. The next section presents a framework for using all this information in nancial statement analysis. 4 . FINANCIAL STATEMENT ANALYSIS FRAMEWORK Analysts work in a variety of positions. Some are equity analysts whose main objective is to evaluate potential equity (share) investments to determine whether a prospective investment is attractive and what an appropriate purchase price might be. Others are credit analysts who evaluate the creditworthiness of a company to decide whether (and with what terms) a loan should be made or what credit rating should be assigned. Analysts may also be involved in a variety of other tasks, such as evaluating the performance of a subsidiary company, evaluating a private equity investment, or nding stocks that are overvalued for purposes of taking a short position. This section presents a generic framework for nancial statement analysis that can be used in these various tasks. The framework is summarized in Exhibit 1-8.5 5 Components of this framework have been adapted from van Greuning and Bratanovic (2003, p. 300) and from Benninga and Sarig (1997, pp. 134156). c01.indd 18 9/17/08 11:23:08 AM Chapter 1 19 Financial Statement Analysis: An Introduction EXHIBIT 1-8 Financial Statement Analysis Framework Phase 1. Articulate the purpose and context of the analysis. Sources of Information The nature of the analysts function, such as evaluating an equity or debt investment or issuing a credit rating. Output Statement of the purpose or objective of analysis. Communication with client or supervisor on needs and concerns. A list (written or unwritten) of specic questions to be answered by the analysis. Institutional guidelines related to developing specic work product. Nature and content of report to be provided. Timetable and budgeted resources for completion. 2. Collect data. Financial statements, other nancial data, questionnaires, and industry/ economic data. Discussions with management, suppliers, customers, and competitors. Organized nancial statements. Financial data tables. Completed questionnaires, if applicable. Company site visits (e.g., to production facilities or retail stores). 3. Process data. Data from the previous phase. Adjusted nancial statements. Common-size statements. Ratios and graphs. Forecasts. 4. Analyze/interpret the processed data. Input data as well as processed data. Analytical results. 5. Develop and communicate conclusions and recommendations (e.g., with an analysis report). Analytical results and previous reports. Analytical report answering questions posed in Phase 1. Institutional guidelines for published reports. Recommendation regarding the purpose of the analysis, such as whether to make an investment or grant credit. 6. Follow up. Information gathered by periodically repeating above steps as necessary to determine whether changes to holdings or recommendations are necessary. Updated reports and recommendations. The following sections discuss the individual phases of nancial statement analysis. 4.1. Articulate the Purpose and Context of Analysis Prior to undertaking any analysis, it is essential to understand the purpose of the analysis. An understanding of the purpose is particularly important in nancial statement analysis because of the numerous available techniques and the substantial amount of data. Some analytical tasks are well dened, in which case articulating the purpose of the analysis requires little decision making by the analyst. For example, a periodic credit review of an c01.indd 19 9/17/08 11:23:09 AM 20 International Financial Statement Analysis investment-grade debt portfolio or an equity analysts report on a particular company may be guided by institutional norms such that the purpose of the analysis is given. Furthermore, the format, procedures, and/or sources of information may also be given. For other analytical tasks, articulating the purpose of the analysis requires the analyst to make decisions. The purpose of an analysis guides further decisions about the approach, the tools, the data sources, the format in which to report results of the analysis, and the relative importance of different aspects of the analysis. When facing a substantial amount of data, a less experienced analyst may be tempted to just start crunching numbers and creating output. It is generally advisable to resist the temptation and thus avoid the black hole of pointless number crunching. Consider the questions: If you could wave a magic wand and have all the numbers crunched, what conclusion would you be able to draw? What question would you be able to answer? What decision would your answer support? The analyst should also dene the context at this stage. Who is the intended audience? What is the end productfor example, a nal report explaining conclusions and recommendations? What is the time frame (i.e., when is the report due)? What resources and resource constraints are relevant to completion of the analysis? Again, the context may be predened (i.e., standard and guided by institutional norms). Having claried the purpose and context of the nancial statement analysis, the analyst should next compile the specic questions to be answered by the analysis. For example, if the purpose of the nancial statement analysis (or, more likely, the particular stage of a larger analysis) is to compare the historical performance of three companies operating in a particular industry, specic questions would include: What has been the relative growth rate of the companies and what has been the relative protability of the companies? 4.2. Collect Data Next, the analyst obtains the data required to answer the specic questions. A key part of this step is obtaining an understanding of the companys business, nancial performance, and nancial position (including trends over time and in comparison with peer companies). For historical analyses, nancial statement data alone are adequate in some cases. For example, to screen a large number of alternative companies for those with a minimum level of profitability, nancial statement data alone would be adequate. But to address more in-depth questions, such as why and how one company performed better or worse than its competitors, additional information would be required. As another example, to compare the historical performance of two companies in a particular industry, the historical nancial statements would be sufcient to determine which had faster-growing sales or earnings and which was more protable; however, a broader comparison with overall industry growth and protability would obviously require industry data. Furthermore, information on the economy and industry is necessary to understand the environment in which the company operates. Analysts often take a top-down approach whereby they (1) gain an understanding of the macroeconomic environment, such as prospects for growth in the economy and ination, (2) analyze the prospects of the industry in which the subject company operates based on the expected macroeconomic environment, and (3) determine the prospects for the company in the expected industry and macroeconomic environments. For example, an analyst may need to forecast future growth in earnings for a company. To project future growth, past company data provide one basis for statistical c01.indd c01.indd 20 9/17/08 11:23:09 AM Chapter 1 Financial Statement Analysis: An Introduction 21 forecasting; however, an understanding of economic and industry conditions can improve the analysts ability to forecast a companys earnings based on forecasts of overall economic and industry activity. 4.3. Process Data After obtaining the requisite nancial statement and other information, the analyst processes this data using appropriate analytical tools. For example, processing the data may involve computing ratios or growth rates; preparing common-size nancial statements; creating charts; performing statistical analyses, such as regressions or Monte Carlo simulations; performing equity valuation; performing sensitivity analyses; or using any other analytical tools or combination of tools that are available and appropriate to the task. A comprehensive nancial analysis at this stage would include the following: Reading and evaluating nancial statements for each company subject to analysis. This includes reading the footnotes and understanding what accounting standards have been used (e.g., IFRS or U.S. GAAP), what accounting choices have been made (e.g., when to report revenue on the income statement), and what operating decisions have been made that affect reported nancial statements (e.g., leasing versus purchasing equipment). Making any needed adjustments to the nancial statements to facilitate comparison, when the unadjusted statements of the subject companies reect differences in accounting standards, accounting choices, or operating decisions. Note that commonly used databases do not make such analyst adjustments. Preparing or collecting common-size nancial statement data (which scale data to directly reect percentages [e.g., of sales] or changes [e.g., from the prior year]) and nancial ratios (which are measures of various aspects of corporate performance based on nancial statement elements). On the basis of common-size nancial statements and nancial ratios, analysts can evaluate a companys relative protability, liquidity, leverage, efciency, and valuation in relation to past results and/or peers results. 4.4. Analyze/Interpret the Processed Data Once the data have been processed, the next stepcritical to any analysisis to interpret the output. The answer to a specic nancial analysis question is seldom the numerical answer alone; the answer to the analytical question relies on the interpretation of the output and the use of this interpreted output to support a conclusion or recommendation. The answers to the specic analytical questions may themselves achieve the underlying purpose of the analysis, but usually, a conclusion or recommendation is required. For example, an equity analysis may require a buy, hold, or sell decision or a conclusion about the value of a share of stock. In support of the decision, the analysis would cite such information as target value, relative performance, expected future performance given a companys strategic position, quality of management, and whatever other information was important in reaching the decision. 4.5. Develop and Communicate Conclusions/Recommendations Communicating the conclusion or recommendation in an appropriate format is the next step in an analysis. The appropriate format will vary by analytical task, by institution, and/or c01.indd 21 9/17/08 11:23:10 AM 22 International Financial Statement Analysis by audience. For example, an equity analyst report would typically include the following components:6 Summary and investment conclusion Business summary Risks Valuation Historical and pro forma tables The contents of reports many also be specied by regulatory agencies or professional standards. For example, the CFA Institute Standards of Practice Handbook (SOPH) dictates standards that must be followed in communicating recommendations. The SOPH provides, in part: Standard V(B) states the responsibility of members and candidates to include in their communications those key factors that are instrumental to the investment recommendation presented. A critical part of this requirement is to distinguish clearly between opinions and facts. In preparing a research report, the member or candidate must present the basic characteristics of the security being analyzed, which will allow the reader to evaluate the report and incorporate information the reader deems relevant to his or her investment decision making process.7 The SOPH requires that limitations to the analysis and any risks inherent to the investment be disclosed. Furthermore, the SOPH requires that any report include elements important to the analysis and conclusions so that readers can evaluate the conclusions themselves. 4.6. Follow Up The process does not end with the report. If an equity investment is made or a credit rating assigned, periodic review is required to determine if the original conclusions and recommendations are still valid. In the case of a rejected investment, follow-up may not be necessary but may be appropriate to determine if the analysis process should be rened (e.g., if a rejected investment turns out to be successful in the market). Follow-up may involve repeating all the above steps in the process on a periodic basis. 5 . SUMMARY This chapter has presented an overview of nancial statement analysis. Among the major points covered are the following: The primary purpose of nancial reports is to provide information and data about a companys nancial position and performance, including protability and cash ows. The information presented in nancial reportsincluding the nancial statements, nancial notes, and managements discussion and analysisallows the nancial analyst to assess a companys nancial position and performance and trends in that performance. 6 Stowe, Robinson, Pinto, and McLeavey (2002, p. 27). Standards of Practice Handbook (2006, p. 105). 7 c01.indd c01.indd 22 9/17/08 11:23:10 AM Chapter 1 Financial Statement Analysis: An Introduction 23 Key nancial statements that are a primary focus of analysis include the income statement, balance sheet, cash ow statement, and statement of owners equity. The income statement presents information on the nancial results of a companys business activities over a period of time. The income statement communicates how much revenue the company generated during a period and what costs it incurred in connection with generating that revenue. The basic equation underlying the income statement is Revenue Expense Net income. The balance sheet discloses what a company owns (assets) and what it owes (liabilities) at a specic point in time. Owners equity represents the portion belonging to the owners or shareholders of the business; it is the residual interest in the assets of an entity after deducting its liabilities. The three parts of the balance sheet are formulated in the accounting relationship of Assets Liabilities Owners equity. Although the income statement and balance sheet provide a measure of a companys success, cash and cash ow are also vital to a companys long-term success. Disclosing the sources and uses of cash in the cash ow statement helps creditors, investors, and other statement users evaluate the companys liquidity, solvency, and nancial exibility. The statement of changes in owners equity reects information about the increases or decreases to a companys owners equity. In addition to the nancial statements, a company provides other sources of nancial information that are useful to the nancial analyst. As part of his or her analysis, the nancial analyst should read and assess the information presented in the companys nancial note disclosures and supplementary schedules as well as the information contained in the MD&A. Analysts must also evaluate footnote disclosures regarding the use of alternative accounting methods, estimates, and assumptions. A publicly traded company must have an independent audit performed on its year-end nancial statements. The auditors opinion provides some assurance about whether the nancial statements fairly reect a companys performance and nancial position. In addition, for U.S. publicly traded companies, management must demonstrate that the companys internal controls are effective. The nancial statement analysis framework provides steps that can be followed in any nancial statement analysis project, including the following: Articulate the purpose and context of the analysis. Collect input data. Process data. Analyze/interpret the processed data. Develop and communicate conclusions and recommendations. Follow up. P RACTICE PROBLEMS 1. Providing information about the performance and nancial position of companies so that users can make economic decisions best describes the role of A. auditing. B. nancial reporting. C. nancial statement analysis. c01.indd c01.indd 23 9/17/08 11:23:11 AM 24 International Financial Statement Analysis 2. A companys current nancial position would best be evaluated using the A. balance sheet. B. income statement. C. cash ow statement. 3. A companys protability for a period would best be evaluated using the A. balance sheet. B. income statement. C. cash ow statement. 4. Accounting methods, estimates, and assumptions used in preparing nancial statements are found A. in footnotes. B. in the auditors report. C. in the proxy statement. 5. Information about management and director compensation would best be found A. in footnotes. B. in the auditors report. C. in the proxy statement. 6. Information about material events and uncertainties would best be found in A. footnotes. B. the proxy statement. C. managements discussion and analysis. 7. What type of audit opinion is preferred when analyzing nancial statements? A. Qualied. B. Adverse. C. Unqualied. 8. Ratios are an input into which step in the nancial analysis framework? A. Process data. B. Collect input data. C. Analyze/interpret the processed data. c01.indd c01.indd 24 9/17/08 11:23:11 AM CHAPTER 2 F INANCIAL REPORTING MECHANICS Thomas R. Robinson, CFA CFA Institute Charlottesville, Virginia Hennie van Greuning, CFA World Bank Washington, DC Elaine Henry, CFA University of Miami Miami, Florida Michael A. Broihahn, CFA Barry University Miami, Florida L EARNING OUTCOMES After completing this chapter, you will be able to do the following: Identify the groups (operating, investing, and nancing activities) into which business activities are categorized for nancial reporting purposes and classify any business activity in the appropriate group. Explain the relationship of nancial statement elements and accounts, and classify accounts into the nancial statement elements. 25 c02.indd 25 9/17/08 11:24:22 AM 26 International Financial Statement Analysis Explain the accounting equation in its basic and expanded forms. Explain the process of recording business transactions using an accounting system based on the accounting equations. Explain the need for accruals and other adjustments in preparing nancial statements. Prepare nancial statements given account balances and/or other elements in the relevant accounting equation, and explain the relationships among the income statement, balance sheet, statement of cash ows, and statement of owners equity. Describe the ow of information in an accounting system. Explain the use of the results of the accounting process in security analysis. 1 . INTRODUCTION The nancial statements of a company are end products of a process for recording transactions of the company related to operations, nancing, and investment. The structures of nancial statements themselves reect the system of recording and organizing transactions. To be an informed user of nancial statements, the analyst must be knowledgeable about the principles of this system. This chapter will supply that essential knowledge, taking the perspective of the user rather than the preparer. Learning the process from this perspective will enable an analyst to grasp the critical concepts without being overwhelmed by the detailed technical skills required by the accountants who prepare nancial statements that are a major component of nancial reports. This chapter is organized as follows: Section 2 describes the three groups into which business activities are classied for nancial reporting purposes. Any transaction affects one or more of these groups. Section 3 describes how the elements of nancial statements relate to accounts, the basic content unit of classifying transactions. The section is also an introduction to the linkages among the nancial statements. Section 4 provides a step-bystep illustration of the accounting process. Section 5 explains the consequences of timing differences between the elements of a transaction. Section 6 provides an overview of how information ows through a businesss accounting system. Section 7 introduces the use of nancial reporting in security analysis, and Section 8 presents a summary of key points. Practice problems in the CFA Institute multiple-choice format conclude the chapter. 2 . THE CLASSIFICATION OF BUSINESS ACTIVITIES Accountants give similar accounting treatment to similar types of business transactions. Therefore, a rst step in understanding nancial reporting mechanics is to understand how business activities are classied for nancial reporting purposes. Business activities may be classied into three groups for nancial reporting purposes: operating, investing, and nancing activities. Operating activities are those activities that are part of the day-to-day business functioning of an entity. Examples include the sale of meals by a restaurant, the sale of services by a consulting rm, the manufacture and sale of ovens by an oven-manufacturing company, and taking deposits and making loans by a bank. Investing activities are those activities associated with acquisition and disposal of longterm assets. Examples include the purchase of equipment or sale of surplus equipment c02.indd 26 9/17/08 11:24:23 AM Chapter 2 Financial Reporting Mechanics 27 EXHIBIT 2-1 Typical Business Activities and Financial Statement Elements Affected Assets (A), Liabilities (L), Owners Equity (E), Revenue (R), and Expenses (X) Operating activities Sales of goods and services to customers: (R) Costs of providing the goods and services: (X) Income tax expense: (X) Holding short-term assets or incurring short-term liabilities directly related to operating activities: (A), (L) Investing activities Purchase or sale of assets, such as property, plant, and equipment: (A) Purchase or sale of other entities equity and debt securities: (A) Financing activities Issuance or repurchase of the companys own preferred or common stock: (E) Issuance or repayment of debt: (L) Payment of distributions (i.e., dividends to preferred or common stockholders): (E) (such as an oven) by a restaurant (contrast this to the sale of an oven by an oven manufacturer, which would be an operating activity), and the purchase or sale of an ofce building, a retail store, or a factory. Financing activities are those activities related to obtaining or repaying capital. The two primary sources for such funds are owners (shareholders) or creditors. Examples include issuing common shares, taking out a bank loan, and issuing bonds. Understanding the nature of activities helps the analyst understand where the company is doing well and where it is not doing so well. Ideally, an analyst would prefer that most of a companys prots (and cash ow) come from its operating activities. Exhibit 2-1 provides examples of typical business activities and how these activities relate to the elements of nancial statements described in the following section. Not all transactions t neatly in this framework for purposes of nancial statement presentation. For example, interest received by a bank on one of its loans would be considered part of operating activities because a bank is in the business of lending money. In contrast, interest received on a bond investment by a restaurant may be more appropriately classied as an investing activity because the restaurant is not in the business of lending money. The next section discusses how transactions resulting from these business activities are reected in a companys nancial records. 3 . ACCOUNTS AND FINANCIAL STATEMENTS Business activities resulting in transactions are reected in the broad groupings of nancial statement elements: assets, liabilities, owners equity, revenue, and expenses.1 In general terms, these elements can be dened as follows: assets are the economic resources of a 1 International Financial Reporting Standards use the term income to include revenue and gains. Gains are similar to revenue; however, they arise from secondary or peripheral activities rather than from a c02.indd c02.indd 27 9/17/08 11:24:24 AM 28 International Financial Statement Analysis company; liabilities are the creditors claims on the resources of a company; owners equity is the residual claim on those resources; revenues are inows of economic resources to the company; and expenses are outows of economic resources or increases in liabilities.2 Accounts provide individual records of increases and decreases in a specic asset, liability, component of owners equity, revenue, or expense. The nancial statements are constructed using these elements. 3.1. Financial Statement Elements and Accounts Within the nancial statement elements, accounts are subclassications. Accounts are individual records of increases and decreases in a specic asset, liability, component of owners equity, revenue, or expense. For nancial statements, amounts recorded in every individual account are summarized and grouped appropriately within a nancial statement element. Exhibit 2-2 provides a listing of common accounts. These accounts will be described throughout this chapter or in following chapters. Unlike the nancial statement elements, there is no standard set of accounts applicable to all companies. Although almost every company has certain accounts, such as cash, each company species the accounts in its accounting system based on its particular needs and circumstances. For example, a company in the restaurant business may not be involved in trading securities and, therefore, may not need an account to record such an activity. Furthermore, each company names its accounts based on its business. A company in the restaurant business might have an asset account for each of its ovens, with the accounts named Oven-1 and Oven-2. In its nancial statements, these accounts would likely be grouped within long-term assets as a single line item called property, plant, and equipment. A companys challenge is to establish accounts and account groupings that provide meaningful summarization of voluminous data but retain enough detail to facilitate decision making and preparation of the nancial statements. The actual accounts used in a companys accounting system will be set forth in a chart of accounts. Generally, the chart of accounts is far more detailed than the information presented in nancial statements. Certain accounts are used to offset other accounts. For example, a common asset account is accounts receivable, also known as trade accounts receivable or trade receivables. A company uses this account to record the amounts it is owed by its customers. In other words, sales made on credit are reected in accounts receivable. In connection with its receivables, a company often expects some amount of uncollectible accounts and, therefore, records an estimate companys primary business activities. For example, for a restaurant, the sale of surplus restaurant equipment for more than its cost is referred to as a gain rather than revenue. Similarly, a loss is like an expense but arises from secondary activities. Gains and losses may be considered part of operations on the income statement (for example, a loss due to a decline in value of inventory) or may be part of nonoperating activities (for example, the sale of nontrading investments). Under U.S. GAAP, nancial statement elements are dened to include assets, liabilities, owners equity, revenue, expenses, gains, and losses. To illustrate business transactions in this reading, we will use the simple classication of revenues and expenses. All gains and revenue will be aggregated in revenue, and all losses and expenses will be aggregated in expenses. 2 The authoritative accounting standards provide signicantly more detailed denitions of the accounting elements. Also note that owners equity is a generic term, and more specic titles are often used such as shareholders equity, stockholders equity, or partners capital. The broader terms equity and capital are also used on occasion. c02.indd 28 9/17/08 11:24:24 AM Chapter 2 Financial Reporting Mechanics 29 EXHIBIT 2-2 Common Accounts Assets Cash and cash equivalents Accounts receivable, trade receivables Prepaid expenses Inventory Property, plant, and equipment Investment property Intangible assets (patents, trademarks, licenses, copyright, goodwill) Financial assets, trading securities, investment securities Investments accounted for by the equity method Current and deferred tax assets (for banks, Loans [receivable]) Liabilities Accounts payable, trade payables Provisions or accrued liabilities Financial liabilities Current and deferred tax liabilities Reserves Minority interest Unearned revenue Debt payable Bonds (payable) (for banks, Deposits) Owners equity Capital, such as common stock par value Additional paid-in capital Retained earnings Other comprehensive income Revenue Revenue, sales Gains Investment income (e.g., interest and dividends) Expense Cost of goods sold Selling, general, and administrative expenses (SG&A; e.g., rent, utilities, salaries, advertising) Depreciation and amortization Interest expense Tax expense Losses of the amount that may not be collected. The estimated uncollectible amount is recorded in an account called allowance for bad debts. Because the effect of the allowance for bad debts account is to reduce the balance of the companys accounts receivable, it is known as a contra asset account. Any account that is offset or deducted from another account is called a contra account. Common contra asset accounts include allowance for bad debts c02.indd c02.indd 29 9/17/08 11:24:24 AM 30 International Financial Statement Analysis (an offset to accounts receivable for the amount of accounts receivable that are estimated to be uncollectible), accumulated depreciation (an offset to property, plant, and equipment reecting the amount of the cost of property, plant, and equipment that has been allocated to current and previous accounting periods), and sales returns and allowances (an offset to revenue reecting any cash refunds, credits on account, and discounts from sales prices given to customers who purchased defective or unsatisfactory items). For presentation purposes, assets are sometimes categorized as current or noncurrent. For example, Tesco (a large European retailer) presents the following major asset accounts in its 2006 nancial reports: Noncurrent assets Intangible assets including goodwill Property, plant, and equipment Investment property Investments in joint ventures and associates Current assets Inventories Trade and other receivables Cash and cash equivalents Noncurrent assets are assets that are expected to benet the company over an extended period of time (usually more than one year). For Tesco, these include the following: intangible assets, such as goodwill;3 property, plant, and equipment used in operations (e.g., land and buildings); other property held for investment, and investments in the securities of other companies. Current assets are those that are expected to be consumed or converted into cash in the near future, typically one year or less. Inventories are the unsold units of product on hand (sometimes referred to as inventory stock). Trade receivables (also referred to as commercial receivables, or simply accounts receivable) are amounts customers owe the company for products that have been sold as well as amounts that may be due from suppliers (such as for returns of merchandise). Other receivables represent amounts owed to the company from parties other than customers. Cash refers to cash on hand (e.g., petty cash and cash not yet deposited to the bank) and in the bank. Cash equivalents are very liquid short-term investments, usually maturing in 90 days or less. The presentation of assets as current or noncurrent will vary from industry to industry and from country to country. Some industries present current assets rst, whereas others list noncurrent assets rst. This is discussed further in later chapters. 3.2. Accounting Equations The ve nancial statement elements noted previously serve as the inputs for equations that underlie the nancial statements. This section describes the equations for three of the nancial statements: balance sheet, income statement, and statement of retained earnings. A statement of retained earnings can be viewed as a component of the statement of stockholders equity, which shows all changes to owners equity, both changes resulting from retained 3 Goodwill is an intangible asset that represents the excess of the purchase price of an acquired company over the value of the net assets acquired. c02.indd 30 9/17/08 11:24:25 AM Chapter 2 31 Financial Reporting Mechanics earnings and changes resulting from share issuance or repurchase. The fourth basic nancial statement, the statement of cash ows, will be discussed in a later section. The balance sheet presents a companys nancial position at a particular point in time. It provides a listing of a companys assets and the claims on those assets (liabilities and equity claims). The equation that underlies the balance sheet is also known as the basic accounting equation. A companys nancial position is reected using the following equation: Assets Liabilities Owners equity (2-1a) Presented in this form, it is clear that claims on assets are from two sources: liabilities or owners equity. Owners equity is the residual claim of the owners (i.e., the owners remaining claim on the companys assets after the liabilities are deducted). The concept of the owners residual claim is well illustrated by the slightly rearranged balance sheet equation, roughly equivalent to the structure commonly seen in the balance sheets of U.K. companies: Assets Liabilities Owners equity (2-1b) Other terms are used to denote owners equity, including shareholders equity, stockholders equity, net assets, equity, net worth, net book value, and partners capital. The exact titles depend upon the type of entity, but the equation remains the same. Owners equity at a given date can be further classied by its origin: capital contributed by owners, and earnings retained in the business up to that date:4 Owners equity Contributed capital Retained earnings (2-2) The income statement presents the performance of a business for a specic period of time. The equation reected in the income statement is the following: Revenue Expenses Net income (loss) (2-3) Note that net income (loss) is the difference between two of the elements: revenue and expenses. When a companys revenue exceeds its expenses, it reports net income; when a companys revenues are less than its expenses, it reports a net loss. Other terms are used synonymously with revenue, including sales and turnover (in the United Kingdom). Other terms used synonymously with net income include net prot and net earnings. Also, as noted earlier, revenue and expenses generally relate to providing goods or services in a companys primary business activities. In contrast, gains (losses) relate to increases (decreases) in resources that are not part of a companys primary business activities. Distinguishing a companys primary business activities from other business activities is important in nancial analysis; however, for purposes of the accounting equation, gains are included in revenue and losses are included in expenses. The balance sheet and income statement are two of the primary nancial statements. Although these are the common terms for these statements, some variations in the names occur. A balance sheet can be referred to as a statement of nancial position or some similar 4 This formula reects the fundamental origins of owners equity and reects the basic principles of accounting. The presentation is somewhat simplied. In practice, the owners equity section of a companys balance sheet may include other items, such as treasury stock (which arises when a company repurchases and holds its own stock) or other comprehensive income. Comprehensive income includes all income of the company. Some items of comprehensive income are not reported on the income statement. These items as a group are called other comprehensive income; such items arise, for example, when there are changes in the value of assets or liabilities that are not reected in the income statement. c02.indd 31 9/17/08 11:24:25 AM 32 International Financial Statement Analysis EXHIBIT 2-3 Simplied Balance Sheet and Income Statement ABC Company, Inc. Balance Sheet As of 31 December 20X1 Assets ABC Company, Inc. Income Statement For the Year Ended 31 December 20X1 2,000 Revenue 250 1,500 Expense 50 2,000 Liabilities Net income 500 Owners equity 200 term that indicates it contains balances at a point in time. Income statements can be titled statement of operations, statement of income, statement of prot and loss, or some other similar term showing that it reects the companys operating activity for a period of time. A simplied balance sheet and income statement are shown in Exhibit 2-3. The balance sheet represents a companys nancial position at a point in time, and the income statement represents a companys activity over a period of time. The two statements are linked together through the retained earnings component of owners equity. Beginning retained earnings is the balance in this account at the beginning of the accounting period, and ending retained earnings is the balance at the end of the period. A companys ending retained earnings is composed of the beginning balance (if any), plus net income, less any distributions to owners (dividends). Accordingly, the equation underlying retained earnings is: Ending retained earnings Beginning retained earnings Dividends Net income (2-4a) Or, substituting Equation 2-3 for Net income, equivalently: Ending retained earnings Beginning retained earnings Expenses Dividends Revenues (2-4b) As its name suggests, retained earnings represent the earnings (i.e., net income) that are retained by the companyin other words, the amount not distributed as dividends to owners. Retained earnings is a component of owners equity and links the as of balance sheet equation with the activity equation of the income statement. To provide a combined representation of the balance sheet and income statement, we can substitute Equation 2-2 into Equation 2-1a. This becomes the expanded accounting equation: Assets Liabilities Contributed capital Ending retained earnings (2-5a) Or equivalently, substituting Equation 2-4b into Equation 2-5a, we can write: Assets Liabilities Revenue Contributed capital Beginning retained earnings Expenses Dividends (2-5b) The last ve items, beginning with contributed capital, are components of owners equity. The statement of retained earnings shows the linkage between the balance sheet and income statement. Exhibit 2-4 shows a simplied example of nancial statements for a company that began the year with retained earnings of $250 and recognized $200 of net income c02.indd 32 9/17/08 11:24:25 AM Chapter 2 33 Financial Reporting Mechanics EXHIBIT 2-4 Simplied Balance Sheet, Income Statement, and Statement of Retained Earnings Point in Time: Beginning of Period Balance Sheet Point in Time: Change over Time: End-of-Period Income Statement and Changes in Retained Earnings Balance Sheet ABC Company, Inc. (Beginning) Balance Sheet As of 31 December 20X0 ABC Company, Inc. Income Statement Year Ended 31 December 20X1 Revenue 250 Assets 2,000 Expense Liabilities Contributed equity Retained earnings Owners equity 500 Net income ABC Company, Inc. (Ending) Balance Sheet As of 31 December 20X1 Assets 2,200 50 200 1,250 Liabilities Contributed equity 250 Retained earnings 1,500 Owners equity 2,000 500 1,250 450 1,700 2,200 ABC Company, Inc. Statement of Retained Earnings Year Ended 31 December 20X1 Beginning 250 retained earnings Plus net income 200 Minus dividends 0 Ending retained earnings 450 during the period. The example assumes the company paid no dividends and, therefore, had ending retained earnings of $450. The basic accounting equation reected in the balance sheet (Assets Liabilities Owners equity) implies that every recorded transaction affects at least two accounts in order to keep the equation in balance, hence the term double-entry accounting that is sometimes used to describe the accounting process. For example, the use of cash to purchase equipment affects two accounts (both asset accounts): cash decreases and equipment increases. As another example, the use of cash to pay off a liability also affects two accounts (one asset account and one liability account): cash decreases and the liability decreases. With each transaction, the accounting equation remains in balance, which is a fundamental accounting concept. Example 2-1 presents a partial balance sheet for an actual company and an application of the accounting equation. Examples 2-2 and 2-3 provide further practice for applying the accounting equations. c02.indd 33 9/17/08 11:24:26 AM 34 International Financial Statement Analysis EXAMPLE 2-1 Using Accounting Equations (1) Canon is a manufacturer of copy machines and other electronic equipment. Abbreviated balance sheets as of 31 December 2004 and 2005 are presented below. Canon and Subsidiaries: Consolidated Balance Sheets (millions) 31 DEC 2005 31 DEC 2004 4,043,553 3,587,021 1,238,535 1,190,331 ? 2,396,690 4,043,553 3,587,021 Assets Total assets Liabilities and stockholders equity Total liabilities Total stockholders equity Total liabilities and stockholders equity Using Equation 2-1a, address the following: 1. Determine the amount of stockholders equity as of 31 December 2005. 2. A. Calculate and contrast the absolute change in total assets in 2005 with the absolute change in total stockholders equity in 2005. B. Based on your answer to 2A, state and justify the relative importance of growth in stockholders equity and growth in liabilities in nancing the growth of assets over the two years. Solution to 1. Total stockholders equity is equal to assets minus liabilities; in other words, it is the residual claim to the companys assets after deducting liabilities. For 2005, the amount of Canons total stockholders equity was thus 4,043,553 million 1,238,535 million 2,805,018 million. Solutions to 2: A. Total assets increased by 4,043,553 million 3,587,021 million 456,532 million. Total stockholders equity increased by 2,805,018 million 2,396,690 million 408,328 million. Thus, in 2005, total assets grew by more than total stockholders equity (456,532 million is larger than 408,328 million). B. Using the relationship Assets Liabilities Owners equity, the solution to 2A implies that total liabilities increased by the difference between the increase in total assets and the increase in total stockholders equity, that is, by 456,532 million 408,328 million 48,204 million. (If liabilities had not increased by 48,204 million, the accounting equation would not be in balance.) Contrasting the growth in total stockholders equity (408,328 million) with the growth in total liabilities (48,204 million), we see that the growth in stockholders equity was relatively much more important than the growth in liabilities in nancing total asset growth in 2005. c02.indd 34 9/17/08 11:24:26 AM Chapter 2 Financial Reporting Mechanics EXAMPLE 2-2 35 Using Accounting Equations (2) An analyst has collected the following information regarding a company in advance of its year-end earnings announcement (amounts in millions): Estimated net income Beginning retained earnings Estimated distributions to owners $ 150 $ 2,000 $ 50 The analysts estimate of ending retained earnings (in millions) should be closest to A. B. C. D. $2,000. $2,100. $2,150. $2,200. Solution. B is correct. Beginning retained earnings is increased by net income and reduced by distributions to owners: $2,000 $150 $50 $2,100. EXAMPLE 2-3 Using Accounting Equations (3) An analyst has compiled the following information regarding RDZ, Inc. Liabilities at year-end Contributed capital at year-end Beginning retained earnings Revenue during the year Expenses during the year 1,000 1,000 500 4,000 3,800 There have been no distributions to owners. The analysts estimate of total assets at year-end should be closest to A. B. C. D. 2,000. 2,300. 2,500. 2,700. Solution. D is correct. Ending retained earnings is rst determined by adding revenue minus expenses to beginning retained earnings to obtain 700. Total assets would be equal to the sum of liabilities, contributed capital, and ending retained earnings: 1,000 1,000 700 2,700. c02.indd 35 9/17/08 11:24:56 AM 36 International Financial Statement Analysis Having described the components and linkages of nancial statements in abstract terms, we now examine more concretely how business activities are recorded. The next section illustrates the accounting process with a simple step-by-step example. 4 . THE ACCOUNTING PROCESS The accounting process involves recording business transactions such that periodic nancial statements can be prepared. This section illustrates how business transactions are recorded in a simplied accounting system. 4.1. An Illustration Key concepts of the accounting process can be more easily explained using a simple illustration. We look at an illustration in which three friends decide to start a business, Investment Advisers, Ltd. (IAL). They plan to issue a monthly newsletter of securities trading advice and to sell investment books. Although they do not plan to manage any clients funds, they will manage a trading portfolio of the owners funds to demonstrate the success of the recommended strategies from the newsletter. Because this illustration is meant to present accounting concepts, any regulatory implications will not be addressed. Additionally, for this illustration, we will assume that the entity will not be subject to income taxes; any income or loss will be passed through to the owners and be subject to tax on their personal income tax returns. As the business commences, various business activities occur. Exhibit 2-5 provides a listing of the business activities that have taken place in the early stages of operations. Note that these activities encompass the types of operating, investing, and nancing business activities discussed above. 4.2. The Accounting Records If the owners want to evaluate the business at the end of January 2006, Exhibit 2-5 does not provide a sufciently meaningful report of what transpired or where the company currently stands. It is clear that a system is needed to track this information and to address three objectives: Identify those activities requiring further action (e.g., collection of outstanding receivable balances). Assess the protability of the operations over the month. Evaluate the current nancial position of the company (such as cash on hand). An accounting system will translate the companys business activities into usable nancial records. The basic system for recording transactions in this illustration is a spreadsheet with each of the different types of accounts represented by a column. The accounting equation provides a basis for setting up this system. Recall the accounting Equation 2-5b: Assets c02.indd 36 Liabilities Revenue Contributed capital Beginning retained earnings Expenses Dividends 9/17/08 11:25:08 AM Chapter 2 Financial Reporting Mechanics 37 EXHIBIT 2-5 Business Activities for Investment Advisers, Ltd. # Date Business Activity 1 31 December 2005 File documents with regulatory authorities to establish a separate legal entity. Initially capitalize the company through deposit of $150,000 from the three owners. 2 2 January 2006 Set up a $100,000 investment account and purchase a portfolio of equities and xed-income securities. 3 2 January 3006 Pay $3,000 to landlord for ofce/warehouse. $2,000 represents a refundable deposit, and $1,000 represents the rst months rent. 4 3 January 2006 Purchase ofce equipment for $6,000. The equipment has an estimated life of two years with no salvage value.5 5 3 January 2006 Receive $1,200 cash for a one-year subscription to the monthly newsletter. 6 10 January 2006 Purchase and receive 500 books at a cost of $20 per book for a total of $10,000. Invoice terms are that payment from IAL is due in 30 days. No cash changes hands. These books are intended for resale. 7 10 January 2006 Spend $600 on newspaper and trade magazine advertising for the month. 8 15 January 2006 Borrow $12,000 from a bank for working capital. Interest is payable annually at 10 percent. The principal is due in two years. 9 15 January 2006 Ship rst order to a customer consisting of ve books at $25 per book. Invoice terms are that payment is due in 30 days. No cash changes hands. 10 15 January 2006 Sell for cash 10 books at $25 per book at an investment conference. 11 30 January 2006 Hire a part-time clerk. The clerk is hired through an agency that also handles all payroll taxes. The company is to pay $15 per hour to the agency. The clerk works six hours prior to 31 January, but no cash will be paid until February. 12 31 January 2006 Mail out the rst months newsletter to customer. This subscription had been sold on 3 January. See item 5. 13 31 January 2006 Review of the investment portfolio shows that $100 of interest income was earned and the market value of the portfolio has increased by $2,000. The balance in the investment account is now $102,100. The securities are classied as trading securities. 5 Salvage value is the amount the company estimates that it can sell the asset for at the end of its useful life. c02.indd 37 9/17/08 11:25:08 AM 38 International Financial Statement Analysis The specic accounts to be used for IALs system include the following: Asset Accounts Cash Investments Prepaid rent (cash paid for rent in advance of recognizing the expense) Rent deposit (cash deposited with the landlord, but returnable to the company) Ofce equipment Inventory Accounts receivable Liability Accounts Unearned fees (fees that have not been earned yet, even though cash has been received) Accounts payable (amounts owed to suppliers) Bank debt Equity Accounts Contributed capital Retained earnings Income Revenue Expenses Dividends Exhibit 2-6 presents the spreadsheet representing IALs accounting system for the rst 10 transactions. Each event is entered on a new row of the spreadsheet as it occurs. To record events in the spreadsheet, the nancial impact of each needs to be assessed and the activity expressed as an accounting transaction. In assessing the nancial impact of each event and converting these events into accounting transactions, the following steps are taken: 1. Identify which accounts are affected, by what amount, and whether the accounts are increased or decreased. 2. Determine the element type for each account identied in Step 1 (e.g., cash is an asset) and where it ts in the basic accounting equation. Rely on the economic characteristics of the account and the basic denitions of the elements to make this determination. 3. Using the information from Steps 1 and 2, enter the amounts in the appropriate column of the spreadsheet. 4. Verify that the accounting equation is still in balance. At any point in time, basic nancial statements can be prepared based on the subtotals in each column. The discussion that follows identies the accounts affected and the related element (Steps 1 and 2) for the rst 10 events listed in Exhibit 2-5. The accounting treatment shows the account affected in bold and the related element in brackets. The recording of these entries into a basic accounting system (Steps 3 and 4) is depicted on the spreadsheet in Exhibit 2-6. c02.indd c02.indd 38 9/17/08 11:25:09 AM 39 c02.indd 39 9/17/08 11:25:10 AM 0 Cash (6,000) 1,200 3 Pay landlord 4 Buy equipment 5 Sell subscription Subtotal 53,850 118,825 (200) Inventory 250 10 Cash sale 12,000 125 Accounts (100) receivable Inventory 10,000 Inventory 6,000 Ofce equipment 1,000 Prepaid rent 2,000 Rent deposit 100,000 Investments 0 Account 9 Sell books on account 8 Borrow 7 Advertise (600) (3,000) 2 Investments 6 Buy books 150,000 (100,000) 1 Capitalize Beg. Balance # Other Assets Assets 23,200 12,000 10,000 1,200 0 Bank debt Accounts payable Unearned fees Account Liabilities Amount EXHIBIT 2-6 Accounting System for Investment Advisers, Ltd. 150,000 150,000 0 Contributed Capital 0 Beginning Retained Earnings 375 250 125 0 Revenue Owners Equity (900) (200) (100) (600) 0 Expense 0 Dividends 40 International Financial Statement Analysis Because this is a new business, the accounting equation begins at zero on both sides. There is a zero beginning balance in all accounts. 31 December 2005 Business Activity 1 Accounting Treatment File documents with regulatory authorities to establish a separate legal entity. Initially capitalize the company through deposit of $150,000 from the three owners. Cash [A] is increased by $150,000, and contributed capital [E]6 is increased by $150,000. Accounting Elements: Assets (A), Liabilites (L), Equity (E), Revenue (R), and Expenses (X). This transaction affects two elements: assets and equity. Exhibit 2-6 demonstrates this effect on the accounting equation. The companys balance sheet at this point in time would be presented by subtotaling the columns in Exhibit 2-6: Investment Advisers, Ltd. Balance Sheet 31 December 2005 Assets Cash $150,000 Total assets $150,000 Liabilities and owners equity Contributed capital $150,000 Total liabilities and owners equity $150,000 The company has assets (resources) of $150,000, and the owners claim on the resources equals $150,000 (their contributed capital) as there are no liabilities at this point. For this illustration, we present an unclassied balance sheet. An unclassied balance sheet is one that does not show subtotals for current assets and current liabilities. Assets are simply listed in order of liquidity (how quickly they are expected to be converted into cash). Similarly, liabilities are listed in the order in which they are expected to be satised (or paid off ). 2 January 2006 Business Activity 2 Accounting Treatment Set up a $100,000 investment account and purchase a portfolio of equities and xed-income securities. Investments [A] were increased by $100,000, and cash [A] was decreased by $100,000. Accounting Elements: Assets (A), Liabilites (L), Equity (E), Revenue (R), and Expenses (X). This transaction affects two accounts, but only one element (assets) and one side of the accounting equation, as depicted in Exhibit 2-6. Cash is reduced when the securities are purchased. Another type of asset, investments, increases. We examine the other transaction from 2 January before taking another look at the companys balance sheet. 6 The account title will vary depending upon the type of entity (incorporated or not) and jurisdiction. Alternative account titles are common shares, common stock, members capital, partners capital, etc. c02.indd 40 9/17/08 11:25:11 AM Chapter 2 41 Financial Reporting Mechanics 2 January 2006 Business Activity 3 Accounting Treatment Pay $3,000 to landlord for ofce/warehouse. $2,000 represents a refundable deposit, and $1,000 represents the rst months rent. Cash [A] was decreased by $3,000, deposits [A] were increased by $2,000, and prepaid rent [A] was increased by $1,000. Accounting Elements: Assets (A), Liabilites (L), Equity (E), Revenue (R), and Expenses (X). Once again, this transaction affects only asset accounts. Note that the rst months rent is initially recorded as an asset, prepaid rent. As time passes, the company will incur rent expense, so a portion of this prepaid asset will be transferred to expenses and thus will appear on the income statement as an expense.7 This will require a later adjustment in our accounting system. Note that the transactions so far have had no impact on the income statement. At this point in time, the companys balance sheet would be: Investment Advisers, Ltd. Balance Sheet As of 2 January 2006 Assets Cash $ 47,000 Investments 100,000 Prepaid rent 1,000 Deposits 2,000 Total assets $150,000 Liabilities and owners equity Contributed capital $150,000 Total liabilities and owners equity $150,000 Note that the items in the balance sheet have changed, but it remains in balance; the amount of total assets equals total liabilities plus owners equity. The company still has $150,000 in resources, but the assets now comprise cash, investments, prepaid rent, and deposits. Each asset is listed separately because they are different in terms of their ability to be used by the company. Note also that the owners equity claim on these assets remains $150,000 because the company still has no liabilities. 3 January 2006 Business Activity 4 Accounting Treatment Purchase ofce equipment for $6,000 in cash. The equipment has an estimated life of two years with no salvage value. Cash [A] was decreased by $6,000, and ofce equipment [A] was increased by $6,000. Accounting Elements: Assets (A), Liabilites (L), Equity (E), Revenue (R), and Expenses (X). 7 An argument can be made for treating this $1,000 as an immediate expense. We adopt the approach of recording a prepaid asset in order to illustrate accrual accounting. A situation in which a company prepays rent (or insurance or any similar expense) for a time span covering multiple accounting periods more clearly requires the use of accrual accounting. c02.indd 41 9/17/08 11:25:12 AM 42 International Financial Statement Analysis The company has once again exchanged one asset for another. Cash has decreased while ofce equipment has increased. Ofce equipment is a resource that will provide benets over multiple future periods and, therefore, its cost must also be spread over multiple future periods. This will require adjustments to our accounting records as time passes. Depreciation is the term for the process of spreading this cost over multiple periods. 3 January 2006 Business Activity 5 Accounting Treatment Receive $1,200 cash for a one-year subscription to the monthly newsletter. Cash [A] was increased by $1,200, and unearned fees [L] was increased by $1,200. Accounting Elements: Assets (A), Liabilites (L), Equity (E), Revenue (R), and Expenses (X). In this transaction, the company has received cash related to the sale of subscriptions. However, the company has not yet actually earned the subscription fees because it has an obligation to deliver newsletters in the future. So, this amount is recorded as a liability called unearned fees (or unearned revenue). In the future, as the company delivers the newsletters and thus fullls its obligation, this amount will be transferred to revenue. If the company fails to deliver the newsletters, the fees will need to be returned to the customer. As of 3 January 2006, the companys balance sheet would appear as Investment Advisers, Ltd. Balance Sheet As of 3 January 2006 Assets Cash $ 42,200 Investments 100,000 Prepaid rent 1,000 Deposits 2,000 Ofce equipment 6,000 Total assets $151,200 Liabilities and owners equity Liabilities Unearned fees $ 1,200 Equity Contributed capital 150,000 Total liabilities and owners equity $151,200 The company now has $151,200 of resources, against which there is a claim by the subscription customer of $1,200 and a residual claim by the owners of $150,000. Again, the balance sheet remains in balance, with total assets equal to total liabilities plus equity. 10 January 2006 Business Activity Accounting Treatment 6 Purchase and receive 500 books at a cost of $20 per book for a total Inventory [A] is increased by of $10,000. Invoice terms are that payment from IAL is due in 30 $10,000, and accounts payable days. No cash changes hands. These books are intended for resale. [L] is increased by $10,000. Accounting Elements: Assets (A), Liabilites (L), Equity (E), Revenue (R), and Expenses (X). c02.indd 42 9/17/08 11:25:13 AM Chapter 2 43 Financial Reporting Mechanics The company has obtained an asset, inventory, which can be sold to customers at a later date. Rather than paying cash to the supplier currently, the company has incurred an obligation to do so in 30 days. This represents a liability to the supplier that is termed accounts payable. 10 January 2006 Business Activity 7 Accounting Treatment Spend $600 on newspaper and trade magazine advertising for the month. Cash [A] was decreased by $600, and advertising expense [X] was increased by $600. Accounting Elements: Assets (A), Liabilites (L), Equity (E), Revenue (R), and Expenses (X). Unlike the previous expenditures, advertising is an expense, not an asset. Its benets relate to the current period. Expenditures such as advertising are recorded as an expense when they are incurred. Contrast this expenditure with that for equipment, which is expected to be useful over multiple periods and thus is initially recorded as an asset, and then reected as an expense over time. Also, contrast this treatment with that for rent expense, which was paid in advance and can be clearly allocated over time, and thus is initially recorded as a prepaid asset and then reected as an expense over time. The advertising expenditure in this example relates to the current period. If the company had paid in advance for several years worth of advertising, then a portion would be capitalized (i.e., recorded as an asset), similar to the treatment of equipment or prepaid rent and expensed in future periods. We can now prepare a partial income statement for the company reecting this expense: Investment Advisers, Ltd. Income Statement For the Period 1 January through 10 January 2006 Total revenue $ 0 Expenses Advertising Total expense Net income (loss) $ 600 600 $ (600) Because the company has incurred a $600 expense but has not recorded any revenue (the subscription revenue has not been earned yet), an income statement for Transactions 1 through 7 would show net income of minus $600 (i.e., a net loss). To prepare a balance sheet for the company, we need to update the retained earnings account. Beginning retained earnings was $0 (zero). Adding the net loss of $600 (made up of $0 revenue minus $600 expense) and deducting any dividend ($0 in this illustration) gives ending retained earnings of minus $600. The ending retained earnings covering Transactions 17 is included in the interim balance sheet: c02.indd 43 9/17/08 11:25:13 AM 44 International Financial Statement Analysis Investment Advisers, Ltd. Balance Sheet As of 10 January 2006 Assets Cash $ 41,600 Investments 100,000 Inventory 10,000 Prepaid rent 1,000 Deposits 2,000 Ofce equipment 6,000 Total assets $160,600 Liabilities and owners equity Liabilities Accounts payable $ 10,000 Unearned fees 1,200 Total liabilities 11,200 Equity Contributed capital 150,000 Retained earnings (600) Total equity 149,400 Total liabilities and owners equity $160,600 As with all balance sheets, the amount of total assets equals total liabilities plus owners equityboth are $160,600. The owners claim on the business has been reduced to $149,400. This is due to the negative retained earnings (sometimes referred to as a retained decit). As noted, the company has a net loss after the rst seven transactions, a result of incurring $600 of advertising expenses but not yet producing any revenue. 15 January 2006 Business Activity 8 Accounting Treatment Borrow $12,000 from a bank for working capital. Interest is payable annually at 10 percent. The principal is due in two years. Cash [A] is increased by $12,000, and bank debt [L] is increased by $12,000. Accounting Elements: Assets (A), Liabilites (L), Equity (E), Revenue (R), and Expenses (X). Cash is increased, and a corresponding liability is recorded to reect the amount owed to the bank. Initially, no entry is made for interest that is expected to be paid on the loan. In the future, interest will be recorded as time passes and interest accrues (accumulates) on the loan. 15 January 2006 Business Activity 9 Accounting Treatment Ship rst order to a customer consisting of ve books at $25 per book. Invoice terms are that payment is due in 30 days. No cash changes hands. Accounts receivable [A] increased by $125, and revenue [R] increased by $125. Additionally, inventory [A] decreased by $100, and cost of goods sold [X] increased by $100. Accounting Elements: Assets (A), Liabilites (L), Equity (E), Revenue (R), and Expenses (X). c02.indd 44 9/17/08 11:25:14 AM Chapter 2 45 Financial Reporting Mechanics The company has now made a sale. Sale transaction records have two parts. One part represents the $125 revenue to be received from the customer, and the other part represents the $100 cost of the goods that have been sold. Although payment has not yet been received from the customer in payment for the goods, the company has delivered the goods (ve books) and so revenue is recorded. A corresponding asset, accounts receivable, is recorded to reect amounts due from the customer. Simultaneously, the company reduces its inventory balance by the cost of the ve books sold and also records this amount as an expense termed cost of goods sold. 15 January 2006 Business Activity 10 Accounting Treatment Sell for cash 10 books at $25 per book at an investment conference. Cash [A] is increased by $250, and revenue [R] is increased by $250. Additionally, inventory [A] is decreased by $200, and cost of goods sold [X] is increased by $200. Accounting Elements: Assets (A), Liabilites (L), Equity (E), Revenue (R), and Expenses (X). Similar to the previous sale transaction, both the $250 sales proceeds and the $200 cost of the goods sold must be recorded. In contrast with the previous sale, however, the sales proceeds are received in cash. Subtotals from Exhibit 2-6 can once again be used to prepare a preliminary income statement and balance sheet to evaluate the business to date: Investment Advisers, Ltd. Income Statement For the Period 1 January through 15 January 2006 Total revenue $ 375 Expenses Cost of goods sold Advertising $300 600 Total expenses 900 Net income (loss) $(525) Investment Advisers, Ltd. Balance Sheet As of 15 January 2006 Assets Cash Accounts receivable Investments $ 53,850 125 100,000 Inventory 9,700 Prepaid rent 1,000 Deposits 2,000 Ofce equipment Total assets 6,000 $172,675 (Continued ) c02.indd 45 9/17/08 11:25:15 AM 46 International Financial Statement Analysis Investment Advisers, Ltd. Balance Sheet As of 15 January 2006 (Continued ) Liabilities and owners equity Liabilities Accounts payable Unearned fees $ 10,000 1,200 Bank debt 12,000 Total liabilities 23,200 Equity Contributed capital Retained earnings Total equity Total liabilities and owners equity 150,000 (525) 149,475 $172,675 An income statement covering Transactions 110 would reect revenue to date of $375 for the sale of books minus the $300 cost of those books and minus the $600 advertising expense. The net loss is $525, which is shown in the income statement as $(525) using the accounting convention that indicates a negative number using parentheses. This net loss is also reected on the balance sheet in retained earnings. The amount in retained earnings at this point equals the net loss of $525 because retained earnings had $0 beginning balance and no dividends have been distributed. The balance sheet reects total assets of $172,675 and claims on the assets of $23,200 in liabilities and $149,475 owners equity. Within assets, the inventory balance represents the cost of the 485 remaining books (a total of 15 have been sold) at $20 each. Transactions 110 occurred throughout the month and involved cash, accounts receivable, or accounts payable; accordingly, these transactions clearly required an entry into the accounting system. The other transactions, items 1113, have also occurred and need to be reected in the nancial statements, but these transactions may not be so obvious. In order to prepare complete nancial statements at the end of a reporting period, an entity needs to review its operations to determine whether any accruals or other adjustments are required. A more complete discussion of accruals and adjustments is set forth in the next section, but generally speaking, such entries serve to allocate revenue and expense items into the correct accounting period. In practice, companies may also make adjustments to correct erroneous entries or to update inventory balances to reect a physical count. In this illustration, adjustments are needed for a number of transactions in order to allocate amounts across accounting periods. The accounting treatment for these transactions is shown in Exhibit 2-7. Transactions are numbered sequentially, and an a is added to a transaction number to denote an adjustment relating to a previous transaction. Exhibit 2-8 presents the completed spreadsheet reecting these additional entries in the accounting system. A nal income statement and balance sheet can now be prepared reecting all transactions and adjustments as shown on page 49. c02.indd c02.indd 46 9/17/08 11:25:15 AM Chapter 2 47 Financial Reporting Mechanics EXHIBIT 2-7 Investment Advisers, Ltd. Accruals and Other Adjusting Entries on 31 January 2006 Items 1113 are repeated from Exhibit 2-5. Items 3a, 4a, and 8a reect adjustments relating to items 3, 4, and 8 from Exhibit 2-5. Business Activity 11 12 Accounting Treatment Hire a part-time clerk. The clerk is hired through an agency that also handles all payroll taxes. The company is to pay $15 per hour to the agency. The clerk works six hours prior to 31 January, but no cash will be paid until February. The company owes $90 for wages at month end. Under accrual accounting, expenses are recorded when incurred, not when paid. Mail out the rst months newsletter to customer. This subscription had been sold on 3 January. One month (or 1/12) of the $1,200 subscription has been satised, so $100 can be recognized as revenue. Accrued wages [L] is increased by $90, and payroll expense [X] is increased by $90. The accrued wage liability will be eliminated when the wages are paid. Unearned fees [L] is decreased by $100, and fee revenue [R] is increased by $100. 13 3a Review of the investment portfolio shows that $100 of interest income was earned and the market value of the portfolio has increased by $2,000. The balance in the investment account is now $102,100. The securities are classied as trading securities. Interest income [R] is increased by $100, and the investments account [A] is increased by $100. In item 3, $3,000 was paid to the landlord for ofce/warehouse, including a $2,000 refundable deposit and $1,000 for the rst months rent. To reect the full amount of the rst months rent as a cost of doing business, prepaid rent [A] is decreased by $1,000, and rent expense [X] is increased by $1,000. The $2,000 increase in the value of the portfolio represents unrealized gains that are part of income for traded securities. The investments account [A] is increased by $2,000, and unrealized gains [R] is increased by $2,000. Now, the rst month has ended, so this rent has become a cost of doing business. 4a In item 4, ofce equipment was purchased for $6,000 in cash. The equipment has an estimated life of two years with no salvage value. Now, one month (or 1/24) of the useful life of the equipment has ended, so a portion of the equipment cost has become a cost of doing business. 8a A portion (1/24) of the total $6,000 cost of the ofce equipment is allocated to the current periods cost of doing business. Depreciation expense [X] is increased by $250, and accumulated depreciation [A] (a contra asset account) is increased by $250. Accumulated depreciation is a contra asset account to ofce equipment. The company borrowed $12,000 from a bank on 15 January, with interest payable annually at 10 percent and the principal due in two years. One-half of one month of interest expense has become a cost of doing business. $12,000 10% $1,200 of annual interest, equivalent to $100 per month or $50 for one-half month. Now, one-half of one month has passed since the borrowing. Interest expense [X] is increased by $50, and interest payable [L] is increased by $50. Accounting Elements: Assets (A), Liabilites (L), Equity (E), Revenue (R), and Expenses (X). c02.indd 47 9/17/08 11:25:16 AM 48 c02.indd 48 9/17/08 11:25:17 AM (6,000) 1,200 4 Buy equipment 5 Sell subscript. Account 12,000 Bank debt 10,000 Accounts payable 1,200 Unearned fees 0 Amount Subtotal 119,675 (250) 4A Depreciate equipment 8A Accrue interest (1,000) 3A Rent expense 53,850 100 2,000 13 Investment income Accumulated depreciation (equipment) Prepaid rent Investments Investments 23,240 50 Interest payable (100) Unearned fees 11 Accrue wages Inventory 90 Accrued wages Inventory Accounts receivable Inventory Ofce equipment Prepaid rent Rent deposit Investments Account Liabilities 12 Earn subscription fees (200) 250 10 Cash sale 12,000 (100) 125 10,000 6,000 1,000 2,000 100,000 0 9 Sell books on account 8 Borrow 7 Advertise (600) (3,000) 3 Pay landlord 6 Buy books (100,000) 2 Investments 0 150,000 Cash 1 Capitalize Beg. Bal # Other Assets Assets EXHIBIT 2-8 Accounting System for Investment Advisers, Ltd. 150,000 150,000 0 Contributed Capital 0 Beginning Retained Earnings 2,575 1002,000 100 250 125 0 Revenue Owners Equity (2,290) (50) (250) (1,000) (90) (200) (100) (600) 0 Expense (enter as negative) 0 Dividends (enter as negative) Chapter 2 49 Financial Reporting Mechanics Investment Advisers, Ltd. Income Statement For the Period 1 January through 31 January 2006 Revenues Fee revenue $ 100 Book sales 375 Investment income 2,100 Total revenues $2,575 Expenses Cost of goods sold $ 300 Advertising 600 Wage 90 Rent 1,000 Depreciation 250 Interest 50 Total expenses 2,290 Net income (loss) $ 285 Investment Advisers, Ltd. Balance Sheet As of 31 January 2006 Assets Cash Accounts receivable Investments Inventory Prepaid rent $ 53,850 125 102,100 9,700 0 Ofce equipment, net 5,750 Deposits 2,000 Total assets $173,525 Liabilities and owners equity Liabilities Accounts payable Accrued wages Interest payable Unearned fees $ 10,000 90 50 1,100 Bank debt 12,000 Total liabilities 23,240 Equity Contributed capital Retained earnings Total equity Total liabilities and owners equity c02.indd c02.indd 49 150,000 285 150,285 $173,525 9/17/08 11:25:19 AM 50 International Financial Statement Analysis From the income statement, we can determine that the business was protable for the month. The business earned $285 after expenses. The balance sheet presents the nancial position. The company has assets of $173,525, and claims against those assets included liabilities of $23,240 and an owners claim of $150,285. The owners claim reects their initial investment plus reinvested earnings. These statements are explored further in the next section. 4.3. Financial Statements The spreadsheet in Exhibit 2-8 is an organized presentation of the companys transactions and can help in preparing the income statement and balance sheet presented above. Exhibit 2-9 presents all nancial statements and demonstrates their relationships. Note that the data for the income statement come from the revenue and expense columns of the spreadsheet (which include gains and losses). The net income of $285 (revenue of $2,575 minus expenses of $2,290) was retained in the business rather than distributed to the owners as dividends. The net income, therefore, becomes part of ending retained earnings on the balance sheet. The detail of retained earnings is shown in the statement of owners equity. The balance sheet presents the nancial position of the company using the assets, liabilities, and equity accounts from the accounting system spreadsheet. The statement of cash ows summarizes the data from the cash column of the accounting system spreadsheet to enable the owners and others to assess the sources and uses of cash. These sources and uses of cash are categorized according to group of business activity: operating, investing, or nancing. The format of the statement of cash ows presented here is known as the direct format, which refers to the operating cash section appearing simply as operating cash receipts less operating cash disbursements. An alternative format for the operating cash section, which begins with net income and shows adjustments to derive operating cash ow, is known as the indirect format. The alternative formats and detailed rules are discussed in the statement of cash ows chapter. Financial statements use the nancial data reported in the accounting system and present this data in a more meaningful manner. Each statement reports on critical areas. Specically, a review of the nancial statements for the IAL illustration provides the following information: Balance sheet. This statement provides information about a companys nancial position at a point in time. It shows an entitys assets, liabilities, and owners equity at a particular date. Two years are usually presented so that comparisons can be made. Less signicant accounts can be grouped into a single line item. One observation from the IAL illustration is that although total assets have increased signicantly (about 16 percent), equity has increased less than 0.2 percentmost of the increase in total assets is due to the increase in liabilities. Income statement. This statement provides information about a companys protability over a period of time. It shows the amount of revenue, expense, and resulting net income or loss for a company during a period of time. Again, less signicant accounts can be grouped into a single line itemin this illustration, expenses other than cost of goods sold are grouped into a single line item. The statement shows that IAL has three sources of revenue and made a small prot in its rst month of operations. Signicantly, most of the revenue came from investments rather than subscriptions or book sales. Statement of cash ows. This statement provides information about a companys cash ows over a period of time. It shows a companys cash inows (receipts) and outows c02.indd 50 9/17/08 11:25:19 AM Chapter 2 51 Financial Reporting Mechanics EXHIBIT 2-9 Investment Advisors, Ltd. Financial Statements Investment Advisers, Ltd. Income Statement For the Month Ended 1/31/2006 Investment Advisers, Ltd. Balance Sheet As of 12/31/2005 Assets Cash Accounts receivable Investments Inventory Office equipment, net Deposits Total assets Liabilities Accounts payable Accrued expenses Unearned fees Bank debt 1/31/2006 150,000 0 0 53,850 125 102,100 9,700 5,750 2,000 173,525 150,000 0 10,000 140 1,100 12,000 Total liabilities 100 375 2,100 2,575 300 1,990 2,290 285 Investment Advisers, Ltd. Statement of Cash Flows For the Month Ended 1/31/2006 150,000 150,000 0 285 Total equity 150,000 150,285 Total liabilities and equity 150,000 173,525 Retained earnings Cash received from customers Cash paid to landlord Cash paid for advertising Investments in trading securities Operating cash flows Capital expenditures Investing cash flows (100,000) (102,150) (6,000) (6,000) Borrowing Financing cash flows Net decrease in cash Cash at 12/31/05 Cash at 1/31/06 Owners equity Contributed capital 23,240 Fee revenue Book sales revenue Investment income Total revenue Cost of g oods sold Other expense Total expense Net income (loss) 12,000 12,000 (96,150) 150,000 53,850 1,450 (3,000) (600) Investment Advisers, Ltd. Statement of Owners Equity 31 January 2006 Balance at 12/31/05 Issuance of stock Net income (loss) Distributions Balance at 1/31/06 Contributed Ca pita l 150,000 Retained Earnings 0 Total 150,000 285 150,000 285 285 150,285 (payments) during the period. These ows are categorized according to the three groups of business activities: operating, nancing, and investing. In the illustration, IAL reported a large negative cash ow from operations ($102,150), primarily because its trading activities involved the purchase of a portfolio of securities but no sales were made from the portfolio. (Note that the purchase of investments for IAL appears in its operating section c02.indd 51 9/17/08 11:25:21 AM 52 International Financial Statement Analysis because the company is in the business of trading securities. In contrast, for a nontrading company, investment activity would be shown as investing cash ows rather than operating cash ows.) IALs negative operating and investing cash ows were funded by $12,000 bank borrowing and a $96,150 reduction in the cash balance. Statement of owners equity. This statement provides information about the composition and changes in owners equity during a period of time. In this illustration, the only change in equity resulted from the net income of $285. A statement of retained earnings (not shown) would report the changes in a companys retained earnings during a period of time. These statements again illustrate the interrelationships among nancial statements. On the balance sheet, we see beginning and ending amounts for assets, liabilities, and owners equity. Owners equity increased from $150,000 to $150,285. The statement of owners equity presents a breakdown of this $285 change. The arrow from the statement of owners equity to the owners equity section of the balance sheet explains that section of the balance sheet. In the IAL illustration, the entire $285 change resulted from an increase in retained earnings. In turn, the increase in retained earnings resulted from $285 net income. The income statement presents a breakdown of the revenues and expenses resulting in this $285. The arrow from the income statement to the net income gure in the owners equity section explains how reported net income came about. Also on the balance sheet, we see that cash decreased from $150,000 at the beginning of the month to $53,850 at the end of the month. The statement of cash ows provides information on the increases and decreases in cash by group of business activity. The arrow from the cash ow statement to the ending cash gure shows that the cash ow statement explains in detail the ending cash amount. In summary, the balance sheet provides information at a point in time (nancial position), whereas the other statements provide useful information regarding the activity during a period of time (protability, cash ow, and changes in owners equity). 5 . ACCRUALS AND VALUATION ADJUSTMENTS In a simple business model such as the investment company discussed in the illustration above, many transactions are handled in cash and settled in a relatively short time frame. Furthermore, assets and liabilities have a xed and determinable value. Translating business transactions into the accounting system is fairly easy. Difculty usually arises when a cash receipt or disbursement occurs in a different period than the related revenue or expense, or when the reportable values of assets vary. This section will address the accounting treatment for these situationsnamely, accruals and valuation adjustments. 5.1. Accruals Accrual accounting requires that revenue be recorded when earned and that expenses be recorded when incurred, irrespective of when the related cash movements occur. The purpose of accrual entries is to report revenue and expense in the proper accounting period. Because accrual entries occur due to timing differences between cash movements and accounting recognition of revenue or expense, it follows that there are only a few possibilities. First, cash movement and accounting recognition can occur at the same time, in which case there is no need for accruals. Second, cash movement may occur before or after accounting recognition, in which case accruals are required. c02.indd 52 9/17/08 11:25:22 AM Chapter 2 53 Financial Reporting Mechanics EXHIBIT 2-10 Accruals Cash Movement Prior to Accounting Recognition Revenue Unearned (Deferred) Revenue Originating entryrecord cash receipt and establish a liability (such as unearned revenue) Adjusting entryreduce the liability while recording revenue Expense Prepaid Expense Originating entryrecord cash payment and establish an asset (such as prepaid expense) Adjusting entryreduce the asset while recording expense Cash Movement in the Same Period as Accounting Recognition Cash Movement after Accounting Recognition Unbilled (Accrued) Revenue Originating entryrecord revenue and establish an asset (such as unbilled revenue) Adjusting entrywhen billing occurs, reduce unbilled revenue and increase accounts receivSettled able. When cash is collected, transactionno accrual entry needed eliminate the receivable. Accrued Expenses Originating entryestablish a liability (such as accrued expenses) and record an expense Adjusting entryreduce the liability as cash is paid The possible situations requiring accrual entries are summarized into four types of accrual entries shown in Exhibit 2-10 and discussed below. Each type of accrual involves an originating entry and at least one adjusting entry at a later date or dates. Unearned (or deferred) revenue arises when a company receives cash prior to earning the revenue. In the IAL illustration, in Transaction 5, the company received $1,200 for a 12-month subscription to a monthly newsletter. At the time the cash was received, the company had an obligation to deliver 12 newsletters and thus had not yet earned the revenue. Each month, as a newsletter is delivered, this obligation will decrease by 1/12th (i.e., $100). And at the same time, $100 of revenue will be earned. The accounting treatment involves an originating entry (the initial recording of the cash received and the corresponding liability to deliver newsletters) and, subsequently, 12 future adjusting entries, the rst one of which was illustrated as Transaction 12. Each adjusting entry reduces the liability and records revenue. In practice, a large amount of unearned revenue may cause some concern about a companys ability to deliver on this future commitment. Conversely, a positive aspect is that increases in unearned revenue are an indicator of future revenues. For example, a large liability on the balance sheet of an airline relates to cash received for future airline travel. Revenue will be recognized as the travel occurs, so an increase in this liability is an indicator of future increases in revenue. Unbilled (or accrued) revenue arises when a company earns revenue prior to receiving cash but has not yet recognized the revenue at the end of an accounting period. In such cases, the accounting treatment involves an originating entry to record the revenue earned through the end of the accounting period and a related receivable reecting amounts due from customers. When the company receives payment (or if goods are returned), an adjusting entry eliminates the receivable. Accrued revenue specically relates to end-of-period accruals; however, the concept is similar to any sale involving deferred receipt of cash. In the IAL illustration, in Transaction 9, c02.indd 53 9/17/08 11:25:23 AM 54 International Financial Statement Analysis the company sold books on account, so the revenue was recognized prior to cash receipt. The accounting treatment involved an entry to record the revenue and the associated receivable. In the future, when the company receives payment, an adjusting entry (not shown) would eliminate the receivable. In practice, it is important to understand the quality of a companys receivables (i.e., the likelihood of collection). Prepaid expense arises when a company makes a cash payment prior to recognizing an expense. In the illustration, in Transaction 3, the company prepaid one months rent. The accounting treatment involves an originating entry to record the payment of cash and the prepaid asset reecting future benets, and a subsequent adjusting entry to record the expense and eliminate the prepaid asset. (See the boxes showing the accounting treatment of Transaction 3, which refers to the originating entry, and Transaction 3a, which refers to the adjusting entry.) In other words, prepaid expenses are assets that will be subsequently expensed. In practice, particularly in a valuation, one consideration is that prepaid assets typically have future value only as future operations transpire, unless they are refundable. Accrued expenses arise when a company incurs expenses that have not yet been paid as of the end of an accounting period. Accrued expenses result in liabilities that usually require future cash payments. In the IAL illustration, the company had incurred wage expenses at month end, but the payment would not be made until after the end of the month (Transaction 11). To reect the companys position at the end of the month, the accounting treatment involved an originating entry to record wage expense and the corresponding liability for wages payable, and a future adjusting entry to eliminate the liability when cash is paid (not shown because wages will be paid only in February). Similarly, the IAL illustration included interest accrual on the companys bank borrowing. (See the boxes showing the accounting treatment of Transaction 8, where Transaction 8 refers to the originating entry, and Transaction 8a, which refers to the adjusting entry.) As with accrued revenues, accrued expenses specically relate to end-of-period accruals. Accounts payable are similar to accrued expenses in that they involve a transaction that occurs now but the cash payment is made later. Accounts payable is also a liability but often relates to the receipt of inventory (or perhaps services) as opposed to recording an immediate expense. Accounts payable should be listed separately from other accrued expenses on the balance sheet because of their different nature. Overall, in practice, complex businesses require additional accruals that are theoretically similar to the four categories of accruals discussed above but which require considerably more judgment. For example, there may be signicant lags between a transaction and cash settlement. In such cases, accruals can span many accounting periods (even 1020 years!), and it is not always clear when revenue has been earned or an expense has been incurred. Considerable judgment is required to determine how to allocate/distribute amounts across periods. An example of such a complex accrual would be the estimated annual revenue for a contractor on a long-term construction project, such as building a nuclear power plant. In general, however, accruals fall under the four general types and follow essentially the same pattern of originating and adjusting entries as the basic accruals described. 5.2. Valuation Adjustments In contrast to accrual entries that allocate revenue and expenses into the appropriate accounting periods, valuation adjustments are made to a companys assets or liabilitiesonly where required by accounting standardsso that the accounting records reect the current market value rather than the historical cost. In this discussion, we focus on valuation adjustments to c02.indd c02.indd 54 9/17/08 11:25:23 AM Chapter 2 Financial Reporting Mechanics 55 assets. For example, in the IAL illustration, Transaction 13 adjusted the value of the companys investment portfolio to its current market value. The income statement reects the $2,100 increase (including interest), and the ending balance sheets report the investment portfolio at its current market value of $102,100. In contrast, the equipment in the IAL illustration was not reported at its current market value and no valuation adjustment was required. As this illustration demonstrates, accounting regulations do not require all types of assets to be reported at their current market value. Some assets (e.g., trading securities) are shown on the balance sheet at their current market value, and changes in that market value are reported in the income statement. Some assets are shown at their historical cost (e.g., specic classes of investment securities being held to maturity). Other assets (e.g., a particular class of investment securities) are shown on the balance sheet at their current market value, but changes in market value bypass the income statement and are recorded directly into shareholders equity under a component referred to as other comprehensive income. This topic will be discussed in more detail in later chapters. In summary, where valuation adjustment entries are required for assets, the basic pattern is the following for increases in assets: An asset is increased with the other side of the equation being a gain on the income statement or an increase to other comprehensive income. Conversely for decreases: An asset is decreased with the other side of the equation being a loss on the income statement or a decrease to other comprehensive income. 6 . ACCOUNTING SYSTEMS The accounting system set forth for the IAL illustration involved a very simple business, a single month of activity, and a small number of transactions. In practice, most businesses are more complicated and have many more transactions. Accordingly, actual accounting systems, although using essentially the same logic as discussed in the illustration, are both more efcient than a spreadsheet and more complex. 6.1. Flow of Information in an Accounting System Accounting texts typically discuss accounting systems in detail because accountants need to understand each step in the process. While analysts do not need to know the same details, they should be familiar with the ow of information through a nancial reporting system. This ow and the key related documents are described in Exhibit 2-11. 6.2. Debits and Credits Reviewing the example of IAL, it is clear that the accounting treatment of every transaction involved at least two accounts and the transaction either increased or decreased the value of any affected account. Traditionally, accounting systems have used the terms debit and credit to describe changes in an account resulting from the accounting processing of a transaction. The correct usage of debit and credit in an accounting context differs from how these terms are used in everyday language.8 The accounting denitions of debit and credit ensure 8 In accounting, debits record increases of asset and expense accounts or decreases in liability and owners equity accounts. Credits record increases in liability, owners equity, and revenue accounts or decreases in asset accounts. Appendix 2A provides more details. c02.indd 55 9/17/08 11:25:24 AM 56 EXHIBIT 2-11 International Financial Statement Analysis Accounting System Flow and Related Documents Journal entries and adjusting entries A journal is a document or computer le in which business transactions are recorded in the order in which they occur (chronological order). The general journal is the collection of all business transactions in an accounting system sorted by date. All accounting systems have a general journal to record all transactions. Some accounting systems also include special journals. For example, there may be one journal for recording sales transactions and another for recording inventory purchases. Journal entriesrecorded in journalsare dated, and show the accounts affected and the amounts. If necessary, the entry will include an explanation of the transaction and documented authorization to record the entry. As the initial step in converting business transactions into nancial information, the journal entry is useful for obtaining detailed information regarding a particular transaction. Adjusting journal entries, a subset of journal entries, are typically made at the end of an accounting period to record items such as accruals that are not yet reected in the accounting system. General ledger and T-accounts A ledger is a document or computer le that shows all business transactions by account. Note that the general ledger, the core of every accounting system, contains all of the same entries as that posted to the general journalthe only difference is that the data are sorted by date in a journal and by account in the ledger. The general ledger is useful for reviewing all of the activity related to a single account. T-accounts, explained in Appendix 2A, are representations of ledger accounts and are frequently used to describe or analyze accounting transactions. Trial balance and adjusted trial balance A trial balance is a document that lists account balances at a particular point in time. Trial balances are typically prepared at the end of an accounting period as a rst step in producing nancial statements. A key difference between a trial balance and a ledger is that the trial balance shows only total ending balances. An initial trial balance assists in the identication of any adjusting entries that may be required. Once these adjusting entries are made, an adjusted trial balance can be prepared. Financial statements The nancial statements, a nal product of the accounting system, are prepared based on the account totals from an adjusted trial balance. that, in processing a transaction, the sum of the debits equals the sum of the credits, which is consistent with the accounting equation (i.e., Equation 2-7) always remaining in balance. Although mastering the usage of the terms debit and credit is essential for an accountant, an analyst can still understand nancial reporting mechanics without speaking in terms of debits and credits. In general, this text avoids the use of debit/credit presentation; however, for reference, Appendix 2A presents the IAL illustration in a debit and credit system. c02.indd 56 9/17/08 11:25:25 AM Chapter 2 Financial Reporting Mechanics 57 The following section broadly describes some considerations for using nancial statements in security analysis. 7 . USING FINANCIAL STATEMENTS IN SECURITY ANALYSIS Financial statements serve as a foundation for credit and equity analysis, including security valuation. Analysts may need to make adjustments to reect items not reported in the statements (certain assets/liabilities and future earnings). Analysts may also need to assess the reasonableness of management judgment (e.g., in accruals and valuations). Because analysts typically will not have access to the accounting system or individual entries, they will need to infer what transactions were recorded by examining the nancial statements. 7.1. The Use of Judgment in Accounts and Entries Quite apart from deliberate misrepresentations, even efforts to faithfully represent the economic performance and position of a company require judgments and estimates. Financial reporting systems need to accommodate complex business models by recording accruals and changes in valuations of balance sheet accounts. Accruals and valuation entries require considerable judgment and thus create many of the limitations of the accounting model. Judgments could prove wrong or, worse, be used for deliberate earnings manipulation. An important rst step in analyzing nancial statements is identifying the types of accruals and valuation entries in an entitys nancial statements. Most of these items will be noted in the critical accounting policies/estimates section of managements discussion and analysis (MD&A) and in the signicant accounting policies footnote, both found in the annual report. Analysts should use this disclosure to identify the key accruals and valuations for a company. The analyst needs to be aware, as Example 2-4 shows, that the manipulation of earnings and assets can take place within the context of satisfying the mechanical rules governing the recording of transactions. EXAMPLE 2-4 The Manipulation of Accounting Earnings As discussed in this chapter, the accounting equation can be expressed as Assets Liabilities Contributed capital Ending retained earnings (Equation 2-5a). Although the equation must remain in balance with each transaction, management can improperly record a transaction to achieve a desired result. For example, when a company spends cash and records an expense, assets are reduced on the left side of the equation and expenses are recorded, which lowers retained earnings on the right side. The balance is maintained. If, however, a company spent cash but did not want to record an expense in order to achieve higher net income, the company could manipulate the system by reducing cash and increasing another asset. The equation would remain in balance and the right-hand side of the equation would not be affected at all. This was one of the techniques used by managers at WorldCom to manipulate nancial reports, c02.indd c02.indd 57 9/17/08 11:25:26 AM 58 International Financial Statement Analysis as summarized in a U.S. Securities and Exchange Commission complaint against the company (emphasis added): In general, WorldCom manipulated its nancial results in two ways. First, WorldCom reduced its operating expenses by improperly releasing certain reserves held against operating expenses. Second, WorldCom improperly reduced its operating expenses by recharacterizing certain expenses as capital assets. Neither practice was in conformity with generally accepted accounting principles (GAAP). Neither practice was disclosed to WorldComs investors, despite the fact that both practices constituted changes from WorldComs previous accounting practices. Both practices falsely reduced WorldComs expenses and, accordingly, had the effect of articially inating the income WorldCom reported to the public in its nancial statements from 1999 through the rst quarter of 2002.9 In 2005, the former CEO of WorldCom was sentenced to 25 years in prison for his role in the fraud.10 The analyst should be aware of the possibility of manipulation of earnings and be on the lookout for large increases in existing assets, new unusual assets, and unexplained changes in nancial ratios. 7.2. Misrepresentations It is rare in this age of computers that the mechanics of an accounting system do not work. Most computer accounting systems will not allow a company to make one-sided entries. It is important to note, however, that just because the mechanics work does not necessarily mean that the judgments underlying the nancial statements are correct. An unscrupulous accountant could structure entries to achieve a desired result. For example, if a manager wanted to record ctitious revenue, a ctitious asset (a receivable) could be created to keep the accounting equation in balance. If the manager paid for something but did not want to record an expense, the transaction could be recorded in a prepaid asset account. If cash is received but the manager does not want to record revenue, a liability could be created. Understanding that there has to be another side to every entry is key in detecting inappropriate accounting becauseusually in the course of xing one accountthere will be another account with a balance that does not make sense. In the case of recording ctitious revenue, there is likely to be a growing receivable whose collectibility is in doubt. Ratio analysis, which is discussed further in later chapters, can assist in detecting suspect amounts in these accounts. Furthermore, the accounting equation can be used to detect likely accounts where aggressive or even fraudulent accounting may have occurred. 9 SEC vs. WorldCom, 5 November 2002: www.sec.gov/litigation/complaints/comp17829.htm. Ebbers Is Sentenced to 25 Years For $11 Billion WorldCom Fraud, Wall Street Journal, 14 July 2005, A1. 10 c02.indd 58 9/17/08 11:25:31 AM Chapter 2 Financial Reporting Mechanics 59 8 . SUMMARY The accounting process is a key component of nancial reporting. The mechanics of this process convert business transactions into records necessary to create periodic reports on a company. An understanding of these mechanics is useful in evaluating nancial statements for credit and equity analysis purposes and in forecasting future nancial statements. Key concepts are as follows: Business activities can be classied into three groups: operating activities, investing activities, and nancing activities. Companies classify transactions into common accounts that are components of the ve nancial statement elements: assets, liabilities, equity, revenue, and expense. The core of the accounting process is the basic accounting equation: Assets Liabilities Owners equity. The expanded accounting equation is Assets Liabilities Contributed capital Beginning retained earnings Revenue Expenses Dividends. Business transactions are recorded in an accounting system that is based on the basic and expanded accounting equations. The accounting system tracks and summarizes data used to create nancial statements: the balance sheet, income statement, statement of cash ows, and statement of owners equity. The statement of retained earnings is a component of the statement of owners equity. Accruals are a necessary part of the accounting process and are designed to allocate activity to the proper period for nancial reporting purposes. The results of the accounting process are nancial reports that are used by managers, investors, creditors, analysts, and others in making business decisions. An analyst uses the nancial statements to make judgments on the nancial health of a company. Company management can manipulate nancial statements, and a perceptive analyst can use his or her understanding of nancial statements to detect misrepresentations. P RACTICE PROBLEMS 1. Which of the following items would most likely be classied as an operating activity? A. Issuance of debt B. Acquisition of a competitor C. Sale of automobiles by an automobile dealer 2. Which of the following items would most likely be classied as a nancing activity? A. Issuance of debt B. Payment of income taxes C. Investments in the stock of a supplier 3. Which of the following elements represents an economic resource? A. Asset B. Liability C. Owners equity c02.indd 59 9/17/08 11:25:35 AM 60 International Financial Statement Analysis 4. Which of the following elements represents a residual claim? A. Asset B. Liability C. Owners equity 5. An analyst has projected that a company will have assets of 2,000 at year-end and liabilities of 1,200. The analysts projection of total owners equity should be closest to A. 800. B. 2,000. C. 3,200. 6. An analyst has collected the following information regarding a company in advance of its year-end earnings announcement (in millions): Estimated net income Beginning retained earnings Estimated distributions to owners $200 $1,400 $100 The analysts estimate of ending retained earnings (in millions) should be closest to A. $1,300. B. $1,500. C. $1,700. 7. An analyst has compiled the following information regarding Rubsam, Inc. Liabilities at year-end Contributed capital at year-end Beginning retained earnings Revenue during the year Expenses during the year 1,000 500 600 5,000 4,300 There have been no distributions to owners. The analysts most likely estimate of total assets at year-end should be closest to A. 2,100. B. 2,300. C. 2,800. 8. A group of individuals formed a new company with an investment of $500,000. The most likely effect of this transaction on the companys accounting equation at the time of the formation is an increase in cash and A. an increase in revenue. B. an increase in liabilities. C. an increase in contributed capital. 9. HVG, LLC paid $12,000 of cash to a real estate company upon signing a lease on 31 December 2005. The payment represents a $4,000 security deposit and $4,000 of rent for each of January 2006 and February 2006. Assuming that the correct accounting is to reect both January and February rent as prepaid, the most likely effect on HVGs accounting equation in December 2005 is c02.indd c02.indd 60 9/17/08 11:25:36 AM Chapter 2 Financial Reporting Mechanics 61 A. no net change in assets. B. a decrease in assets of $8,000. C. a decrease in assets of $12,000. 10. TRR Enterprises sold products to customers on 30 June 2006 for a total price of 10,000. The terms of the sale are that payment is due in 30 days. The cost of the products was 8,000. The most likely net change in TRRs total assets on 30 June 2006 related to this transaction is A. 0. B. 2,000. C. 10,000. 11. On 30 April 2006, Pinto Products received a cash payment of $30,000 as a deposit on production of a custom machine to be delivered in August 2006. This transaction would most likely result in which of the following on 30 April 2006? A. No effect on liabilities B. A decrease in assets of $30,000 C. An increase in liabilities of $30,000 12. Squires & Johnson, Ltd., recorded 250,000 of depreciation expense in December 2005. The most likely effect on the companys accounting equation is A. no effect on assets. B. a decrease in assets of 250,000. C. an increase in liabilities of 250,000. 13. An analyst who is interested in assessing a companys nancial position is most likely to focus on which nancial statement? A. Balance sheet B. Income statement C. Statement of cash ows 14. The statement of cash ows presents the ows into which three groups of business activities? A. Operating, nonoperating, and nancing B. Operating, investing, and nancing C. Operating, nonoperating, and investing 15. Which of the following statements about cash received prior to the recognition of revenue in the nancial statements is most accurate? The cash is recorded as A. deferred revenue, an asset. B. accrued revenue, a liability. C. deferred revenue, a liability. 16. When, at the end of an accounting period, a revenue has been recognized in the nancial statements but no billing has occurred and no cash has been received, the accrual is to A. unbilled (accrued) revenue, an asset. B. deferred revenue, an asset. C. unbilled (accrued) revenue, a liability. c02.indd c02.indd 61 9/17/08 11:25:36 AM 62 International Financial Statement Analysis 17. When, at the end of an accounting period, cash has been paid with respect to an expense incurred but not yet recognized in the nancial statements, the business should then record A. an accrued expense, an asset. B. a prepaid expense, an asset. C. an accrued expense, a liability. 18. When, at the end of an accounting period, cash has not been paid with respect to an expense that has been incurred but not recognized yet in the nancial statements, the business should then record A. an accrued expense, an asset. B. a prepaid expense, an asset. C. an accrued expense, a liability. 19. The collection of all business transactions sorted by account in an accounting system is referred to as A. a trial balance. B. a general ledger. C. a general journal. 20. If a company reported ctitious revenue, it could try to cover up its fraud by A. decreasing assets. B. increasing liabilities. C. creating a ctitious asset. A PPENDIX 2A: A DEBIT/CREDIT ACCOUNTING SYSTEM The main section of this chapter presented a basic accounting system represented as a spreadsheet. An alternative system that underlies most manual and electronic accounting systems uses debits and credits. Both a spreadsheet and a debit/credit system are based on the basic accounting equation: Assets Liabilities Owners equity Early generations of accountants desired a system for recording transactions that maintained the balance of the accounting equation and avoided the use of negative numbers (which could lead to errors in recording). The system can be illustrated with T-accounts for every account involved in recording transactions. The T-account is so named for its shape: T-Account Debit c02.indd c02.indd 62 Credit 9/17/08 11:25:36 AM Chapter 2 63 Financial Reporting Mechanics The left-hand side of the T-account is called a debit, and the right-hand side is termed a credit. The names should not be construed as denoting value. A debit is not better than a credit and vice versa. Debit simply means the left side of the T-account, and credit simply means the right side. Traditionally, debit is abbreviated as DR, whereas credit is abbreviated CR. The T-account is also related to the balance sheet and accounting equation as follows: Balance Sheet Assets Liabilities Owners Equity Assets are referred to as the left side of the balance sheet (and accounting equation) and hence are on the left side of the T-account. Assets are, therefore, recorded with a debit balance. In other words, to record an increase in an asset, an entry is made to the left-hand side of a T-account. A decrease to an asset is recorded on the right side of a T-account. Liabilities and owners equity are referred to as the right side of the balance sheet (and accounting equation). Increases to liabilities and owners equity are recorded on the right side of a T-account; decreases to liabilities and owners equity are recorded on the left side. At any point in time, the balance in an account is determined by summing all the amounts on the left side of the account, summing all the amounts on the right side of the account, and calculating the difference. If the sum of amounts on the left side of the account is greater than the sum of amounts on the right side of the account, the account has a debit balance equal to the difference. If the sum of amounts on the right side of the account is greater than the sum of amounts on the left side of the account, the account has a credit balance. A T-account is created for each asset account, liability account, and owners equity account. The collection of these T-accounts at the beginning of the year for a ctitious company, Investment Advisers, Ltd. (IAL), is presented in Exhibit 2A-1. Each balance sheet T-account is termed a permanent or real account because the balance in the account carries over from year-to-year. T-accounts are also set up for each income statement account. These T-accounts are referred to as temporary or nominal accounts because they are transferred at the end of each scal year by transferring any net income or loss to the balance sheet account, retained earnings. Income statement T-accounts for IAL are presented in Exhibit 2A-2. The collection of all business transactions sorted by account, real and temporary, for a company comprise the general ledger. The general ledger is the core of every accounting system, where all transactions are ultimately entered. To illustrate the use of T-accounts, we will use the transactions for IAL summarized in Exhibit 2A-3. We will rst enter each transaction into the general ledger T-accounts, then use the information to prepare nancial statements. Because this is a new business, the companys general ledger T-accounts initially have a zero balance. c02.indd c02.indd 63 9/17/08 11:25:37 AM 64 International Financial Statement Analysis EXHIBIT 2A-1 Balance Sheet T-Accounts for Investment Advisers, Ltd. Cash Accounts Receivable Inventory Investments Ofce Equipment Accumulated Depreciation Deposits Prepaid Rent Accounts Payable Accrued Wages Unearned Fees Bank Debt Accrued Interest Contributed Capital Retained Earnings EXHIBIT 2A-2 Income Statement T-Accounts for Investment Advisers, Ltd. Fee Revenue Investment Income Cost of Goods Sold Advertising Expense Rent Expense Depreciation Expense c02.indd 64 Book Sales Revenue Wage Expense Interest Expense 9/17/08 11:25:37 AM Chapter 2 65 Financial Reporting Mechanics EXHIBIT 2A-3 Business Transactions for Investment Advisers, Ltd. # Date Business Activity 1 31 December 2005 File documents with regulatory authorities to establish a separate legal entity. Initially capitalize the company through deposit of $150,000 from the three owners. 2 2 January 2006 Set up a $100,000 investment account and purchase a portfolio of equities and xed-income securities. 3 2 January 2006 Pay $3,000 to landlord for ofce/warehouse. $2,000 represents a refundable deposit, and $1,000 represents the rst months rent. 4 3 January 2006 Purchase ofce equipment for $6,000. The equipment has an estimated life of two years with no salvage value. 5 3 January 2006 Receive $1,200 cash for a one-year subscription to the monthly newsletter. 6 10 January 2006 Purchase and receive 500 books at a cost of $20 per book for a total of $10,000. Invoice terms are that payment from IAL is due in 30 days. No cash changes hands. These books are intended for resale. 7 10 January 2006 Spend $600 on newspaper and trade magazine advertising for the month. 8 15 January 2006 Borrow $12,000 from a bank for working capital. Interest is payable annually at 10 percent. The principal is due in two years. 9 15 January 2006 Ship rst order to a customer consisting of ve books at $25 per book. Invoice terms are that payment is due in 30 days. No cash changes hands. 10 15 January 2006 Sell for cash 10 books at $25 per book at an investment conference. 11 30 January 2006 Hire a part-time clerk. The clerk is hired through an agency that also handles all payroll taxes. The company is to pay $15 per hour to the agency. The clerk works six hours prior to 31 January, but no cash will be paid until February. 12 31 January 2006 Mail out the rst months newsletter to customer. This subscription had been sold on 3 January. See item 5. 13 31 January 2006 Review of the investment portfolio shows that $100 of interest income was earned and the market value of the portfolio has increased by $2,000. The balance in the investment account is now $102,100. Securities are classied as trading securities. 31 December 2005 Business Activity 1 Accounting Treatment File documents with regulatory authorities to establish a separate legal entity. Initially capitalize the company through deposit of $150,000 from the three owners. Cash [A] is increased by $150,000, and contributed capital [E]11 is increased by $150,000. Accounting Elements: Assets (A), Liabilites (L), Equity (E), Revenue (R), and Expenses (X). 11 The account title will vary depending upon the type of entity (incorporated or not) and jurisdiction. Alternative account titles are common shares, common stock, members capital, partners capital, etc. c02.indd 65 9/17/08 11:25:38 AM 66 International Financial Statement Analysis This transaction affects two accounts: cash and contributed capital. (Cash is an asset, and contributed capital is part of equity.) The transaction is entered into the T-accounts as shown below. The number in parentheses references the transaction number. Cash Contributed Capital 150,000 (1) 150,000 (1) Cash is an asset account, and assets are on the left-hand side of the balance sheet (and basic accounting equation); therefore, cash is increased by recording the $150,000 on the debit (left) side of the T-account. Contributed capital is an equity account, and equity accounts are on the right-hand side of the balance sheet; therefore, contributed capital is increased by recording $150,000 on the credit (right) side of the T-account. Note that the sum of the debits for this transaction equals the sum of the credits: DR CR DR $150,000 $150,000 CR Each transaction must always maintain this equality. This ensures that the accounting system (and accounting equation) is kept in balance. At this point in time, the company has assets (resources) of $150,000, and the owners claim on the resources equals $150,000 (their contributed capital) because there are no liabilities at this point. Transactions are recorded in a journal, which is then posted to (recorded in) the general ledger. When a transaction is recorded in a journal, it takes the form: Date Account 13 Dec 2005 DR Cash CR 150,000 Contributed Capital 150,000 This kind of entry is referred to as a journal entry, and it is a summary of the information that will be posted in the general ledger T-accounts. 2 January 2006 Business Activity 2 Accounting Treatment Set up a $100,000 investment account and purchase a portfolio of equities and xed-income securities. Investments [A] were increased by $100,000, and cash [A] was decreased by $100,000. Accounting Elements: Assets (A), Liabilites (L), Equity (E), Revenue (R), and Expenses (X). This transaction affects two accounts but only one side of the accounting equation. Cash is reduced when the investments are purchased. Another type of asset, investments, increases. The T-account entries are shown below: c02.indd 66 9/17/08 11:25:39 AM Chapter 2 67 Financial Reporting Mechanics Cash 150,000 (1) Investments 100,000 (2) 100,000 (2) The cash account started with a $150,000 debit balance from the previous transaction. Assets are reduced by credit entries, so the reduction in cash is recorded by entering the $100,000 on the credit (right) side of the cash T-account. The investment account is also an asset, and the increase in investments is recorded by entering $100,000 on the debit side of the investments T-account. Transaction 2 balances because Transaction 2 debits equal Transaction 2 credits. Going forward, we will use the traditional accounting terms of debit (debiting, debited) to indicate the action of entering a number in the debit side of an account, and credit (crediting, credited) to indicate the action of entering an amount on the credit side of an account. 2 January 2006 Business Activity 3 Accounting Treatment Pay $3,000 to landlord for ofce/warehouse. Cash [A] was decreased by $3,000, deposits [A] $2,000 represents a refundable deposit, and were increased by $2,000, and prepaid rent [A] $1,000 represents the rst months rent. was increased by $1,000. Accounting Elements: Assets (A), Liabilites (L), Equity (E), Revenue (R), and Expenses (X). Cash is reduced once again by crediting the account by $3,000. On the other side of the transaction, two asset accounts increase. Deposits are increased by debiting the account for $2,000, while prepaid rent is increased by debiting that account for $1,000: Cash 150,000 (1) Deposits 100,000 (2) Prepaid Rent 2,000 (3) 1,000 (3) 3,000 (3) The sum of the debits for Transaction 3 equals the sum of the credits (i.e., $3,000). 3 January 2006 Business Activity 4 Accounting Treatment Purchase ofce equipment for $6,000 in cash. The equipment has an estimated life of two years with no salvage value. Cash [A] was decreased by $6,000, and ofce equipment [A] was increased by $6,000. Accounting Elements: Assets (A), Liabilites (L), Equity (E), Revenue (R), and Expenses (X). Cash is credited for $6,000, while ofce equipment is debited for $6,000. Both are asset accounts, so these entries reect a reduction in cash and an increase in ofce equipment. c02.indd c02.indd 67 9/17/08 11:25:39 AM 68 International Financial Statement Analysis Cash 150,000 (1) Ofce Equipment 100,000 (2) 6,000 (4) 3,000 (3) 6,000 (4) 3 January 2006 Business Activity 5 Accounting Treatment Receive $1,200 cash for a one-year subscription to Cash [A] was increased by $1,200, and the monthly newsletter. unearned fees [L] was increased by $1,200. Accounting Elements: Assets (A), Liabilites (L), Equity (E), Revenue (R), and Expenses (X). In this transaction, the company has received cash related to the sale of subscriptions. However, the company has not yet actually earned the subscription fees because it has an obligation to deliver newsletters in the future. So, this amount is recorded as a liability called unearned fees (or unearned revenue). In the future, as the company delivers the newsletters and thus fullls its obligation, this amount will be transferred to revenue. If they fail to deliver the newsletters, the fees will need to be returned to the customer. To record the transaction, cash is debited (increased), while a liability account, unearned fees, is credited. Liabilities are on the right-hand side of the balance sheet and are, therefore, increased by crediting the T-account. Cash Unearned Fees 150,000 (1) 100,000 (2) 1,200 (5) 3,000 (3) 1,200 (5) 6,000 (4) The sum of Transaction 5 debits and credits each equal $1,200. 10 January 2006 Business Activity 6 Accounting Treatment Purchase and receive 500 books at a cost of $20 per book for Inventory [A] is increased by a total of $10,000. Invoice terms are that payment from IAL $10,000, and accounts payable [L] is increased by $10,000. is due in 30 days. No cash changes hands. These books are intended for resale. Accounting Elements: Assets (A), Liabilites (L), Equity (E), Revenue (R), and Expenses (X). The company has obtained an asset, inventory, which can be sold to customers at a later date. Rather than paying cash to the supplier currently, the company has an obligation to do so in 30 days. This represents a liability (accounts payable) to the supplier. Inventory is debited for $10,000, while the liability, accounts payable, is credited for $10,000. Note that there is no impact on the cash account. c02.indd c02.indd 68 9/17/08 11:25:40 AM Chapter 2 69 Financial Reporting Mechanics Inventory Accounts Payable 10,000 (6) 10,000 (6) 10 January 2006 Business Activity 7 Accounting Treatment Spend $600 on newspaper and trade magazine advertising for the month Cash [A] was decreased by $600, and advertising expense [X] was increased by $600. Accounting Elements: Assets (A), Liabilites (L), Equity (E), Revenue (R), and Expenses (X). Unlike the previous expenditures, advertising is not an asset. Its future economic benets are unclear, unlike equipment, which is expected to be useful over multiple periods. Expenditures such as advertising are recorded as an expense when they are incurred. To record the advertising expense, cash is credited for $600, and advertising expense is debited for $600. Expenses reduce net income, and thus reduce retained earnings. Decreases in retained earnings, as with any equity account, are recorded as debits. The entries with respect to retained earnings will be presented later in this section after the income statement. Cash Advertising Expense 150,000 (1) 100,000 (2) 1,200 (5) 3,000 (3) 600 (7) 6,000 (4) 600 (7) 15 January 2006 Business Activity 8 Accounting Treatment Borrow $12,000 from a bank for working capital. Interest is payable annually at 10 percent. The principal is due in two years. Cash [A] is increased by $12,000, and Bank debt [L] is increased by $12,000. Accounting Elements: Assets (A), Liabilites (L), Equity (E), Revenue (R), and Expenses (X). Cash is debited, and a corresponding liability is credited. Initially, no entry is made for interest that is expected to be paid on the loan. Interest will be recorded in the future as time passes and interest accrues (accumulates) on the loan. Cash Bank Debt 150,000 (1) 100,000 (2) 1,200 (5) 3,000 (3) 12,000 (8) 12,000 (8) 6,000 (4) 600 (7) c02.indd c02.indd 69 9/17/08 11:25:41 AM 70 International Financial Statement Analysis The debits and credits of Transaction 8 each total $12,000. 15 January 2006 Business Activity 9 Accounting Treatment Ship rst order to a customer consisting of ve books at $25 per book. Invoice terms are that payment is due in 30 days. No cash changes hands. Accounts receivable [A] increased by $125, and book sales revenue [R] increased by $125. Additionally, inventory [A] decreased by $100, and cost of goods sold [X] increased by $100. Accounting Elements: Assets (A), Liabilites (L), Equity (E), Revenue (R), and Expenses (X). The company has now made a sale. Sale transaction records have two parts. One part records the $125 revenue to be received from the customer, and the other part records the $100 cost of the goods that have been sold. For the rst part, accounts receivable is debited (increased) for $125, and a revenue account is credited for $125. Accounts Receivable Book Sales Revenue 125 (9) 125 (9) For the second part, inventory is credited (reduced) for $100, and an expense, cost of goods sold, is debited (increased) to reect the cost of inventory sold. Inventory 10,000 (6) 100 (9) Cost of Goods Sold 100 (9) Note that the sum of debits and the sum of credits for Transaction 9 both equal $225. The $225 is not meaningful by itself. What is important is that the debits and credits balance. 15 January 2006 Business Activity 10 Accounting Treatment Sell for cash 10 books at $25 per book at an investment conference. Cash [A] is increased by $250, and book sales revenue [R] is increased by $250. Additionally, inventory [A] is decreased by $200, and cost of goods sold [X] is increased by $200. Accounting Elements: Assets (A), Liabilites (L), Equity (E), Revenue (R), and Expenses (X). Similar to the previous transaction, both the sales proceeds and cost of the goods sold must be recorded. In this case, however, the sales proceeds are received in cash. To record the sale proceeds, the entries include a debit to cash for $250 and a corresponding credit to book sales revenue for $250. To record cost of goods sold, the entries include a debit to cost of goods sold and a credit to inventory. c02.indd c02.indd 70 9/17/08 11:25:42 AM Chapter 2 71 Financial Reporting Mechanics Cash Book Sales Revenue 150,000 (1) 100,000 (2) 1,200 (5) 3,000 (3) 12,000 (8) 6,000 (4) 250 (10) 125 (9) 250 (10) 600 (7) Inventory 10,000 (6) Cost of Goods Sold 100 (9) 100 (9) 200 (10) 200 (10) Transaction 10s debits and credits are equal, maintaining the accounting systems balance. 30 January 2006 11 Hire a part-time clerk. The clerk is hired through an agency that also handles all payroll taxes. The company is to pay $15 per hour to the agency. The clerk works six hours prior to 31 January, but no cash will be paid until February. The company owes $90 for wages at month-end. Under accrual accounting, expenses are recorded when incurred, not when paid. Accrued wages [L] is increased by $90, and wage expense [X] is increased by $90. The accrued wage liability will be eliminated when the wages are paid. Accounting Elements: Assets (A), Liabilites (L), Equity (E), Revenue (R), and Expenses (X). Accrued wages is a liability that is increased by crediting that account, whereas payroll is an expense account that is increased with a debit. Accrued Wages 90 (11) Wage Expense 90 (11) 31 January 2006 12 Mail out the rst months newsletter to customer. This subscription had been sold on 3 January. One month (or 1/12) of the $1,200 subscription has been satised, and thus $100 can be recognized as revenue. Unearned fees [L] is decreased by $100, and fee revenue [R] is increased by $100. Accounting Elements: Assets (A), Liabilites (L), Equity (E), Revenue (R), and Expenses (X). To record the recognition of one month of the subscription fee, the account fee revenue is credited (increased) by $100, and the related liability is debited (decreased) by $100. c02.indd c02.indd 71 9/17/08 11:25:42 AM 72 International Financial Statement Analysis Fee Revenue Unearned Fees 100 (12) 100 (12) 1,200 (5) 31 January 2006 13 Review of the investment portfolio shows that $100 of interest income was earned and the market value of the portfolio has increased by $2,000. The balance in the investment account is now $102,100. The securities are classied as trading securities. Investment income [R] is increased by $100, and the investments account [A] is increased by $100. The $2,000 increase in the value of the portfolio represents unrealized gains that are part of income for traded securities. The investments account [A] is increased by $2,000, and investment income [R] is increased by $2,000. Accounting Elements: Assets (A), Liabilites (L), Equity (E), Revenue (R), and Expenses (X). The investments account is an asset account that is debited (increased) for $2,100, and investment income is a revenue account that is credited (increased) by $2,100. Investments 100,000 (2) Investment Income 2,100 (13) 2,100 (13) These entries complete the recording of the rst 13 transactions. In this illustration, there are three adjustments. An adjustment must be made related to Transaction 3 to account for the fact that a month has passed and rent expense has been incurred. We refer to this as Transaction 3a. Adjustments must also be made for an estimate of the depreciation of the ofce equipment (Transaction 4a) and for interest that has accrued on the loan (Transaction 8a). 3a In item 3, $3,000 was paid to the landlord for ofce/warehouse, including a $2,000 refundable deposit and $1,000 for the rst months rent. Now, the rst month has ended, so this rent has become a cost of doing business. To reect the full amount of the rst months rent as a cost of doing business, prepaid rent [A] is decreased by $1,000, and rent expense [X] is increased by $1,000. Accounting Elements: Assets (A), Liabilites (L), Equity (E), Revenue (R), and Expenses (X). Prepaid rent (an asset) is credited for $1,000 to reduce the balance, and rent expense is debited for the same amount to record the fact that the expense has now been incurred. After this entry, the balance of the prepaid rent asset account is $0. c02.indd c02.indd 72 9/17/08 11:25:43 AM Chapter 2 73 Financial Reporting Mechanics Prepaid Rent 1,000 (3) 4a 1,000 (3a) In item 4, ofce equipment was purchased for $6,000 in cash. The equipment has an estimated life of two years with no salvage value. Now, one month (or 1/24) of the useful life of the equipment has ended so a portion of the equipment cost has become a cost of doing business. Rent Expense 1,000 (3a) A portion (1/24) of the total $6,000 cost of the ofce equipment is allocated to the current periods cost of doing business. Depreciation expense [X] is increased by $250, and accumulated depreciation is increased by $250. Accumulated depreciation is a contra asset account to ofce equipment Accounting Elements: Assets (A), Liabilites (L), Equity (E), Revenue (R), and Expenses (X). Because some time has passed, accounting principles require that the estimated depreciation of the equipment be recorded. In this case, one could directly credit ofce equipment for $250; however, a preferred method is to credit an account called accumulated depreciation, which is associated with the ofce equipment account. This accumulated depreciation account holds the cumulative amount of the depreciation related to the ofce equipment. When nancial reports are prepared, a user is able to see both the original cost of the equipment as well as the accumulated depreciation. The user, therefore, has insight into the age of the asset, and perhaps how much time remains before it is likely to be replaced. Accumulated depreciation is termed a contra asset account and is credited for $250, while depreciation expense is debited (increased) for $250. Accumulated Depreciation 250 (4a) 8a The company borrowed $12,000 from a bank on 15 January, with interest payable annually at 10 percent and the principal due in two years. Now, one-half of one month has passed since the borrowing. Depreciation Expense 250 (4a) One-half of one month of interest expense has become a cost of doing business. $12,000 times 10% equals $1,200 of annual interest, equivalent to $100 per month and $50 for one-half month. Interest expense [X] is increased by $50, and accrued interest [L] is increased by $50. Accrued interest is a liability that is credited (increased) for $50, and interest expense is debited (increased) for $50. Accrued interest is also sometimes referred to as interest payable. Accrued Interest 50 (8a) c02.indd c02.indd 73 Interest Expense 50 (8a) 9/17/08 11:25:44 AM 74 International Financial Statement Analysis Exhibit 2A-4 summarizes the general ledger T-accounts for IAL at this point in time. For accounts with multiple entries, a line is drawn and the debit and credit columns are summed and netted to determine the current balance in the account. The balance is entered below the line. These individual account totals are then summarized in a trial balance as depicted in Exhibit 2A-5. A trial balance is a summary of the account balances at a point in time. An accountant can prepare a trial balance at any time to ensure that the system is in balance and to review current amounts in the accounts. Note that the debit and credit columns each EXHIBIT 2A-4 General Ledger T-Accounts for Investment Advisers, Ltd. Cash Accounts Receivable 150,000 (1) 100,000 (2) 1,200 (5) 3,000 (3) 12,000 (8) 6,000 (4) 250 (10) 125 (9) Inventory 10,000 (6) 100 (9) 200 (10) 9,700 600 (7) 53,850 Investments 100,000 (2) Ofce Equipment 6,000 (4) Accumulated Depreciation 250 (4a) 2,100 (13) 102,100 Deposits 2,000 (3) Prepaid Rent 1,000 (3) 1,000 (3a) Accounts Payable 10,000 (6) 0 Accrued Wages 90 (11) Unearned Fees 100 (12) 1,200 (5) Bank Debt 12,000 (8) 1,100 Accrued Interest 50 (8a) Fee Revenue 100 (12) Contributed Capital Retained Earnings 150,000 (1) Book Sales Revenue 125 (9) Investment Income 2,100 (13) 250 (10) 375 c02.indd 74 9/17/08 11:25:45 AM Chapter 2 75 Financial Reporting Mechanics Cost of Goods Sold 100 (9) Advertising Expense 600 (7) Rent Expense 1,000 (3a) 200 (10) 300 Depreciation Expense 250 (4a) Wage Expense 90 (11) Interest Expense 50 (8a) EXHIBIT 2A-5 Investment Advisers, Ltd. Trial Balance DR Cash Accounts receivable Inventory Investments Ofce equipment CR 53,850 125 9,700 102,100 6,000 Accumulated depreciation Deposits Prepaid rent 250 2,000 0 Accounts payable 10,000 Accrued wages 90 Unearned fees 1,100 Bank debt 12,000 Accrued interest 50 Contributed capital 150,000 Retained earnings Fee revenue 100 Book sales revenue 375 Investment income Cost of goods sold Advertising expense Rent expense Depreciation expense 2,100 300 600 1,000 250 Wage expense 90 Interest expense 50 Total c02.indd 75 176,065 176,065 9/17/08 11:25:45 AM 76 International Financial Statement Analysis total $176,065, conrming that the system is in balance. Any difference in the column totals would indicate an error had been made. The trial balance totals have no particular signicance and are not used in preparing nancial statements. These totals are simply the sum of debits and credits in the accounting system at that point in time. After ensuring that the balances in the trial balance are correct (if there are errors, they are corrected and an adjusted trial balance is prepared), we prepare the nancial statements. The trial balance provides the information necessary to prepare the balance sheet and the income statement. The detail in the general ledger must be reviewed to prepare the statement of cash ows and statement of owners equity. After the income statement is prepared, the temporary accounts are closed out (i.e., taken to a zero balance) by transferring each of their balances to retained earnings. This typically occurs at year-end and is termed the closing process. Exhibits 2A-6 and 2A-7 show the post-closing general ledger and trial balance, respectively. EXHIBIT 2A-6 Post-Closing General Ledger T-Accounts for Investment Advisers, Ltd. Cash Accounts Receivable 150,000 (1) 100,000 (2) 1,200 (5) 6,000 (4) Inventory 3,000 (3) 12,000 (8) 250 (10) 125 (9) 10,000 (6) 100 (9) 200 (10) 9,700 600 (7) 53,850 Investments 100,000 (2) Ofce Equipment 6,000 (4) Accumulated Depreciation 250 (4a) 2,100 (13) 102,100 Deposits 2,000 (3) Prepaid Rent 1,000 (3) 1,000 (3a) Accounts Payable 10,000 (6) 0 Accrued Wages 90 (11) Unearned Fees 100 (12) 1,200 (5) Bank Debt 12,000 (8) 1,100 Accrued Interest 50 (8a) c02.indd 76 Contributed Capital 150,000 (1) Retained Earnings 285 9/17/08 11:25:46 AM Chapter 2 77 Financial Reporting Mechanics Fee Revenue Book Sales Revenue 0 0 Cost of Goods Sold 0 0 Advertising Expense Rent Expense 0 Depreciation Expense 0 EXHIBIT 2A-7 Investment Income 0 Wage Expense Interest Expense 0 0 Investment Advisers, Ltd. Postclosing Trial Balance DR Cash Accounts receivable Inventory Investments Ofce equipment CR 53,850 125 9,700 102,100 6,000 Accumulated depreciation Deposits Prepaid rent 250 2,000 0 Accounts payable 10,000 Accrued wages 90 Unearned fees 1,100 Bank debt 12,000 Accrued interest 50 Contributed capital 150,000 Retained earnings 285 Fee revenue 0 Book sales revenue 0 Investment income 0 Cost of goods sold 0 (Continued ) c02.indd 77 9/17/08 11:25:47 AM 78 International Financial Statement Analysis EXHIBIT 2A-7 Continued DR CR Advertising expense 0 Rent expense 0 Depreciation expense 0 Wage expense 0 Interest expense 0 Total 173,775 173,775 Financial statements are identical whether using a spreadsheet approach or a debit/credit approach. Accordingly, the nancial statements for IAL that would be prepared using the trial balances are identical to those presented in the main body of the chapter as Exhibit 2-9. c02.indd 78 9/17/08 11:25:48 AM CHAPTER 3 F INANCIAL REPORTING STANDARDS Thomas R. Robinson, CFA CFA Institute Charlottesville, Virginia Hennie van Greuning, CFA World Bank Washington, DC Elaine Henry, CFA University of Miami Miami, Florida Michael A. Broihahn, CFA Barry University Miami, Florida L EARNING OUTCOMES After completing this chapter, you will be able to do the following: Explain the objective of nancial statements and the importance of reporting standards in security analysis and valuation. Explain the role of nancial reporting standard-setting bodies (including the International Accounting Standards Board and the U.S. Financial Accounting Standards Board) and 79 c03.indd 79 9/17/08 11:26:31 AM 80 International Financial Statement Analysis regulatory authorities such as the International Organization of Securities Commissions, the U.K. Financial Services Authority, and the U.S. Securities and Exchange Commission in establishing and enforcing reporting standards. Discuss the status of global convergence of accounting standards and the ongoing barriers to developing one universally accepted set of nancial reporting standards. Describe the International Financial Reporting Standards (IFRS) framework, including the objective of nancial statements, their qualitative characteristics, required reporting elements, and the constraints and assumptions in preparing nancial statements. Explain the general requirements for nancial statements. Compare and contrast the key concepts of nancial reporting standards under IFRS and alternative reporting systems, and discuss the implications for nancial analysis of differing nancial reporting systems. Identify the characteristics of a coherent nancial reporting framework and barriers to creating such a framework. Discuss the importance of monitoring developments in nancial reporting standards and evaluate company disclosures of signicant accounting policies. 1 . INTRODUCTION Financial reporting standards determine the types and amounts of information that must be provided to investors and creditors so that they may make informed decisions. This chapter focuses on the broad framework within which these standards are created. An understanding of the underlying framework of nancial reporting standards, which is broader than knowledge of specic accounting rules, will allow an analyst to assess the valuation implications of any nancial statement element or transactionincluding newly developed transactions that are not specically addressed by the standards. Section 2 of this chapter discusses the objective of nancial statements and the importance of nancial standards in security analysis and valuation. Section 3 describes the nancial reporting standard-setting bodies and regulatory authorities that establish nancial reporting standards. Section 4 examines the trend toward convergence of global nancial reporting standards. The International Financial Reporting Standards (IFRS) framework is presented in section 5, and section 6 compares IFRS with alternative reporting systems.1 Section 7 discusses the characteristics of an effective nancial reporting framework. Section 8 discusses the importance of monitoring developments in nancial reporting standards. Section 9 summarizes the key points of the chapter, and practice problems in the CFA Institute multiplechoice format conclude the chapter. 2 . THE OBJECTIVE OF FINANCIAL REPORTING Financial reporting begins with a simple enough premise. The International Accounting Standards Board (IASB), which is the international accounting standard-setting body, expresses it as follows in its Framework for the Preparation and Presentation of Financial Statements: 1 The body of standards issued by the IASB is referred to as International Financial Reporting Standards, which include previously issued International Accounting Standards (IAS). Financial reporting is a broad term including reporting on accounting, nancial statements, and other information found in company nancial reports. c03.indd 80 9/17/08 11:26:32 AM Chapter 3 Financial Reporting Standards 81 The objective of nancial statements is to provide information about the nancial position, performance, and changes in nancial position of an entity; this information should be useful to a wide range of users for the purpose of making economic decisions.2 Until recently, nancial reporting standards were developed mostly independently by each countrys standard-setting body. This has created a wide range of standards, some of which are quite comprehensive and complex, and others more general. Recent accounting scandals have raised awareness of the need for more uniform global nancial reporting standards and provided the impetus for stronger coordination among the major standard-setting bodies. Such coordination is also a natural outgrowth of the increased globalization of capital markets. Developing nancial reporting standards is complicated because the underlying economic reality is complicated. The nancial transactions and organizations that nancial statements purport to represent are complicated. There is often uncertainty about transactions, resulting in the need for accruals and estimates. These accruals and estimates necessitate judgment. Judgment varies from one preparer to the next. Accordingly, standards are needed to achieve some type of consistency in these judgments. Even with such standards there will be no one right answer. Nevertheless, nancial reporting standards try to limit the range of acceptable answers to ensure some measure of consistency in nancial statements. EXAMPLE 3-1 Estimates in Financial Reporting In order to make comparisons across companies (cross-sectional analysis) and over time for a single company (time-series analysis), it is important that accounting methods are comparable and consistently applied. However, accounting standards must be exible enough to recognize that there are differences in the underlying economics between businesses. Suppose two companies buy the same model of machinery to be used in their respective businesses. The machine is expected to last for several years. Financial reporting standards should require that both companies account for this equipment by initially recording the cost of the machinery as an asset. Without such a standard, the companies could report the purchase of the equipment differently. For example, one company might record the purchase as an asset and the other might record the purchase as an expense. An accounting standard ensures that both companies would be required to record the transaction in a similar manner. Accounting standards typically would require the cost of the machine to be apportioned over the estimated useful life of an asset as an expense called depreciation. Because the two companies may be operating the machinery differently, nancial reporting standards must retain some exibility. One company might operate the machinery only a few days per week, whereas the other company operates the equipment continuously throughout the week. Given the difference in usage, it would not be appropriate for the two companies to report an identical amount of depreciation expense each period. Financial reporting standards must allow for some discretion such that management can match their nancial reporting choices to the underlying economics of their business while ensuring that similar transactions are recorded in a similar manner between companies. 2 Framework for the Preparation and Presentation of Financial Statements, International Accounting Standards Committee, 1989, adopted by IASB 2001, paragraph 12. c03.indd 81 9/17/08 11:26:33 AM 82 International Financial Statement Analysis The IASB and the U.S. Financial Accounting Standards Board (FASB) have developed similar nancial reporting frameworks, both of which specify the overall objective and qualities of information to be provided. Financial reports are intended to provide information to many users, including investors, creditors, employees, customers, and others. As a result of this multipurpose nature, nancial reports are not designed with only asset valuation in mind. However, nancial reports provide important inputs into the process of valuing a company or the securities a company issues. Understanding the nancial reporting frameworkincluding how and when judgments and estimates can affect the numbers reportedenables an analyst to evaluate the information reported and to use the information appropriately when assessing a companys nancial performance. Clearly, such an understanding is also important in assessing the nancial impact of business decisions and in making comparisons across entities. 3 . FINANCIAL REPORTING STANDARD - SETTING BODIES AND REGULATORY AUTHORITIES A distinction needs to be made between standard-setting bodies and regulatory authorities. Standard-setting bodies, such as the IASB and FASB, are typically private-sector organizations consisting of experienced accountants, auditors, users of nancial statements, and academics. Regulatory authorities, such as the Securities and Exchange Commission (SEC) in the United States and the Financial Services Authority (FSA) in the United Kingdom, are governmental entities that have the legal authority to enforce nancial reporting requirements and exert other controls over entities that participate in the capital markets within their jurisdiction. In other words, generally, standard-setting bodies make the rules and regulatory authorities enforce the rules. Note, however, that regulators often retain the legal authority to establish nancial reporting standards in their jurisdiction and can overrule the private sector standard-setting bodies. EXAMPLE 3-2 Industry-Specic Regulation In certain cases, there exist multiple regulatory bodies that affect a companys nancial reporting requirements. For example, in almost all jurisdictions around the world, banking-specic regulatory bodies establish requirements related to risk-based capital measurement, minimum capital adequacy, provisions for doubtful loans, and minimum monetary reserves. An awareness of such regulations provides an analyst with the context to understand a banks business, including the objectives and scope of allowed activities. In the United States, the Ofce of the Comptroller of the Currency charters and regulates all national banks. In the United Kingdom, the FSA regulates the nancial services industry. In some countries, a single entity serves both as the central bank and as the regulatory body for the countrys nancial institutions. This section provides a brief overview of the most important international standardsetting body, the IASB, followed by a description of the International Organization of c03.indd c03.indd 82 9/17/08 11:26:40 AM Chapter 3 Financial Reporting Standards 83 Securities Commissions (IOSCO), capital markets regulation in the European Union (EU), and an overview of the U.S. SEC. 3.1. International Accounting Standards Board The IASB is the standard-setting body responsible for developing international nancial reporting and accounting standards. The four goals of the IASB are: (a) to develop, in the public interest, a single set of high quality, understandable and enforceable global accounting standards that require high quality, transparent and comparable information in nancial statements and other nancial reporting to help participants in the worlds capital markets and other users make economic decisions; (b) to promote the use and rigorous application of those standards; (c) in fullling the objectives associated with (a) and (b), to take account of, as appropriate, the special needs of small and medium-sized entities and emerging economies; and (d) to bring about convergence of national accounting standards and International Accounting Standards and International Financial Reporting Standards to high quality solutions.3 The predecessor of the IASB, the International Accounting Standards Committee (IASC), was founded in June 1973 as a result of an agreement by accountancy bodies in Australia, Canada, France, Germany, Japan, Mexico, the Netherlands, the United Kingdom and Ireland, and the United States. By 1998, the IASC had expanded membership to 140 accountancy bodies in 101 countries. In 2001, the IASC was reconstituted into the IASB. The IASB has 14 full-time board members who deliberate new nancial reporting standards.4 The IASB is overseen by the International Accounting Standards Committee Foundation, which has 19 trustees who appoint the members of the IASB, establish the budget, and monitor the IASBs progress. The IASB is advised by the Standards Advisory Council, which is composed of about 50 members representing organizations and individuals with an interest in international nancial reporting. 3.2. International Organization of Securities Commissions IOSCO, formed in 1983 as the successor organization of an inter-American regional association (created in 1974), has 181 members that regulate more than 90 percent of the worlds nancial capital markets. 3 International Accounting Standards Committee Foundation Constitution, IASCF, July 2005, part A, paragraph 2. 4 Although the name of the IASB incorporates Accounting Standards and early standards were titled International Accounting Standards (IAS), the term International Financial Reporting Standards is being used for new standards. The use of the words nancial reporting recognizes the importance of disclosures outside of the core nancial statements, such as management discussion of the business, risks, and future plans. c03.indd 83 9/17/08 11:26:43 AM 84 International Financial Statement Analysis In 1998, IOSCO adopted a comprehensive set of Objectives and Principles of Securities Regulation, which is recognized as international benchmarks for all markets. IOSCO sets out three core objectives of securities regulation: 1. Protecting investors. 2. Ensuring that markets are fair, efcient, and transparent. 3. Reducing systematic risk. Standards related to nancial reporting, including accounting and auditing standards, are key components in achieving these objectives. IOSCOs Objectives and Principles of Securities Regulation states: Full disclosure of information material to investors decisions is the most important means for ensuring investor protection. Investors are, thereby, better able to assess the potential risks and rewards of their investments and, thus, to protect their own interests. As key components of disclosure requirements, accounting and auditing standards should be in place and they should be of a high and internationally acceptable quality.5 Historically, regulation and related nancial reporting standards were developed within individual countries and were often based on the cultural, economic, and political norms of each country. As nancial markets have become more global, it has become desirable to establish comparable nancial reporting standards internationally. Ultimately, laws and regulations are established by individual jurisdictions, so this also requires cooperation among regulators. In order to ensure adherence to international nancial standards, it is important to have uniform regulation across national boundaries. IOSCO aims to assist in attaining this goal of uniform regulation. 3.3. Capital Markets Regulation in Europe Each individual member state of the EU regulates capital markets in its jurisdiction. There are, however, certain regulations that have been adopted at the EU level. These include standards and directives related to enforcement of IFRS, a proposed directive to adopt International Standards on Auditing, and proposed directives concerning the board of directors responsibility for a companys nancial statements. The EU, under its Accounting Regulation, will likely serve a role similar to the SEC in the United States as it must endorse each international standard for use in Europe. In 2001, the European Commission established two committees related to securities regulation: the European Securities Committee (ESC) and the Committee of European Securities Regulators (CESR). The ESC consists of high-level representatives of member states and advises the European Commission on securities policy issues. The CESR is an independent advisory body composed of representatives of regulatory authorities of the member states. As noted earlier, regulation still rests with the individual member states and, therefore, requirements for registering shares and ling periodic nancial reports vary from country to country. Over time, this process is expected to become more uniform in the EU. 5 Objectives and Principles of Securities Regulation, IOSCO, May 2003, section 4.2.1. c03.indd 84 9/17/08 11:26:43 AM Chapter 3 Financial Reporting Standards 85 3.4. Capital Markets Regulation in the United States Any company issuing securities within the United States, or otherwise involved in U.S. capital markets, is subject to the rules and regulations of the U.S. SEC. The SEC, one of the oldest and most developed regulatory authorities, originated as a result of reform efforts made after the great stock market crash of 1929, sometimes referred to as simply the Great Crash. 3.4.1. Signicant Securities-Related Legislation There are numerous SEC rules and regulations affecting reporting companies, broker/dealers, and other market participants. From a nancial reporting and analysis perspective, the most signicant of these acts are the Securities Acts of 1933 and 1934 and the SarbanesOxley Act of 2002. Securities Act of 1933 (The 1933 Act). This act species the nancial and other signicant information that investors must receive when securities are sold, prohibits misrepresentations, and requires initial registration of all public issuances of securities. Securities Exchange Act of 1934 (The 1934 Act). This act created the SEC, gave the SEC authority over all aspects of the securities industry, and empowered the SEC to require periodic reporting by companies with publicly traded securities. Sarbanes-Oxley Act of 2002. The Sarbanes-Oxley Act of 2002 created the Public Company Accounting Oversight Board (PCAOB) to oversee auditors. The SEC is responsible for carrying out the requirements of the act and overseeing the PCAOB. The act addresses auditor independence; for example, it prohibits auditors from providing certain nonaudit services to the companies they audit. The act strengthens corporate responsibility for nancial reports; for example, it requires the chief executive ofcer and the chief nancial ofcer to certify that the companys nancial reports fairly present the companys condition. Furthermore, section 404 of the Sarbanes-Oxley Act requires management to report on the effectiveness of the companys internal control over nancial reporting and to obtain a report from its external auditor attesting to managements assertion about the effectiveness of the companys internal control. 3.4.2. SEC Filings: Key Sources of Information for Analysts Companies satisfy compliance with these acts principally through the completion and submission (i.e., ling) of standardized forms issued by the SEC. There are more than 50 different types of SEC forms that are used to satisfy reporting requirements; the discussion herein will be limited to those forms most relevant for nancial analysts. In 1993, the SEC began to mandate electronic lings of the required forms through its Electronic Data Gathering, Analysis, and Retrieval (EDGAR) system. As of 2005, most SEC lings are required to be made electronically. EDGAR has made corporate and nancial information more readily available to investors and the nancial community. Most of the SEC lings that an analyst would be interested in can be retrieved from the Internet from one of many web sites, including the SECs own web site. Some lings are required upon the initial offering of securities, whereas others are required on a periodic basis thereafter. The following are some of the more common information sources used by analysts. Securities offerings registration statement. The 1933 Act requires companies offering securities to le a registration statement. New issuers as well as previously registered companies that are issuing new securities are required to le these statements. Required information and the precise form vary depending upon the size and nature of the offering. Typically, required information includes: (1) disclosures about the securities being offered for sale, c03.indd 85 9/17/08 11:26:43 AM 86 International Financial Statement Analysis (2) the relationship of these new securities to the issuers other capital securities, (3) the information typically provided in the annual lings, (4) recent audited nancial statements, and (5) risk factors involved in the business. EXAMPLE 3-3 Initial Registration Statement In 2004, Google led a Form S-1 registration statement with the U.S. SEC to register its initial public offering of securities (Class A common stock). In addition to copious amounts of nancial and business information, the registration statement provided a 20-page discussion of risks related to Googles business and industry. This type of qualitative information is helpful, if not essential, in making an assessment of a companys credit or investment risk. Forms 10-K, 20-F, and 40-F. These are forms that companies are required to le annually. Form 10-K is for U.S. registrants, Form 40-F is for certain Canadian registrants, and Form 20-F is for all other non-U.S. registrants. These forms require a comprehensive overview, including information concerning a companys business, nancial disclosures, legal proceedings, and information related to management. The nancial disclosures include a historical summary of nancial data (usually 10 years), managements discussion and analysis (MD&A) of the companys nancial condition and results of operations, and audited nancial statements. Annual report. In addition to the SECs annual lings (e.g., Form 10-K), most companies prepare an annual report to shareholders. This is not a requirement of the SEC. The annual report is usually viewed as one of the most signicant opportunities for a company to present itself to shareholders and other external parties; accordingly, it is often a highly polished marketing document with photographs, an opening letter from the chief executive ofcer, nancial data, market segment information, research and development activities, and future corporate goals. In contrast, the Form 10-K is a more legal type of document with minimal marketing emphasis. Although the perspectives vary, there is considerable overlap between a companys annual report and its Form 10-K. Some companies elect to prepare just the Form 10-K or a document that integrates both the 10-K and annual report. Proxy statement/Form DEF-14A. The SEC requires that shareholders of a company receive a proxy statement prior to a shareholder meeting. A proxy is an authorization from the shareholder giving another party the right to cast its vote. Shareholder meetings are held at least once a year, but any special meetings also require a proxy statement. Proxies, especially annual meeting proxies, contain information that is often useful to nancial analysts. Such information typically includes proposals that require a shareholder vote, details of security ownership by management and principal owners, biographical information on directors, and disclosure of executive compensation. Proxy statement information is led with the SEC as Form DEF-14A. Forms 10-Q and 6-K. These are forms that companies are required to submit for interim periods (quarterly for U.S. companies on Form 10-Q, semiannually for many non-U.S. companies on Form 6-K). The ling requires certain nancial information, including unaudited nancial statements and a MD&A for the interim period covered by the report. Additionally, if certain types of nonrecurring eventssuch as the adoption of a signicant accounting policy, c03.indd 86 9/17/08 11:26:44 AM Chapter 3 Financial Reporting Standards 87 commencement of signicant litigation, or a material limitation on the rights of any holders of any class of registered securitiestake place during the period covered by the report, these events must be included in the Form 10-Q report. Companies may provide the 10-Q report to shareholders or may prepare a separate, abbreviated, quarterly report to shareholders. Other lings. There are other SEC lings that a company or its ofcers makeeither periodically, or, if signicant events or transactions have occurred, in between the periodic reports noted above. By their nature, these forms sometimes contain the most interesting and timely information and may have signicant valuation implications. Form 8-K. In addition to ling annual and interim reports, SEC registrants must report material corporate events on a more current basis. Form 8-K (6-K for non-U.S. registrants) is the current report companies must le with the SEC to announce such major events as acquisitions or disposals of corporate assets, changes in securities and trading markets, matters related to accountants and nancial statements, corporate governance and management changes, and Regulation FD disclosures.6 Form 144. This form must be led with the SEC as notice of the proposed sale of restricted securities or securities held by an afliate of the issuer in reliance on Rule 144. Rule 144 permits limited sales of restricted securities without registration. Forms 3, 4, and 5. These forms are required to report benecial ownership of securities. These lings are required for any director or ofcer of a registered company as well as benecial owners of greater than 10 percent of a class of registered equity securities. Form 3 is the initial statement, Form 4 reports changes, and Form 5 is the annual report. These forms, along with Form 144, can be used to examine purchases and sales of securities by ofcers, directors, and other afliates of the company. Form 11-K. This is the annual report of employee stock purchase, savings, and similar plans. It might be of interest to analysts for companies with signicant employee benet plans because it contains more information than that disclosed in the companys nancial statements. 4 . CONVERGENCE OF GLOBAL FINANCIAL REPORTING STANDARDS Recent activities have moved the goal of one set of universally accepted nancial reporting standards out of the theoretical sphere into the realm of reality. In 2002, the IASB and FASB each acknowledged their commitment to the development of high-quality, compatible accounting standards that could be used for both domestic and cross-border nancial reporting (in an agreement referred to as the Norwalk Agreement). Both the IASB and FASB pledged to use their best efforts to (1) make their existing nancial reporting standards fully compatible as soon as practicable, and (2) to coordinate their future work programs to ensure that, once achieved, compatibility is maintained. The Norwalk Agreement was certainly an important milestone, and both bodies are working toward convergence through an ongoing short-term convergence project, a convergence research project, and joint projects such as revenue recognition and business combinations. 6 Regulation FD provides that when an issuer discloses material nonpublic information to certain individuals or entitiesgenerally, securities market professionals such as stock analysts or holders of the issuers securities who may trade on the basis of the informationthe issuer must make public disclosure of that information. In this way, the rule aims to promote full and fair disclosure. c03.indd 87 9/17/08 11:26:46 AM 88 International Financial Statement Analysis In 2004, the IASB and FASB agreed that, in principle, any signicant accounting standard would be developed cooperatively. It is likely to take considerable time to work out differences on existing IFRS and U.S. generally accepted accounting principles (GAAP) because of other pressing priorities and honest differences in principles. Development of one universally accepted nancial reporting framework is a major undertaking and is expected to take a number of years. Exhibit 3-1 provides a summary of the worldwide adoption status of IFRS. EXHIBIT 3-1 International Adoption Status of IFRS as of December 2006 Europe The EU requires companies listed in EU countries to adopt IFRS for the 2005 nancial statements. The IASB decides in late 2006 that it will not require the application of new IFRS or major amendments to existing standards before 1 January 2009. Switzerland requires that multinational main board companies must choose either U.S. GAAP or IFRS. United States The SEC accepts IFRS for non-U.S. registrants but currently requires a reconciliation to U.S. GAAP. It has indicated that it will revisit this requirement after the ling of 2005 nancial statements. The FASB is engaged in numerous projects with the IASB to achieve convergence of U.S. GAAP to IFRS. Full convergence, however, is not expected to be completed in the foreseeable future. Canada In 2006, Canadas Accounting Standards Board decided to converge Canadian GAAP with IFRS. Central and South America Guatemala, Costa Rica, Ecuador, Nicaragua, Panama, Peru, and Honduras require IFRS for all domestic listed companies. Venezuela required adoption of IFRS beginning in 2006 for listed companies and 2007 for others. El Salvador permits IFRS for domestic listed companies. Caribbean Bahamas, Barbados, Jamaica, Trinidad and Tobago, Dominican Republic, and Haiti require IFRS for all domestic listed companies. Asia Pacic Countries Bangladesh requires the use of IFRS, and Australia and New Zealand have adopted IFRS equivalent standards for the 2005 and 2007, respectively, nancial statements. Japan has launched a joint project with the IASB to reduce differences between Japanese accounting standards and IFRS. China requires IFRS for some domestic listed companies. Hong Kong and Philippines have adopted national standards that are equivalent to IFRS except for some effective dates and transition. Singapore has adopted many IFRS. Myanmar and Sri Lanka permit the use of IFRS for domestic listed companies. Africa and the South Africa, Tanzania, Kenya, Egypt, and Malawi require IFRS for all domestic Middle East listed companies. Russian Federation and former Soviet Union The Russian Federation requires IFRS for banks and has proposed phasing in requiring all domestic listed companies to use IFRS beginning in 2006. Sources: Based on data from www.iasb.org and www.iasplus.com. c03.indd 88 9/17/08 11:26:47 AM Chapter 3 Financial Reporting Standards 89 In some ways, the move toward one global set of nancial reporting standards has made the barriers to full convergence more apparent. Standard-setting bodies and regulators can have differing views. In addition, they may be inuenced by strong industry lobbying groups and others that will be subject to these reporting standards. For example, the FASB faced strong opposition when it rst attempted to adopt standards requiring companies to expense employee stock compensation plans.7 The IASB has experienced similar political pressures. The issue of political pressure is compounded when international standards are involved, simply because there are many more interested parties and many more divergent views and objectives. The integrity of the nancial reporting framework depends on the standard setters ability to balance various points of view. 5 . THE INTERNATIONAL FINANCIAL REPORTING STANDARDS FRAMEWORK The IFRS Framework for the Preparation and Presentation of Financial Statements (referred to here as the Framework) sets forth the concepts that underlie the preparation and presentation of nancial statements for external uses. The Framework is designed to assist the IASB in developing standards and to instruct preparers of nancial statements on the principles of nancial statement construction. Importantly, the Framework is also designed to assist users of nancial statementsincluding nancial analystsin interpreting the information contained therein. The Framework is diagrammed in Exhibit 3-2. The top part shows how the objective of nancial statements determines the characteristics that the reporting elements (relating to performance and nancial position) should embody. In practice, decisions in nancial statement preparation must satisfy a number of constraints, such as costbenet trade-offs. Finally, underlying nancial statement preparation, and, therefore, placed at the bottom of the exhibit, are certain important assumptions. In the following, we discuss the Framework starting at the center: the objective of nancial statements. 5.1. Objective of Financial Statements At the center of the Framework is the objective: fair presentation of the companys nancial position, its nancial performance, and its cash ows. All other aspects of the Framework ow from that central objective. Fair presentation to whom? And for what purpose? The introduction to the Framework states that the objective of nancial statements is to provide information about the nancial position, performance, and changes in nancial position of an entity; this information should be useful to a wide range of users for the purpose of making economic decisions.8 The range of users includes investors, employees, lenders, suppliers, other creditors, customers, government agencies, the public, and analysts. The purpose of all this information 7 The second attempt was successful and FASB Statement 123R now requires the expensing of stock options. 8 Framework for the Preparation and Presentation of Financial Statements, IASC, 1989, adopted by IASB 2001, paragraph 12. c03.indd 89 9/17/08 11:26:47 AM 90 International Financial Statement Analysis EXHIBIT 3-2 IFRS Framework for the Preparation and Presentation of Financial Statements Reporting Elements Qualitative Characteristics Objective To Provide a Fair Presentation of: Financial Position Financial Performance Cash Flows Understandability Relevance Performance o Income o Expenses o Capital Maintenance Adjustments Reliability* Comparability Financial Position o Assets o Liabilities o Equity Constraints Timeliness Benefit versus Cost Balance between Qualitative Characteristics Underlying Assumptions Accrual Basis Going Concern *Reliability Faithful representation, substance over form, neutrality, prudence, completeness is to be useful in making economic decisions. The types of economic decisions differ by users, so the specic information needed differs as well. However, although these users may have unique information needs, there are some information needs that are common across all users. One common need is for information about the companys nancial position: its resources and its nancial obligations. Information about a companys nancial performance explains how and why the companys nancial position changed in the past and can be useful in evaluating potential changes in the future. The third common information need reected in the Framework diagram is the need for information about a companys cash. How did the company obtain cash? By selling its products and services, borrowing, other? How did the company use cash? Paying expenses, investing in new equipment, paying dividends, other? c03.indd 90 9/17/08 11:26:48 AM Chapter 3 Financial Reporting Standards 91 5.2. Qualitative Characteristics of Financial Statements Flowing from the central objective of providing a fair presentation of information that is useful to decision makers, the Framework elaborates on what constitutes usefulness. The Framework identies four principal qualitative characteristics that make nancial information useful: understandability, relevance, reliability, and comparability.9 1. Understandability. Understandability of information is dened in terms of who should be able to understand it. The Framework species that the information should be readily understandable by users who have a basic knowledge of business, economic activities, and accounting, and who have a willingness to study the information with reasonable diligence. 2. Relevance. Relevance of information is dened in terms of whether the information inuences economic decisions of users, helping them to evaluate past, present, and future events, or to conrm or correct their past evaluations. Relevant information is typically timely, rather than dated. Relevant information is detailed enough to help users assess the risks and opportunities of a company (e.g., information on business segments or geographical segments). In choosing the level of detail to present, a criterion of materiality is applied. Materiality means that omission or misstatement of the information could make a difference to users decisions. 3. Reliability. Reliable information is free from material error and bias. It is information that a user can depend upon to represent a companys nancial situation faithfully and completely (within the bounds of materiality and cost). Reliable information also reects economic reality, not just the legal form of a transaction or event. The following factors contribute to reliability: Faithful representation. Information must represent faithfully the transactions and other events it either purports to represent or could reasonably be expected to represent. Substance over form. It is necessary that transactions and other events be accounted for and represented in accordance with their substance and economic reality and not merely their legal form. Neutrality. Information contained in the nancial statements must be neutralthat is, free from bias. Prudence. Prudence is the inclusion of a degree of caution in making the estimates required under conditions of uncertainty. It does not, however, allow the deliberate misstatement of elements in the nancial statements in an attempt to be conservative by providing for hidden reserves or excessive provisions. Completeness. Financial statements must be complete within the bounds of materiality and cost. 4. Comparability. Information should be presented in a consistent manner over time and in a consistent manner between entities to enable users to make signicant comparisons. Financial information exhibiting these principal qualitative characteristics normally results in fair presentation (sometimes termed a true and fair view). 9 Ibid., paragraphs 2442. c03.indd 91 9/17/08 11:26:48 AM 92 International Financial Statement Analysis 5.3. Constraints on Financial Statements Although it would be ideal for nancial statements to exhibit all of these qualitative characteristics and thus to achieve maximal usefulness, there are several constraints in achieving this goal.10 One constraint is the necessity for trade-offs across the desirable characteristics. For example, to be relevant, information must be timely; however, it may take considerable time to ensure the information is error-free (i.e., reliable). The aim is a balance between relevance and reliability. Another constraint on useful nancial information is the cost of providing this information. Optimally, benets derived from information should exceed the cost of providing it. Again, the aim is a balance between costs and benets. A further constraint involves what nancial statements omit. Financial statements, by necessity, omit information that is nonquantiable. For example, the creativity, innovation, and competence of a companys work force are not directly captured in the nancial statements. Similarly, customer loyalty, a positive corporate culture, environmental respectfulness, and many other nonquantiable aspects about a company are not directly reected in the nancial statements. Of course, to the extent that these nonquantiable items result in superior nancial performance, a companys nancial reports will reect the results. EXAMPLE 3-4 Balancing Qualitative Characteristics of Useful Information A trade-off between qualitative characteristics often occurs. For example, when a company records sales revenue, it is required to simultaneously estimate and record an expense for potential bad debts (uncollectible accounts). This is considered to provide relevant information about the net prots for the accounting period. However, because bad debts may not be known with certainty until a later period, there is a sacrice of reliability. The bad debt expense is simply an estimate. It is apparent that it is not always possible to simultaneously fulll all qualitative characteristics. 5.4. The Elements of Financial Statements Financial statements portray the nancial effects of transactions and other events by grouping them into broad classes (elements) according to their economic characteristics. Three elements of nancial statements are directly related to the measurement of the nancial position: assets, liabilities, and equity.11 Assets. Resources controlled by the enterprise as a result of past events and from which future economic benets are expected to ow to the enterprise. Assets are what a company owns (e.g., inventory and equipment). 10 Ibid., paragraphs 4345. Ibid., paragraph 49. 11 c03.indd 92 9/17/08 11:26:49 AM Chapter 3 Financial Reporting Standards 93 Liabilities. Present obligations of an enterprise arising from past events, the settlement of which is expected to result in an outow of resources embodying economic benets. Liabilities are what a company owes (e.g., bank borrowings). Equity (commonly known as shareholders equity). Assets less liabilities. Equity is the residual interest in the assets after subtracting the liabilities. The elements of nancial statements directly related to the measurement of performance are income and expenses.12 Income. Increases in economic benets in the form of inows or enhancements of assets, or decreases of liabilities that result in an increase in equity (other than increases resulting from contributions by owners). Income includes both revenues and gains. Revenues represent income from the ordinary activities of the enterprise (e.g., the sale of products). Gains may result from ordinary activities or other activities (the sale of surplus equipment). Expenses. Decreases in economic benets in the form of outows or depletions of assets, or increases in liabilities that result in decreases in equity (other than decreases because of distributions to owners). Expenses include losses, as well as those items normally thought of as expenses, such as the cost of goods sold or wages. 5.4.1. Underlying Assumptions in Financial Statements At the base of the Framework, two important assumptions underlying nancial statements are shown: accrual basis and going concern. These assumptions determine how nancial statement elements are recognized and measured.13 Accrual basis refers to the underlying assumption that nancial statements aim to reect transactions when they actually occur, not necessarily when cash movements occur. For example, accrual accounting species that a company reports revenues when they are earned, regardless of whether the company received cash before delivering the product, after delivering the product, or at the time of delivery. Going concern refers to the assumption that the company will continue in business for the foreseeable future. To illustrate, consider the value of a companys inventory if it is assumed that the inventory can be sold over a normal period of time versus the value of that same inventory if it is assumed that the inventory must all be sold in a day (or a week). Companies with the intent to liquidate or materially curtail operations would require different information for a fair presentation. EXAMPLE 3-5 Going Concern In reporting the nancial position of a company that is assumed to be a going concern, it may be appropriate to list assets at some measure of a current value based upon normal market conditions. However, if a company is expected to cease operations and be liquidated, it may be more appropriate to list such assets at an appropriate liquidation value, namely, a value that would be obtained in a forced sale. 12 Ibid., paragraph 70. Ibid., paragraphs 22 and 23. 13 c03.indd 93 9/17/08 11:26:51 AM 94 International Financial Statement Analysis 5.4.2. Recognition of Financial Statement Elements Recognition is the process of incorporating in the balance sheet or income statement an item that meets the denition of an element and satises the criteria for recognition. A nancial statement element (assets, liabilities, equity, income, and expenses) should be recognized in the nancial statements if14 It is probable that any future economic benet associated with the item will ow to or from the enterprise; and The item has a cost or value that can be measured with reliability. 5.4.3. Measurement of Financial Statement Elements Measurement is the process of determining the monetary amounts at which the elements of the nancial statements are to be recognized and carried in the balance sheet and income statement. The following alternative bases of measurement are used to different degrees and in varying combinations to measure assets and liabilities: Historical cost. Historical cost is simply the amount of cash or cash equivalents paid to purchase an asset, including any costs of acquisition and/or preparation. If the asset was not bought for cash, historical cost is the fair value of whatever was given in order to buy the asset. When referring to liabilities, the historical cost basis of measurement means the amount of proceeds received in exchange for the obligation. Current cost. In reference to assets, current cost is the amount of cash or cash equivalents that would have to be paid to buy the same or an equivalent asset today. In reference to liabilities, the current cost basis of measurement means the undiscounted amount of cash or cash equivalents that would be required to settle the obligation today. Realizable (settlement) value. In reference to assets, realizable value is the amount of cash or cash equivalents that could currently be obtained by selling the asset in an orderly disposal. For liabilities, the equivalent to realizable value is called settlement valuethat is, settlement value is the undiscounted amount of cash or cash equivalents expected to be paid to satisfy the liabilities in the normal course of business. Present value. For assets, present value is the present discounted value of the future net cash inows that the asset is expected to generate in the normal course of business. For liabilities, present value is the present discounted value of the future net cash outows that are expected to be required to settle the liabilities in the normal course of business. Fair value. Fair value is the amount at which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arms-length transaction, which may involve either market measures or present value measures. 5.5. General Requirements for Financial Statements The Framework provides a basis for establishing standards and the elements of nancial statements, but it does not address the contents of the nancial statements. Having discussed the Framework, we now need to address the general requirements for nancial statements. The required nancial statements, the fundamental principles underlying their presentation, and the principles of presentation are provided by International Accounting Standard (IAS) No. 1, Presentation of Financial Statements. These general requirements are illustrated in Exhibit 3-3 and described in the subsections below. 14 Ibid., paragraph 83. c03.indd 94 9/17/08 11:26:53 AM Chapter 3 95 Financial Reporting Standards EXHIBIT 3-3 IASB General Requirements for Financial Statements Required Financial Statements Balance sheet Income statement Statement of changes in equity Cash flow statement Accounting policies and notes Fundamental Principles Presentation Requirements Fair presentation Aggregation where appropriate Going concern No offsetting Accrual basis Classified balance sheet Consistency Minimum information on face Materiality Minimum note disclosures Comparative information In the following, we discuss required nancial statements, the fundamental principles underlying the preparation of nancial statements, and the principles of presentation in greater detail. 5.5.1. Required Financial Statements Under IAS No. 1, a complete set of nancial statements includes:15 A balance sheet. An income statement. A statement of changes in equity showing either all changes in equity, or changes in equity other than those arising from transactions with equity holders acting in their capacity as equity holders.16 A cash ow statement. Notes comprising a summary of signicant accounting policies and other explanatory notes. Entities are encouraged to furnish other related nancial and nonnancial information in addition to the nancial statements. Financial statements need to present fairly the nancial position, nancial performance, and cash ows of an entity. 15 IAS No. 1, Presentation of Financial Statements, paragraph 8. Examples of transactions with equityholders acting in their capacity as equityholders include sale of equity securities to investors, distributions of earnings to investors, and repurchases of equity securities from investors. 16 c03.indd 95 9/17/08 11:26:54 AM 96 International Financial Statement Analysis 5.5.2. Fundamental Principles Underlying the Preparation of Financial Statements A company that applies the IFRS states explicitly in the notes to its nancial statements that it is in compliance with the standards. Except in extremely rare circumstances, such a statement is only made when a company is in compliance with all requirements of IFRS. IAS No. 1 species a number of fundamental principles underlying the preparation of nancial statements. These principles clearly reect the Framework. Fair presentation. The application of IFRS is presumed to result in nancial statements that achieve a fair presentation. The IAS describes fair presentation as follows: Fair presentation requires faithful representation of the effects of transactions, events and conditions in accordance with the denitions and recognition criteria for assets, liabilities, income and expenses set out in the Framework.17 Going concern. Financial statements are prepared on a going concern basis unless management either intends to liquidate the entity or to cease trading, or has no realistic alternative but to do so. If not presented on a going concern basis, the fact and rationale should be disclosed. Accrual basis. Financial statements (except for cash ow information) are to be prepared using the accrual basis of accounting. Consistency. The presentation and classication of items in the nancial statements are usually retained from one period to the next. Comparative information of prior periods is disclosed for all amounts reported in the nancial statements, unless an IFRS requires or permits otherwise. Materiality. Omissions or misstatements of items are material if they could, individually or collectively, inuence the economic decisions of users taken on the basis of the nancial statements. Any material item shall be presented separately. 5.5.3. Presentation Requirements IAS No. 1 also species a number of principles that guide the presentation of nancial statements. These principles include the following: Aggregation. Each material class of similar items is presented separately. Dissimilar items are presented separately unless they are immaterial. No offsetting. Assets and liabilities, and income and expenses, are not offset unless required or permitted by an IFRS. Classied balance sheet. The balance sheet should distinguish between current and noncurrent assets, and between current and noncurrent liabilities unless a presentation based on liquidity provides more relevant and reliable information (e.g., in the case of a bank or similar nancial institution). Minimum information on the face of the nancial statements. IAS No. 1 species the minimum line item disclosures on the face of, or in the notes to, the balance sheet, the income statement, and the statement of changes in equity. For example, companies are specically required to disclose the amount of their plant, property, and equipment as a line item on the face of the balance sheet. The specic requirements are listed in Exhibit 3-4. 17 IAS No. 1, Presentation of Financial Statements, paragraph 13. c03.indd 96 9/17/08 11:26:54 AM Chapter 3 Financial Reporting Standards 97 EXHIBIT 3-4 IAS No. 1: Minimum Required Line Items in Financial Statements On the face of the balance sheet Plant, property, and equipment Investment property Intangible assets Financial assets (not listed in other line items) Investments accounted for using the equity method Biological assets Inventories Trade and other receivables Cash and cash equivalents Trade and other payables Provisions Financial liabilities (not listed in other line items) Liabilities and assets for current tax Deferred tax liabilities and deferred tax assets Minority interest, presented within equity Issued capital and reserves attributable to equity holders of the parent On the face of the income statement Revenue Finance costs Share of the prot or loss of associates and joint ventures accounted for using the equity method Pretax gain or loss recognized on the disposal of assets or settlement of liabilities attributable to discontinuing operations Tax expense Prot or loss Prot or loss attributable to minority interest Prot or loss attributable to equity holders of the parent On the face of the statement of changes in equity Prot or loss for the period Each item of income and expense for the period that, as required by other Standards or by Interpretations, is recognized directly in equity, and the total of these items Total income and expense for the period, showing separately the total amounts attributable to equity holders of the parent and to minority interest For each component of equity, the effects of changes in accounting policies and corrections of errors recognized in accordance with IAS No. 8 Minimum information in the notes (or on face of nancial statements). IAS No. 1 species disclosures about information to be presented in the nancial statements. This information must be provided in a systematic manner and cross-referenced from the face of the nancial statements to the notes. The required information is summarized in Exhibit 3-5. c03.indd 97 9/17/08 11:26:55 AM 98 International Financial Statement Analysis EXHIBIT 3-5 Summary of IFRS Required Disclosures in the Notes to the Financial Statements Disclosure of accounting policies Measurement bases used in preparing nancial statements Each accounting policy used even if not covered by the IFRS Judgments made in applying accounting policies that have the most signicant effect on the amounts recognized in the nancial statements Estimation uncertainty Key assumptions about the future and other key sources of estimation uncertainty that have a signicant risk of causing material adjustment to the carrying amount of assets and liabilities within the next year Other disclosures Description of the entity, including its domicile, legal form country of incorporation, and registered ofce or business address Nature of operations or principal activities, or both Name of parent and ultimate parent Comparative information. For all amounts reported in a nancial statement, comparative information should be provided for the previous period unless another standard requires or permits otherwise. Such comparative information allows users to better understand reported amounts. 6 . COMPARISON OF IFRS WITH ALTERNATIVE REPORTING SYSTEMS The recent adoption of IFRS as the required nancial reporting standard by the EU and other countries has advanced the goal of global convergence. Nevertheless, there are still signicant differences in nancial reporting in the global capital markets. Arguably, the most critical are the differences that exist between IFRS and U.S. GAAP. After the EU adoption of IFRS in 2005, these two reporting standards account for a signicant number of the worlds listed companies. This section will discuss the differences between IFRS and U.S. GAAP that affect the framework and general nancial reporting requirements. The chapters on individual nancial statements will review in more detail the differences in these nancial reporting standards as they apply to specic nancial statements. The chapter on the convergence of international standards also makes relevant points. 6.1. U.S. GAAP The FASB or its predecessor organizations have been issuing nancial reporting standards in the United States since the 1930s. Currently, the FASB is the primary body setting these standards. There are, however, several other organizations that have issued guidance in the past. These include the American Institute of Certied Public Accountants (AICPA) Accounting Standards Executive Committee (AcSEC), the Emerging Issues Task Force (EITF), and the FASB staff. Since the introduction of the SarbanesOxley Act, changes have been made that essentially limit these other bodies from providing any new guidance unless it is directly under the direction of the FASB. The EITF has come under the more formal oversight of the FASB, and the AICPAs AcSEC will no longer issue new standards applicable to public companies. c03.indd 98 9/17/08 11:26:55 AM Chapter 3 Financial Reporting Standards 99 6.1.1. U.S. GAAP Authoritative Guidance Together, the standards and interpretations issued by these bodies comprise U.S. GAAP. A GAAP hierarchy was established to provide guidance as to the order of authority of the various sources of accounting pronouncements. In other words, the GAAP hierarchy denes the sources of accounting principles and a framework for selecting the right principle. This hierarchy is especially important for new transactions and those policies where there is no explicit authoritative guidance. The GAAP hierarchy was originally established in the auditing area rather than the accounting area, but it is currently being reexamined by the FASB. The FASB is also working on a project to bring all authoritative guidance from these various sources into one set of authoritative literature called the Codication. The top level of the hierarchy includes standards issued by the FASB. If an answer is not found at that level, preparers and auditors consider other sources of GAAP. The literature referred to in the GAAP hierarchy that comprises U.S. GAAP is extensive. The FASB has stated that there are more than 2,000 pronouncements comprising U.S. GAAP. The FASB alone has issued 7 concept statements, 153 standards, 47 interpretations, and numerous technical bulletins. Recently, the FASB began issuing FASB staff positions, which provide still another source of U.S. GAAP. As these standards have been developed over many years and by various bodies, they are more a patchwork than a cohesive framework. Although U.S. GAAP does have an explicit conceptual framework that was developed in the late 1970s/early 1980s, not all of the standards adhere completely to the framework. Some standards were developed prior to the framework and certain of the more recent standards are rule based as preparers and auditors request detailed rules and clear-cut dos and donts in an effort to reduce the need for judgment. 6.1.2. Role of the SEC in U.S. GAAP U.S. GAAP, as established by the standard-setting bodies noted above, is ofcially recognized as authoritative by the SEC (Financial Reporting Release No. 1, section 101, and reafrmed in the April 2003 Policy Statement). However, the SEC retains the authority to establish standards. Although it has rarely overruled the FASB, the SEC does issue staff accounting bulletins (SABs). SABs reect the SECs views regarding accounting-related disclosure practices and can be found on the SEC web site. 6.1.3. Convergence of the U.S. GAAP and IASB Framework A joint IASBFASB project was begun in October 2004 to develop a common conceptual framework. The project, which currently has a ve-year timetable, is divided into seven phases. The initial focus is on achieving the convergence of the frameworks and improving particular aspects of the framework dealing with objectives, qualitative characteristics, elements recognition, and measurement. A December 2004 discussion paper presented the broad differences between the two frameworks. These differences are summarized in Exhibit 3-6. Additionally, under U.S. GAAP, there is not a single standard like IAS No. 1 that species the presentation of nancial statements; instead, standards for presentation of nancial statements are dispersed in many different FASB pronouncements and SEC regulations. 6.2. Implications of Other Reporting Systems As more countries adopt IFRS, the need to examine other nancial reporting systems will be minimized. Additionally, the IASB and FASB are considering frameworks from other jurisdictions in developing their joint framework. Nevertheless, analysts are likely c03.indd c03.indd 99 9/17/08 11:26:55 AM 100 International Financial Statement Analysis EXHIBIT 3-6 Summary of Differences between IFRS and U.S. GAAP Frameworks U.S. GAAP (FASB) Framework Purpose of the framework The FASB framework is similar to the IASB framework in its purpose to assist in developing and revising standards, but it resides at a lower level in the hierarchya very important difference. Under IFRS, management is expressly required to consider the framework if there is no standard or interpretation for that issue. The FASB framework does not have a similar provision. Objectives of nancial statements There is general agreement on the objectives of nancial statements: Both frameworks have a broad focus to provide relevant information to a wide range of users. The principle difference is that the U.S. GAAP framework provides separate objectives for business entities versus nonbusiness entities rather than one objective as in the IASB framework. Underlying assumptions Although the U.S. GAAP framework recognizes the importance of the accrual and going concern assumptions, these are not given as much prominence as in the IASB framework. In particular, the going concern assumption is not well developed in the FASB framework. Qualitative characteristics The U.S. GAAP framework identies the same qualitative characteristics but also establishes a hierarchy of those characteristics. Relevance and reliability are considered primary qualities, whereas comparability is deemed to be a secondary quality under the FASB framework. The fourth qualitative characteristic, understandability, is treated as a user-specic quality in the U.S. GAAP framework and is seen as a link between the characteristics of individual users and decision-specic qualities of information. The FASB framework indicates that it cannot base its decisions on the specic circumstances of individual users. Constraints There is similar discussion of the constraints in both frameworks. Financial statement elements (denition, recognition, and measurement) Performance elements. The FASB framework includes three elements relating to nancial performance in addition to revenue and expenses: gains, losses, and comprehensive income. Comprehensive income is a more encompassing concept than net income, as it includes all changes in equity during a period except those resulting from investments by and distributions to owners. Financial position elements. The FASB framework denes an asset as a future economic benet rather than the resource from which future economic benets are expected to ow to the entity as in the IASB framework. It also includes the term probable to dene the assets and liabilities elements. As discussed below, the term probable is part of the IASB framework recognition criteria. Additionally, the frameworks have different meanings of probable. Recognition of elements. The FASB framework does not discuss the term probable in its recognition criteria, whereas the IASB framework requires that it is probable that any future economic benet ow to/from the entity. The FASB framework also has a separate recognition criterion of relevance. Measurement of elements. Measurement attributes (historical cost, current cost, settlement value, current market value, and present value) are broadly consistent, and both frameworks lack fully developed measurement concepts. Furthermore, the FASB framework prohibits revaluations except for certain categories of nancial instruments, which have to be carried at fair value. c03.indd 100 9/17/08 11:26:56 AM Chapter 3 101 Financial Reporting Standards to encounter nancial statements that are prepared on a basis other than IFRS. Although the number and relevance of different local GAAP reporting systems are likely to decline, industry-specic nancial reportssuch as those required for banking or insurance companieswill continue to exist. 6.3. Reconciliation of Financials Prepared According to Different Standards When analyzing nancial statements created under different frameworks, reconciliation schedules and disclosures regarding the signicant differences between the reporting bases are usually available. For example, the SEC currently requires reconciliation for foreign private issuers that do not prepare nancial statements in accordance with U.S. GAAP. The EU is currently considering requiring reconciliations for companies trading on European markets that do not prepare nancial statements using IFRS. Such reconciliations can reveal additional information related to the more judgmental components of the nancial statements and can have important implications for security valuation. A rst look at the disclosure related to any such differences can sometimes be daunting, particularly if the reconciliation is lengthy. For example, Syngentas 2005 U.S. SEC Form 20-F ling discusses these differences in Note 33, Signicant Differences between IFRS and United States Generally Accepted Accounting Principles. This note is longer than 15 pages! Given the length of reconciliation disclosure, a systematic method to quickly digest the information can be helpful. A good starting point is the chart that provides the numerical reconciliation of net income and shareholders equity (see Exhibit 3-7). These reconciliations can EXHIBIT 3-7 Reconciliation of GAAP IncomeSyngenta (US$ millions) 2005 Net income (loss) reported under IFRS attributable to Syngenta AG shareholders 2004 2003 (adjusted) 622 460 248 (7) 62 43 (80) (62) (67) U.S. GAAP adjustments: Purchase accounting: Zaneca agrochemicals business Purchase accounting: other acquisitions Restructuring charges Pension provisions (including post-retirement benets) Deferred taxes on stock-based compensation Deferred taxes on unrealized prot in inventory (9) 47 32 (15) 43 2 3 (3) 2 36 (33) (61) Impairment losses (7) (1) Other items 28 (17) (4) Valuation allowance against deferred tax assets 26 (34) Tax on undistributed earnings of subsidiaries 1 (27) Deferred tax effect of U.S. GAAP adjustments 27 (55) (42) Net income/(loss) reported under U.S. GAAP 556 352 250 Source: 2005 U.S. SEC Form 20-F. c03.indd 101 9/17/08 11:26:56 AM 102 International Financial Statement Analysis be reviewed to identify the signicant items; large amounts should be examined in more detail. The Syngenta disclosure indicates that the companys 2005 net income based on U.S. GAAP was $556 million, compared with the $622 million of net income reported under IFRS. The reconciliation indicates that most signicant differences relate to accounting for acquisitions (purchase accounting adjustments include a $7 million decrease and an $80 million decrease), accounting for pension provisions ($15 million), and accounting for various tax-related items. In some instances, further analysis would be undertaken to determine the implications of each signicant difference based on disclosures in the indicated notes. 7 . EFFECTIVE FINANCIAL REPORTING A discussion of the characteristics of an effective framework and the barriers to the creation of such a framework offer additional perspective on the nancial reporting frameworks reviewed above. 7.1. Characteristics of an Effective Financial Reporting Framework Any effective nancial reporting system needs to be a coherent one (i.e., a framework in which all the pieces t together according to an underlying logic). Such frameworks have several characteristics: Transparency. A framework should enhance the transparency of a companys nancial statements. Transparency means that users should be able to see the underlying economics of the business reected clearly in the companys nancial statements. Full disclosure and fair presentation create transparency. Comprehensiveness. To be comprehensive, a framework should encompass the full spectrum of transactions that have nancial consequences. This spectrum includes not only transactions currently occurring but also new types of transactions as they are developed. So, an effective nancial reporting framework is based on principles that are universal enough to provide guidance for recording both existing and newly developed transactions. Consistency. An effective framework should ensure reasonable consistency across companies and time periods. In other words, similar transactions should be measured and presented in a similar manner regardless of industry, company size, geography, or other characteristics. Balanced against this need for consistency, however, is the need for sufcient exibility to allow companies sufcient discretion to report results in accordance with underlying economic activity. 7.2. Barriers to a Single Coherent Framework Although effective frameworks all share the characteristics of transparency, comprehensiveness, and consistency, there are some conicts that create inherent limitations in any nancial reporting standards framework. Specically, it is difcult to completely satisfy all these characteristics concurrently, so any framework represents an attempt to balance the relative importance of these characteristics. Three areas of conict include valuation, standard-setting approach, and measurement. Valuation. As discussed, various bases for measuring the value of assets and liabilities exist, such as historical cost, current cost, realizable value, and present value. Historical c03.indd 102 9/17/08 11:26:57 AM Chapter 3 Financial Reporting Standards 103 cost valuation, under which an assets value is its initial cost, requires minimal judgment. In contrast, other valuation approaches require considerable judgment. Over time, both the IASB and FASB have recognized that it may be more appropriate to measure certain elements of nancial statements using some fair value method in spite of the judgment required.18 Fair value is the amount at which an asset could be exchanged, or a liability settled, between knowledgeable willing parties in an arms-length transaction; clearly, in many cases, determining fair value requires considerable judgment. Fair value may be more relevant, whereas historical cost may be more reliable. Standard-setting approach. Financial reporting standards can be established based on (1) principles, (2) rules, or (3) a combination of principles and rules (sometimes referred to as objectives oriented). A principles-based approach provides a broad nancial reporting framework with little specic guidance on how to report a particular element or transaction. Such principles-based approaches require the preparers of nancial reports and auditors to exercise considerable judgment in nancial reporting. In contrast, a rules-based approach establishes specic rules for each element or transaction. Rules-based approaches are characterized by a list of yes-or-no rules, specic numerical tests for classifying certain transactions (known as bright-line tests), exceptions, and alternative treatments. The third alternative, an objectives-oriented approach, combines the other two approaches by including both a framework of principles and appropriate levels of implementation guidance. IFRS has been referred to as a principles-based approach. The FASB, which has been criticized for having a rules-based approach in the past, has explicitly stated that it is moving to adopt a more objectives-oriented approach to standard setting. There is a joint project underway to develop a common conceptual framework, and this is likely to be more objectives oriented. Measurement. The balance sheet presents elements at a point in time, whereas the income statement reects changes during a period of time. Because these statements are related, standards regarding one of the statements have an effect on the other statement. Financial reporting standards can be established taking an asset/liability approach, which gives preference to proper valuation of the balance sheet, or a revenue/expense approach that focuses more on the income statement. This conict can result in one statement being reported in a theoretically sound manner, but the other statement reecting less relevant information. In recent years, standard setters have predominantly used an asset/liability approach. EXAMPLE 3-6 Conicts between Measurement Approaches Prime Retailers (PR), a U.S.-based distributor of mens shirts, has a policy of marking its merchandise up by $5 per unit. At the beginning of 2005, PR had 10,000 units of inventory on hand, which cost $15 per unit. During 2006, PR purchased 100,000 units of inventory at a cost of $22 per unit. Also during 2006, PR sold 18 The FASB is currently developing a Fair Value Measurement standard that will be also be reviewed by the IASB. This standard is expected to be effective for scal years beginning after 15 November 2007 in the United States. c03.indd c03.indd 103 9/17/08 11:26:58 AM 104 International Financial Statement Analysis 100,000 units of inventory at $27 per unit. How shall PR reect the cost of the inventory sold: $15 or $22? In order to match current costs with current revenues, PR (which does not operate in an IFRS jurisdiction) may decide that it is appropriate to use a method of inventory costing that assumes that the most recently purchased inventory is sold rst. So, the assumption is that the 100,000 units of sales had a cost of $22. A partial income statement for PR would be: Sales $2,700,000 Cost of sales 2,200,000 Gross prot $500,000 The gross prot reected in this manner reects the current cost of goods matched with the current level of revenues. But PR still has 10,000 units of inventory on hand. The assumption must be that the 10,000 remaining units had a cost of $15 per unit. Therefore, the value of the inventory reected on the balance sheet would be $150,000. Although the income statement reects current costs, the remaining inventory on the balance sheet does not reect current information. The inventory is reected at the older cost of $15 per unit. An analyst would likely nd this older cost less relevant than the current cost of that inventory. 8 . MONITORING DEVELOPMENTS IN FINANCIAL REPORTING STANDARDS In studying nancial reporting and nancial statement analysis in general, the analyst needs to be aware that reporting standards are evolving rapidly. Analysts need to monitor ongoing developments in nancial reporting and assess their implications for security analysis and valuation. The need to monitor developments in nancial reporting standards does not mean that analysts should be accountants. An accountant monitors these developments from a preparers perspective; an analyst needs to monitor from a users perspective. More specically, analysts need to know how these developments will affect nancial reports. Analysts can remain aware of developments in nancial reporting standards by monitoring three areas: new products or transactions, actions of standard setters and other groups representing users of nancials statements (such as CFA Institute), and company disclosures regarding critical accounting policies and estimates. 8.1. New Products or Types of Transactions New products and new types of transactions can have unusual or unique elements to them such that no explicit guidance in the nancial reporting standards exists. New products or transactions typically arise from economic events, such as new businesses (e.g., the Internet), or from a newly developed nancial instrument or nancial structure. Financial instruments, exchange-traded or not, are typically designed to enhance a companys business or to mitigate c03.indd 104 9/17/08 11:27:00 AM Chapter 3 Financial Reporting Standards 105 inherent risks. However, at times, nancial instruments or structured transactions have been developed primarily for purposes of nancial report window dressing. Although companies might discuss new products and transactions in their nancial reports, the analyst can also monitor business journals and the capital markets to identify such items. Additionally, when one company in an industry develops a new product or transaction, other companies in the industry often do the same. Once new products, nancial instruments, or structured transactions are identied, it is helpful to gain an understanding of the business purpose. If necessary, an analyst can obtain further information from a companys management, which should be able to describe the economic purpose, the nancial statement reporting, signicant estimates, judgments applied in determining the reporting, and future cash ow implications for these items. The nancial reporting framework presented here is useful in evaluating the potential effect on nancial statements even though a standard may not have been issued as to how to report a particular transaction. 8.2. Evolving Standards and the Role of CFA Institute Although the actions of standard setters and regulators are unlikely to be helpful in identifying new products and transactions given the lag between new product development and regulatory action, monitoring the actions of these authorities is, nonetheless, important for another reason: Changes in regulations can affect companies nancial reports and, thus, valuations. This is particularly true if the nancial reporting standards change to require more explicit identication of matters affecting asset/liability valuation or nancial performance. For example, a recent regulatory change requires companies to report the value of employee stock options as an expense in the income statement. Prior to the required expensing, an analyst could assess the impact of stock options on a companys performance and the dilutive effect to shareholders by reviewing information disclosed in the notes to the nancial statements. To the extent that some market participants do not examine nancial statement details and thus ignore this expense when valuing a companys securities, more explicit identication could affect the value of the companys securities. The IASB and FASB have numerous major projects under way that will most likely result in new standards. It is important to keep up to date on these evolving standards. The IASB (www.iasb.org) and FASB (www.fasb.org) provide a great deal of information on their web sites regarding new standards and proposals for future changes in standards. In addition, the IASB and FASB seek input from the nancial analyst communitythose who regularly use nancial statements in making investment and credit decisions. When a new standard is proposed, an exposure draft is made available and users of nancial statements can draft comment letters and position papers for submission to the IASB and FASB in order to evaluate the proposal. CFA Institute is active through its CFA Centre for Financial Market Integrity in advocating improvements to nancial reporting. Volunteer members of CFA Institute serve on several liaison committees that meet regularly to make recommendations to the IASB and FASB on proposed standards and to draft comment letters and position papers. You can view the CFA Centres positions on nancial reporting issues at www.cfainstitute.org/cfacentre/. In October 2005, the CFA Centre issued a position paper titled A Comprehensive Business Reporting Model: Financial Reporting for Investors, which provides a suggested model for signicantly improving nancial reporting. The position paper states: Corporate nancial statements and their related disclosures are critical to sound investment decision making. The well being of the worlds nancial markets, and of the millions of investors who entrust their nancial present and future to those markets, depends c03.indd c03.indd 105 9/17/08 11:27:03 AM 106 International Financial Statement Analysis directly on the quality of the information nancial statements and disclosures provide. Consequently, the quality of the information drives global nancial markets. The quality, in turn, depends directly on the quality of the principles and standards by which managers recognize and measure the economic activities and events affecting their companies operations. To succeed, a partnership is needed among standard setters, common shareowners, and other investors to bring full transparency and the highest integrity to the standards and the processes by which those standards are developed. CFA Institute and the CFA Centre for Financial Market Integrity are committed to join in a partnership to improve nancial market integrity in the 21st century.19 Among other principles, the proposed model stresses the importance of information regarding the current fair value of assets and liabilities, of neutrality in nancial reporting, and of providing detailed information on cash ows to investors through the choice of the so-called direct format for the cash ow statement.20 In summary, analysts can improve their investment decision making by keeping current on nancial reporting standards, and various web-based sources provide the means to do so. In addition, analysts can contribute to improving nancial reporting by sharing their users perspective with standard-setting bodies, which typically invite comments concerning proposed changes. 8.3. Company Disclosures A good source for obtaining information regarding the effect of nancial reporting standards on a companys nancial statements is typically the company itself. This information is provided in the footnotes to the nancial statements and accompanying discussion. 8.3.1. Disclosures Relating to Critical and Signicant Accounting Policies As noted earlier, nancial reporting standards need to restrict alternatives but retain exibility in allowing enterprises to match their accounting methods with underlying economics. As a result, companies choose among alternative accounting policies (e.g., depreciation methods) and use estimates (e.g., depreciable lives of assets). Under both IFRS and U.S. GAAP, companies are required to disclose their accounting policies and estimates in the footnotes to the nancial statements. Public companies must discuss their accounting policies and estimates in managements discussion and analysis (MD&A). This disclosure indicates the policies that management deems most important. Although many of the policies are discussed in both the MD&A and the footnotes to the nancial statement, there is typically a distinction between the two discussions. The MD&A disclosure relates to those policies that require signicant judgments and estimates, whereas the footnote discusses all accounting policies, irrespective of whether judgment was required. Each disclosure has value. In analyzing nancial reporting disclosures, the following questions should be addressed: What policies have been discussed? Do these policies appear to cover all of the signicant balances on the nancial statements? Which policies are identied as requiring signicant estimates? Have there been any changes in these disclosures from one year to the next? 19 A Comprehensive Business Reporting Model: Financial Reporting for Investors, CFA Institute Centre for Financial Market Integrity, 24 October 2005, p. 3. 20 See the chapter on understanding the cash ow statement for further information on the direct format. c03.indd 106 9/17/08 11:27:04 AM Chapter 3 Financial Reporting Standards 107 Example 3-7 summarizes the accounting policies discussed in Disneys 2004 annual report MD&A and Note 2, Summary of Signicant Accounting Policy. Two items usually requiring signicant judgment include revenue recognition and timing of reporting the related expenses. As a result, the types of judgments and estimates in revenue recognition and expense reporting are usually discussed in both the MD&A and in the footnotes. EXAMPLE 3-7 List of Signicant Accounting Policy Disclosures: Disney MD&A Notes Film and television revenue and costs Revenue recognition Pension and post-retirement benet plan actuarial assumptions Goodwill, intangible assets, long-lived assets, and investments Contingencies and litigation Income tax audit Principles of consolidation Accounting changes Use of estimates Advertising expenses Cash and cash equivalents Investments Translation policy Inventories Film and television costs Capitalized software costs Parks, resorts, and other property Goodwill and other intangible assets Risk management contracts Earnings per share Stock options Reclassications 8.3.2. Disclosures Regarding the Impact of Recently Issued Accounting Standards Internationally, public companies face disclosure requirements related to recently issued accounting standards. In the United States, the SEC (in its SABs) also requires public companies to provide information regarding the likely future impact of recently issued accounting standards. Under IFRS, IAS No. 8 similarly requires discussion about pending implementations of new standards and the known or estimable information relevant to assessing the impact of the new standards. These disclosures can alert an analyst to signicant changes in reported nancial statement amounts that could affect security valuation. c03.indd c03.indd 107 9/17/08 11:27:04 AM 108 International Financial Statement Analysis Although each discussion will be different, the conclusions that a company can reach about a new standard include: The standard does not apply. The standard will have no material impact. Management is still evaluating the impact. The impact of adoption is discussed. Exhibit 3-8 provides some of the disclosures provided by Syngenta in its 2004 Form 20-F relating to recently issued accounting standards. In the exhibit, IFRIC refers to the International Financial Reporting Interpretations Committeeformerly known as the Standing Interpretations Committee or SICwhich is responsible for interpreting IAS and IFRS. Clearly, disclosures indicating the expected impact provide the most meaningful information. In addition, disclosures indicating that the standard does not apply or will not have a material effect are also helpful. However, disclosures indicating that management is still evaluating the impact of a new standard create some uncertainty about whether the change might materially affect the company. EXHIBIT 3-8 Impact of Recently Issued Accounting Standards: Syngenta (emphasis added) Standard does not apply No material impact Amendment to IAS No. 39, Transition and Initial Recognition of Financial Assets and Financial Liabilities, was issued in December 2004. It will be effective from Syngenta as from 1 January 2005. The amendment changes the transitional requirements on adoption of IAS No. 39 (revised December 2003). Syngenta does not expect the amendment to have a material effect on its consolidated nancial statements. Evaluating the impact IFRIC 4, Determining Whether an Arrangement Contains a Lease, was issued in December 2004 and requires contracts for the supply of goods or services that depend upon the use of a specic asset to be treated in certain circumstances as containing a lease of that asset in addition to a supply contract. IFRIC 4 will be mandatory for Syngenta with effect from 1 January 2006. During 2005, Syngenta will assess the impact on its consolidated nancial statements from adopting IFRIC 4. Impact described c03.indd 108 IFRIC amendment to SIC-12, Special Purpose Entities, was published in October 2004 and requires employee share trusts and similar entities established under share participation plans to be consolidated with effect from 1 January 2005. Syngenta operates its employee share participation plans without using entities of this type, and the amendment will have no effect on the consolidated nancial statements. As stated in Note 2 above, Syngenta will apply IFRS 3, Business Combinations, and the related revisions to IAS No. 36 and IAS No. 38, to all previous business combinations with effect from 1 January 2005. Goodwill amortization expense will no longer be recorded. Goodwill amortization expense on these acquisitions in 2004 was US$56 million. The related tax credit was US$2 million because in most cases the amortization is not tax deductible. Syngenta will test goodwill for impairment annually. 9/17/08 11:27:10 AM Chapter 3 Financial Reporting Standards 109 9 . SUMMARY An awareness of the reporting framework underlying nancial reports can assist in security valuation and other nancial analysis. The framework describes the objectives of nancial reporting, desirable characteristics for nancial reports, the elements of nancial reports, and the underlying assumptions and constraints of nancial reporting. An understanding of the framework, broader than knowledge of a particular set of rules, offers an analyst a basis from which to infer the proper nancial reporting, and thus security valuation implications, of any nancial statement element or transaction. We have discussed how nancial reporting systems are developed, the conceptual objectives of nancial reporting standards, the parties involved in standard-setting processes, and how nancial reporting standards are converging into one global set of standards. A summary of the key points for each section is noted below: The objective of nancial reporting: The objective of nancial statements is to provide information about the nancial position, performance, and changes in nancial position of an entity; this information should be useful to a wide range of users for the purpose of making economic decisions.21 Financial reporting requires policy choices and estimates. These choices and estimates require judgment, which can vary from one preparer to the next. Accordingly, standards are needed to attempt to ensure some type of consistency in these judgments. Financial reporting standard-setting bodies and regulatory authorities. Private sector standard-setting bodies and regulatory authorities play signicant but different roles in the standard-setting process. In general, standard-setting bodies make the rules, and regulatory authorities enforce the rules. However, regulators typically retain legal authority to establish nancial reporting standards in their jurisdiction. Convergence of global nancial reporting standards. The IASB and FASB, along with other standard setters, are working to achieve convergence of nancial reporting standards. Listed companies in many countries are adopting IFRS. Barriers to full convergence still exist. The IFRS Framework. The IFRS Framework sets forth the concepts that underlie the preparation and presentation of nancial statements for external users, provides further guidance on the elements from which nancial statements are constructed, and discusses concepts of capital and capital maintenance. The objective of fair presentation of useful information is the center of the Framework. The qualitative characteristics of useful information include understandability, relevance, reliability, and comparability. The IFRS Framework identies the following elements of nancial statements: assets, liabilities, equity, income, expense, and capital maintenance adjustments. The Framework is constructed based on the underlying assumptions of accrual basis and going concern but acknowledges three inherent constraints: timeliness, benet versus cost, and balance between qualitative characteristics. IFRS nancial statements. IAS No. 1 prescribes that a complete set of nancial statements includes a balance sheet, an income statement, a statement of changes in equity, a cash ow statement, and notes. The notes include a summary of signicant accounting policies and other explanatory information. 21 Framework for the Preparation and Presentation of Financial Statements, IASC, 1989, adopted by IASB 2001, paragraph 12. c03.indd 109 9/17/08 11:27:10 AM 110 International Financial Statement Analysis Financial statements need to adhere to the fundamental principles of fair presentation, going concern, accrual basis, consistency, and materiality. Financial statements must also satisfy the presentation requirements of appropriate aggregation, no offsetting, and a classied balance sheet. Statements must provide the required minimum information on the face of the nancial statements and note disclosures. Comparison with alternative reporting systems. A signicant number of the worlds listed companies report under either IFRS or U.S. GAAP. Although these standards are moving toward convergence, there are still signicant differences in the framework and individual standards. Frequently, companies provide reconciliations and disclosures regarding the signicant differences between reporting bases. These reconciliations can be reviewed to identify signicant items that could affect security valuation. Characteristics of a coherent nancial reporting framework. Effective frameworks share three characteristics: transparency, comprehensiveness, and consistency. Effective standards can, however, have conicting approaches on valuation, the bases for standard setting (principle or rules based), and resolution of conicts between balance sheet and income statement focus. Monitoring developments. Analysts can remain aware of ongoing developments in nancial reporting by monitoring three areas: new products or transactions, standard setters and regulators actions, and company disclosures regarding critical accounting policies and estimates. P RACTICE PROBLEMS 1. Which of the following is not an objective of nancial statements as expressed by the International Accounting Standards Board? A. To provide information about the performance of an entity B. To provide information about the nancial position of an entity C. To provide information about the users of an entitys nancial statements 2. International accounting standards are currently developed by which entity? A. Financial Services Authority B. International Accounting Standards Board C. International Accounting Standards Committee 3. U.S. Financial Accounting Standards are currently developed by which entity? A. U.S. Congress B. Financial Services Authority C. Financial Accounting Standards Board 4. The SEC requires which of the following be issued to shareholders before a shareholder meeting? A. Form 10-K B. Statement of cash ow C. Proxy statement c03.indd 110 9/17/08 11:27:11 AM Chapter 3 Financial Reporting Standards 111 5. According to the Framework for the Preparation and Presentation of Financial Statements, which of the following is a qualitative characteristic of information in nancial statements? A. Accuracy B. Timeliness C. Comparability 6. Which of the following is not a constraint on the nancial statements according to the IFRS Framework? A. Timeliness B. Understandability C. Benet versus cost 7. The assumption that an entity will continue to operate for the foreseeable future is called A. accrual basis. B. comparability. C. going concern. 8. The assumption that the effects of transactions and other events are recognized when they occur, not necessarily when cash movements occur, is called A. accrual basis. B. going concern. C. relevance. 9. Neutrality of information in the nancial statements most closely contributes to which qualitative characteristic? A. Relevance B. Reliability C. Comparability 10. Does fair presentation entail full disclosure and transparency? Full Disclosure A. B. C. Transparency No Yes Yes Yes No Yes 11. Valuing assets at the amount of cash or equivalents paid, or the fair value of the consideration given to acquire them at the time of acquisition, most closely describes which measurement of nancial statement elements? A. Current cost B. Realizable cost C. Historical cost c03.indd c03.indd 111 9/17/08 11:27:11 AM 112 International Financial Statement Analysis 12. The valuation technique under which assets are recorded at the amount that would be received in an orderly disposal is A. current cost. B. present value. C. realizable value. 13. Which of the following is not a required nancial statement according to IAS No. 1? A. Income statement B. Statement of changes in equity C. Statement of changes in income 14. Which of the following elements of nancial statements is most closely related to measurement of performance? A. Assets B. Expenses C. Liabilities 15. Which of the following elements of nancial statements is most closely related to measurement of nancial position? A. Equity B. Income C. Expenses 16. Which of the following is not a characteristic of a coherent nancial reporting framework? A. Timeliness B. Consistency C. Transparency 17. In the past, the Financial Accounting Standards Board has been criticized as having A. a rules-based approach to standards. B. a principles-based approach to standards. C. an objectives-oriented approach to standards. 18. Which of the following types of discussions regarding new accounting standards in managements discussion would provide the most meaningful information to an analyst? A. The standard does not apply. B. The impact of adoption is discussed. C. The standard will have no material impact. c03.indd c03.indd 112 9/17/08 11:27:12 AM CHAPTER 4 U NDERSTANDING THE INCOME STATEMENT Thomas R. Robinson, CFA CFA Institute Charlottesville, Virginia Hennie van Greuning, CFA World Bank Washington, DC Elaine Henry, CFA University of Miami Miami, Florida Michael A. Broihahn, CFA Barry University Miami, Florida L EARNING OUTCOMES After completing this chapter, you will be able to do the following: Describe the components of the income statement and the alternative presentation formats of that statement. Discuss the general principles of revenue recognition and accrual accounting, specic revenue recognition applications (including accounting for long-term contracts, installment sales, barter transactions, gross and net reporting of revenue), and the implications of revenue recognition principles for nancial analysis. 113 c04.indd 113 9/17/08 11:28:10 AM 114 International Financial Statement Analysis Discuss the general principles of expense recognition, such as the matching principle, specic expense recognition applications (including depreciation of long-term assets and inventory methods), and the implications of expense recognition principles for nancial analysis. Distinguish between the operating and nonoperating components of the income statement. Discuss the nancial reporting treatment and analysis of nonrecurring items, including discontinued operations, extraordinary items, unusual or infrequent items, and changes in accounting standards. Describe the components of earnings per share and calculate a companys earnings per share (both basic and diluted earnings per share) for both a simple and complex capital structure. Evaluate a companys nancial performance using common-size income statements and nancial ratios based on the income statement. State the accounting classication for items that are excluded from the income statement but affect owners equity, and list the major types of items receiving that treatment. Describe and calculate comprehensive income. 1 . INTRODUCTION The income statement presents information on the nancial results of a companys business activities over a period of time. The income statement communicates how much revenue the company generated during a period and what costs it incurred in connection with generating that revenue. The basic equation underlying the income statement is: Revenue Expense Net income. The income statement is also called the statement of operations or statement of earnings or, sometimes, in business jargon, it is called the P&L (for prot and loss). Investment analysts intensely scrutinize companies income statements. Equity analysts are interested in them because equity markets often reward relatively high- or low-earnings growth companies with above-average or below-average valuations, respectively. Fixed-income analysts examine the components of income statements, past and projected, for information on companies abilities to make promised payments on their debt over the course of the business cycle. Corporate nancial announcements frequently emphasize income statements more than the other nancial statements. This chapter is organized as follows: Section 2 describes the components of the income statement and its format. Section 3 describes basic principles and selected applications related to the recognition of revenue, and section 4 describes basic principles and selected applications related to the recognition of expenses. Section 5 covers nonrecurring items and nonoperating items. Section 6 explains the calculation of earnings per share. Section 7 introduces income statement analysis. Section 8 explains comprehensive income and its reporting. Section 9 summarizes the chapter. Practice problems in the CFA Institute multiple-choice format complete the chapter. 2 . COMPONENTS AND FORMAT OF THE INCOME STATEMENT On the top line of the income statement, companies typically report revenue. Revenue refers to amounts charged for the delivery of goods or services in the ordinary activities of a business. The term net revenue means that the revenue number is shown after adjustments c04.indd 114 9/17/08 11:28:11 AM Chapter 4 115 Understanding the Income Statement EXHIBIT 4-1 Groupe Danone: Consolidated Statements of Income ( millions) Year ended 31 December 2002 Net sales 2003 2004 13,555 13,131 13,700 Cost of goods sold (6,442) (5,983) (6,369) Selling expenses (4,170) (4,176) (4,294) General and administrative expenses (964) (977) (997) Research and development expenses (133) (130) (131) Other (expense) income (256) (261) (204) Operating income 1,590 1,604 1,705 Nonrecurring items 458 (60) (105) Interest expense, net (110) (70) (73) Income before provision for income taxes and minority interests Provision for income taxes Income before minority interests Minority interests Share in net income of afliates Net income 1,938 (490) 1,448 1,474 (488) 986 1,527 (457) 1,070 (182) (184) (189) 17 37 (564) 1,283 839 317 (e.g., for estimated returns or for amounts unlikely to be collected). Revenue is often used synonymously with sales.1 Exhibits 4-1 and 4-2 show the income statements for Groupe Danone, a French food manufacturer, and Kraft Foods, a U.S. food manufacturer. For the year ended 31 December 2004, Danone reports 13.7 billion of net sales, whereas Kraft reports $32.2 billion of net revenues.2 Note that Groupe Danone lists the years in increasing order from left to right with the most recent year in the last column, whereas Kraft lists the years in decreasing order, with the most recent year listed in the rst column. These alternative formats are common. There are also differences in presentations of items, such as expenses. Groupe Danone shows expenses such as cost of goods sold in parentheses to explicitly show that these are subtracted from revenue. Kraft, however, does not place cost of sales in parentheses. Rather, it is implicitly understood that this is an expense and is subtracted in arriving at subtotals and totals. The analyst should always verify the order of years and presentation of negative items before analysis is begun because there is exibility in how companies may present the income statement. 1 Sales is sometimes understood to refer to the sale of goods, whereas revenue can include the sale of goods or services; however, the terms are often used interchangeably. In some countries, turnover is used in place of revenue. 2 Following net income, the income statement will also present earnings per share, the amount of earnings per common share of the company. Earnings per share will be discussed in detail later in this reading, and the per-share display has been omitted from these exhibits to focus on the core income statement. c04.indd 115 9/17/08 11:28:12 AM 116 International Financial Statement Analysis EXHIBIT 4-2 Kraft Foods and Subsidiaries: Consolidated Statements of Earnings ($ millions except per-share data) Year Ended 31 December 2004 2003 2002 Net revenues $32,168 $30,498 $29,248 Cost of sales 20,281 18,531 17,463 11,887 11,967 11,785 6,658 6,136 5,644 Gross prot Marketing, administration, and research costs Integration costs and a loss on sale of a food factory Asset impairment and exit costs Losses (gains) on sales of businesses Amortization of intangibles Operating income Interest and other debt expense, net Earnings from continuing operations before income taxes and minority interest Provision for income taxes Earnings from continuing operations before minority interest Minority interest in earnings from continuing operations, net Earnings from continuing operations (Loss) earnings from discontinued operations, net of income taxes Net earnings (13) 603 111 6 142 3 (31) (80) 11 9 7 4,612 5,860 5,961 666 665 847 3,946 5,195 5,114 1,274 1,812 1,813 2,672 3,383 3,301 3 4 4 2,669 3,379 3,297 97 97 $3,476 $3,394 (4) $2,665 At the bottom of the income statement, companies report net income (or, essentially synonymously, net earnings or prot). For 2004, Danone reports 317 million of net income and Kraft reports $2,665 million of net earnings. Net income is often referred to as the bottom line. The basis for this expression is that net income is the nalor bottomline in an income statement. Because net income is often viewed as the single most relevant number to describe a companys performance over a period of time, the term bottom line sometimes is used in general business jargon to mean any nal or most relevant result. Net income also includes gains and losses, which are asset inows and outows, respectively, not directly related to the ordinary activities of the business. For example, if a company sells products, these are reported as revenue and the costs are listed separately. However, if a company sells surplus land that is not needed, the cost of the land is subtracted from the sales price and the net result is reported as a gain or a loss. In addition to presenting the net income, income statements also present subtotals that are signicant to users of nancial statements. Some of the subtotals are specied by International Financial Reporting Standards (IFRS), particularly nonrecurring items, but c04.indd c04.indd 116 9/17/08 11:28:12 AM Chapter 4 Understanding the Income Statement 117 other subtotals are not specied.3 International Accounting Standard (IAS) No. 1, Presentation of Financial Statements, requires that certain items, such as revenue, nance costs, and tax expense, be separately stated on the face of the income statement. IAS No. 1 also requires that headings and subtotals should also be presented on the face of the income statement when such presentation is relevant to an understanding of the entitys nancial performance.4 IAS No. 1 states that expenses may be grouped together either by their nature or function. For example, grouping together expenses such as depreciation on manufacturing equipment and depreciation on administrative facilities into a single line item called depreciation represents a grouping by nature of the expense. An example of grouping by function would be grouping together expenses into a category such as cost of goods sold, which would include some salaries (e.g., salespeoples), material costs, depreciation, and other direct sales-related expenses. One subtotal often shown in an income statement is gross prot (or, synonymously, gross margin). When an income statement shows a gross prot subtotal, it is said to use a multi-step format rather than a single-step format. The Kraft Foods income statement is an example of the multi-step format, whereas the Danone income statement is a single step. For manufacturing and merchandising companies, for whom gross prot is most relevant, gross prot is calculated as revenue minus the cost of the goods that were sold.5 For service companies, gross prot is calculated as revenue minus the cost of services that were provided. In summary, gross prot is the amount of revenue available after subtracting the costs of delivering goods or services such as material and labor. Other expenses related to running the business are subtracted after gross prot. Another important subtotal shown on the income statement is operating prot (or, synonymously, operating income). Operating prot further deducts operating expenses such as selling, general, administrative, and research and development expenses. Operating prot reects a companys prots on its usual business activities before deducting taxes. For nancial rms, interest expense would be included in operating expenses and subtracted in arriving at operating prot. For nonnancial companies, interest expense would not be included in operating expenses and would be subtracted after operating prot because it relates to nonoperating activities for such companies. For some companies composed of a number of separate business segments, operating prot can be useful in evaluating the performance of the individual businesses, reecting the reality that interest and tax expenses are more relevant at the level of the overall company rather than an individual segment level. For example, in its Investor Relations information, DaimlerChrysler notes, Especially on the pre-tax level, Operating Prot is the principal earnings indicator for the Segments, Divisions and Business Units.6 The specic calculations of gross margin and operating prot may vary by company, and a reader of nancial statements can consult the notes to the statements to identify signicant variations across companies. Note that both Groupe Danone and Kraft Foods include a line item on their income statements referring to minority interest. Danone and Kraft both consolidate subsidiaries 3 The body of standards issued by the International Accounting Standards Board is now referred to as International Financial Reporting Standards, which include previously issued International Accounting Standards. Financial reporting is a broad term including reporting on accounting, nancial statements, and other information found in company nancial reports. 4 IAS No. 1, Presentation of Financial Statements, paragraph 83. 5 Later chapters will provide additional information about alternative methods to calculate cost of goods sold. 6 DaimlerChrysler/Investor Relations/Basic Information/Controlling systems at www.daimlerchrysler.com. c04.indd 117 9/17/08 11:28:13 AM 118 International Financial Statement Analysis EXHIBIT 4-3 Charles River Associates Incorporated: Consolidated Statements of Income ($ thousands except per-share data) Year Ended 27 Nov. 2004 (52 weeks) 29 Nov. 2003 (52 weeks) 30 Nov. 2002 (53 weeks) $216,735 $163,458 $130,690 127,716 100,168 80,659 Gross prot 89,019 63,290 50,031 Selling, general, and administrative expenses 57,286 43,055 36,600 Income from operations 31,733 20,235 13,431 904 429 486 (1,751) (38) (120) (260) (306) (29) Revenues Cost of services Interest income Interest expense Other expense Income before provision for income taxes and minority interest Provision for income taxes Income before minority interest Minority interest Net income 30,626 20,320 13,768 (13,947) (8,737) (5,879) 16,679 11,583 7,889 (335) $16,344 (154) $11,429 547 $8,436 over which they have control. Consolidation means that they include all of the revenues and expenses of those subsidiaries even if they own less than 100 percent. Minority interest represents the portion of income that belongs to minority shareholders of these consolidated subsidiaries, as opposed to the parent company. Exhibit 4-3 shows the income statement for CRA International (then known as Charles River Associates), a company providing management consulting services. These examples illustrate basic points about the income statement, including variations across the statements some of which depend on the industry, whereas others reect differences in accounting policies and practices of a particular company. In addition, some differences within an industry are primarily differences in terminology, whereas others are more fundamental accounting differences. Footnotes to the nancial statements are helpful in identifying such differences. Having introduced the components and format of an income statement, the next objective is to understand the actual reported numbers in it. To accurately interpret reported numbers, the analyst needs to be familiar with the principles of revenue and expense recognitionthat is, how revenue and expenses are measured and attributed to a given accounting reporting period. Revenue and expense recognition are our next topics. 3 . REVENUE RECOGNITION Revenue is the top line in an income statement, so we begin the discussion with revenue recognition. A rst task is to explain some relevant accounting terminology. c04.indd 118 9/17/08 11:28:14 AM Chapter 4 Understanding the Income Statement 119 The terms revenue, sales, gains, losses, and net income (prot, net earnings) have been previously briey dened. The IFRS Framework for the Preparation and Presentation of Financial Statements (referred to here as the Framework) provides further relevant details. The Framework provides that prot is a frequently used measure of performance that is composed of income and expenses.7 It denes income as follows: Income is increases in economic benets during the accounting period in the form of inows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants.8 International Financial Reporting Standards use the term income to include revenue and gains. Gains are similar to revenue; however, they arise from secondary or peripheral activities rather than from a companys primary business activities. For example, for a restaurant, the sale of surplus restaurant equipment for more than its cost is referred to as a gain rather than as revenue. Similarly, a loss is like an expense but arises from secondary activities. Gains and losses may be considered part of operating activities (e.g., a loss due to a decline in the value of inventory) or may be considered part of nonoperating activities (e.g., the sale of nontrading investments). In a simple hypothetical scenario, revenue recognition would not be an issue. For instance, a company sells goods to a buyer for cash with no returns allowed: When should the company recognize revenue? In this instance, it is clear that revenue should be recognized when the exchange of goods for cash takes place. In practice, however, determining when revenue should be recognized can be somewhat more complex for a number of reasons discussed in the following sections. 3.1. General Principles An important concept concerning revenue recognition is that it can occur independently of cash movements. For example, assume a company sells goods to a buyer on credit and so does not actually receive cash until some later time. A fundamental principle of accrual accounting is that revenue is recognized when it is earned, so the companys nancial records reect the sale when it is made and a related accounts receivable is created. Later, when cash changes hands, the companys nancial records simply reect that cash has been received to settle an account receivable. Similarly, there are situations when a company receives cash upfront and actually delivers the product or service later, perhaps over a period of time. In this case, the company would record unearned revenue, which is then recognized as being earned over time. (One example would be a subscription payment received up front for a publication that is to be delivered periodically over time, the accounting for which was illustrated earlier.) The basic revenue recognition principles promulgated by accounting regulators deal with the denition of earned. The International Accounting Standards Board (IASB) provides that revenue for the sale of goods is to be recognized (reported on the income statement) when the following conditions are satised:9 The entity has transferred to the buyer the signicant risks and rewards of ownership of the goods. 7 IASB, International Framework for the Preparation and Presentation of Financial Statements, paragraph 69. Ibid., paragraph 70. 9 IASB, IAS No. 18, Revenue, paragraph 14. 8 c04.indd 119 9/17/08 11:28:14 AM 120 International Financial Statement Analysis The entity retains neither continuing managerial involvement to the degree usually associated with ownership nor effective control over the goods sold. The amount of revenue can be measured reliably. It is probable that the economic benets associated with the transaction will ow to the entity. The costs incurred or to be incurred in respect of the transaction can be measured reliably. The IASB notes that the transfer of the risks and rewards of ownership normally occurs when goods are delivered to the buyer or when legal title to goods transfers. However, as noted by the above remaining conditions, transfer of goods will not always result in the recognition of revenue. For example, if goods are delivered to a retail store to be sold on consignment and title is not transferred, the revenue would not yet be recognized.10 The Financial Accounting Standards Board (FASB)11 species that revenue should be recognized when it is realized or realizable and earned. The U.S. Securities and Exchange Commission (SEC),12 motivated in part because of the frequency with which overstating revenue occurs in connection with fraud and/or misstatements, provides guidance on how to apply the accounting principles. This guidance names four criteria to determine when revenue is realized or realizable and earned: 1. There is evidence of an arrangement between buyer and seller. For instance, this would disallow the practice of recognizing revenue in a period by delivering the product just before the end of an accounting period and then completing a sales contract after the period end. 2. The product has been delivered, or the service has been rendered. For instance, this would preclude revenue recognition when the product has been shipped but the risks and rewards of ownership have not actually passed to the buyer. 3. The price is determined, or determinable. For instance, this would preclude a company from recognizing revenue that is based on some contingency. 4. The seller is reasonably sure of collecting money. For instance, this would preclude a company from recognizing revenue when the customer is unlikely to pay. The IASB standards separately deal with the recognition of revenue for services:13 When the outcome of a transaction involving the rendering of services can be estimated reliably, revenue associated with the transaction shall be recognized by reference to the stage of completion of the transaction at the balance sheet date. The outcome of a transaction can be estimated reliably when all the following conditions are satised: The amount of revenue can be measured reliably. It is probable that the economic benets associated with the transaction will ow to the entity. 10 IAS No. 18 describes a consignment sale as one in which the recipient undertakes to sell the goods for the shipper. Revenue is recognized when the recipient sells the goods to a third party. IAS No. 18, Appendix, paragraph 2. 11 See Statement of Financial Accounting Concepts No. 5, paragraph 83(b). 12 See SEC Staff Accounting Bulletin 101. 13 IASB, IAS No. 18, paragraph 20. c04.indd 120 9/17/08 11:28:15 AM Chapter 4 Understanding the Income Statement 121 EXHIBIT 4-4 Partial Revenue Recognition Footnote for DaimlerChrysler Revenue for sales of vehicles, service parts, and other related products is recognized when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the price of the transaction is xed and determinable, and collectability is reasonably assured. Revenues are recognized net of discounts, cash sales incentives, customer bonuses and rebates granted. Noncash sales incentives that do not reduce the transaction price to the customer are classied within cost of sales. Shipping and handling costs are recorded as cost of sales in the period incurred. DaimlerChrysler uses price discounts to adjust market pricing in response to a number of market and product factors, including: pricing actions and incentives offered by competitors, economic conditions, the amount of excess industry production capacity, the intensity of market competition, and consumer demand for the product. The Group may offer a variety of sales incentive programs at any point in time, including: cash offers to dealers and consumers, lease subsidies which reduce the consumers monthly lease payment, or reduced nancing rate programs offered to consumers. The Group records as a reduction to revenue at the time of sale to the dealer the estimated impact of sales incentives programs offered to dealers and consumers. This estimated impact represents the incentive programs offered to dealers and consumers as well as the expected modications to these programs in order for the dealers to sell their inventory. The stage of completion of the transaction at the balance sheet date can be measured reliably. The costs incurred for the transaction and the costs to complete the transaction can be measured reliably. Companies must disclose their revenue recognition policies in the footnotes to their nancial statements. Analysts should review these policies carefully to understand how and when a company recognizes revenue, which may differ depending upon the types of product sold and services rendered. Exhibit 4-4 presents a portion of the revenue recognition footnote for DaimlerChrysler from its 2005 annual report prepared under IFRS. The topic of revenue recognition remains important, and new challenges have evolved, particularly in areas of e-commerce and services such as software development. Standard setters continue to evaluate current revenue recognition standards and issue new guidance periodically to deal with new types of transactions. Additionally, there are occasional special cases for revenue recognition, as discussed in the next section. 3.2. Revenue Recognition in Special Cases The general principles discussed above are helpful for dealing with most revenue recognition issues. There are some areas where revenue recognition is more difcult to determine. For example, in limited circumstances, revenue may be recognized before or after goods are delivered or services are rendered, as summarized in Exhibit 4-5. The following sections discuss revenue recognition in the case of long-term contracts, installment sales, and barter. 3.2.1. Long-Term Contracts A long-term contract is one that spans a number of accounting periods. Such contracts raise issues in determining when the earnings process has been completed. How should a company c04.indd 121 9/17/08 11:28:15 AM 122 International Financial Statement Analysis EXHIBIT 4-5 Revenue Recognition in Special Cases Before Goods Are Delivered or Services Rendered At the Time Goods Are Delivered or Services Rendered For example, with long-term contracts where the outcome can be reliably measured, the percentage-of-completion method is used. Recognize revenues using normal revenue recognition criteria (IAS, FAS, SEC). After Goods Are Delivered or Services Rendered For example, with real estate sales where there is doubt about the buyers ability to complete payments, the installment method and cost recovery method are appropriate. apportion the revenue earned under a long-term contract to each accounting period? If, for example, the contract is a service contract or a licensing arrangement, the company may recognize the revenue ratably over the period of time of the contract rather than at the end of the contract term. As stated in IAS No. 18 regarding the rendering of services: The recognition of revenue by reference to the stage of completion of a transaction is often referred to as the percentage-of-completion method. Under this method, revenue is recognized in the accounting periods in which the services are rendered. The recognition of revenue on this basis provides useful information on the extent of service activity and performance during a period. IAS 11 Construction Contracts also requires the recognition of revenue on this basis. The requirements of that Standard are generally applicable to the recognition of revenue and the associated expenses for a transaction involving the rendering of services.14 As noted in IAS No. 18, construction contracts are another example of contracts that may span a number of accounting periods. IAS No. 11 provides that when the outcome of a construction contract can be measured reliably, revenue and expenses should be recognized in reference to the stage of completion. U.S. generally accepted accounting principles (U.S. GAAP) have a similar requirement. In both cases, the percentage-of-completion method of accounting is used. Under the percentage-of-completion method, in each accounting period, the company estimates what percentage of the contract is complete and then reports that percentage of the total contract revenue in its income statement. Contract costs for the period are expensed against the revenue. Therefore, net income or prot is reported each year as work is performed. Under IAS No. 11, if the outcome of the contract cannot be measured reliably, then revenue is only reported to the extent of contract costs incurred (if it is probable the costs will be recovered). Costs are expensed in the period incurred. Under this method, no prot would be reported until completion of the contract. Under U.S. GAAP, a different method is used when the outcome cannot be measured reliably, termed the completed contract method. Under the completed contract method, the company does not report any revenue until the contract is nished. Under U.S. GAAP, the completed contract method is also appropriate when the contract is not a long-term contract. Note, however, that when a contract is started and completed in the same period, there is no difference between the percentage-of-completion and completed contract methods. 14 IAS No. 18, paragraph 21. c04.indd 122 9/17/08 11:28:15 AM Chapter 4 Understanding the Income Statement 123 Examples 4-1, 4-2, and 4-3 provide illustrations of these revenue recognition methods. As shown, the percentage-of-completion method results in revenue recognition sooner than the completed contract method and thus may be considered a less conservative approach. In addition, the percentage-of-completion method relies on management estimates and is thus not as objective as the completed contract method. However, an advantage of the percentageof-completion method is that it results in better matching of revenue recognition with the accounting period in which it was earned. Because of better matching with the periods in which work is performed, the percentage-of-completion method is the preferred method of revenue recognition for long-term contracts and is required when the outcome can be measured reliably under both IFRS and U.S. GAAP. Under both IFRS and U.S. GAAP, if a loss is expected on the contract, the loss is reported immediately, not upon completion of the contract, regardless of the method used (e.g., percentage-of-completion or completed contract). EXAMPLE 4-1 Revenue Recognition for Long-Term Contracts: Recognizing Revenue Ratably New Era Network Associates has a ve-year license to provide networking support services to a customer. The total amount of the license fee to be received by New Era is $1 million. New Era recognizes license revenue ratably regardless of the time at which cash is received. How much revenue will New Era recognize for this license? Solution. For this license, New Era Network Associates will recognize $200,000 each year for ve years (calculated as $1 million divided by 5). EXAMPLE 4-2 Revenue Recognition for Long-Term Contracts: Percentage-of-Completion Method Stelle Technology has a contract to build a network for a customer for a total sales price of $10 million. The network will take an estimated three years to build, and total building costs are estimated to be $6 million. Stelle recognizes long-term contract revenue using the percentage-of-completion method and estimates percentage complete based on expenditure incurred as a percentage of total estimated expenditures. 1. At the end of Year 1, the company has spent $3 million. Total costs to complete are estimated to be another $3 million. How much revenue will Stelle recognize in Year 1? 2. At the end of Year 2, the company has spent $5.4 million. Total costs to complete are estimated to be another $0.6 million. How much revenue will Stelle recognize in Year 2? 3. At the end of Year 3, the contract is complete. The company spent a total of $6 million. How much revenue will Stelle recognize in Year 3? c04.indd 123 9/17/08 11:28:16 AM 124 International Financial Statement Analysis Solution to 1. Stelle has spent 50 percent of the total project costs ($3 million divided by $6 million), so in Year 1, the company will recognize 50 percent of the total contract revenue (i.e., $5 million). Solution to 2. Because Stelle has spent 90 percent of the total project costs ($5.4 million divided by $6 million), by the end of Year 2, it will need to have recognized 90 percent of the total contract revenue (i.e., $9 million). Stelle has already recognized $5 million of revenue in Year 1, so in Year 2, the company will recognize $4 million revenue ($9 million minus $5 million). Solution to 3. Because Stelle has spent 100 percent of the total project costs, by the end of Year 3, it will need to have recognized 100 percent of the total contract revenue (i.e., $10 million). Stelle had already recognized $9 million of revenue by the end of Year 2, so in Year 3, the company will recognize $1 million revenue ($10 million minus $9 million). Year 1 Revenue Year 2 Year 3 Total $5 million $4 million $1 million $10 million EXAMPLE 4-3 Revenue Recognition for Long-Term Contracts: Completed Contract Method Kolenda Technology Group has a contract to build a network for a customer for a total sales price of $10 million. This network will take an estimated three years to build, but considerable uncertainty surrounds total building costs because new technologies are involved. Kolenda recognizes contract revenue using the completed contract method. 1. At the end of Year 1, Kolenda has spent $3 million. How much revenue will the company recognize in Year 1? 2. At the end of Year 2, Kolenda has spent $5.4 million. How much revenue will the company recognize in Year 2? 3. At the end of Year 3, the contract is complete. Kolenda spent a total of $6 million. How much revenue will the company recognize in Year 3? Solution to 1. No revenue will be recognized until the contract is complete. In Year 1, Kolenda will recognize $0. Solution to 2. No revenue will be recognized until the contract is complete. In Year 2, Kolenda will recognize $0. Solution to 3. Because the contract is complete, Kolenda will recognize the total contract revenue (i.e., $10 million). Year 1 Revenue c04.indd 124 Year 2 Year 3 Total $0 million $0 million $10 million $10 million 9/17/08 11:28:28 AM Chapter 4 Understanding the Income Statement 125 3.2.2. Installment Sales As noted above, revenue is normally reported when goods are delivered or services are rendered, independent of the period in which cash payments for those goods or services are received. This principle applies even to installment salessales in which proceeds are to be paid in installments over an extended period. Under limited circumstances, recognition of revenue or prot may be required to be deferred for some installment sales. An example of such deferral arises for certain sales of real estate on an installment basis. Revenue recognition for sales of real estate15 varies depending on specic aspects of the sale transaction. Under normal conditions, sales of real estate are reported at the time of sale using the normal revenue recognition conditions. International standards note that in the case of real estate sales, the time at which legal title transfers may differ from the time at which the buyer acquires a vested interest. Continuing involvement in the real estate by the seller may also indicate that risks and rewards of ownership of the property have not been transferred. There may also be signicant doubt of the ability of the buyer to complete payment for a real estate sales contract. IAS No. 18 provides that in the case of real estate where the down payment and payments received do not provide sufcient evidence of the commitment of the buyer, revenue should be reported only to the extent cash is received. This is a conservative treatment because the reporting of revenue is deferred. Similar provisions exist under U.S. GAAP except that under U.S. GAAP the full revenue is shown in the year of sale but some of the prot is deferred. Two methods may be appropriate in these limited circumstances and relate to the amount of prot to be recognized each year from the transaction: the installment method and the cost recovery method. Under the installment method, the portion of the total prot of the sale that is recognized in each period is determined by the percentage of the total sales price for which the seller has received cash. Exhibit 4-6 presents an example of a disclosure of an installment sale of real estate under U.S. GAAP where a portion of the prot was recognized and the remainder was deferred. EXHIBIT 4-6 Installment Sale Disclosure for First Bancshares On June 22, 2004, an agreement was entered into to sell the property and equipment of South Central Missouri Title Company, Inc for $252,000. In addition, South Central entered into a covenant not to compete agreement with the purchaser. Expense related to the sale totaled $61,512. As of the date of the sale, the assets sold had a net book value of $100,166. The majority of the sales price was in the form of a promissory note to South Central with a ve year maturity. The transaction closed on July 16, 2004. As a result of this sale, the subsidiary will no longer offer sales of title insurance or real estate closing services. The company accounted for this sale on the installment method because the initial investment by the buyer was not substantial enough to warrant full recognition of the gain. However, the recovery of the cost of the property is reasonably assured if the buyer defaults. The following schedule summarizes certain information for the transaction: Revenue Cost of Sale Deferred gain Deferred gain recognized during FY 2005 Deferred gain at June 30, 2005 $252,000 161,678 90,322 8,026 $82,296 Source: First Bancshares Form 10K, led 11/1/2005. 15 IAS No. 18, Appendix, paragraph 9, and FASB Statement No. 66, Accounting for Sales of Real Estate. c04.indd 125 9/17/08 11:28:42 AM 126 International Financial Statement Analysis The cost recovery method of revenue recognition is an appropriate alternative for many of the same situations as the installment method. Under the cost recovery method, the seller does not report any prot until the cash amounts paid by the buyerincluding principal and interest on any nancing from the sellerare greater than all the sellers costs of the property. Example 4-4 below provides an example of the differences between the installment method and the cost recovery method. Installment sales and cost recovery treatment of revenue recognition are rare for nancial reporting purposes, especially for assets other than real estate. IAS No. 18 provides that installment sales other than real estate generally require revenue to be recognized at the time of sale; however, it further provides that the guidance found in IAS No. 18 must be considered in light of local laws regarding the sale of goods in a particular country. EXAMPLE 4-4 The Installment and Cost Recovery Methods of Revenue Recognition Assume the total sales price and cost of a property are $2,000,000 and $1,100,000, respectively, so that the total prot to be recognized is $900,000. The amount of cash received by the seller as a down payment is $300,000, with the remainder of the sales price to be received over a 10-year period. It has been determined that there is signicant doubt about the ability and commitment of the buyer to complete all payments. How much prot will be recognized attributable to the down payment if: 1. The installment method is used? 2. The cost recovery method is used? Solution to 1. The installment method apportions the cash receipt between cost recovered and prot using the ratio of prot to sales value; here, this ratio equals $900,000 $2,000,000 0.45 or 45 percent. Therefore, the seller will recognize the following prot attributable to the down payment: 45 percent of $300,000 $135,000. Solution to 2. Under the cost recovery method of revenue recognition, the company would not recognize any prot attributable to the down payment because the cash amounts paid by the buyer still do not exceed the cost of $1,100,000. 3.2.3. Barter Revenue recognition issues related to barter transactions became particularly important as e-commerce developed. As an example, if Company A exchanges advertising space for computer equipment from Company B but no cash changes hands, can Company A and B both report revenue? Such an exchange is referred to as a barter transaction. An even more challenging revenue recognition issue evolved from barter transactions round-trip transactions. As an example, if Company A sells advertising services (or energy contracts, or commodities) to Company B and almost simultaneously buys an almost identical product from Company B, can Company A report revenue at the fair value of the product sold? Because the companys revenue would be approximately equal to its expense, the net effect of the transaction would have no impact on net income or cash ow. However, the c04.indd c04.indd 126 9/17/08 11:28:44 AM Chapter 4 Understanding the Income Statement 127 amount of revenue reported would be higher, and the amount of revenue can be important to a companys valuation. In the earlier stages of e-commerce, for example, some equity valuations were based on sales (because many early Internet companies reported no net income). Under IFRS, revenue from barter transactions must be measured based on the fair value of revenue from similar nonbarter transactions with unrelated parties (parties other than the barter partner).16 Similarly, the FASB states that revenue can be recognized at fair value only if a company has historically received cash payments for such services and can thus use this historical experience as a basis for determining fair value.17 3.2.4. Gross versus Net Reporting Another revenue recognition issue that became particularly important with the emergence of e-commerce is the issue of gross versus net reporting. Merchandising companies typically sell products that they purchased from a supplier. In accounting for their sales, the company records the amount of the sale proceeds as sales revenue and their cost of the products as the cost of goods sold. As Internet-based merchandising companies developed, many sold products that they had never held in inventory; they simply arranged for the supplier to ship the products directly to the end customer. In effect, many such companies were agents of the supplier company, and the net difference between their sales proceeds and their costs was equivalent to a sales commission. What amount should these companies record as their revenuesthe gross amount of sales proceeds received from their customers, or the net difference between sales proceeds and their cost? U.S. GAAP indicates that the approach should be based on the specic situation and provides guidance for determining when revenue should be reported gross versus net.18 To report gross revenues, the following criteria are relevant: The company is the primary obligor under the contract, bears inventory risk and credit risk, can choose its supplier, and has reasonable latitude to establish price. If these criteria are not met, the company should report revenues net. Example 4-5 provides an illustration. EXAMPLE 4-5 Gross versus Net Reporting of Revenues Flyalot has agreements with several major airlines to obtain airline tickets at reduced rates. The company pays only for tickets it sells to customers. In the most recent period, Flyalot sold airline tickets to customers over the internet for a total of $1.1 million. The cost of these tickets to Flyalot was $1 million. The companys direct selling costs were $2,000. Once the customers receive their ticket, the airline is responsible for providing all services associated with the customers ight. 1. Demonstrate the reporting of revenues under A. gross reporting. B. net reporting. 16 IASB, SIC Interpretation 31, RevenueBarter Transactions Involving Advertising Services, paragraph 5. See Emerging Issues Task Force EITF 99-17, Accounting for Advertising Barter Transactions. 18 See Emerging Issues Task Force EITF 99-19, Reporting Revenue Gross as a Principal versus Net as an Agent. 17 c04.indd 127 9/17/08 11:28:50 AM 128 International Financial Statement Analysis 2. Determine and justify the appropriate method for reporting revenues. Solution to 1. The table below shows how reporting would appear on a gross and a net basis. A. Gross Reporting Revenues B. Net Reporting $1,100,000 $100,000 Cost of sales 1,002,000 2,000 Gross margin $ 98,000 $ 98,000 Solution to 2. Flyalot should report revenue on a net basis. Flyalot pays only for tickets it sells to customers and thus did not bear inventory risk. In addition, the airlinenot Flyalotis the primary obligor under the contract. Revenues should be reported as $100,000. 3.3. Implications for Financial Analysis As we have seen, companies use a variety of revenue recognition methods. Furthermore, a single company may use different revenue recognition policies for different businesses. Companies disclose their revenue recognition policies in the footnotes to their nancial statement, often in the rst note. The following aspects of a companys revenue recognition policy are particularly relevant to nancial analysis: whether a policy results in recognition of revenue sooner rather than later (sooner is less conservative), and to what extent a policy requires the company to make estimates. In order to analyze a companys nancial statements, and particularly to compare one companys nancial statements with those of another company, it is helpful to understand any differences in their revenue recognition policies. Although it may not be possible to calculate the monetary effect of differences between particular companies revenue recognition policies and estimates, it is generally possible to characterize the relative conservatism of a companys policies and to qualitatively assess how differences in policies might affect nancial ratios. EXAMPLE 4-6 Revenue Recognition Policy for Motorola As disclosed in the footnotes to the nancial statements shown below (emphasis added), Motorola (NYSE: MOT) uses different revenue recognition policies depending on the type of revenue-producing activity, including product sales, long-term contracts, contracts involving unproven technology, revenue for services, and revenue for licensing agreements. c04.indd 128 9/17/08 11:28:53 AM Chapter 4 Understanding the Income Statement 129 Revenue Recognition: The Company recognizes revenue for product sales when title transfers, the risks and rewards of ownership have been transferred to the customer, the fee is xed and determinable, and collection of the related receivable is probable, which is generally at the time of shipment. Accruals are established, with the related reduction to revenue, for allowances for discounts and price protection, product returns and incentive programs for distributors and end customers related to these sales based on actual historical exposure at the time the related revenues are recognized. For long-term contracts, the Company uses the percentage-of-completion method to recognize revenues and costs based on the percentage of costs incurred to date compared to the total estimated contract costs. For contracts involving new unproven technologies, revenues and prots are deferred until technological feasibility is established, customer acceptance is obtained and other contract-specic terms have been completed. Provisions for losses are recognized during the period in which the loss rst becomes apparent. Revenue for services is recognized ratably over the contract term or as services are being performed. Revenue related to licensing agreements is recognized over the licensing period or at the time the Company has fullled its obligations and the fee to be received is xed and determinable. Source: Motorola 10-K nancial statement footnotes for the year ended 31 December 2004, as led with the SEC; emphasis added. EXAMPLE 4-7 Revenue Recognition of i2 Technologies On 9 June 2004, the SEC announced it had settled a securities fraud case against i2 Technologies (NASDAQ: ITWO) involving the misstatement of approximately $1 billion in revenues. The SEC announcement explains that the company recognized revenue up front on its software licenses, which was inappropriate because some of the software lacked complete functionality either for general use or for use by a particular customer. Source: SEC Accounting and Auditing Enforcement Release No. 2034. With familiarity of the basic principles of revenue recognition in hand, the next section begins a discussion of expense recognition. 4 . EXPENSE RECOGNITION Expenses are deducted against revenue to arrive at a companys net prot or loss. Under the IASB Framework, expenses are decreases in economic benets during the accounting period in the form of outows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants.19 19 IASB, Framework for the Preparation and Presentation of Financial Statements, paragraph 70. c04.indd 129 9/17/08 11:28:57 AM 130 International Financial Statement Analysis The IASB Framework also states: The denition of expenses encompasses losses as well as those expenses that arise in the course of the ordinary activities of the enterprise. Expenses that arise in the course of the ordinary activities of the enterprise include, for example, cost of sales, wages and depreciation. They usually take the form of an outow or depletion of assets such as cash and cash equivalents, inventory, property, plant and equipment. Losses represent other items that meet the denition of expenses and may, or may not, arise in the course of the ordinary activities of the enterprise. Losses represent decreases in economic benets and as such they are no different in nature from other expenses. Hence, they are not regarded as a separate element in this Framework. Losses include, for example, those resulting from disasters such as re and ood.20 Similar to the issues with revenue recognition, in a simple hypothetical scenario, expense recognition would not be an issue. For instance, assume a company purchased inventory for cash and sold the entire inventory in the same period. When the company paid for the inventory, absent indications to the contrary, it is clear that the inventory cost has been incurred and should be recognized as an expense (cost of goods sold) in the nancial records. Assume also that the company paid all operating and administrative expenses in cash within each accounting period. In such a simple hypothetical scenario, no issues of expense recognition would arise. In practice, however, as with revenue recognition, determining when expenses should be recognized can be somewhat more complex. 4.1. General Principles In general, a company recognizes expenses in the period that it consumes (i.e., uses up) the economic benets associated with the expenditure, or loses some previously recognized economic benet.21 A general principle of expense recognition is the matching principle, also known as the matching of costs with revenues.22 Under the matching principle, a company directly matches some expenses (e.g., cost of goods sold) with associated revenues. Unlike the simple scenario in which a company purchases inventory and sells all of the inventory within the same accounting period, in practice, it is more likely that some of the current periods sales are made from inventory purchased in a previous period. It is also more likely that some of the inventory purchased in the current period will remain unsold at the end of the current period and so will be sold in the following period. The matching principle requires that the company match the cost of goods sold with the revenues of the period. Period costs, expenditures that less directly match the timing of revenues, are reected in the period when a company makes the expenditure or incurs the liability to pay. Administrative expenses are an example of period costs. Other expenditures that also less directly match the timing of revenues relate more directly to future expected benets; in this 20 Ibid., paragraphs 7880. Ibid., paragraph 94. 22 Ibid., paragraph 95. 21 c04.indd 130 9/17/08 11:29:03 AM Chapter 4 131 Understanding the Income Statement case, the expenditures are allocated systematically with the passage of time. An example is depreciation expense (discussed below). Examples 4-8 and 4-9 demonstrate the matching principle applied to inventory and cost of goods sold. EXAMPLE 4-8 Revenues The Matching of Inventory Costs with Kahn Distribution Limited (KDL) purchases inventory items for resale. During 2006, Kahn had the following transactions: Inventory Purchases First quarter 2,000 units at $40 per unit Second quarter 1,500 units at $41 per unit Third quarter 2,200 units at $43 per unit Fourth quarter 1,900 units at $45 per unit Total 7,600 units at a total cost of $321,600 Inventory sales during the year were 5,600 units at $50 per unit. KDL determines that there were 2,000 remaining units of inventory and specically identies that 1,900 were those purchased in the fourth quarter and 100 were purchased in the third quarter. What are the revenue and expense associated with these transactions during 2006? Solution. The revenue for 2006 would be $280,000 (5,600 units $50 per unit). Initially, the total cost of the goods purchased would be recorded as inventory (an asset) in the amount of $321,600. During 2006, the cost of the 5,600 units sold would be expensed (matched against the revenue) while the cost of the 2,000 remaining unsold units would remain in inventory as follows: Cost of Goods Sold From the rst quarter 2,000 units at $40 per unit $ 80,000 From the second quarter 1,500 units at $41 per unit $61,500 From the third quarter 2,100 units at $43 per unit Total cost of goods sold $90,300 $231,800 Cost of Goods Remaining in Inventory From the third quarter From the fourth quarter 1,900 units at $45 per unit Total remaining (or ending) inventory cost To conrm that total costs are accounted for: $231,800 c04.indd 131 $4,300 100 units at $43 per unit $85,500 $89,800 $89,800 $321,600 9/17/08 11:29:03 AM 132 International Financial Statement Analysis The cost of the goods sold would be expensed against the revenue of $280,000 as follows: Revenue Cost of goods sold Gross prot $280,000 231,800 $ 48,200 The remaining inventory amount of $89,800 will be matched against revenue in a future year when the inventory items are sold. EXAMPLE 4-9 Alternative Inventory Costing Methods In Example 4-8, KDL was able to specically identify which inventory items were sold and which remained in inventory to be carried over to later periods. That method is called the specic identication method. It is not always possible to specically identify which items were sold, so the accounting standards permit the assignment of inventory costs to costs of goods sold and to ending inventory using cost ow assumptions. Under both IFRS and U.S. GAAP, companies may use either of two methods to assign costs: the rst in, rst out (FIFO) method, or the weighted average cost method. Under the FIFO method, it is simply assumed that the earliest items purchased were sold rst. Ending inventory would, therefore, include only the latest purchases. It turns out that those items specically identied as sold in Example 4-8 were also the rst items purchased, so in this example, under FIFO, the cost of goods sold would also be $231,800, calculated as above. The weighted average cost method simply averages the total available costs over the total available units. For KDL, the weighted average cost would be $ 321,600/7,600 units $42.3158 per unit Cost of goods sold using the weighted average cost method would be 5,600 units at $42.3158 $236,968 Ending inventory using the weighted average cost method would be 2,000 units at $42.3158 $ 84,632 Another method is available under U.S. GAAP but is not permitted under IFRS. This method is the last in, rst out (LIFO) method. Under the LIFO method, it is assumed that the most recent items purchased were sold rst. Although this may seem contrary to common sense, it is logical in certain circumstances. For example, lumber in a lumberyard may be stacked up with the oldest lumber on the bottom. As lumber c04.indd c04.indd 132 9/17/08 11:29:14 AM Chapter 4 133 Understanding the Income Statement is sold, it is sold from the top of the stack, so the last lumber in is the rst lumber out. Theoretically, a company should choose this method under U.S. GAAP if the physical inventory ows in this manner.23 Under the LIFO method, in the KDL example, it would be assumed that the 2,000 units remaining in ending inventory would have come from the rst quarters purchases:24 Ending inventory 2,000 units at $40 per unit $80,000 The remaining costs would be allocated to cost of goods sold under LIFO: Total costs of $321,600 less $80,000 remaining in ending inventory $241,600 Alternatively, the cost of the last 5,600 units purchased is allocated to cost of goods sold under LIFO: 1,900 units at $45 per unit 2,200 units at $43 per unit 1,500 units at $41 per unit $241,600 Exhibit 4-7 summarizes and compares inventory costing methods. EXHIBIT 4-7 Summary Table on Inventory Costing Methods Cost of Goods Sold When Prices Are Rising, Relative to Other Two Methods Ending Inventory When Prices Are Rising, Relative to Other Two Methods Method Description FIFO (rst in, rst out) Assumes that earliest items purchased were sold rst Lowest Highest LIFO (last in, rst out) Assumes most recent items purchased were sold rst Highesta Lowesta Weighted average cost Averages total costs over total units available Middle Middle a Assumes no LIFO layer liquidation. LIFO layer liquidation occurs when the volume of sales rises above the volume of recent purchases so that some sales are made from existing, relatively low-priced inventory rather than from more recent purchases. 23 Practically, the reason some companies choose to use LIFO in the United States is to reduce taxes. When prices and inventory quantities are rising, LIFO will normally result in lower income and hence lower taxes. U.S. tax regulations require that if LIFO is used on a companys tax return, it must also be used on the companys GAAP nancial statements. 24 If data on the precise timing of quarterly sales were available, the answer would differ because the cost of goods sold would be determined during the quarter rather than at the end of the quarter. c04.indd 133 9/17/08 11:29:24 AM 134 International Financial Statement Analysis 4.2. Issues in Expense Recognition The following sections cover applications of the principles of expense recognition to certain common situations. 4.2.1. Doubtful Accounts When a company sells its products or services on credit, it is likely that some customers will ultimately default on their obligations (i.e., fail to pay). At the time of the sale, it is not known which customer will default. (If it were known that a particular customer would ultimately default, presumably a company would not sell on credit to that customer.) One possible approach to recognizing credit losses on customer receivables would be for the company to wait until such time as a customer defaulted and only then recognize the loss (direct write-off method). Such an approach would usually not be consistent with generally accepted accounting principles. Under the matching principle, at the time revenue is recognized on a sale, a company is required to record an estimate of how much of the revenue will ultimately be uncollectible. Companies make such estimates based on previous experience with uncollectible accounts. Such estimates may be expressed as a proportion of the overall amount of sales, the overall amount of receivables, or the amount of receivables overdue by a specic amount of time. The company records its estimate of uncollectible amounts as an expense on the income statement, not as a direct reduction of revenues. 4.2.2. Warranties At times, companies offer warranties on the products they sell. If the product proves decient in some respect that is covered under the terms of the warranty, the company will incur an expense to repair or replace the product. At the time of sale, the company does not know the amount of future expenses it will incur in connection with its warranties. One possible approach would be for a company to wait until actual expenses are incurred under the warranty and to reect the expense at that time. However, this would not result in a matching of the expense with the associated revenue. Under the matching principle, a company is required to estimate the amount of future expenses resulting from its warranties, to recognize an estimated warranty expense in the period of the sale, and to update the expense as indicated by experience over the life of the warranty. 4.2.3. Depreciation and Amortization Companies commonly incur costs to obtain long-lived assets. Long-lived assets are assets expected to provide economic benets over a future period of time greater than one year. Examples are land (property), plant, equipment, and intangible assets (assets lacking physical substance) such as trademarks. The costs of most long-lived assets are allocated over the period of time during which they provide economic benets. The two main types of longlived assets whose costs are not allocated over time are land and those intangible assets with indenite useful lives. Depreciation is the process of systematically allocating costs of long-lived assets over the period during which the assets are expected to provide economic benets. Depreciation is the term commonly applied to this process for physical long-lived assets such as plant and equipment (land is not depreciated), and amortization is the term commonly applied to this c04.indd c04.indd 134 9/17/08 11:29:27 AM Chapter 4 Understanding the Income Statement 135 process for intangible long-lived assets with a nite useful life.25 Examples of intangible longlived assets with a nite useful life include an acquired mailing list, an acquired patent with a set expiration date, and an acquired copyright with a set legal life. The term amortization is also commonly applied to the systematic allocation of a premium or discount relative to the face value of a xed-income security over the life of the security. IAS No. 16, Property, Plant, and Equipment, requires that the depreciable amount (cost less residual value) be allocated on a systematic basis over the remaining useful life of the asset. The method used to compute depreciation must reect the pattern over which the economic benets of the asset are expected to be consumed. IAS No. 16 does not prescribe a particular method for computing depreciation but notes that several methods are commonly used, such as the straight-line method, diminishing balance method (accelerated depreciation), and the units of production method (depreciation varies depending upon production or usage). The straight-line method allocates evenly the cost of long-lived assets less estimated residual value over the estimated useful life of an asset. (The term straight line derives from the fact that the annual depreciation expense, if represented as a line graph over time, would be a straight line. In addition, a plot of the cost of the asset minus the cumulative amount of annual depreciation expense, if represented as a line graph over time, would be a straight line with a negative downward slope.) Calculating depreciation and amortization requires two signicant estimates: the estimated useful life of an asset and the estimated residual value (also known as salvage value) of an asset. Under IAS No. 16, the residual value is the amount that the company expects to receive upon sale of the asset at the end of its useful life. Example 4-10 assumes that an item of equipment is depreciated using the straight-line method and illustrates how the annual depreciation expense varies under different estimates of the useful life and estimated residual value of an asset. As shown, annual depreciation expense is sensitive to both the estimated useful life and to the estimated residual value. EXAMPLE 4-10 Sensitivity of Annual Depreciation Expense to Varying Estimates of Useful Life and Residual Value Using the straight-line method of depreciation, annual depreciation expense is calculated as Cost Residual value _________________ Estimated useful life Assume the cost of an asset is $10,000. If, for example, the residual value of the asset is estimated to be $0 and its useful life is estimated to be 5 years, the annual depreciation expense under the straight-line method would be ($10,000 $0)/5 years $2,000. 25 Under SFAS No. 142, intangible assets with indenite life are not amortized. Instead, they are tested at least annually for impairment (i.e., if the current value of an intangible asset is materially lower than its value in the companys books, the value of the asset is considered to be impaired and its value must be decreased). c04.indd c04.indd 135 9/17/08 11:29:27 AM 136 International Financial Statement Analysis In contrast, holding the estimated useful life of the asset constant at 5 years but increasing the estimated residual value of the asset to $4,000 would result in annual depreciation expense of only $1,200 [calculated as ($10,000 $4,000)/5 years]. Alternatively, holding the estimated residual value at $0 but increasing the estimated useful life of the asset to 10 years would result in annual depreciation expense of only $1,000 [calculated as ($10,000 $0)/10 years]. Exhibit 4-8 shows annual depreciation expense for various combinations of estimated useful life and residual value. EXHIBIT 4-8 Annual Depreciation Expense (in dollars) Estimated Useful Life (years) Estimated Residual Value 0 1,000 2,000 3,000 4,000 5,000 2 5,000 4,500 4,000 3,500 3,000 2,500 4 2,500 2,250 2,000 1,750 1,500 1,250 5 2,000 1,800 1,600 1,400 1,200 1,000 8 1,250 1,125 1,000 875 750 625 10 1,000 900 800 700 600 500 Generally, alternatives to the straight-line method of depreciation are called accelerated methods of depreciation because they accelerate (i.e., speed up) the timing of depreciation. Accelerated depreciation methods allocate a greater proportion of the cost to the early years of an assets useful life. These methods are appropriate if the plant or equipment is expected to be used up faster in the early years (e.g., an automobile). A commonly used accelerated method is the diminishing balance method, as mentioned in IAS No. 16 (also known as the declining balance method). The diminishing balance method is demonstrated in Example 4-11. EXAMPLE 4-11 An Illustration of Diminishing Balance Depreciation Assume the cost of computer equipment was $11,000, the estimated residual value is $1,000, and the estimated useful life is ve years. Under the diminishing or declining balance method, the rst step is to determine the straight-line rate, the rate at which the asset would be depreciated under the straight-line method. This rate is measured as 100 percent divided by the useful life or 20 percent for a ve-year useful life. Under the straight-line method, 1/5 or 20 percent of the depreciable cost of the asset (here, $11,000 $1,000 $10,000) would be expensed each year for ve years: The depreciation expense would be $2,000 per year. c04.indd 136 9/17/08 11:29:30 AM Chapter 4 137 Understanding the Income Statement The next step is to determine an acceleration factor that approximates the pattern of the assets wear. Common acceleration factors are 150 percent and 200 percent. The latter is known as double-declining balance depreciation because it depreciates the asset at double the straight-line rate. Using the 200 percent acceleration factor, the diminishing balance rate would be 40 percent (20 percent 2.0). This rate is then applied to the remaining undepreciated balance of the asset each period (known as the net book value). At the beginning of the rst year, the net book value is $11,000. Depreciation expense for the rst full year of use of the asset would be 40 percent of $11,000, or $4,400. Under this method, the residual value, if any, is generally not used in the computation of the depreciation each period (the 40 percent is applied to $11,000 rather than to $11,000 minus residual value). However, the company will stop taking depreciation when the salvage value is reached. At the beginning of Year 2, the net book value is measured as Asset cost Less: Accumulated depreciation Net book value $11,000 (4,400) $ 6,600 For the second full year, depreciation expense would be $6,600 40 percent, or $2,640. At the end of the second year (i.e., beginning of the third year), a total of $7,040 ($4,400 $2,640) of depreciation would have been recorded. So, the remaining net book value at the beginning of the third year would be Asset cost Less: Accumulated depreciation Net book value $11,000 (7,040) $ 3,960 For the third full year, depreciation would be $3,960 40 percent, or $1,584. At the end of the third year, a total of $8,624 ($4,400 $2,640 $1,584) of depreciation would have been recorded. So, the remaining net book value at the beginning of the fourth year would be Asset cost Less: Accumulated depreciation Net book value $11,000 (8,624) $ 2,376 For the fourth full year, depreciation would be $2,376 40 percent, or $950. At the end of the fourth year, a total of $9,574 ($4,400 $2,640 $1,584 $950) of depreciation would have been recorded. So, the remaining net book value at the beginning of the fth year would be Asset cost Less: Accumulated depreciation Net book value c04.indd 137 $11,000 (9,574) $ 1,426 9/17/08 11:29:36 AM 138 International Financial Statement Analysis For the fth year, if deprecation were determined as in previous years, it would amount to $570 ($1,426 40 percent). However, this would result in a remaining net book value of the asset below its estimated residual value of $1,000. So, instead, only $426 would be depreciated, leaving a $1,000 net book value at the end of the fth year. Asset cost $11,000 Less: Accumulated depreciation (10,000) Net book value $ 1,000 Companies often use a zero or small residual value, which creates problems for diminishing balance depreciation because the asset never fully depreciates. In order to fully depreciate the asset over the initially estimated useful life when a zero or small residual value is assumed, companies often adopt a depreciation policy that combines the diminishing balance and straight-line methods. An example would be a deprecation policy of using double-declining balance depreciation and switching to the straight-line method halfway through the useful life. Under accelerated depreciation methods, there is a higher depreciation expense in early years relative to the straight-line method. This results in higher expenses and lower net income in the early depreciation years. In later years, there is a reversal with accelerated depreciation expense lower than straight-line depreciation. Accelerated deprecation is sometimes referred to as a conservative accounting choice because it results in lower net income in the early years of asset use. For those intangible assets that must be amortized (those with an identiable useful life), the process is the same as for depreciation; only the name of the expense is different. IAS No. 38, Intangible Assets, states that if a pattern cannot be determined over the useful life, then the straight-line method should be used. In most cases under international accounting standards and U.S. GAAP, amortizable intangible assets are amortized using the straight-line method with no residual value. Goodwill26 and intangible assets with indenite life are not amortized. Instead, they are tested at least annually for impairment (i.e., if the current value of an intangible asset or goodwill is materially lower than its value in the companys books, the value of the asset is considered to be impaired and its value in the companys books must be decreased). In summary, to calculate depreciation and amortization, a company must choose a method, estimate the assets useful life, and estimate residual value. Clearly, different choices have a differing effect on depreciation or amortization expense and, therefore, on reported net income. 26 Goodwill is recorded in acquisitions and is the amount by which the price to purchase an entity exceeds the amount of net identiable assets acquired (the total amount of identiable assets acquired less liabilities assumed). c04.indd 138 9/17/08 11:29:48 AM Chapter 4 Understanding the Income Statement 139 4.3. Implications for Financial Analysis A companys estimates for doubtful accounts and/or for warranty expenses can affect its reported net income. Similarly, a companys choice of depreciation or amortization method, estimates of assets useful lives, and estimates of assets residual values can affect reported net income. These are only a few of the choices and estimates that affect a companys reported net income. As with revenue recognition policies, a companys choice of expense recognition can be characterized by its relative conservatism. A policy that results in recognition of expenses later rather than sooner is considered less conservative. In addition, many items of expense require the company to make estimates that can signicantly affect net income. Analysis of a companys nancial statements, and particularly comparison of one companys nancial statements with those of another, requires an understanding of differences in these estimates and their potential impact. If, for example, a company shows a signicant year-to-year change in its estimates of uncollectible accounts as a percentage of sales, warranty expenses as percentage of sales, or estimated useful lives of assets, the analyst should seek to understand the underlying reasons. Do the changes reect a change in business operations (e.g., lower estimated warranty expenses reecting recent experience of fewer warranty claims because of improved product quality)? Or are the changes seemingly unrelated to changes in business operations and thus possibly a signal that a company is manipulating estimates in order to achieve a particular effect on its reported net income? As another example, if two companies in the same industry have dramatically different estimates for uncollectible accounts as a percentage of their sales, warranty expenses as a percentage of sales, or estimated useful lives as a percentage of assets, it is important to understand the underlying reasons. Are the differences consistent with differences in the two companies business operations (e.g., lower uncollectible accounts for one company reecting a different, more creditworthy customer base or possibly stricter credit policies)? Another difference consistent with differences in business operations would be a difference in estimated useful lives of assets if one of the companies employs newer equipment. Or, alternatively, are the differences seemingly inconsistent with differences in the two companies business operations, possibly signaling that a company is manipulating estimates? Information about a companys accounting policies and signicant estimates are described in the footnotes to the nancial statements and in the management discussion and analysis section of a companys annual report. When possible, the monetary effect of differences in expense recognition policies and estimates can facilitate more meaningful comparisons with a single companys historical performance or across a number of companies. An analyst can use the monetary effect to adjust the reported expenses so that they are on a comparable basis. Even when the monetary effects of differences in policies and estimates cannot be calculated, it is generally possible to characterize the relative conservatism of the policies and estimates and, therefore, to qualitatively assess how such differences might affect reported expenses and thus nancial ratios. 5 . NONRECURRING ITEMS AND NONOPERATING ITEMS From a companys income statements, we can see its earnings from last year and in the previous year. Looking forward, the question is: What will the company earn next year and in the years after? c04.indd c04.indd 139 9/17/08 11:29:51 AM 140 International Financial Statement Analysis To assess a companys future earnings, it is helpful to separate those prior years items of income and expense that are likely to continue in the future from those items that are less likely to continue.27 Some items from prior years are clearly not expected to continue in the future periods and are separately disclosed on a companys income statement. Two such items are (1) discontinued operations, and (2) extraordinary items (the latter category is no longer permitted under IFRS). These two items, if applicable, must be reported separately from continuing operations.28 For other items on a companys income statement, such as unusual items, accounting changes, and nonoperating income, the likelihood of their continuing in the future is somewhat less clear and requires the analyst to make some judgments. 5.1. Discontinued Operations When a company disposes of or establishes a plan to dispose of one of its component operations and will have no further involvement in the operation, the income statement reports separately the effect of this disposal as a discontinued operation under both IFRS and U.S. GAAP. Financial standards provide various criteria for reporting the effect separately, which are generally that the discontinued component must be separable both physically and operationally.29 Because the discontinued operation will no longer provide earnings (or cash ow) to the company, an analyst can eliminate discontinued operations in formulating expectations about a companys future nancial performance. In Exhibit 4-2, Kraft reported a loss from discontinued operations of $4 million in 2004 and earnings of $97 million in both 2003 and 2002. In Footnote 5 of its nancial statements, Kraft explains that it sold substantially all of its sugar confectionary business (including brands such as Life Savers and Altoids). The $4 million loss and $97 million earnings refer to the amount of loss (earnings) of the sugar confectionary business in each of those years. 5.2. Extraordinary Items IAS No. 1 prohibits classication of any income or expense items as being extraordinary.30 Under U.S. GAAP, an extraordinary item is one that is both unusual in nature and infrequent in occurrence. Extraordinary items are presented separately on the income statement and allow a reader of the statements to see that these items are not part of a companys operating activities and are not expected to occur on an ongoing basis. Extraordinary items are shown net of tax and appear on the income statement below discontinued operations. An example of an extraordinary item is provided in Example 4-12. 27 In business writing, items expected to continue in the future are often described as persistent or permanent, whereas those not expected to continue are described as transitory. 28 These requirements apply to material amounts. 29 IFRS No. 5, Non-Current Assets Held for Sale and Discontinued Operations, paragraphs 3133. 30 IAS No. 1, Presentation of Financial Statements, paragraph 85, effective 2005. In prior years, classication of items as extraordinary was permitted. c04.indd 140 9/17/08 11:29:51 AM Chapter 4 Understanding the Income Statement 141 EXAMPLE 4-12 Extraordinary Gain: Purchase of a Business for Less than the Fair Value of the Identiable Net Assets Vicon Industries in its annual report made the following disclosure: On October 1, 2004, the Company entered into an agreement to purchase all of the operating assets of Videotronic Infosystems GmbH (Videotronic), a Germany based video system supplier which was operating under insolvency protection, for 700,000 Eurodollars [sic] (approximately $868,000). . . . During the year ended September 30, 2005, the Company recognized a $211,000 extraordinary gain on the recovery of Videotronic net assets in excess of their allocated purchase price. Such gain includes adjustments to assigned values of accounts receivable, inventories, trade payables and severance liabilities. Source: Vicon Industries 10-K Report for scal year ended 30 September 2005, led 29 December 2005: Note 15. Companies apply judgment to determine whether an item is extraordinary based on guidance from accounting standards (Accounting Practices Board Opinion No. 30). Judgment on whether an item is unusual in nature requires consideration of the companys environment, including its industry and geography. Determining whether an item is infrequent in occurrence is based on expectations of whether it will occur again in the near future. Standard setters offer specic guidance in some cases. For example, following Hurricanes Katrina and Rita in 2005, the American Institute of Certied Public Accountants issued Technical Practice Aid 5400.05, which states (the material in square brackets has been added): A natural disaster [such as a hurricane, tornado, re, or earthquake] of a type that is reasonably expected to re-occur would not meet both conditions [for classication as an extraordinary item]. Given the requirements for classication of an item as extraordinaryunusual and infrequentan analyst can generally eliminate extraordinary items from expectations about a companys future nancial performance unless there is some indication that such an extraordinary item may reoccur. 5.3. Unusual or Infrequent Items Items that do not meet the denition of extraordinary are shown as part of a companys continuing operations. Items that are unusual or infrequentbut not bothcannot be shown as extraordinary. For example, restructuring charges, such as costs to close plants and employee termination costs, are considered part of a companys ordinary activities. As another example, gains and losses arising when a company sells an asset or part of a business for more or less c04.indd 141 9/17/08 11:29:52 AM 142 International Financial Statement Analysis than its carrying value are also disclosed separately on the income statement but are not considered extraordinary because such sales are considered ordinary business activities.31 Highlighting the unusual or infrequent nature of these items assists an analyst in judging the likelihood that such items will reoccur. In Exhibit 4-2, Krafts income statement showed several such infrequent but not unusual items, all of which are included as part of operating income. The company reported a $111 million loss in 2002 from integration costs and a loss on sale of a food factory, followed by a $13 million reduction of these costs in 2003. In Note 14 of its nancial statements, the company explains that these costs arose from consolidating production lines in North America. Also, the company reported $142 million, $6 million, and $603 million in 2002, 2003, and 2004, respectively, for asset impairment and exit costs and explains in the footnotes that the large costs in 2004 are related to its restructuring program and reect asset disposals, severance, and other implementation aspects. Finally, Kraft reported an $80 million gain on the sale of businesses in 2002 and a $31 million gain in 2003, followed by a $3 million loss on the sale of businesses in 2004. In Note 14 of its nancial statements, Kraft explains that the $80 million gain in 2002 arose from the sale of its Latin American bakery ingredient business and several small food businesses; the $31 million gain in 2003 arose from the sale of a European rice business and an Italian fresh cheese business; and the $3 million loss in 2004 arose from the sale of a Brazilian snack nuts business and Norwegian candy business trademarks. An analyst would seek to understand how these disposals t with the companys strategy and what effect, if material, these disposals would have on the companys future operations. Generally, in forecasting future operations, an analyst would assess whether the items reported are likely to reoccur and also possible implications for future earnings. It is generally not advisable simply to ignore all unusual items. 5.4. Changes in Accounting Standards At times, standard setters issue new pronouncements that require companies to change accounting principles. In other cases, changes in accounting principles (e.g., from one acceptable inventory costing method to another) are made for other reasons, such as providing a better reection of the companys performance. Changes in accounting principles are reported through retrospective application,32 unless it is impractical to do so. Retrospective application means that the nancial statements for all scal years shown in a companys nancial report are presented as if the newly adopted accounting principle had been used throughout the entire period. Footnotes to the nancial statements describe the change and explain the justication for the change. Because changes in accounting principles are retrospectively applied, the nancial statements that appear within a nancial report are comparable. So, if a companys annual report for 2006 includes its nancial statements for scal years 2004, 2005, and 2006, all of these statements will be comparable. 31 In its nancial statement footnotes, Groupe Danone provides a reconciliation between operating income under French GAAP, which excludes certain exceptional items (such as gains and losses on disposals), and U.S. GAAP. 32 IAS No. 8, Accounting Policies, Changes in Accounting Estimates and Errors, and FASB Financial Accounting Statement No. 154, Accounting Changes and Error Corrections. c04.indd 142 9/17/08 11:29:55 AM Chapter 4 Understanding the Income Statement 143 In years prior to 2005, under both IFRS and U.S. GAAP, the cumulative effect of changes in accounting policies was typically shown at the bottom of the income statement in the year of change instead of using retrospective application. It is possible that future accounting standards may occasionally require a company to report the change differently than retrospective application. Footnote disclosures are required to explain how the transition from the old standard to the new one was handled. During the period when companies make the transition from the old standard to the new, an analyst would examine disclosures to ensure comparability across companies. In contrast to changes in accounting policies (such as whether to expense the cost of employee stock options), companies sometimes make changes in accounting estimates (such as the useful life of a depreciable asset). Changes in accounting estimates are handled prospectively, with the change affecting the nancial statements for the period of change and future periods.33 No adjustments are made to prior statements, and the adjustment is not shown on the face of the income statement. Signicant changes should be disclosed in the footnotes. Another possible adjustment is a correction of an error for a prior period (e.g., in nancial statements issued for an earlier year). This cannot be handled by simply adjusting the current period income statement. Correction of an error for a prior period is handled by restating the nancial statements (including the balance sheet, statement of owners equity, and cash ow statement) for the prior periods presented in the current nancial statements.34 Footnote disclosures are required regarding the error. These disclosures should be examined carefully because they may reveal weaknesses in the companys accounting systems and nancial controls. 5.5. Nonoperating Items: Investing and Financing Activities Nonoperating items are reported separately from operating income. For example, if a nonnancial service company invests in equity or debt securities issued by another company, any interest, dividends, or prots from sales of these securities will be shown as nonoperating income. In general, for nonnancial services companies,35 nonoperating income that is disclosed separately on the income statement (or in the notes) includes amounts earned through investing activities. Among nonoperating items on the income statement (or accompanying notes), nonnancial service companies also disclose the interest expense on their debt securities, including amortization of any discount or premium. The amount of interest expense is related to the amount of a companys borrowings and is generally described in the nancial footnotes. For nancial service companies, interest income and expense are likely components of operating activities. In practice, investing and nancing activities may be disclosed on a net basis, with the components disclosed separately in the footnotes. In its income statement for 2004, Kraft, for example, disclosed net interest and other debt expense of $666 million. The nancial statement footnotes (not shown) further disclose that Krafts total interest expense was $679 million and interest income was $13 million, thus the net $666 million. Groupe Danones footnotes provide similar disclosures. 33 Ibid. Ibid. 35 Examples of nancial services rms are insurance companies, banks, brokers, dealers, and investment companies. 34 c04.indd 143 9/17/08 11:29:55 AM 144 International Financial Statement Analysis For purposes of assessing a companys future performance, the amount of nancing expense will depend on the companys nancing policy (target capital structure) and borrowing costs. The amount of investing income will depend on the purpose and success of investing activities. For a nonnancial company, a signicant amount of nancial income would typically warrant further exploration. What are the reasons underlying the companys investments in the securities of other companies? Is the company simply investing excess cash in short-term securities to generate income higher than cash deposits, or is the company purchasing securities issued by other companies for strategic reasons, such as access to raw material supply or research? 6 . EARNINGS PER SHARE One metric of particular importance to an equity investor is earnings per share (EPS). EPS is an input into ratios such as the price/earnings ratio. Additionally, each shareholder in a company owns a different number of shares. A presentation of EPS, therefore, enables each shareholder to compute his or her share of the companys earnings. Under IFRS, IAS No. 33, Earnings per Share, requires the presentation of EPS on the face of the income statement for net prot or loss (net income) and prot or loss (income) from continuing operations. Similar presentation is required under U.S. GAAP by Financial Accounting Statement No. 128, Earnings per Share. This section outlines the calculations for EPS and explains how the calculation differs for a simple versus complex capital structure. 6.1. Simple versus Complex Capital Structure A companys capital is composed of its equity and debt. Some types of equity have preference over others, and some debt (and other instruments) may be converted into equity. Under IFRS, the type of equity for which EPS is presented are ordinary shares. Ordinary shares are those equity shares that are subordinate to all other types of equity. This is the basic ownership of the companythe equity holders who are paid last in a liquidation of the company and who benet the most when the company does well. Under U.S. GAAP, this equity is referred to as common stock or common shares, reecting U.S. language usage. The terms ordinary shares, common stock, and common shares are used equivalently in the remaining discussion. When a company has any securities that are potentially convertible into common stock, it is said to have a complex capital structure. Specic examples of securities that are potentially convertible into common stock include convertible bonds, convertible preferred stock, employee stock options, and warrants.36 If a companys capital structure does not include securities that are potentially convertible into common stock, it is said to have a simple capital structure. The distinction between simple versus complex capital structure is relevant to the calculation of EPS because any securities that are potentially convertible into common stock 36 A warrant is a call option typically attached to securities issued by a company, such as bonds. A warrant gives the holder the right to acquire the companys stock from the company at a specied price within a specied time period. IFRS and U.S. GAAP standards regarding earnings per share apply equally to call options, warrants, and equivalent instruments. c04.indd 144 9/17/08 11:29:56 AM Chapter 4 Understanding the Income Statement 145 could, as a result of conversion, potentially dilute (i.e., decrease) EPS. Information about such a potential dilution is valuable to a companys current and potential shareholders; therefore, accounting standards require companies to disclose what their EPS would be if all dilutive securities were converted into common stock. The EPS that would result if all dilutive securities were converted is called diluted EPS. In contrast, basic EPS is calculated using the actual earnings available to common stock and the weighted average number of shares outstanding. Companies are required to report both their basic EPS and their diluted EPS. In Exhibit 4-2, Kraft reported basic EPS of $1.56 and diluted EPS of $1.55 for 2004, lower than EPS (from continuing operations) of $1.95 for 2003. In Exhibit 4-1, Danone reported basic EPS of 1.26 and diluted EPS of 1.25 for 2004, much lower than 2003. An analyst would try to determine the causes underlying the changes in EPS, a topic we will address following an explanation of the calculations of both basic and diluted EPS. 6.2. Basic EPS Basic EPS is the amount of income available to common shareholders divided by the weighted average number of common shares outstanding over a period. The amount of income available to common shareholders is the amount of net income remaining after preferred dividends (if any) have been paid. Thus, the formula to calculate basic EPS is: Basic EPS Net income Preferred dividends ______________________________________ Weighted average number of shares outstanding (4-1) The weighted average number of shares outstanding is a time weighting of common shares outstanding, and the methodology applies to calculating diluted EPS. As an example, assume a company began the year with 2,000,000 shares outstanding and repurchased 100,000 shares on 1 July. The weighted average number of shares outstanding would be the sum of 2,000,000 shares 1/2 year 1,900,000 shares 1/2 year, or 1,950,000 shares. So, the company would use 1,950,000 shares in calculating its basic EPS. If the number of shares of common stock increases as a result of a stock dividend, stock bonus, or a stock split (all three represent the receipt of additional shares by existing shareholders), the EPS calculation reects the change retroactively to the beginning of the period. Examples of a basic EPS computation are presented in Examples 4-13, 4-14, and 4-15. EXAMPLE 4-13 A Basic EPS Calculation (1) For the year ended 31 December 2006, Shopalot Company had net income of $1,950,000. The company had an average of 1,500,000 shares of common stock outstanding, no preferred stock, and no convertible securities. What was Shopalots basic EPS? Solution. Shopalots basic EPS was $1.30, calculated as $1,950,000 divided by 1,500,000 shares. c04.indd 145 9/17/08 11:29:56 AM 146 International Financial Statement Analysis EXAMPLE 4-14 A Basic EPS Calculation (2) For the year ended 31 December 2006, Angler Products had net income of $2,500,000. The company declared and paid $200,000 of dividends on preferred stock. The company also had the following common stock share information: Shares outstanding on 1 January 2006 1,000,000 Shares issued on 1 April 2006 200,000 Shares repurchased (treasury shares) on 1 October 2006 Shares outstanding on 31 December 2006 (100,000) 1,100,000 1. What is the companys weighted average number of shares outstanding? 2. What is the companys basic EPS? Solution to 1. The weighted average number of shares outstanding is determined by the length of time each quantity of shares was outstanding: 1,000,000 (3 months/12 months) 250,000 1,200,000 (6 months/12 months) 600,000 1,100,000 (3 months/12 months) 275,000 Weighted average number of shares outstanding 1,125,000 Solution to 2. Basic EPS is (Net income Preferred dividends)/Weighted average number of shares ($2,500,000 $200,000)/1,125,000 $2.04 EXAMPLE 4-15 A Basic EPS Calculation (3) Assume the same facts as in Example 4-14 except that on 1 December 2006, the company institutes a two-for-one stock split. Each shareholder receives two shares in exchange for each current share that he or she owns. What is the companys basic EPS? Solution. For EPS calculation purposes, a stock split is treated as if it occurred at the beginning of the period. The weighted average number of shares would, therefore, be 2,250,000, and the basic EPS would be $1.02. 6.3. Diluted EPS If a company has a simple capital structure (i.e., one with no potentially dilutive securities), then its basic EPS is equal to its diluted EPS. If, however, a company has dilutive securities, its diluted EPS is lower than its basic EPS. The sections below describe the effects of three c04.indd c04.indd 146 9/17/08 11:29:59 AM Chapter 4 Understanding the Income Statement 147 types of potentially dilutive securities: convertible preferred, convertible debt, and employee stock options. 6.3.1. Diluted EPS When a Company Has Convertible Preferred Stock Outstanding When a company has convertible preferred stock outstanding, diluted EPS is calculated using the if-converted method (i.e., what EPS would have been if the convertible preferred securities had been converted at the beginning of the period). What would have been the effect if the securities had been converted? If the convertible preferred securities had converted, these securities would no longer be outstanding; instead, additional common stock would be outstanding. Therefore, if such a conversion had taken place, the company would not have paid preferred dividends and would have had more shares of common stock. The diluted EPS using the if-converted method for convertible preferred stock is equal to the amount of net income divided by the weighted average number of shares outstanding plus the new shares of common stock that would be issued upon conversion of the preferred. Thus, the formula to calculate diluted EPS using the if-converted method for preferred stock is: Diluted EPS (Net income)/(Weighted average number of shares outstanding New common shares that would have been issued at conversion) (4-2) A diluted EPS calculation using the if-converted method for preferred stock is provided in Example 4-16 on page 148. 6.3.2. Diluted EPS When a Company Has Convertible Debt Outstanding When a company has convertible debt outstanding, the diluted EPS calculation is similar to the calculation for convertible preferred: Diluted EPS is calculated using the if-converted method (i.e., what EPS would have been if the convertible debt had been converted at the beginning of the period). If the convertible debt had been converted, the debt securities would no longer be outstanding; instead, additional common stock would be outstanding. Therefore, if such a conversion had taken place, the company would not have paid interest on the convertible debt and would have had more shares of common stock. To calculate diluted EPS using the if-converted method for convertible debt, the amount of net income available to common shareholders must be increased by the amount of after-tax interest related to the convertible debt. In addition, the weighted average number of shares in the denominator increases by the number of new shares of common stock that would be issued upon conversion of the convertible debt. Thus, the formula to calculate diluted EPS using the if-converted method for convertible debt is: Diluted EPS (Net income After-tax interest on convertible debt Preferred dividends)/(Weighted average number of shares outstanding New common shares that could have been issued at conversion) (4-3) A diluted EPS calculation using the if-converted method for convertible debt is provided in Example 4-17. c04.indd c04.indd 147 9/17/08 11:30:06 AM 148 International Financial Statement Analysis EXAMPLE 4-16 A Diluted EPS Calculation Using the If-Converted Method for Preferred Stock For the year ended 31 December 2006, Bright-Warm Utility Company had net income of $1,750,000. The company had an average of 500,000 shares of common stock outstanding, 20,000 shares of convertible preferred, and no other potentially dilutive securities. Each share of preferred pays a dividend of $10 per share, and each is convertible into ve shares of the companys common stock. Calculate the companys basic and diluted EPS. Solution. If the 20,000 shares of convertible preferred had each converted into 5 shares of the companys common stock, the company would have had an additional 100,000 shares of common stock (5 shares of common for each of the 20,000 shares of preferred). If the conversion had taken place, the company would not have paid preferred dividends of $200,000 ($10 per share for each of the 20,000 shares of preferred). As shown in Exhibit 4-9, the companys basic EPS was $3.10 and its diluted EPS was $2.92. EXHIBIT 4-9 Calculation of Diluted EPS for Bright-Warm Utility Company Using the If-Converted Method: Case of Preferred Stock Basic EPS Net income Preferred dividend Numerator Weighted average number of shares outstanding If converted Denominator EPS $1,750,000 Diluted EPS Using If-Converted Method $1,750,000 200,000 0 $1,550,000 $1,750,000 500,000 500,000 0 100,000 500,000 600,000 $3.10 $2.92 EXAMPLE 4-17 A Diluted EPS Calculation Using the If-Converted Method for Convertible Debt Oppnox Company reported net income of $750,000 for the year ended 31 December 2005. The company had an average of 690,000 shares of common stock outstanding. In addition, the company has only one potentially dilutive security: $50,000 of 6 percent convertible bonds, convertible into a total of 10,000 shares. Assuming a tax rate of 30 percent, calculate Oppnoxs basic and diluted EPS. Solution. If the convertible debt had been converted, the debt securities would no longer be outstanding; instead, an additional 10,000 shares of common stock would c04.indd 148 9/17/08 11:30:07 AM Chapter 4 149 Understanding the Income Statement be outstanding. Also, if such a conversion had taken place, the company would not have paid interest on the convertible debt of $3,000, equivalent to $3,000(1 0.30) $2,100 on an after-tax basis. To calculate diluted EPS using the if-converted method for convertible debt, the amount of net income available to common shareholders is increased by $2,100. Also, the weighted average number of shares in the denominator increases by 10,000 shares. EXHIBIT 4-10 Calculation of Diluted EPS for Oppnox Company Using the If-Converted Method: Case of a Convertible Bond Basic EPS Net income $750,000 After-tax cost of interest Numerator Weighted average number of shares outstanding If converted Denominator EPS Diluted EPS Using If-Converted Method $750,000 2,100 $750,000 $752,100 690,000 690,000 0 10,000 690,000 700,000 $1.09 $1.07 6.3.3. Diluted EPS When a Company Has Stock Options, Warrants, or Their Equivalents Outstanding Under U.S. GAAP, when a company has stock options, warrants, or their equivalents37 outstanding, the diluted EPS is calculated using the treasury stock method (i.e., what EPS would have been if the options had been exercised and the company had used the proceeds to repurchase common stock). If the options had been exercised, the company would have received cash for the amount of the option exercise price. The options would no longer be outstanding; instead, additional common stock would be outstanding. Under the treasury stock method, a further calculation is made to adjust the number of shares outstanding by the number of shares that could have been purchased with the cash received upon exercise of the options. To calculate diluted EPS using the treasury stock method for options, the weighted average number of shares in the denominator increases by the number of new shares of common stock that would be issued upon exercise of the options minus the number of shares that could have been purchased with the cash received upon exercise of the options. No change is 37 Hereafter, options, warrants, and their equivalents will be referred to simply as options because the accounting treatment is interchangeable for these instruments under IFRS and U.S. GAAP. c04.indd 149 9/17/08 11:30:16 AM 150 International Financial Statement Analysis made to the numerator. Thus, the formula to calculate diluted EPS using the treasury stock method for options is Diluted EPS (Net income Preferred dividends)/(Weighted average number of shares outstanding New shares that could have been issued at option exercise Shares that could have been purchased with cash received upon exercise) (4-4) A diluted EPS calculation using the treasury stock method for options is provided in Example 4-18. EXAMPLE 4-18 A Diluted EPS Calculation Using the Treasury Stock Method for Options Hihotech Company reported net income of $2.3 million for the year ended 30 June 2005 and had an average of 800,000 common shares outstanding. The company has outstanding 30,000 options with an exercise price of $35 and no other potentially dilutive securities. Over the year, the companys market price has averaged $55 per share. Calculate the companys basic and diluted EPS. Solution. Using the treasury stock method, we rst calculate that the company would have received $1,050,000 ($35 for each of the 30,000 options exercised) if all the options had been exercised. The options would no longer be outstanding; instead, 30,000 new shares of common stock would be outstanding. Under the treasury stock method, we reduce the number of new shares by the number of shares that could have been purchased with the cash received upon exercise of the options. At an average market price of $55 per share, the $1,050,000 proceeds from option exercise could have purchased 19,091 shares of treasury stock. Therefore, the net new shares issued would have been 10,909 (calculated as 30,000 minus 19,091). No change is made to the numerator. As shown in Exhibit 4-11, the companys basic EPS was $2.88 and the diluted EPS was $2.84. EXHIBIT 4-11 Calculation of Diluted EPS for Hihotech Company Using the Treasury Stock Method: Case of Stock Options Basic EPS Diluted EPS Using Treasury Stock Method Net income $2,300,000 $2,300,000 Numerator $2,300,000 $2,300,000 800,000 800,000 Weighted average number of shares outstanding If converted Denominator EPS c04.indd 150 0 10,909 800,000 810,909 $2.88 $2.84 9/17/08 11:30:22 AM Chapter 4 Understanding the Income Statement 151 Under IFRS, IAS No. 33 requires a similar computation but does not refer to it as the treasury stock method. The company is required to consider that any assumed proceeds are received from the issuance of new shares at the average market price for the period. These new inferred shares would be disregarded in the computation of diluted EPS, but the excess of the new shares issued under options contracts over the new inferred shares would be added into the weighted average number of shares outstanding. The results are similar to the treasury stock method, as shown in Example 4-19. EXAMPLE 4-19 Diluted EPS for Options under IFRS Assuming the same facts as in Example 4-18, calculate the weighted average number of shares outstanding for diluted EPS under IFRS. Solution. If the options had been converted, the company would have received $1,050,000. If this amount had been received from the issuance of new shares at the average market price of $55 per share, the company would have sold 19,091 shares. The excess of the shares issued under options (30,000) over the shares the company could have sold at market prices (19,091) is 10,909. This amount is added to the weighted average number of shares outstanding of 800,000 to get diluted shares of 810,909. Note that this is the same result as that obtained under U.S. GAAP; it is just derived in a different manner. 6.3.4. Other Issues with Diluted EPS It is possible that some potentially convertible securities could be antidilutive (i.e., their inclusion in the computation would result in an EPS higher than the companys basic EPS). Under accounting standards, antidilutive securities are not included in the calculation of diluted EPS. In general, diluted EPS reects maximum potential dilution. Example 4-20 provides an illustration of an antidilutive security. EXAMPLE 4-20 An Antidilutive Security For the year ended 31 December 2006, Dim-Cool Utility Company had net income of $1,750,000. The company had an average of 500,000 shares of common stock outstanding, 20,000 shares of convertible preferred, and no other potentially dilutive securities. Each share of preferred pays a dividend of $10 per share, and each is convertible into three shares of the companys common stock. What was the companys basic and diluted EPS? Solution. If the 20,000 shares of convertible preferred had each converted into 3 shares of the companys common stock, the company would have had an additional 60,000 shares of common stock (3 shares of common for each of the 20,000 shares of preferred). If the conversion had taken place, the company would not have paid preferred c04.indd c04.indd 151 9/17/08 11:30:31 AM 152 International Financial Statement Analysis dividends of $200,000 ($10 per share for each of the 20,000 shares of preferred). The effect of using the if-converted method would be EPS of $3.13, as shown in Exhibit 4-12. Because this is greater than the companys basic EPS of $3.10, the securities are said to be antidilutive and the effect of their conversion would not be included in diluted EPS. Diluted EPS would be the same as basic EPS (i.e., $3.10). EXHIBIT 4-12 Calculation for an Antidilutive Security Basic EPS Preferred dividend Numerator Weighted average number of shares outstanding If converted Denominator EPS $1,750,000 $1,750,000 200,000 0 $1,550,000 $1,750,000 500,000 500,000 0 60,000 500,000 560,000 $3.10 $3.13 Net income Diluted EPS Using If-Converted Method Exceeds basic EPS; security is antidilutive and, therefore, not included. 7 . ANALYSIS OF THE INCOME STATEMENT In this section, we apply two analytical tools to analyze the income statement: common-size analysis and income statement ratios. In analyzing the income statement, the objective is to assess a companys performance over a period of timecompared with its own historical performance or to the performance of another company. 7.1. Common-Size Analysis of the Income Statement Common-size analysis of the income statement can be performed by stating each line item on the income statement as a percentage of revenue.38 Common-size statements facilitate comparison across time periods (time-series analysis) and across companies of different sizes (cross-sectional analysis). 38 This format can be distinguished as vertical common-size analysis. As the reading on nancial statement analysis discusses, there is another type of common-size analysis, known as horizontal common-size analysis, that states items in relation to a selected base year value. Unless otherwise indicated, text references to common-size analysis refer to vertical analysis. c04.indd 152 9/17/08 11:30:36 AM Chapter 4 153 Understanding the Income Statement EXHIBIT 4-13 Income Statements for Company A, B, and C Panel A: Income Statements for Company A, Company B, and Company C ($) A B C $10,000,000 $10,000,000 $2,000,000 Cost of sales 3,000,000 7,500,000 600,000 Gross prot 7,000,000 2,500,000 1,400,000 Selling, general, and administrative expenses 1,000,000 1,000,000 200,000 Research and development 2,000,000 400,000 Advertising 2,000,000 400,000 Operating prot 2,000,000 1,500,000 400,000 Sales Panel B: Common-Size Income Statements for Companies A, B, and C (%) A B C Sales 100% 100% 100% Cost of sales 30 75 30 Gross prot 70 25 70 Selling, general, and administrative expenses 10 10 10 Research and development 20 0 20 Advertising 20 0 20 Operating prot 20 15 20 Note: Each line item is expressed as a percentage of the companys sales. To illustrate, Panel A of Exhibit 4-13 presents an income statement for three hypothetical companies. Company A and Company B, each with $10 million in sales, are larger (as measured by sales) than Company C, which has only $2 million in sales. In addition, Companies A and B both have higher operating prot: $2 million and $1.5 million, respectively, compared with Company Cs operating prot of only $400,000. How can an analyst meaningfully compare the performance of these companies? By preparing a common-size income statement, as illustrated in Panel B, an analyst can readily see that the percentages of Company Cs expenses and prot relative to its sales are exactly the same as for Company A. Furthermore, although Company Cs operating prot is lower than Company Bs in absolute dollars, it is higher in percentage terms (20 percent for Company C compared with only 15 percent for Company B). For each $100 of sales, Company C generates $5 more operating prot than Company B. In other words, Company C is more protable than Company B based on this measure. The common-size income statement also highlights differences in companies strategies. Comparing the two larger companies, Company A reports signicantly higher gross prot as a percentage of sales than does Company B (70 percent compared with 25 percent). Given c04.indd c04.indd 153 9/17/08 11:30:42 AM 154 International Financial Statement Analysis that both companies operate in the same industry, why can Company A generate so much higher gross prot? One possible explanation is found by comparing the operating expenses of the two companies. Company A spends signicantly more on research and development and on advertising than Company B. Expenditures on research and development likely result in products with superior technology. Expenditures on advertising likely result in greater brand awareness. So, based on these differences, it is likely that Company A is selling technologically superior products with a better brand image. Company B may be selling its products more cheaply (with a lower gross prot as a percentage of sales) but saving money by not investing in research and development or advertising. In practice, differences across companies are more subtle, but the concept is similar. An analyst, noting signicant differences, would seek to understand the underlying reasons for the differences and their implications for the future performance of the companies. For most expenses, comparison to the amount of sales is appropriate. However, in the case of taxes, it is more meaningful to compare the amount of taxes with the amount of pretax income. Using nancial footnote disclosure, an analyst can then examine the causes for differences in effective tax rates. To project the companies future net income, an analyst would project the companies pretax income and apply an estimated effective tax rate determined in part by the historical tax rates. Vertical common-size analysis of the income statement is particularly useful in crosssectional analysiscomparing companies with each other for a particular time period or comparing a company with industry or sector data. The analyst could select individual peer companies for comparison, use industry data from published sources, or compile data from databases based on a selection of peer companies or broader industry data. For example, Exhibit 4-14 presents common-size income statement data compiled for the components of the Standard & Poors 500 classied into the 10 S&P/MSCI Global Industrial Classication System (GICS) sectors using 2005 data. Note that when compiling aggregate data such as this, some level of aggregation is necessary and less detail may be available than from peer company nancial statements. The performance of an individual company can be compared with industry or peer company data to evaluate its relative performance. 7.2. Income Statement Ratios One aspect of nancial performance is protability. One indicator of protability is net prot margin, also known as prot margin and return on sales, which is calculated as net income divided by revenue (or sales).39 Net prot margin Net income __________ Revenue Net prot margin measures the amount of income that a company was able to generate for each dollar of revenue. A higher level of net prot margin indicates higher protability and is thus more desirable. Net prot margin can also be found directly on the common-size income statements. For Kraft Foods, net prot margin for 2004 was 8.3 percent (calculated as earnings from continuing operations of $2,669 million, divided by net revenues of $32,168 million). 39 In the denition of margin ratios of this type, sales is often used interchangeably with revenue. Return on sales has also been used to refer to a class of protability ratios having revenue in the denominator. c04.indd 154 9/17/08 11:30:43 AM 155 c04.indd 155 9/17/08 11:30:43 AM 29 5.63 13.97 66.52 3.82 Pretax margin Taxes Prot margin Cost of goods sold Selling, general, and administrative expenses 5.44 32.22 Selling, general, and administrative expenses Average tax rate computed on mean Source: Based on data from Compustat. 62.36 Cost of goods sold 3.38 7.72 16.02 Taxes Prot margin 12.58 23.96 Pretax margin 26.89 13.05 67.87 8.58 14.12 23.13 No. observations Operating margin 30 10.20 68.35 7.68 2.87 10.95 11.85 30 Materials 29 19.17 Operating margin Panel B: Mean Data 17.24 No. observations Panel A: Median Data Energy 30.04 17.45 68.92 7.69 3.33 11.09 13.16 49 15.88 69.02 7.28 2.94 10.55 11.94 49 Industrials 37.98 22.82 62.41 6.32 3.94 10.38 12.69 85 22.46 63.29 6.87 3.59 10.17 11.15 85 Consumer Discretionary 31.65 25.88 56.62 8.15 3.81 12.03 14.51 36 25.07 56.24 6.74 3.26 10.76 12.53 36 Consumer Staples Classied by S&P/MSCI GICS Sector Data for 2005 EXHIBIT 4-14 Common-Size Income Statement Statistics for the S&P 500 31.21 30.48 49.20 10.80 4.94 15.83 17.84 52 31.77 45.29 9.35 4.69 14.03 16.73 52 Health Care 28.40 27.68 51.47 16.37 6.65 23.42 35.45 87 28.98 42.29 16.09 6.51 23.28 34.62 87 Financials 32.66 33.06 46.65 10.26 4.98 15.25 15.13 73 31.81 47.17 11.60 4.06 13.60 12.59 73 Information Technology 33.82 22.81 40.61 9.52 5.14 15.19 20.66 9 22.40 41.76 10.91 4.27 18.18 22.85 9 Telecom. Services 30.99 4.91 76.51 5.68 2.48 8.00 14.60 31 4.91 76.79 6.93 3.12 9.27 13.52 31 Utilities 156 International Financial Statement Analysis To judge this ratio, some comparison is needed. Krafts protability can be compared with that of another company or with its own previous performance. Compared with previous years, Krafts protability has declined. In 2003, net prot margin was 11.1 percent, and in 2002, it was 11.3 percent. Another measure of protability is the gross prot margin. Gross prot is calculated as revenue minus cost of goods sold, and the gross prot margin is calculated as the gross prot divided by revenue. Gross prot __________ Gross prot margin Revenue The gross prot margin measures the amount of gross prot that a company generated for each dollar of revenue. A higher level of gross prot margin indicates higher protability and thus is generally more desirable, although differences in gross prot margins across companies reect differences in companies strategies. For example, consider a company pursuing a strategy of selling a differentiated product (e.g., a product differentiated based on brand name, quality, superior technology, or patent protection). The company would likely be able to sell the differentiated product at a higher price than a similar, but undifferentiated, product and, therefore, would likely show a higher gross prot margin than a company selling an undifferentiated product. Although a company selling a differentiated product would likely show a higher gross prot margin, this may take time. In the initial stage of the strategy, the company would likely incur costs to create a differentiated product, such as advertising or research and development, which would not be reected in the gross margin calculation. Krafts gross prot (shown in Exhibit 4-2) was $11,785 in 2002 and $11,887 in 2004. In other words, in absolute terms, Krafts gross prot increased. However, expressing gross prot as a percentage of net revenues,40 it is apparent that Krafts gross prot margin declined, as Exhibit 4-15 illustrates. From over 40 percent in 2002, Krafts prot margin declined to 36.95 percent in 2004. The net prot margin and gross prot margin are just two of the many subtotals that can be generated from common-size income statements. Other margins used by analysts include the operating margin (operating income divided by revenue) and pretax margin (earnings before taxes divided by revenue). EXHIBIT 4-15 Krafts Gross Prot Margin 2004 2003 2002 $ millions % $ millions % $ millions % Net revenues 32,168 100.00 30,498 100.00 29,248 100.00 Cost of sales 20,281 63.05 18,531 60.76 17,463 59.71 Gross prot 11,887 36.95 11,967 39.24 11,785 40.29 40 Some items disclosed separately in Krafts actual income statement have been summarized as other operating costs (income) for this display. c04.indd 156 9/17/08 11:30:44 AM Chapter 4 Understanding the Income Statement 157 8 . COMPREHENSIVE INCOME The general expression for net income is revenue minus expenses. There are, however, certain items of revenue and expense that, by accounting convention, are excluded from the net income calculation. To understand how reported shareholders equity of one period links with reported shareholders equity of the next period, we must understand these excluded items, known as other comprehensive income. Comprehensive income is dened as the change in equity [net assets] of a business enterprise during a period from transactions and other events and circumstances from nonowner sources. It includes all changes in equity during a period except those resulting from investments by owners and distributions to owners.41 So, comprehensive income includes both net income and other revenue and expense items that are excluded from the net income calculation (other comprehensive income). Assume, for example, a companys beginning shareholders equity is 110 million, its net income for the year is 10 million, its cash dividends for the year are 2 million, and there was no issuance or repurchase of common stock. If the companys actual ending shareholders equity is 123 million, then 5 million [123 (110 10 2)] has bypassed the net income calculation by being classied as other comprehensive income. (If the company had no other comprehensive income, its ending shareholders equity would have been 118 million [110 10 2].) In U.S. nancial statements, according to U.S. GAAP, four types of items are treated as other comprehensive income. Foreign currency translation adjustments. In consolidating the nancial statements of foreign subsidiaries, the effects of translating the subsidiaries balance sheet assets and liabilities at current exchange rates are included as other comprehensive income. Unrealized gains or losses on derivatives contracts accounted for as hedges. Changes in the fair value of derivatives are recorded each period, but these changes in value for certain derivatives (those considered hedges) are treated as other comprehensive income and thus bypass the income statement. Unrealized holding gains and losses on a certain category of investment securities, namely, available-for-sale securities. Changes in the funded status of a companys dened benet postretirement plans. The third type of item is perhaps the simplest to illustrate. Holding gains on securities arise when a company owns securities over an accounting period, during which time the securities value increases. Similarly, holding losses on securities arise when a company owns securities over a period during which time the securities value decreases. If the company has not sold the securities (i.e., realized the gain or loss), its holding gain or loss is said to be unrealized. The question is: Should the company reect these unrealized holding gains and losses in its income statement? According to accounting standards, the answer depends on how the company has categorized the securities. Categorization depends on what the company intends to do with the securities. If the company intends to actively trade the securities, the answer is yes; the company should categorize the securities as trading securities and reect unrealized holding gains and losses in its income statement. However, if the company does not intend to 41 See SFAS No. 130, Concepts Statement 6, paragraph 70. c04.indd 157 9/17/08 11:30:45 AM 158 International Financial Statement Analysis actively trade the securities, the securities may be categorized as available-for-sale securities. For available-for-sale securities, the company does not reect unrealized holding gains and losses in its income statement. Instead, unrealized holding gains and losses on available-forsale securities bypass the income statement and go directly to shareholders equity. Even though unrealized holding gains and losses on available-for-sale securities are excluded from a companys net income, they are included in a companys comprehensive income. The fourth item, concerning dened benet postretirement plans, has changed. Until recently, so-called minimum pension liability adjustments were treated as other comprehensive income; however, a new standard (SFAS No. 158, effective for public companies as of the end of scal years after 15 December 2006) will eliminate the need for minimum pension liability adjustments. The need for those adjustments resulted from pension accounting that often created a divergence between a pension plans funded status and the amount reported on the balance sheet. Under the new standard, companies are required to recognize the overfunded or underfunded status of a dened benet postretirement plan as an asset or a liability on its balance sheet.42 SFAS No. 130 allows companies to report comprehensive income at the bottom of the income statement, on a separate statement of comprehensive income, or as a column in the statement of shareholders equity; however, presentation alternatives are currently being reviewed by both U.S. and non-U.S. standard setters. Particularly in comparing nancial statements of two companies, it is relevant to examine signicant differences in comprehensive income. EXAMPLE 4-21 Other Comprehensive Income Assume a companys beginning shareholders equity is 200 million, its net income for the year is 20 million, its cash dividends for the year are 3 million, and there was no issuance or repurchase of common stock. The companys actual ending shareholders equity is 227 million. 1. What amount has bypassed the net income calculation by being classied as other comprehensive income? A. 0 B. 7 million C. 10 million D. 30 million 2. Which of the following statements best describes other comprehensive income? A. Income earned from diverse geographic and segment activities. B. Income earned from activities that are not part of the companys ordinary business activities. 42 A dened benet plan is said to be overfunded if the amount of assets in a trust fund for that plan exceeds that plans obligations. If the amount of assets in a trust fund for that plan is less than the plans obligations, it is underfunded. c04.indd 158 9/17/08 11:30:45 AM Chapter 4 159 Understanding the Income Statement C. Income related to the sale of goods and delivery of services. D. Income that increases stockholders equity but is not reected as part of net income. Solution to 1. C is correct. If the companys actual ending shareholders equity is 227 million, then 10 million [227 (200 20 3)] has bypassed the net income calculation by being classied as other comprehensive income. Solution to 2. D is correct. Answers A and B are not correct because they do not specify whether such income is reported as part of net income and shown in the income statement. Answer C is not correct because such activities would typically be reported as part of net income on the income statement. EXAMPLE 4-22 Other Comprehensive Income in Analysis An analyst is looking at two comparable companies. Company A has a lower price/ earnings (P/E) ratio than Company B, and the conclusion that has been suggested is that Company A is undervalued. As part of examining this conclusion, the analyst decides to explore the question: What would the companys P/E look like if total comprehensive income per sharerather than net income per sharewere used as the relevant metric? Company A Company B Price $35 $30 EPS $ 1.60 $ 0.90 P/E ratio 21.9x Other comprehensive income (loss) $ million Shares (millions) 33.3x ($16.272) $ (1.757) 22.6 25.1 Solution. As shown by the following table, part of the explanation for Company As lower P/E ratio may be that its signicant lossesaccounted for as other comprehensive income (OCI)are not included in the P/E ratio. Company A Company B Price $35 EPS $ 1.60 $0.90 ($16.272) $ (1.757) OCI (loss) $ million Shares (millions) 22.6 EPS Price/Comprehensive EPS ratio c04.indd 159 OCI per share 25.1 $ (0.72) OCI (loss) per share Comprehensive EPS $ 30 $ (0.07) $ 0.88 $ 0.83 39.8x 36.1x 9/17/08 11:30:48 AM 160 International Financial Statement Analysis 9 . SUMMARY This chapter has presented the elements of income statement analysis. The income statement presents information on the nancial results of a companys business activities over a period of time; it communicates how much revenue the company generated during a period and what costs it incurred in connection with generating that revenue. A companys net income and its components (e.g., gross margin, operating earnings, and pretax earnings) are critical inputs into both the equity and credit analysis processes. Equity analysts are interested in earnings because equity markets often reward relatively high- or low-earnings growth companies with above-average or below-average valuations, respectively. Fixed-income analysts examine the components of income statements, past and projected, for information on companies abilities to make promised payments on their debt over the course of the business cycle. Corporate nancial announcements frequently emphasize income statements more than the other nancial statements. Key points to this chapter include the following: The income statement presents revenue, expenses, and net income. The components of the income statement include: revenue; cost of sales; sales, general, and administrative expenses; other operating expenses; nonoperating income and expenses; gains and losses; nonrecurring items; net income; and EPS. An income statement that presents a subtotal for gross prot (revenue minus cost of goods sold) is said to be presented in a multi-step format. One that does not present this subtotal is said to be presented in a single-step format. Revenue is recognized in the period it is earned, which may or may not be in the same period as the related cash collection. Recognition of revenue when earned is a fundamental principal of accrual accounting. In limited circumstances, specic revenue recognition methods may be applicable, including percentage of completion, completed contract, installment sales, and cost recovery. An analyst should identify differences in companies revenue recognition methods and adjust reported revenue where possible to facilitate comparability. Where the available information does not permit adjustment, an analyst can characterize the revenue recognition as more or less conservative and thus qualitatively assess how differences in policies might affect nancial ratios and judgments about protability. The general principles of expense recognition include the matching principle. Expenses are matched either to revenue or to the time period in which the expenditure occurs (period costs) or to the time period of expected benets of the expenditures (e.g. depreciation). In expense recognition, choice of method (i.e., depreciation method and inventory cost method), as well as estimates (i.e., uncollectible accounts, warranty expenses, assets useful life, and salvage value) affect a companys reported income. An analyst should identify differences in companies expense recognition methods and adjust reported nancial statements where possible to facilitate comparability. Where the available information does not permit adjustment, an analyst can characterize the policies and estimates as more or less conservative and thus qualitatively assess how differences in policies might affect nancial ratios and judgments about companies performance. To assess a companys future earnings, it is helpful to separate those prior years items of income and expense that are likely to continue in the future from those items that are less likely to continue. Some items from prior years clearly are not expected to continue in future periods and are separately disclosed on a companys income statement. Two such items are (1) discontinued c04.indd 160 9/17/08 11:30:57 AM Chapter 4 161 Understanding the Income Statement operations and (2) extraordinary items. Both of these items are required to be reported separately from continuing operations. For other items on a companys income statement, such as unusual items and accounting changes, the likelihood of their continuing in the future is somewhat less clear and requires the analyst to make some judgments. Nonoperating items are reported separately from operating items. For example, if a nonnancial service company invests in equity or debt securities issued by another company, any interest, dividends, or prots from sales of these securities will be shown as nonoperating income. Basic EPS is the amount of income available to common shareholders divided by the weighted average number of common shares outstanding over a period. The amount of income available to common shareholders is the amount of net income remaining after preferred dividends (if any) have been paid. If a company has a simple capital structure (i.e., one with no potentially dilutive securities), then its basic EPS is equal to its diluted EPS. If, however, a company has dilutive securities, its diluted EPS is lower than its basic EPS. Diluted EPS is calculated using the if-converted method for convertible securities and the treasury stock method for options. Common-size analysis of the income statement involves stating each line item on the income statement as a percentage of sales. Common-size statements facilitate comparison across time periods and across companies of different sizes. Two income-statement-based indicators of protability are net prot margin and gross prot margin. Comprehensive income includes both net income and other revenue and expense items that are excluded from the net income calculation. P RACTICE PROBLEMS 1. Expenses on the income statement may be grouped by A. nature, but not by function. B. function, but not by nature. C. either function or nature. 2. An example of an expense classication by function is A. tax expense. B. interest expense. C. cost of goods sold. 3. Denali Limited, a manufacturing company, had the following income statement information: Revenue $4,000,000 Cost of goods sold $3,000,000 Other operating expenses Interest expense $100,000 Tax expense c04.indd 161 $500,000 $120,000 9/17/08 11:30:58 AM 162 International Financial Statement Analysis Denalis gross prot is equal to A. $280,000. B. $500,000. C. $1,000,000. 4. Under IFRS, income includes increases in economic benets from A. increases in owners equity related to owners contributions. B. increases in liabilities not related to owners contributions. C. enhancements of assets not related to owners contributions. 5. Fairplay had the following information related to the sale of its products during 2006, which was its rst year of business: Revenue $1,000,000 Returns of goods sold $100,000 Cash collected $800,000 Cost of goods sold $700,000 Under the accrual basis of accounting, how much net revenue would be reported on Fairplays 2006 income statement? A. $200,000 B. $800,000 C. $900,000 6. If the outcome of a long-term contract can be measured reliably, the preferred accounting method under both IFRS and U.S. GAAP is A. the installment method. B. the completed contract method. C. the percentage-of-completion method. 7. At the beginning of 2006, Florida Road Construction entered into a contract to build a road for the government. Construction will take four years. The following information as of 31 December 2006 is available for the contract: Total revenue according to contract $10,000,000 Total expected cost $8,000,000 Cost incurred during 2006 $1,200,000 Under the completed contract method, how much revenue will be reported in 2006? A. None B. $300,000 C. $1,500,000 8. During 2006, Argo Company sold 10 acres of prime commercial zoned land to a builder for $5,000,000. The builder gave Argo a $1,000,000 down payment and will pay the remaining balance of $4,000,000 to Argo in 2007. Argo purchased the land in 1999 for $2,000,000. Using the installment method, how much prot will Argo report for 2006? c04.indd c04.indd 162 9/17/08 11:30:58 AM Chapter 4 Understanding the Income Statement 163 A. None B. $600,000 C. $1,000,000 9. Using the same information as in Question 8, how much prot will Argo report for 2006 by using the cost recovery method? A. None B. $1,000,000 C. $3,000,000 10. Under IFRS, revenue from barter transactions should be measured based on the fair value of revenue from A. similar barter transactions with related parties. B. similar barter transactions with unrelated parties. C. similar nonbarter transactions with unrelated parties. 11. Apex Consignment sells items over the Internet for individuals on a consignment basis. Apex receives the items from the owner, lists them for sale on the Internet, and receives a 25 percent commission for any items sold. Apex collects the full amount from the buyer and pays the net amount after commission to the owner. Unsold items are returned to the owner after 90 days. During 2006, Apex had the following information: Total sales price of items sold during 2006 on consignment was 2,000,000. Total commissions retained by Apex during 2006 for these items was 500,000. How much revenue should Apex report on its 2006 income statement? A. 500,000 B. 2,000,000 C. 1,500,000 12. During 2007, Accent Toys Plc., which began business in October of that year, purchased 10,000 units of its most popular toy at a cost of 10 per unit in October. In anticipation of heavy December sales, Accent purchased 5,000 additional units in November at a cost of 11 per unit. During 2007, Accent sold 12,000 units at a price of 15 per unit. Under the rst in, rst out (FIFO) method, what is Accents cost of goods sold for 2007? A. 105,000 B. 120,000 C. 122,000 13. Using the same information as in Question 12, what would Accents cost of goods sold be under the weighted average cost method? A. 120,000 B. 122,000 C. 124,000 14. Which inventory method is least likely to be used under IFRS? A. First in, rst out (FIFO) B. Last in, rst out (LIFO) C. Weighted average c04.indd 163 9/17/08 11:30:58 AM 164 International Financial Statement Analysis 15. At the beginning of 2007, Glass Manufacturing purchased a new machine for its assembly line at a cost of $600,000. The machine has an estimated useful life of 10 years and estimated residual value of $50,000. Under the straight-line method, how much depreciation would Glass take in 2008 for nancial reporting purposes? A. None B. $55,000 C. $60,000 16. Using the same information as in Question 15, how much depreciation would Glass take in 2007 for nancial reporting purposes under the double-declining balance method? A. $60,000 B. $110,000 C. $120,000 17. Which combination of depreciation methods and useful lives is most conservative in the year a depreciable asset is acquired? A. Straight-line depreciation with a long useful life. B. Straight-line depreciation with a short useful life. C. Declining balance depreciation with a short useful life. 18. Under IFRS, a loss from the destruction of property in a re would most likely be classied as A. continuing operations. B. an extraordinary item. C. discontinued operations. 19. For 2007, Flamingo Products had net income of $1,000,000. On 1 January 2007, there were 1,000,000 shares outstanding. On 1 July 2007, the company issued 100,000 new shares for $20 per share. The company paid $200,000 in dividends to common shareholders. What is Flamingos basic earnings per share for 2007? A. $0.73 B. $0.91 C. $0.95 20. Cell Services (CSI) had 1,000,000 average shares outstanding during all of 2007. During 2007, CSI also had 10,000 options outstanding with exercise prices of $10 each. The average stock price of CSI during 2007 was $15. For purposes of computing diluted earnings per share, how many shares would be used in the denominator? A. 1,000,000 B. 1,003,333 C. 1,010,000 c04.indd c04.indd 164 9/17/08 11:30:59 AM CHAPTER 5 U NDERSTANDING THE BALANCE SHEET Thomas R. Robinson, CFA CFA Institute Charlottesville, Virginia Hennie van Greuning, CFA World Bank Washington, DC Elaine Henry, CFA University of Miami Miami, Florida Michael A. Broihahn, CFA Barry University Miami, Florida L EARNING OUTCOMES After completing this chapter, you will be able to do the following: Dene and interpret the asset and liability categories on the balance sheet, and discuss the uses of a balance sheet. Describe the various formats of balance sheet presentation. Compare and contrast current and noncurrent assets and liabilities. 165 c05.indd 165 9/17/08 11:31:52 AM 166 International Financial Statement Analysis Explain the measurement bases (e.g., historical cost and fair value) of assets and liabilities, including current assets, current liabilities, tangible assets, and intangible assets. List and explain the appropriate classications and related accounting treatments for nancial instruments. List and explain the components of shareholders equity. Interpret balance sheets, common-size balance sheets, the statement of changes in equity, and commonly used balance sheet ratios. 1 . INTRODUCTION The starting place for analyzing a companys nancial position is typically the balance sheet. Creditors, investors, and analysts recognize the value of the balance sheet and also its limitations. The balance sheet provides such users with information on a companys resources (assets) and its sources of capital (its equity and liabilities/debt). It normally also provides information about the future earnings capacity of a companys assets as well as an indication of cash ows that may come from receivables and inventories. However, the balance sheet does have limitations, especially relating to how assets and liabilities are measured. Liabilities and, sometimes, assets may not be recognized in a timely manner. Furthermore, the use of historical costs rather than fair values to measure some items on the balance sheet means that the nancial analyst may need to make adjustments to determine the real (economic) net worth of the company. By understanding how a balance sheet is constructed and how it may be analyzed, the reader should be able to make appropriate use of it. This chapter is organized as follows: In section 2, we describe and illustrate the format, structure, and components of the balance sheet. Section 3 discusses the measurement bases for assets and liabilities. Section 4 describes the components of equity and illustrates the statement of changes in shareholders equity. Section 5 introduces balance sheet analysis. Section 6 summarizes the chapter, and practice problems in the CFA Institute multiple-choice format conclude the chapter. 2 . COMPONENTS AND FORMAT OF THE BALANCE SHEET The balance sheet discloses what an entity owns and what it owes at a specic point in time; thus, it is also referred to as the statement of nancial position.1 The nancial position of an entity is described in terms of its assets, liabilities, and equity: Assets (A) are resources controlled by the company as a result of past events and from which future economic benets are expected to ow to the entity. Liabilities (L) represent obligations of a company arising from past events, the settlement of which is expected to result in an outow of economic benets from the entity. Equity (E) Commonly known as shareholders equity or owners equity, equity is determined by subtracting the liabilities from the assets of a company, giving rise to the accounting equation: A L E or A L E. Equity can be viewed as a residual or balancing amount, taking assets and liabilities into account. 1 The balance sheet is also known as the statement of nancial condition. c05.indd c05.indd 166 9/17/08 11:31:53 AM Chapter 5 167 Understanding the Balance Sheet EXHIBIT 5-1 Listing of Assets, Liabilities, and Owners Equity Funds Element 20X7 20X6 Financial Statement Element Inventory 20,000 16,000 Asset 53,000 27,000 Asset 43,000 Property, plant, and equipment Equation A Subtotal 73,000 Trade creditors (14,000) (7,000) Liability Bond repayable in 5 years time (37,000) (16,000) Liability L Equity (balancing amount) E Owners equity 22,000 20,000 Assets and liabilities arise as a result of business transactions (e.g., the purchase of a building or issuing a bond.) The accounting equation is useful in assessing the impact of transactions on the balance sheet. For example, if a company borrows money in exchange for a note payable, assets and liabilities increase by the same amount. Assets and liabilities also arise from the accrual process. As noted in earlier chapters, the income statement reects revenue and expenses reported on an accrual basis regardless of the period in which cash is received and paid. Differences between accrued revenue and expenses and cash ows will result in assets and liabilities. Specically: Revenue reported on the income statement before cash is received; this results in accrued revenue or accounts receivable, which is an asset. This is ultimately reected on the balance sheet as an increase in accounts receivable and an increase in retained earnings. Cash received before revenue is to be reported on the income statement; this results in a deferred revenue or unearned revenue, which is a liability. For example, if a company pays in advance for delivery of custom equipment, the balance sheet reects an increase in cash and an increase in liabilities. Expense reported on the income statement before cash is paid; this results in an accrued expense, which is a liability. This is reected on the balance sheet as an increase in liabilities and a decrease in retained earnings. Cash paid before an expense is to be reported on the income statement; this results in a deferred expense, also known as a prepaid expense, which is an asset. On the balance sheet, cash is reduced and prepaid assets are increased. Exhibit 5-1 illustrates what an unformatted balance sheet might look like, providing examples of a selection of assets and liabilities. The account trade creditors (also known as accounts payable) arises when goods are purchased on credit and received into inventory before their purchase price is paid in cash. Because an expense is recognized before cash is paid, it is an example of the type of accrual described in the third bullet point. 2.1. Structure and Components of the Balance Sheet As noted above, the balance sheet presents the nancial position of a company. The nancial position shows the relative amounts of assets, liabilities, and equity held by the enterprise at a particular point in time. c05.indd c05.indd 167 9/17/08 11:31:54 AM 168 International Financial Statement Analysis 2.1.1. Assets Assets are generated either through purchase (investing activities), or generated through business activities (operating activities), or nancing activities, such as issuance of debt. Through the analysis of the liabilities and equity of an entity, the analyst is able to determine how assets are acquired or funded. Funding for the purchase may come from shareholders (nancing activities) or from creditors (either through direct nancing activities, or indirectly through the surplus generated through operating activities that may be funded by current liabilities/trade nance). The chapter on nancial reporting standards dened assets as resources controlled by the enterprise as a result of past events and from which future economic benets are expected to ow to the enterprise. This formal denition of an asset tells us that its essence lies in its capability to generate future benets, which, therefore, alerts the reader of the nancial statements about the future earnings capability of the entitys assets. A simpler denition of an asset is that it is a store of wealth (such as cash, marketable securities, and property). Turning back to the ofcial denition of assets, we note that nancial statement elements (such as assets) should be recognized in the nancial statements only if: It is probable that any future economic benet associated with the item will ow to the entity. The item has a cost or value that can be measured with reliability (this aspect will be discussed more fully in section 3 of this chapter). Values that are typically included in assets will include amounts that have been spent but which have not been recorded as an expense on the income statement (as in the case of inventories) because of the matching principle, or amounts that have been reported as earned on an income statement but have not been received (as in the case of accounts receivable). Exhibit 5-1 included inventories as well as property, plant, and equipment as examples of assets. Exhibit 5-2 provides a more complete list of assets that may be found on the face of the balance sheet. EXHIBIT 5-2 Typical Assets Disclosed on the Balance Sheet Cash and cash equivalents Inventories Trade and other receivables Prepaid expenses Financial assets Deferred tax assets Property, plant, and equipment Investment property Intangible assets Investments accounted for using the equity method Natural resource assets Assets held for sale c05.indd c05.indd 168 9/17/08 11:31:54 AM Chapter 5 169 Understanding the Balance Sheet 2.1.2. Liabilities Liabilities (and equity capital) represent the ways in which the funds were raised to acquire the assets. Liabilities are technically dened as probable future sacrices of economic benets arising from present obligations of an entity to transfer assets or provide services to other entities in the future as a result of past transactions or events. Alternatively, a liability can be described as: Amounts received but which have not been reported as revenues or income on an income statement and/or will have to be repaid (e.g., notes payable). Amounts that have been reported as expenses on an income statement but have not been paid (e.g., accounts payable, accruals, and taxes payable). Exhibit 5-1 included trade creditors as well as a long-term bond payable as examples of liabilities. Exhibit 5-3 provides a more complete list of liabilities that may be found on the face of the balance sheet. EXHIBIT 5-3 Typical Liabilities Disclosed on the Balance Sheet Bank borrowings/notes payable Trade and other payables Provisions Unearned revenues Financial liabilities Accrued liabilities Deferred tax liabilities 2.1.3. Equity Equity represents the portion belonging to the owners or shareholders of a business. Equity is the residual interest in the assets of an entity after deducting its liabilities, also referred to as net asset value: Equity Assets Liabilities Equity is increased by contributions by the owners or by prots (including gains) made during the year and is decreased by losses or withdrawals in the form of dividends. Almost every aspect of a company is either directly or indirectly inuenced by the availability and/or the cost of equity capital. The adequacy of equity capital is one of the key factors to be considered when the safety and soundness of a particular company is assessed. An adequate equity base serves as a safety net for a variety of risks to which any entity is exposed in the course of its business. Equity capital provides a cushion to absorb possible losses and thus provides a basis for maintaining creditor condence in a company. Equity capital also is the ultimate determinant of a companys borrowing capacity. In practice, a companys balance sheet cannot be expanded beyond a level determined by its equity capital without increasing the risk of nancial distress to an unacceptable level; the availability of equity capital consequently determines the maximum level of assets. The cost and amount of capital affect a companys competitive position. Because shareholders expect a return on their equity, the obligation to earn such a return impacts the c05.indd c05.indd 169 9/17/08 11:31:55 AM 170 International Financial Statement Analysis EXHIBIT 5-4 Typical Equity Information Disclosed on the Balance Sheet Minority interest, presented within equity Issued capital and paid-in capital attributable to equity holders of the parent Earnings retained in the company Parent shareholders equity Information that is usually disclosed for each class of equity on the face of the balance sheet or in notes to the nancial statements includes: Number of shares authorized Number of shares issued and fully paid Number of shares issued and not fully paid Par (or stated) value per share, or a statement that it has no par (stated) value Reconciliation of shares at beginning and end of reporting period Rights, preferences, and restrictions attached to that class Shares in the entity held by entity, subsidiaries, or associates Shares reserved for issue under options and sales contracts pricing of company products. There is also another important aspect to the level of capital, namely, the perspective of the market. The issuance of debt requires public condence in a company, which, in turn, can best be established and maintained by an equity capital buffer. If a company faces a shortage of equity capital or if the cost of capital is high, a company stands to lose business to its competitors. The key purposes of equity capital are to provide stability and to absorb losses, thereby providing a measure of protection to creditors in the event of liquidation. As such, the capital of a company should have three important characteristics: It should be permanent. It should not impose mandatory xed charges against earnings (in the case of banks). It should allow for legal subordination to the rights of creditors. Exhibit 5-4 provides a list of equity information that is disclosed on the balance sheet. The total amount of equity capital is of fundamental importance. Also important is the nature of the company ownershipthe identity of those owners who can directly inuence the companys strategic direction and risk management policies. This is particularly critical for nancial institutions, such as banks. For example, a banks ownership structure must ensure the integrity of its capital and owners must be able to supply more capital if and when needed. 2.2. Format of the Balance Sheet As the balance sheet provides information about the nancial position of the company, it should distinguish between major categories and classications of assets and liabilities. Detail and formats of balance sheets vary from company to company. The basic information contained in balance sheets is the same though, regardless of the format. When using the report format, assets, liabilities, and equity are listed in a single column. The account format follows the pattern of the traditional general ledger accounts, with assets at the left c05.indd c05.indd 170 9/17/08 11:31:55 AM Chapter 5 171 Understanding the Balance Sheet and liabilities and equity at the right of a central dividing line. The report format is most commonly preferred and used by nancial statement preparers. If a company were to have many assets and liabilities, the balance sheet might become quite difcult to read. Grouping together the various classes of assets and liabilities, therefore, results in a balance sheet format described as a classied balance sheet. Classication, in this case, is the term used to describe the grouping of accounts into subcategoriesit helps readers to gain a quick perspective of the companys nancial position. Classication assists in drawing attention to specic amounts and also to groups of accounts. Classications most often distinguish between current and noncurrent assets/liabilities, or by nancial and nonnancial categoriesall in order to provide information related to the liquidity of such assets or liabilities (albeit indirectly in many cases). 2.2.1. Current and Noncurrent Distinction The balance sheet should distinguish between current and noncurrent assets and between current and noncurrent liabilities unless a presentation based on liquidity provides more relevant and reliable information (e.g., in the case of a bank or similar nancial institution). From Exhibit 5-5, it should be clear that in essence, the current/noncurrent distinction is also an attempt at incorporating liquidity expectations into the structure of the balance sheet. Assets expected to be liquidated or used up within one year or one operating cycle of the business, whichever is greater, are classied as current assets. A companys operating cycle is the amount of time that elapses between spending cash for inventory and supplies and collecting the cash from its sales to customers. Assets not expected to be liquidated or used up within one year or one operating cycle of the business, whichever is greater, are classied as noncurrent (long-term) assets. The excess of current assets over current liabilities is called working capital. The level of working capital tells analysts about the ability of an entity to meet liabilities as they fall due. Yet, working capital should not be too large because funds could be tied up that could be used more productively elsewhere. Some current assets are allocated to expenses immediately (e.g., inventory) when sales or cash transactions take place, whereas noncurrent assets are allocated over the useful lives of such assets. Current assets are maintained for operating purposes and represent cash or items EXHIBIT 5-5 Balance Sheet: Current versus Noncurrent Distinction Apex Corporation 20X7 20X6 20,000 16,000 Assets Current assets Noncurrent assets Total assets 53,000 27,000 73,000 43,000 14,000 7,000 Liabilities and equity Current liabilities Noncurrent liabilities 37,000 16,000 Total liabilities 51,000 23,000 Equity 22,000 20,000 73,000 43,000 Total liabilities and equity c05.indd c05.indd 171 9/17/08 11:31:56 AM 172 International Financial Statement Analysis expected to be converted into cash or used up (e.g., prepaid expenses) in the current period. Current assets, therefore, tell us more about the operating activities and the operating capability of the entity. Noncurrent assets represent the infrastructure from which the entity operates and are not consumed or disposed in the current period. Such assets represent potentially less liquid investments made from a strategic or longer-term perspective (e.g., to secure trading advantages, supply lines, or other synergies, such as equity securities held, investments in associates, or investments in subsidiaries). A current liability is a liability that satises any of the following criteria: It is expected to be settled in the entitys normal operating cycle. It is held primarily for the purpose of being traded. It is due to be settled within one year after the balance sheet date. The entity does not have an unconditional right to defer settlement of the liability for at least one year after the balance sheet date. Financial liabilities are classied as current if they are due to be settled within one year after the balance sheet date, even if the original term was for a period longer than one year. All other liabilities are classied as noncurrent. International Accounting Standard (IAS) No. 1 species that some current liabilities, such as trade payables and some accruals for employee and other operating costs, are part of the working capital used in the entitys normal operating cycle. Such operating items are classied as current liabilities even if they will be settled more than one year after the balance sheet date. When the entitys normal operating cycle is not clearly identiable, its duration is assumed to be one year. Noncurrent liabilities include nancial liabilities that provide nancing on a long-term basis, and they are, therefore, not part of the working capital used in the entitys normal operating cycle; neither are they due for settlement within one year after the balance sheet date. 2.2.2. Liquidity-Based Presentation Paragraph 51 of IAS No. 1 requires the use of the current/noncurrent format of presentation for the balance sheet, except when a presentation based on liquidity provides information that is reliable and is more relevant. When that exception applies, all assets and liabilities shall be presented broadly in order of liquidity. Entities such as banks are clearly candidates for such a liquidity-based presentation in their balance sheets. Exhibit 5-6 shows how the asset side of a banks balance sheet could be ordered using a liquidity-based presentation. 2.2.3. IFRS and U.S. GAAP Balance Sheet Illustrations This section illustrates actual corporate balance sheets prepared under International Financial Reporting Standards (IFRS) and generally accepted accounting principles (GAAP) via examples from Roche Group and Sony Corporation, respectively. Roche is a leading international health care company based in Switzerland and prepares its nancial statements in accordance with IFRS. Exhibit 5-7 presents the comparative balance sheets from the companys annual report for the scal years ended 31 December 2005 and 2004. Roche prepares its balance sheets using the report format. The balance sheet also gives noncurrent assets before current assets and long-term liabilities before current liabilities, c05.indd 172 9/17/08 11:31:56 AM Chapter 5 173 Understanding the Balance Sheet EXHIBIT 5-6 Bank Balance Sheet: Asset Side Order. Using a Liquidity-Based Presentation Assets 1. Cash and balances with the central bank 2. Trading securities 3. Securities held for stable liquidity portfolio purposes 4. Placements with and loans to banks and credit institutions (net of specic provisions) 5. Loans and advances to other customers 6. Investmentslong-term interests in other entities 7. Property, plant, and equipment 8. Other assets (prepayments, etc.) Total Assets EXHIBIT 5-7 Roche GroupConsolidated Balance Sheets (CHF millions) 31 December 2005 2004 Noncurrent assets Property, plant, and equipment 15,097 12,408 Goodwill 6,132 5,532 Intangible assets 6,256 6,340 58 55 2,190 1,227 Investments in associated companies Financial long-term assets 660 484 Deferred income tax assets Other long-term assets 1,724 1,144 Post-employment benet assets 1,622 1,577 33,739 28,767 Inventories 5,041 4,614 Accounts receivables 7,698 7,014 Total noncurrent assets Current assets Current income tax assets 299 159 1,703 2,007 2,886 16,657 10,394 4,228 2,605 Total current assets 35,626 29,679 Total assets 69,365 58,446 Other current assets Receivable from Bayer Group collected on 1 January 2005 Marketable securities Cash and cash equivalents Noncurrent liabilities Long-term debt (7,077) Deferred income tax liabilities c05.indd 173 (9,322) (3,518) (3,564) (Continued ) 9/17/08 11:31:57 AM 174 International Financial Statement Analysis EXHIBIT 5-7 (Continued ) 31 December 2005 2004 Post-employment benets liabilities (2,937) (2,744) Provisions (1,547) (683) Other noncurrent liabilities (806) (961) (18,130) (15,029) Short-term debt (348) (2,013) Current income tax liabilities (811) (947) Provisions (833) (1,223) (2,373) (1,844) Total noncurrent liabilities Current Liabilities Accounts payable Accrued and other current liabilities (5,127) (4,107) Total current liabilities (9,492) (10,134) Total liabilities (27,622) (25,163) Total net assets 41,743 33,283 34,922 27,998 6,821 5,285 41,743 33,283 Equity Capital and reserves attributable to Roche shareholders Equity attributable to minority interests Total equity following common practice under IFRS. Note also that Roche shows the minority interest for its consolidated subsidiary companies in the shareholders equity section as required under IFRS. Minority interest represents the portion of consolidated subsidiaries owned by others. For example, if a company owns 85 percent of a subsidiary, 100 percent of the subsidiarys assets and liabilities are included in the consolidated balance sheet. Minority interest represents the 15 percent of the net assets of the subsidiary not owned by the parent company. Sony Corporation and its consolidated subsidiaries are engaged in the development, design, manufacture, and sale of various kinds of electronic equipment, instruments, and devices for consumer and industrial markets. Sony is also engaged in the development, production, and distribution of recorded music and image-based software. Sony Corporation has prepared a set of consolidated nancial statements in accordance with U.S. GAAP. Exhibit 5-8 presents the comparative balance sheets from the companys U.S. GAAP annual report for the scal years ended 31 March 2005 and 2004. Sony prepares its balance sheets using the report format. Under U.S. GAAP, current assets are presented before long-term assets, and current liabilities are presented before longterm liabilities. The current/long-term presentation rule is applicable for all manufacturing, merchandising, and service companies, although there are some regulated industry exceptions (e.g., utility companies) where the presentation is reversed (similar to the common c05.indd c05.indd 174 9/17/08 11:31:57 AM Chapter 5 175 Understanding the Balance Sheet EXHIBIT 5-8 Sony Corporation: Consolidated Balance Sheets ( millions) 31 March 2005 2004 779,103 849,211 1,492 4,662 460,202 274,748 1,113,071 1,123,863 Assets Current Assets Cash and cash equivalents Time deposits Marketable securities Notes and accounts receivable, trade Allowance for doubtful accounts and sales returns (87,709) (112,674) Inventories 631,349 666,507 Deferred income taxes 141,154 125,532 Prepaid expenses and other current assets 517,509 431,506 3,556,171 3,363,355 278,961 256,740 252,905 86,253 2,492,784 2,426,697 2,745,689 2,512,950 182,900 189,785 Total current assets Film costs Investments and Advances Afliated companies Securities investments and other Property, Plant, and Equipment Land Buildings Machinery and equipment Construction in progress LessAccumulated depreciation 925,796 930,983 2,192,038 2,053,085 92,611 98,480 (2,020,946) (1,907,289) 1,372,399 1,365,044 Intangibles, net 187,024 248,010 Goodwill 283,923 277,870 Deferred insurance acquisition costs 374,805 349,194 Deferred income taxes 240,396 203,203 Other 459,732 514,296 1,545,880 1,592,573 9,499,100 9,090,662 63,396 91,260 Other Assets Total assets Liabilities and Stockholders Equity Current Liabilities Short-term borrowings Current portion of long-term debt 166,870 383,757 (Continued ) c05.indd 175 9/17/08 11:31:58 AM 176 International Financial Statement Analysis EXHIBIT 5-8 (Continued ) 31 March 2005 2004 Notes and accounts payable, trade 806,044 778,773 Accounts payable, other and accrued expenses 746,466 812,175 Accrued income and other taxes 55,651 57,913 Deposits from customers in the banking business 546,718 378,851 Other 424,223 479,486 2,809,368 2,982,215 Long-term debt 678,992 777,649 Accrued pension and severance costs 352,402 368,382 Total current liabilities Long-Term Liabilities Deferred income taxes Other Minority Interest in Consolidated Subsidiaries 72,227 96,193 2,464,295 2,178,626 227,631 286,737 3,795,547 Future insurance policy benets and other 3,707,587 23,847 22,858 3,917 3,917 Stockholders Equity Subsidiary tracking stock, no par value Authorized 100,000,000 shares, outstanding 3,072,000 shares Common stock, no par value 2004Authorized 3,500,000,000 shares, outstanding 926,418,280 shares 2005Authorized 3,500,000,000 shares, outstanding 997,211,213 shares 476,350 617,792 Additional paid-in capital 1,134,222 992,817 Retained earnings 1,506,082 1,367,060 Unrealized gains on securities 62,669 69,950 Unrealized losses on derivative investments (2,490) (600) Minimum pension liability adjustments (90,030) (89,261) Foreign currency translation adjustments (355,824) (430,048) (385,675) (449,959) (0) (0) (6,000) (12,183) Accumulated other comprehensive income Treasury stock, at cost Subsidiary tracking stock (20040 shares, 2005-32 shares) Common stock (20042,468,258 shares, 2005-1,118,984 shares) 2,870,338 Total liabilities and stockholders equity c05.indd c05.indd 176 2,378,002 9,499,100 9,090,662 9/17/08 11:31:59 AM Chapter 5 Understanding the Balance Sheet 177 IFRS practice of presenting long-term assets before current assets and long-term liabilities before current liabilities). Note also that Sony shows the minority interest for its consolidated subsidiary companies in an in-between or mezzanine section between the liabilities and shareholders equity sections. This mezzanine presentation for minority interest is common under U.S. GAAP; however, minority interest may also be shown under either liabilities or shareholders equity. By contrast, under IFRS, a minority interest is presented in the shareholders equity section. The Financial Accounting Standards Board (FASB) is considering a change to U.S. GAAP to conform their standards to IFRS. 3 . MEASUREMENT BASES OF ASSETS AND LIABILITIES In portraying an asset or liability on the balance sheet, the question arises as to how it should be measured. For example, an asset may have been acquired many years ago at a cost of $1 million but may have a current value of $5 million. Should this asset be listed at its historic cost or its current value? On the one hand, historical cost provides a reliable and objectively determined measurement basethere would be no dispute regarding what the asset cost. On the other hand, users of nancial statements (e.g., creditors) may prefer to know what the asset could be sold for currently if the company needed to raise cash. Some assets and liabilities can be more objectively valued in the marketplace than others (e.g., when an established market exists in which the asset or liability trades regularly, such as an investment in another publicly traded company). As a result, the balance sheet under current standards is a mixed model: Some assets and liabilities are reported based on historical cost, sometimes with adjustments, whereas other assets and liabilities are measured based upon a current value intended to represent the assets fair value. Fair value and historical value can be dened as follows: Fair value. Fair value is the amount at which an asset could be exchanged, or a liability settled, between knowledgeable willing parties in an arms-length transaction. When the asset or liability trades regularly, its fair value is usually readily determinable from its market price (sometimes referred to as fair market value). Historical cost. The historical cost of an asset or liability is its cost or fair value at acquisition, including any costs of acquisition and/or preparation. In limited circumstances other measurement bases are sometimes used, such as current cost (the cost to replace an asset) or present value (the present discounted value of future cash ows). The key question for analysts is how the reported measures of assets and liabilities on the balance sheet relate to economic reality and to each other. To answer this question, the analyst needs to understand the accounting policies applied in preparing the balance sheet and the measurement bases used. Analysts may need to make adjustments to balance sheet measures of assets and liabilities in assessing the investment potential or creditworthiness of a company. For example, land is generally reported at historical cost on the balance sheet because this measure is objective and any measure of current value (other than an actual sale) would be very subjective. Through diligent research, an analyst may nd companies that own valuable land that is not adequately reected on the balance sheet.2 2 See, for example, Beyond the Balance-Sheet: Land-Ho, Forbes, 4 September 2006, pp. 8485, which examines a handful of stocks with valuable land holdings not reected on the balance sheet. c05.indd c05.indd 177 9/17/08 11:31:59 AM 178 International Financial Statement Analysis For all of these reasons, the balance sheet value of total assets should not be accepted as an accurate measure of the total value of a company. The value of a company is a function of many factors, including future cash ows expected to be generated by the company and current market conditions. The balance sheet provides important information about the value of some assets and information about future cash ows but does not represent the value of the company as a whole. Once individual assets and liabilities are measured, additional decisions may be necessary as to how these measures are reected on the balance sheet. Accounting standards generally prohibit the offsetting of assets and liabilities other than in limited circumstances. For example, if a building is purchased for $10 million subject to a mortgage of $8 million, the building is reported as an asset for $10 million while the mortgage is shown separately as a liability ($8 million). It is important that these assets and liabilities be reported separately. Offsetting in the balance sheet, except when offsetting reects the substance of the transaction or other event, detracts from the ability of users to understand the transactions, events, and conditions that have occurred and to assess the entitys future cash ows. However, disclosing or measuring assets net of valuation allowances (e.g., obsolescence allowances on inventories and doubtful accounts allowances on receivables) is not considered to be offsetting. Offsetting is also permitted in limited circumstances where there are restrictions on the availability of assets (such as with pension plans). According to IFRS, fair presentation requires the faithful representation on the balance sheet of the effects of transactions, other events, and conditions in accordance with the denitions and recognition criteria for assets, liabilities, income, and expenses set out in the IFRS Framework, as presented in the chapter on nancial reporting standards. The application of IFRS is presumed to result in fair presentation. The nancial statements should disclose the following information related to the measures used for assets and liabilities shown on the balance sheet: Accounting policies, including the cost formulas used. Total carrying amount of inventories and amount per category. Amount of inventories carried at fair value less costs to sell. Amount of any write-downs and reversals of any write-down. Circumstances or events that led to the reversal of a write-down. Inventories pledged as security for liabilities. Amount of inventories recognized as an expense. The notes to nancial statements and managements discussion and analysis are integral parts of the U.S. GAAP and IFRS nancial reporting processes. They provide important required detailed disclosures, as well as other information provided voluntarily by management. This information can be invaluable when determining whether the measurement of assets is comparable to other entities being analyzed. The notes include information on such topics as the following: c05.indd 178 Specic accounting policies that were used in compiling the nancial statements. Terms of debt agreements. Lease information. Off-balance-sheet nancing. Breakdowns of operations by important segments. Contingent assets and liabilities. Detailed pension plan disclosure. 9/17/08 11:32:00 AM Chapter 5 179 Understanding the Balance Sheet The notes would also provide information in respect of: Disclosure of accounting policies Measurement bases used in preparing nancial statements. Each accounting policy used. Judgments made in applying accounting policies that have the most signicant effect on the amounts recognized in the nancial statements. Estimation uncertainty Key assumptions about the future and other key sources of estimation uncertainty that have a signicant risk of causing material adjustment to the carrying amount of assets and liabilities within the next year. Other disclosures Description of the entity, including its domicile, legal form, country of incorporation, and registered ofce or business address. Nature of operations or principal activities, or both. Name of parent and ultimate parent. EXAMPLE 5-1 Analysis of Off-Balance-Sheet Disclosures Hewitt Associates (NYSE: HEW) posted the following table on page 43 of its SEC Form 10-K for the scal year ending 30 September 2005. The table was included in the Management Discussion and Analysis. Contractual Obligations (in millions) Payments Due in Fiscal Year Total 2006 200708 200910 Thereafter 737 89 149 123 376 Principal 80 Interest 41 4 9 11 56 6 11 9 15 121 10 20 20 71 Principal 259 36 50 30 143 Interest 50 12 18 13 7 309 48 68 43 150 Purchase commitments 73 34 37 2 Other long-term liabilities 72 8 16 9 39 $1,312 $189 $290 $197 $636 Operating leases (1) Capital leases: Total leases: Debt: Total debt Total contractual obligations c05.indd c05.indd 179 9/17/08 11:32:00 AM 180 International Financial Statement Analysis On pages 5657 of the 10-K, Hewitt posted the following balance sheet (abbreviated below). Of the obligations listed above, only the capital leases and other long-term liabilities are included explicitly on the balance sheet. Hewitt Associates, Inc.: Consolidated Balance Sheets (Dollars in thousands except share and per-share amounts) 30 September 2005 2004 $163,928 $129,481 Assets Current assets: Cash and cash equivalents Short-term investments 53,693 183,205 595,691 522,882 Refundable income taxes 23,100 Prepaid expenses and other current assets 60,662 50,546 Funds held for clients 97,907 14,693 5,902 246 1,000,883 901,053 Deferred contract costs 253,505 162,602 Property and equipment, net 302,875 236,099 Capitalized software, net 110,997 85,350 Other intangible assets, net 261,999 107,322 Goodwill 694,370 285,743 32,711 29,805 Client receivables and unbilled work in process Deferred income taxes, net Total current assets Noncurrent assets: Other assets, net Total noncurrent assets 1,656,457 906,921 Total assets 2,657,340 1,807,974 Accounts payable 57,412 20,909 Accrued expenses 156,575 83,226 97,907 14,693 Advanced billings to clients 156,257 106,934 Accrued compensation and benets 141,350 181,812 35,915 13,445 Liabilities Current liabilities: Funds held for clients Short-term debt and current portion of long-term debt Current portion of capital lease obligations Employee deferred compensation and accrued prot sharing Total current liabilities c05.indd c05.indd 180 3,989 5,373 30,136 49,450 679,541 475,842 9/17/08 11:32:07 AM Chapter 5 181 Understanding the Balance Sheet Long-term liabilities: Deferred contract revenues 140,474 118,025 Debt, less current portion 222,692 121,253 76,477 79,982 Other long-term liabilities 127,376 83,063 Deferred income taxes, net 99,423 70,456 Total long-term liabilities 666,442 472,779 1,345,983 948,621 1,311,357 859,353 $2,657,340 $1,807,974 Capital lease obligations, less current portion Total liabilities Commitments and contingencies (Notes 12 and 17) Stockholders Equity Total stockholders equity Total liabilities and stockholders equity Operating leases represent assets used by the company but for which accounting standards do not currently require the assets or related obligations be reported on the companys balance sheet. Analysts, however, frequently prefer to adjust the balance sheet to determine how it would look if the assets had been purchased and nanced. Credit analysts, such as Standard & Poors, also make this adjustment to better reect the creditworthiness of the company. Ideally, the analyst would like to know the implied interest rate in the lease agreements and use this to determine the present value of the asset and related liability, because each lease payment effectively has an interest and a principal component. For this initial example, we will use a shortcut method. Assuming operating leases can be segregated into principal and interest components at approximately the same rate as the capital leases, they represent a liability worth nearly $500 million that is not recorded on the balance sheet. The analyst would adjust the balance sheet by adding that amount to xed assets and liabilities to examine the current economic position. This information would not have been uncovered based solely upon a review of the balance sheet. Important disclosures about assets and liabilities can be found in the footnotes to the nancial statements and in managements discussion of the nancial statements. 3.1. Current Assets Current assets are assets expected to be realized or intended for sale or consumption in the entitys normal operating cycle. Typical current assets that appear on the face of the balance sheet include: c05.indd 181 Assets held primarily for trading. Assets expected to be realized within 12 months after the balance sheet date. Cash or cash equivalents, unless restricted in use for at least 12 months. Marketable securitiesdebt or equity securities that are owned by a business, traded in a public market, and whose value can be determined from price information in a public 9/17/08 11:32:19 AM 182 International Financial Statement Analysis market. Examples of marketable securities include treasury bills, notes, bonds, and equity securities, such as common stocks and mutual fund shares. Trade receivablesamounts owed to a business by its customers for products and services already delivered are included as trade receivables. Allowance has to be made for bad debt expenses, reducing the gross receivables amount. Inventoriesphysical products on hand such as goods that will eventually be sold to an entitys customers, either in their current form (nished goods) or as inputs into a process to manufacture a nal product (raw materials and work-in-process). Other current assetsshort-term items not easily classiable into the above categories (e.g., prepaid expenses). Exhibit 5-9 illustrates how the current asset amounts of 20,000 (20X7) and 16,000 (20X6) have been expanded from the one amount shown in Exhibit 5-5. In the sections below, some of the issues surrounding the measurement principles for inventories and prepaid expenses are discussed. EXHIBIT 5-9 Apex Current Assets 20X7 Current Assets 20X6 20,000 16,000 Cash and cash equivalents 3,000 2,000 Marketable securities 3,000 4,000 Trade receivables 5,000 3,000 Inventories 7,000 6,000 Other current assetsprepaid expenses 2,000 1,000 3.1.1. Inventories Inventories should be measured at the lower of cost or net realizable value. The cost of inventories comprises all costs of purchase, costs of conversion, and other costs incurred in bringing the inventories to their present location and condition. The following amounts should be excluded in the determination of inventory costs: Abnormal amounts of wasted materials, labor, and overhead. Storage costs, unless they are necessary prior to a further production process. Administrative overheads. Selling costs. The net realizable value (NRV) is the estimated selling price less the estimated costs of completion and costs necessary to make the sale. Accounting standards allow different valuation methods. For example, IAS No. 2 allows only the rst in, rst out (FIFO), weighted average cost (WAC), and specic identication methods. Some accounting standard setters (such as U.S. GAAP) also allow LIFO (last in, rst out) as an additional inventory valuation method, whereas LIFO is not allowed under IFRS. c05.indd 182 9/17/08 11:32:28 AM Chapter 5 Understanding the Balance Sheet 183 The following techniques can be used to measure the cost of inventories if the resulting valuation amount approximates cost: Standard cost, which should take into account the normal levels of materials, labor, and actual capacity. The standard cost should be reviewed regularly in order to ensure that it approximates actual costs. The retail method in which the sales value is reduced by the gross margin to calculate cost. An average gross margin percentage should be used for each homogeneous group of items. In addition, the impact of marked-down prices should be taken into consideration. EXAMPLE 5-2 Analysis of Inventory Cisco Systems is the worlds leading provider of networking equipment. In its third quarter 2001 Form 10-Q led with the U.S. Securities and Exchange Commission (SEC) on 1 June 2001, the company made the following disclosure: We recorded a provision for inventory, including purchase commitments, totaling $2.36 billion in the third quarter of scal 2001, of which $2.25 billion related to an additional excess inventory charge. Inventory purchases and commitments are based upon future sales forecasts. To mitigate the component supply constraints that have existed in the past, we built inventory levels for certain components with long lead times and entered into certain longer-term commitments for certain components. Due to the sudden and signicant decrease in demand for our products, inventory levels exceeded our requirements based on current 12-month sales forecasts. This additional excess inventory charge was calculated based on the inventory levels in excess of 12-month demand for each specic product. We do not currently anticipate that the excess inventory subject to this provision will be used at a later date based on our current 12-month demand forecast. Even after the inventory charge, Cisco held approximately $2 billion of inventory on the balance sheet, suggesting that the write-off amounted to half its inventory. In addition to the obvious concerns raised as to managements poor performance anticipating how much they would need, many analysts were concerned about how the write-off would affect Ciscos future reported earnings. When this inventory is sold in a future period, a gain could be reported based on a lower cost basis for the inventory. In this case, management indicated that the intent was to scrap the inventory. When the company subsequently released its annual earnings, the press release stated:3 Net sales for scal 2001 were $22.29 billion, compared with $18.93 billion for scal 2000, an increase of 18%. Pro forma net income, which excludes the effects of acquisition charges, payroll tax on stock option exercises, restructuring costs and 3 Cisco Press Release dated 7 August 2001 from www.cisco.com. c05.indd c05.indd 183 9/17/08 11:32:28 AM 184 International Financial Statement Analysis other special charges, excess inventory charge (benet), and net gains realized on minority investments, was $3.09 billion or $0.41 per share for scal 2001, compared with pro forma net income of $3.91 billion or $0.53 per share for scal 2000, decreases of 21% and 23%, respectively. Actual net loss for scal 2001 was $1.01 billion or $0.14 per share, compared with actual net income of $2.67 billion or $0.36 per share for scal 2000. Note that the company focused on pro forma earnings initially, which excluded the impact of many items, including the inventory write-off. The company only gave a brief mention of actual (U.S. GAAP) results. 3.1.2. Prepaid Expenses Prepaid expenses are normal operating expenses that have been paid in advance. The advance payment creates an asset out of a transaction that would normally have resulted in an expense. Examples might include prepaid rent or prepaid insurance. Prepaid expenses will be expensed in future periods as they are used up. Generally, expenses are reported in the period in which they are incurred as opposed to when they are paid. If a company pays its insurance premium for the next calendar year on 31 December, the expense is not incurred at that date; the expense is incurred as time passes (in this example, 1/12 in each following month). 3.2. Current Liabilities Current liabilities are those liabilities that are expected to be settled in the entitys normal operating cycle, held primarily for trading and due to be settled within 12 months after the balance sheet date. Exhibit 5-10 illustrates how the current liabilities amounts of 14,000 (20X7) and 7,000 (20X6) have been expanded from the one amount shown in Exhibit 5-5. In the sections below, some of the issues surrounding the measurement principles for payables, accrued liabilities, and unearned revenue are discussed. EXHIBIT 5-10 Apex Current Liabilities 20X7 Current Liabilities 20X6 14,000 7,000 Trade and other payables 5,000 2,000 Notes payable 3,000 1,000 Current portion of noncurrent borrowings 2,000 1,000 Current tax payable 2,000 2,000 Accrued liabilities c05.indd c05.indd 184 1,000 500 Unearned revenue 1,000 500 9/17/08 11:32:37 AM Chapter 5 Understanding the Balance Sheet 185 Noncurrent interest-bearing liabilities to be settled within 12 months after the balance sheet date can be classied as noncurrent liabilities if: The original term of the liability is greater than 12 months, It is the intention to renance or reschedule the obligation, or The agreement to renance or reschedule the obligation is completed on or before the balance sheet date. 3.2.1. Trade and Other Payables (Accounts Payable) Accounts payable are amounts that a business owes its vendors for goods and services that were purchased from them but which have not yet been paid. 3.2.2. Notes Payable Notes payable are amounts owed by a business to creditors as a result of borrowings that are evidenced by a (short-term) loan agreement. Examples of notes payable include bank loans and other current borrowings other than those arising from trade credit. Notes payable may also appear in the long-term liability section of the balance sheet if they are due after one year or the operating cycle, whichever is longer. 3.2.3. Current Portion of Noncurrent Borrowings By convention, liabilities expected to be repaid or liquidated within one year or one operating cycle of the business, whichever is greater, are classied as current liabilities. Other liabilities are classied as noncurrent. For example, Exhibit 5-10 shows that 2,000 of Apexs noncurrent borrowings will come due within a year; therefore, the 2,000 constitutes a current liability. 3.2.4. Current Tax Payable Current taxes payable are tax expenses that have been determined and recorded on a companys income statement but which have not yet been paid. 3.2.5. Accrued Liabilities Accrued liabilities (also known as accrued expenses) are expenses that have been reported on a companys income statement but which have not yet been paid because there is no legal obligation to pay them as of the balance sheet date. Common examples of accrued liabilities are accrued interest payable and accrued wages payable. 3.2.6. Unearned Revenue Unearned revenue (also known as deferred revenue) is the collection of money in advance of delivery of the goods and services associated with the revenue. Examples include rental income received in advance, advance fees for servicing ofce equipment, and advance payments for magazine subscriptions received from customers. c05.indd 185 9/17/08 11:32:40 AM 186 International Financial Statement Analysis EXAMPLE 5-3 Analysis of Unearned Revenue Germanys SAP AG is one of the worlds leading providers of business software solutions and one of the worlds three largest independent software companies based on market capitalization. At year-end 2005, SAP reported the following assets and liabilities on its balance sheet (in thousands):4 2005 2004 Assets Goodwill 626,546 456,707 Other intangible assets 139,697 68,186 1,094,965 999,083 534,155 100,382 2,395,363 1,624,358 Property, plant, and equipment Financial assets Fixed assets Inventories Accounts receivable, net Other assets 19,376 11,692 2,251,027 1,929,100 635,554 537,645 2,886,581 2,466,745 209,565 10,164 Liquid assets 3,213,572 3,196,542 Nonxed assets 6,329,094 5,685,143 250,698 205,601 Accounts receivable and other assets Marketable securities Deferred taxes Prepaid expenses and deferred charges 87,587 70,370 Total assets 9,062,742 7,585,472 thereof total current assets 6,241,125 4,849,537 316,458 316,004 (775,318) (569,166) 372,767 322,660 5,986,186 4,830,156 Shareholders Equity and Liabilities Subscribed capital(1) Treasury stock Additional paid-in capital Retained earnings Accumulated other comprehensive loss (117,855) (305,401) Shareholders equity 5,782,238 4,594,253 4 In its annual report, SAP AG chose to provide the subtotal of current assets and current liabilities at the bottom of the respective portions of the balance sheet rather than within the balance sheet to distinguish how much of its nonxed assets are current. According to Footnote 1 of SAP AGs 2005 annual report: Non-xed assets are comprised of Inventories, Accounts receivable, Other assets, Marketable securities, and Liquid assets including amounts to be realized in excess of one year. c05.indd c05.indd 186 9/17/08 11:32:40 AM Chapter 5 187 Understanding the Balance Sheet Minority interests Pension liabilities and similar obligations Other reserves and accrued liabilities Reserves and accrued liabilities Bonds Other liabilities Other liabilities Deferred income 7,615 21,971 183,619 139,690 1,839,140 1,768,723 2,022,759 1,908,413 6,927 7,277 838,778 728,838 845,705 736,115 404,425 324,720 Total shareholders equity and liabilities 9,062,742 7,585,472 thereof current liabilities 2,781,685 2,591,872 The nal line shows that deferred income rose nearly 25 percent to end 2005 with a value of $404.4 million. SAP describes the line as follows: Deferred income consists mainly of prepayments for maintenance and deferred software license revenues. Such amounts will be recognized as software, maintenance, or service revenue, depending upon the reasons for the deferral when the basic criteria in SOP 97-2 have been met (see Note 3). Although investors prefer to see many liabilities minimized, deferred revenue represents money the company has already been paid for services that will be delivered in the future. Because it will then be recognized as revenue, many investors monitor the deferred income line (when signicant) as an indicator of future revenue growth. 3.3. Tangible Assets Tangible assets are long-term assets with physical substance that are used in company operations. These noncurrent assets are carried at their historical cost less any accumulated depreciation or accumulated depletion. Historical cost generally consists of vendor invoice cost, freight cost, and any other additional costs incurred to make the asset operable. Examples of tangible assets include land, buildings, equipment, machinery, furniture, and natural resources owned by the company, such as copper mines, oil and gas properties, and timberlands. If any of these assets are not used in company operations, they must be classied as investment assets. 3.4. Intangible Assets Intangible assets are amounts paid by a company to acquire certain rights that are not represented by the possession of physical assets. A distinction can be made between identiable intangibles and unidentiable intangibles. An identiable intangible can be acquired singly and is typically linked to specic rights or privileges having nite benet periods. Examples include patents and trademarks. An unidentiable intangible cannot be acquired singly and typically possesses an indenite benet period. An example is accounting goodwill, discussed further in section 3.4.2. c05.indd c05.indd 187 9/17/08 11:32:50 AM 188 International Financial Statement Analysis A company should assess whether the useful life of an intangible asset is nite or innite and, if nite, the length of its life, or number of production or similar units constituting its useful life. Amortization and impairment principles apply as follows: An intangible asset with a nite useful life is amortized on a systematic basis over the best estimate of its useful life. An intangible asset with an innite useful life should be tested for impairment annually but not amortized. The balance sheet and notes should disclose the gross carrying amount (book value) less accumulated amortization for each class of asset at the beginning and the end of the period. Companies may also have intangible assets that are not recorded on their balance sheets. These intangible assets might include management skill, valuable trademarks and name recognition, a good reputation, proprietary products, and so forth. Such assets are valuable and would fetch their worth if a company were to be sold. Financial analysts have traditionally viewed the values assigned to intangible assets, particularly unidentiable intangibles, with caution. Consequently, in assessing nancial statements, they often exclude the book value assigned to intangibles, particularly unidentiable intangibles, reducing net equity by an equal amount and increasing pretax income by any amortization expense or impairment associated with the intangibles. An arbitrary assignment of zero value to intangibles is not advisable. The analyst should examine each listed intangible and assess whether an adjustment should be made. 3.4.1. Specically Identiable Intangibles Under IFRS, specically identiable intangible assets are nonnancial assets without physical substance but which can be identied. Such assets are recognized on the balance sheet if it is probable that future economic benets will ow to the company and the cost of the asset can be measured reliably. Examples of identiable intangible assets include patents, trademarks, copyrights, franchises, and other rights. Identiable intangible assets may have been created or purchased by a company. Determining the cost of internally created intangible assets can be difcult and subjective. For these reasons, internally created identiable intangibles are less likely to be reported on the balance sheet under IFRS or U.S. GAAP. IAS No. 38 applies to all intangible assets that are not specically dealt with in other international accounting standards. This standard determines that the intangible assets reported on a balance sheet are only those intangibles that have been purchased or created (in strictly limited instances). IAS No. 38 provides that for internally created intangible assets, the company must identify the research phase and the development phase. The research phase includes activities that seek new knowledge or products. The development phase occurs after the research phase and includes design or testing of prototypes and models. IAS No. 38 prohibits the capitalization of costs as intangible assets during the research phase. Instead, these costs must be expensed on the income statement. Costs incurred in the development stage can be capitalized as intangible assets if certain criteria are met, including technological feasibility, the ability to use or sell the resulting asset, and the ability to complete the project. All other expenses related to the following categories are expensed. They include: Internally generated brands, mastheads, publishing titles, customer lists, etc. Start-up costs. Training costs. c05.indd 188 9/17/08 11:32:56 AM Chapter 5 189 Understanding the Balance Sheet Administrative and other general overhead costs. Advertising and promotion. Relocation and reorganization expenses. Redundancy and other termination costs. U.S. GAAP prohibits the capitalization as an asset of almost all research and development costs. All such costs usually must be expensed. Generally, under U.S. GAAP, acquired intangible assets are reported as separately identiable intangibles (as opposed to goodwill) if they arise from contractual rights (such as a licensing agreement), other legal rights (such as patents), or have the ability to be separated and sold (such as a customer list). EXAMPLE 5-4 Measuring Intangible Assets Alpha Inc., a motor vehicle manufacturer, has a research division that worked on the following projects during the year: Project 1: Research aimed at nding a steering mechanism that does not operate like a conventional steering wheel but reacts to the impulses from a drivers ngers. Project 2: The design of a prototype welding apparatus that is controlled electronically rather than mechanically, which has been determined to be technologically feasible. The following is a summary of the expenses of the particular department: General Project 1 Project 2 000 000 000 128 935 620 620 320 720 Direct 340 410 Indirect 270 110 60 Material and Services Labor Direct labor Administrative personnel Overhead Five percent of administrative personnel costs can be attributed to each of Projects 1 and 2. Explain the capitalization of Alphas development costs for Projects 1 and 2 under IFRS. Solution. Under IFRS, the capitalization of development costs for Projects 1 and 2 would be as follows: 000 Project 1: Classied as research so all costs are recognized as expenses. NIL Project 2: (620 1,410 320 410 60) Note that Project 2 is in the development stage and costs related to the project should be capitalized under IFRS. However, under IAS No. 38, administrative personnel costs should be expensed. c05.indd 189 9/17/08 11:32:57 AM 190 International Financial Statement Analysis 3.4.2. Goodwill In a purchase acquisition, the excess of the cost of acquisition over the acquirers interest in the fair value of the identiable assets and liabilities acquired is described as goodwill and is recognized as an asset. The subject of recognizing goodwill in nancial statements has found both proponents and opponents among professionals. The proponents of goodwill recognition assert that goodwill is the present value of excess returns that a company is able to earn. This group claims that determining the present value of these excess returns is analogous to determining the present value of future cash ows associated with other assets and projects. Opponents of goodwill recognition claim that the prices paid for acquisitions often turn out to be based on unrealistic expectations, thereby leading to future write-offs of goodwill. Analysts should distinguish between accounting goodwill and economic goodwill. Economic goodwill is based on the economic performance of the entity, whereas accounting goodwill is based on accounting standards and only reported for past acquisitions. Economic goodwill is what should concern analysts and investors, and it is often not reected on the balance sheet. This economic goodwill should be reected in the stock price. Many analysts believe that goodwill should not be listed on the balance sheet, as it cannot be sold separately from the entity. These analysts believe that only assets that can be separately identied and sold be reected on the balance sheet. Other nancial statement users may desire to analyze goodwill and any subsequent impairment charges to assess managements performance on prior acquisitions. Under IFRS and U.S. GAAP, goodwill should be capitalized and tested for impairment annually. Goodwill is not amortized. Impairment of goodwill is a noncash expense. If goodwill is deemed to be impaired, it is charged against income in the current period. This charge reduces current earnings. Assets are also reduced, so some performance measures, such as return on assets (net income divided by average total assets), may actually increase in future periods. Under IFRS No. 3, the purchase method of accounting can be summarized by the following steps: The cost of acquisition is determined. The fair value of the acquirees assets is determined. The fair value of the acquirees liabilities and contingent liabilities is determined. Calculate the goodwill arising from the purchase as follows: The book value of the acquirers assets and liabilities should be combined with the fair value adjustments of the acquirees assets, liabilities, and contingent liabilities. Any goodwill should be recognized as an asset in the combined entitys balance sheet. Despite the clear guidance incorporated in IFRS No. 3, many analysts believe that the determination of fair values involve considerable management discretion. Values for intangible assets, such as computer software, might not be easily validated when analyzing purchase acquisitions. Management judgment can be particularly apparent in the allocation of the excess purchase price (after all other allocations to assets and liabilities). If, for example, the remaining excess purchase price is allocated to goodwill, there will be no impact on the companys net income because goodwill is not amortized (but is tested for impairment). If the excess were to be allocated to xed assets, depreciation would rise, thus reducing net income and producing incorrect nancial statements. (Depreciation is the allocation of the costs of a long-term [tangible] asset over its useful life.) c05.indd c05.indd 190 9/17/08 11:33:05 AM Chapter 5 191 Understanding the Balance Sheet Goodwill can signicantly affect the comparability of nancial statements between companies using different accounting methods. As such, an analyst should remove any distortion that the recognition, amortization, and impairment of goodwill might create by adjusting the companys nancial statements. Adjustments should be made by: Computing nancial ratios using balance sheet data that exclude goodwill. Reviewing operating trends using data that exclude the amortization of goodwill or impairment to goodwill charges. Evaluating future business acquisitions by taking into account the purchase price paid relative to the net assets and earnings prospects of the acquired company. IFRS No. 3 requires disclosure of the factors that contributed to goodwill and a description of each intangible asset that was not recognized separately from goodwill. EXAMPLE 5-5 Goodwill Impairment Vodafone Group, PLC, is a leading international provider of mobile communications services. It entered many of its international markets by acquiring local carriers. On 27 February 2006, Vodafone issued a press release that included the following information: Reecting the increasingly competitive environment in the industry, Vodafone has incorporated into its latest ten year plan a lower view of growth prospects for a number of key operating companies, particularly in the medium to long term, than those it has used previously. The result of these factors is that Vodafone expects to report: 1. An impairment of the Groups goodwill in the range of GBP 23 billion to GBP 28 billion in respect of reductions in the aggregate goodwill for Vodafone Germany, Vodafone Italy and, potentially, Vodafone Japan. It is expected that most of the total will be attributable to Vodafone Germany. 2. No impairment for any other subsidiary, joint venture or investment in associated undertakings. 3. No impairment in respect of nite lived assets. A summary of the Groups goodwill in respect of subsidiary undertakings and joint ventures as of 30 September 2005 is set out below: GBP Billion Germany 19.7 Japan c05.indd c05.indd 191 35.5 Italy 9.0 9/17/08 11:33:06 AM 192 International Financial Statement Analysis Spain 10.3 United Kingdom 0.7 Other subsidiaries and joint ventures 6.3 81.5 How signicant is this goodwill impairment and, with reference to acquisition prices, what might it indicate? Solution. Given that the goodwill impairment was approximately equal to one-third the total value of goodwill recorded, it would appear to be signicant. According to the press release, the impairment has arisen due to a competitive environment and lower expected growth rates. The operations involved appear now to be worth less than the price that was paid for their acquisition. 3.5. Financial Instruments: Financial Assets and Financial Liabilities International accounting standards dene a nancial instrument as a contract that gives rise to a nancial asset of one entity, and a nancial liability or equity instrument of another entity. Financial instruments, both assets and liabilities, come in a variety of forms. Financial assets include investments in stocks and bonds and similar instruments. Financial liabilities include bonds, notes payable, and similar instruments. Some nancial instruments may be classied as either an asset or a liability depending upon the contractual terms and current market conditions. One example of such a complex nancial instrument is a derivative. A derivative is a nancial instrument for which the value is derived based on some underlying factor (interest rate, exchange rate, commodity price, security price, or credit rating) and for which little or no initial investment is required. Derivatives may be used to hedge business transactions or for speculation. Mark-to-market (fair value adjustments to nancial assets and liabilities) is the process whereby the value of most trading assets (e.g., those held for trading and that are available for sale) and trading liabilities are adjusted to reect current fair value. Such adjustments are often made on a daily basis, and cumulative balances are reversed on the subsequent day, prior to recalculating a fresh cumulative mark-to-market adjustment. All nancial assets and nancial liabilities (including derivatives) should be recognized when the entity becomes a party to the contractual provisions of an instrument. For the purchase or sale of nancial assets where market convention determines a xed period between trade and settlement dates, the trade or settlement date can be used for recognition. Interest is not normally accrued between trade and settlement dates, but mark-to-market adjustments are made regardless of whether the entity uses trade date or settlement date accounting. Although IAS No. 39 allows the use of either date, trade date accounting is preferred by most treasury accountants. Exhibit 5-11 provides a summary of how various nancial assets and liabilities are classied and measured. From Exhibit 5-11, marketable securities such as stocks and bonds may be classied as trading, available for sale, and held to maturity. To illustrate the different accounting c05.indd 192 9/17/08 11:33:13 AM Chapter 5 193 Understanding the Balance Sheet EXHIBIT 5-11 Measurement of Financial Assets and Liabilities Measured at Fair Value Measured at Cost or Amortized Cost Financial Assets Financial Assets Financial assets held for trading (e.g., stocks and bonds) Unlisted instruments (investments where the fair value is not reliably measurable) Available-for-sale nancial assets (e.g., stocks and bonds) Held-to-maturity investments (bonds intended to be held to maturity) Derivatives whether stand-alone or imbedded in nonderivative instruments Loans and receivables Nonderivative instruments (including nancial assets) with fair value exposures hedged by derivatives Financial Liabilities Financial Liabilities Derivatives All other liabilities (such as bonds payable or notes payable) Financial liabilities held for trading Nonderivative instruments (including nancial liabilities) with fair value exposures hedged by derivatives treatments of the gains and losses on marketable securities, consider an entity that invests 100 million in a 5 percent coupon xed-income security portfolio. After six months, the company receives the rst coupon payment of 2,500,000. Additionally, interest rates have declined and the value of the xed-income securities has increased by 2 million. Exhibit 5-12 illustrates how this situation will be portrayed in the balance sheet assets and equity, as well as the income statement of the entity concerned, under each of the following three accounting policies for marketable securities: assets held for trading purposes, assets available for sale, and held-to-maturity assets. In the case of marketable securities classied as either trading or available for sale, the investments are listed under assets at fair market value. For exposition purposes, Exhibit 5-12 shows the unrealized gain on a separate line. Practically, the investments would be listed at their fair value of 102 million on one line within assets. In the case of trading securities, the unrealized gain is included on the income statement and thus reected in retained earnings. In the case of available-for-sale securities, the unrealized gain is not included on the income statement; rather, it is deferred as part of other comprehensive income within owners equity. As noted in the chapter on the income statement, other comprehensive income includes gains and losses that have not yet been reported on the income statement due to particular accounting standards. In the case of held-to-maturity securities, the unrealized gain is not reected on either the balance sheet or income statement. In the case of liabilities such as bonds issued by a company, these are normally reported at amortized cost on the balance sheet, as noted in Exhibit 5-12. For example, if a company issues bonds with a total par value of $10 million at a price of $9,750,000 (issued at a discount), the bonds are reported as a liability of $9,750,000 (cost). As time passes, the discount of $250,000 is amortized such that the bond will be listed as a liability of $10 million at maturity. Similarly, any bond premium would be amortized for bonds issued at a premium. c05.indd c05.indd 193 9/17/08 11:33:16 AM 194 International Financial Statement Analysis EXHIBIT 5-12 Accounting for Gains and Losses on Marketable Securities BALANCE SHEET As of 30 June 200X Trading Portfolio Available-forSale Portfolio Held to Maturity Assets Deposits Unrealized gains (losses) on securities 2,500,000 2,500,000 2,500,000 100,000,000 100,000,000 100,000,000 2,000,000 2,000,000 104,500,000 Cost of securities 104,500,000 102,500,000 100,000,000 100,000,000 100,000,000 4,500,000 2,500,000 2,500,000 Liabilities Equity Paid-in capital Retained earnings Other comprehensive income (losses) 2,000,000 104,500,000 104,500,000 102,500,000 Interest income 2,500,000 2,500,000 2,500,000 Unrealized gains (losses) 2,000,000 INCOME STATEMENT For period 1 January30 June 200X 4,500,000 2,500,000 2,500,000 4 . EQUITY Equity is the residual claim on a companys assets after subtracting liabilities. It represents the claim of the owner against the company. Equity includes funds directly invested in the company by the owners, as well as earnings that have been reinvested over time. Equity can also include items of gain or loss that are not yet recognized on the companys income statement. 4.1. Components of Equity IFRS and U.S. GAAP both dene equity (or net assets) as the residual interest in the assets of an entity that remain after deducting its liabilities. There are ve potential components that comprise the owners equity section of the balance sheet: 1. Capital contributed by owners. Capital ownership in a corporation is evidenced through the issuance of common stock, although preferred stock (a hybrid security with some characteristics of debt) may be issued by some companies in addition to common stock. Preferred shares have rights that take precedence over the rights of common shareholdersrights that generally pertain to receipt of dividends (not always cumulative if omitted by the board of directors) and receipt of assets if the company is liquidated. Common and preferred shares c05.indd c05.indd 194 9/17/08 11:33:17 AM Chapter 5 2. 3. 4. 5. 195 Understanding the Balance Sheet may have a par value (or stated value) or may be issued as no par shares (depending on governmental requirements at the time of incorporation). Where par or stated value requirements exist, it must be disclosed in the stockholders equity section of the balance sheet. In addition, the number of shares authorized, issued, and outstanding must be disclosed for each class of stock issued by the company. The number of authorized shares is the number of shares that may be sold by the company under its articles of incorporation. The number of issued shares is those shares that have been sold to investors while the number of outstanding shares consists of the issued shares less those shares repurchased (treasury stock) by the company. Minority interest (or noncontrolling interest). The equity interests of minority shareholders in the subsidiary companies that have been consolidated by the parent (controlling) company but that are not wholly owned by the parent company. Retained earnings (or retained decit). Amounts that have been recognized as cumulatively earned in the companys income statements but which have not been paid to the owners of the company through dividends. Treasury stock (or own shares repurchased). The repurchase of company shares may occur when management considers the shares undervalued or when it wants to limit the effects of dilution from various employee stock compensation plans. Treasury stock is a reduction of shareholders equity and a reduction of total shares outstanding. Treasury shares are nonvoting and do not receive dividends if declared by the company. Accumulated comprehensive income (or other reserves). Amounts that may either increase or decrease total shareholders equity but are not derived from the income statement or through any company transactions in its own equity shares. In June 1997, the FASB released Statement of Financial Accounting Standard (SFAS) No. 130, Reporting of Comprehensive Income. This statement established certain standards for reporting and presenting comprehensive income in the general-purpose nancial statements. SFAS No. 130 was issued in response to users concerns that certain changes in assets and liabilities were bypassing the income statement and appearing in the statement of changes in stockholders equity. The purpose of SFAS No. 130 was to report all items that met the denition of comprehensive income in a prominent nancial statement for the same period in which they were recognized. In accordance with the denition provided by Statement of Financial Accounting Concepts No. 6, comprehensive income was to include all changes in owners equity that resulted from transactions of the business entity with nonowners. Comprehensive income can be dened as: Comprehensive income Net income Other comprehensive income According to SFAS No. 130, other comprehensive income (OCI) is part of total comprehensive income but generally excluded from net income. Prior to SFAS No. 130, these three itemsforeign currency translation adjustments, minimum pension liability adjustments, and unrealized gains or losses on available-for-sale investmentswere disclosed as separate components of stockholders equity on the balance sheet. Under SFAS No. 130, they are to be reported as OCI. Furthermore, they must be reported separately, as the FASB decided that information about each component is more important than information about the aggregate. Later, under SFAS No. 133, net unrealized losses on derivatives were also included in the denition of OCI. The intent of SFAS No. 130 was that if used with related disclosures and other information in nancial statements, the information provided by reporting comprehensive income would assist investors, creditors, and other nancial statement users in assessing an enterprises economic activities and its timing and magnitude of future cash ows. c05.indd c05.indd 195 9/17/08 11:33:17 AM 196 International Financial Statement Analysis EXHIBIT 5-13 Apex Stockholders Equity 20X7 Equity Share capital 20X6 22,000 20,000 10,000 10,000 Preferred shares 2,000 2,000 Share premium (paid-in capital) Other reserves (unrealized gains and losses) 1,000 Retained earnings 9,000 8,000 Own shares repurchased (treasury shares) Although the FASB required that an enterprise shall display total comprehensive income and its components in a nancial statement that is displayed with the same prominence as other nancial statements that constitute a full set of nancial statements, it did not specify which format was required, except that net income should be shown as a component of comprehensive income in that nancial statement. According to SFAS No. 130, three alternative formats are allowed for presenting OCI and total comprehensive income: 1. Below the line for net income in a traditional income statement (as a combined statement of net income and comprehensive income). 2. In a separate statement of comprehensive income that begins with the amount of net income for the year. 3. In a statement of changes in stockholders equity. Under IFRS, the component changes are also reported in the statement of equity; however, it is not presently required that a comprehensive income amount be reported. Exhibit 5-13 illustrates how the equity amounts of 22,000 (20X7) and 20,000 (20X6) have been expanded from the one amount shown in Exhibit 5-5. 4.2. Statement of Changes in Shareholders Equity The statement of changes in shareholders equity reects information about the increases or decreases to a companys net assets or wealth. With respect to comprehensive income, the following items, if present, must be disclosed: Unrealized gains or losses on available-for-sale investments. Gains or losses from derivatives that qualify as net investment hedges or cash ow hedges. Minimum pension liability adjustments from underfunded dened-benet plans. Foreign currency translation adjustments on foreign subsidiary companies. Other information in the changes in equity statement or in notes includes the following: Capital transactions with owners and distributions to owners. Reconciliation of the balance of accumulated prot or loss (retained earnings) at the beginning and end of the year. c05.indd c05.indd 196 9/17/08 11:33:18 AM Chapter 5 197 Understanding the Balance Sheet Reconciliation of the carrying amount of each class of equity capital, share premium (paid-in capital), and accumulated comprehensive income (reserve) at the beginning and end of the period. Exhibit 5-14 presents Sony Corporations Consolidated Statement of Changes in Stockholders Equity for the scal years ended 31 March 2004 and 2005. In this statement, Sony complies with the reconciliation and disclosure requirements that were discussed above. EXHIBIT 5-14 Sony Corporation and Consolidated Subsidiaries: Consolidated Statement of Changes in Stockholders Equity ( millions) Subsidiary Additional Tracking Common Paid-In Stock Stock Capital Balance on 31 March 2003 Conversion of convertible bonds Stock issued under exchange offering 3,917 472,361 3,989 Retained Earnings 984,196 1,301,740 Accumulated Other CompreTreasury hensive stock, at Income Cost (471,978) Total (9,341) 2,280,895 3,988 7,977 5,409 5,409 Comprehensive income: Net income 88,511 88,511 Other comprehensive income, net of tax Unrealized gains on securities: Unrealized holding gains or losses arising during period 57,971 57,971 (5,679) (5,679) 7,537 7,537 Less: Reclassication adjustment for gains or losses included in net income Unrealized losses on derivative instruments: Unrealized holding gains or losses arising during period Less: Reclassication adjustment for gains or losses included in net income c05.indd 197 (3,344) (3,344) (Continued ) 9/17/08 11:33:18 AM 198 International Financial Statement Analysis EXHIBIT 5-14 (Continued ) Subsidiary Additional Tracking Common Paid-In Stock Stock Capital Retained Earnings Minimum pension liability adjustment Accumulated Other CompreTreasury hensive stock, at Income Cost Total 93,415 93,415 (129,113) (129,113) Foreign currency translation adjustments: Translation adjustments arising during period Less: Reclassication adjustment for losses included in net income 1,232 1,232 Total comprehensive income 110,530 Stock issue costs, net of tax (53) (23,138) Dividends declared (53) (23,138) Purchase of treasury stock (8,523) Reissuance of treasury stock 5,681 (776) (8,523) 4,905 Balance on 31 March 2004 3,917 476,350 992,817 1,367,060 (449,959) (12,183) 2,378,022 Balance on 31 March 2004 3,917 476,350 992,817 1,367,060 (449,959) (12,183) 2,378,022 Exercise of stock acquisition rights 52 53 105 Conversion of convertible bonds 141,390 141,354 282,744 340 340 Stock-based compensation Comprehensive income: Net income 163,838 163,838 Other comprehensive income, net of tax c05.indd c05.indd 198 9/17/08 11:33:19 AM Chapter 5 199 Understanding the Balance Sheet Subsidiary Additional Tracking Common Paid-In Stock Stock Capital Retained Earnings Accumulated Other CompreTreasury hensive stock, at Income Cost Total Unrealized gains on securities: Unrealized holding gains or losses arising during period 5,643 5,643 (12,924) (12,924) (209) (209) (1,681) (1,681) (769) (769) Less: Reclassication adjustment for gains or losses included in net income Unrealized losses on derivative instruments: Unrealized holding gains or losses arising during period Less: Reclassication adjustment for gains or losses included in net income Minimum pension liability adjustment Foreign currency translation adjustments: Translation adjustments arising during period 74,224 74,224 Total comprehensive income 228,122 Stock issue costs, net of tax (541) (24,030) Dividends declared (541) (24,030) Purchase of treasury stock Reissuance of treasury stock Balance on 31 March 2005 c05.indd c05.indd 199 (416) (342) (245) 3,917 617,792 1,134,222 1,506,082 6,599 (385,675) (416) 6,012 (6,000) 2,870,338 9/17/08 11:33:19 AM 200 International Financial Statement Analysis 5 . USES AND ANALYSIS OF THE BALANCE SHEET The classied sections of Apex Corporations balance sheets have been discussed and illustrated throughout this chapter. Exhibit 5-15 now presents the complete detailed balance sheets for Apex, which we will use as the basis for a discussion of how to analyze a balance sheet. EXHIBIT 5-15 Apex Detailed Balance Sheets Balance Sheet (000) 20X6 Assets Current Assets Cash and cash equivalents Marketable securities: 3 types Trade receivables Inventories Other current assets Noncurrent Assets Property, plant, and equipment Goodwill Other intangible assets Noncurrent investments (subsidiaries, associates, joint ventures) Total Assets 20,000 3,000 3,000 5,000 7,000 2,000 53,000 35,000 5,000 3,000 10,000 73,000 16,000 2,000 4,000 3,000 6,000 1,000 27,000 20,000 1,000 1,000 5,000 43,000 Liabilities and Equity Current Liabilities Trade and other payables Current borrowings Current portion of noncurrent borrowings Current tax payable Accrued liabilities Unearned revenue Noncurrent Liabilities Noncurrent borrowings Deferred tax Noncurrent provisions Total Liabilities Equity Share capital Preference shares Share premium (paid-in capital) Other reserves (unrealized gains and losses) Retained earnings Own shares repurchased (treasury shares) Total Liabilities and Shareholders Equity c05.indd c05.indd 200 20X7 14,000 5,000 3,000 2,000 2,000 1,000 1,000 37,000 30,000 6,000 1,000 51,000 22,000 10,000 2,000 1,000 9,000 73,000 7,000 2,000 1,000 1,000 2,000 500 500 16,000 10,000 5,000 1,000 23,000 20,000 10,000 2,000 8,000 43,000 9/17/08 11:33:20 AM Chapter 5 201 Understanding the Balance Sheet If a company is growing or shrinking, comparing balance sheet amounts from year to year may not clearly show trends. Additionally, comparing companies is difcult unless adjustments are made for size. Two techniques used to analyze balance sheets adjusted for differences or changes are common-size analysis and ratio analysis. 5.1. Common-Size Analysis of the Balance Sheet The rst technique, common-size analysis, involves stating all balance sheet items as a percentage of total assets.5 Common-size statements are useful in comparing a companys current balance sheet with prior-year balance sheets or to other companies in the same industry. Horizontal common-size analysis provides a format to accomplish the former but not the latter. Exhibit 5-16 illustrates vertical common-size balance sheets for Apex Corporation. Horizontal common-size analysis is demonstrated in a later chapter. EXHIBIT 5-16 Apex Common-Size Balance Sheets Balance Sheet (Percent of Total Assets) 20X7 20X6 Assets Current Assets 27.4 37.2 Cash and cash equivalents 4.1 4.7 Marketable securities: 3 types 4.1 9.3 Trade receivables 6.8 7.0 Inventories 9.6 14.0 Other current assets 2.7 2.3 Noncurrent Assets 72.6 62.8 Property, plant, and equipment 47.9 46.5 6.8 2.3 Goodwill Other intangible assets 4.1 2.3 13.7 11.6 100.0 100.0 19.2 16.3 Trade and other payables 6.8 4.7 Current borrowings 4.1 2.3 Current portion of noncurrent borrowings 2.7 2.3 Current tax payable 2.7 4.7 (Continued ) Noncurrent investments (subsidiaries, associates, joint ventures) Total Assets Liabilities and Equity Current Liabilities 5 This format can be distinguished as vertical common-size analysis. As the chapter on nancial statement analysis will discuss, another type of common-size analysis, known as horizontal common-size analysis, states quantities in terms of a selected base-year value. Unless otherwise indicated, text references to common-size analysis refer to vertical analysis. c05.indd 201 9/17/08 11:33:21 AM 202 International Financial Statement Analysis EXHIBIT 5-16 (Continued ) Balance Sheet (Percent of Total Assets) 20X7 1.4 Accrued liabilities Unearned revenue 20X6 1.2 1.4 1.2 Noncurrent Liabilities 50.7 37.2 Noncurrent borrowings 41.1 23.3 Deferred tax 8.2 11.6 Noncurrent provisions 1.4 2.3 Total Liabilities 69.9 53.5 Shareholders Equity 30.1 46.5 Share capital 13.7 23.3 Preference shares 2.7 4.7 Share premium (paid-in capital) Other reserves (unrealized gains and losses) 1.4 12.3 18.6 Retained earnings Own shares repurchased (treasury shares) Total Liabilities and Shareholders Equity 100.0 100.0 The common-size analysis for Apex clearly shows that for 20X7, the company is less liquid and is more leveraged than it was in 20X6. Regarding liquidity, current assets have decreased and current liabilities have increased when compared with the prior year. With respect to leverage, both noncurrent and total liabilities have increased when compared with the prior year. EXAMPLE 5-6 Common-Size Analysis Applying common-size analysis to the Roche Group balance sheets presented in Exhibit 5-7, which one of the following line items increased in 2005 relative to 2004? A. B. C. D. Goodwill Inventories Long-term debt Accounts receivables Solution. C is correct. Long-term debt increased as a percentage of total assets from 12.1 percent of total assets in 2004 (CHF7,077 CHF58,446) to 13.4 percent in 2005 (CHF9,322 CHF69,365). c05.indd c05.indd 202 9/17/08 11:33:21 AM Chapter 5 Understanding the Balance Sheet 203 Although goodwill, inventories, and accounts receivables all increased in absolute Swiss franc amounts during 2005, they declined as a percentage of total assets when compared with the previous year. Vertical common-size analysis of the balance sheet is particularly useful in crosssectional analysiscomparing companies to each other for a particular time period or comparing a company with industry or sector data. The analyst could select individual peer companies for comparison, use industry data from published sources, or compile data from databases. Some common sources of published data are: Annual Statement Studies, published by the Risk Management Association (RMA). This volume provides abbreviated common-size (and ratio) data by industry. The source of data includes both public and nonpublic company data collected by nancial institutions and may reect non-GAAP, unaudited data. Almanac of Business and Industrial Financial Ratios, by Leo Troy. This is an annually revised publication, currently published by CCH. When analyzing a company, many analysts prefer to select the peer companies for comparison or to compile their own industry statistics. For example, Exhibit 5-17 presents common-size balance sheet data compiled for the 10 sectors of Standard & Poors 500 using 2005 data. The sector classication follows the S&P/MSCI Global Industrial Classication System (GICS). The exhibit presents mean and median common-size balance sheet data for those companies in the S&P 500 for which 2005 data was available in the Compustat database.6 Some interesting general observations can be made from these data: Energy and utility companies have the largest amounts of property, plant, and equipment. Utilities also have the highest level of long-term debt and use some preferred stock. Financial companies have the greatest percentage of liabilities. Telecommunications services and utility companies have the lowest level of receivables. Inventory levels are highest for consumer discretionary and consumer staples companies. Information technology companies use the least amount of leverage as evidenced by the entries for long-term debt and total liabilities. Example 5-7 shows an analyst using cross-sectional common-size balance sheet data. 6 An entry of zero for an item (e.g., current assets) was excluded from the data, except in the case of preferred stock. Note that most nancial institutions did not provide current asset or current liability data, so these are reported as not available in the database. c05.indd 203 9/17/08 11:33:24 AM 204 c05.indd c05.indd 204 9/17/08 11:33:26 AM 50.72 0.00 49.28 49.28 Preferred stock Common equity Total equity 7.50 Accts payable Total liabilities 54.70 PP&E 14.77 27.29 Current assets 17.94 1.64 Other current LT debt 3.98 Current liabilities 11.16 Receivables 7.55 Cash Inventories 29 No. observations Panel A. Median Data Energy 36.18 36.18 0.00 63.82 19.86 20.18 7.01 37.21 35.65 2.51 10.21 13.56 6.07 30 Materials 37.71 37.71 0.00 62.29 17.43 24.48 6.91 15.79 36.58 3.59 10.38 16.50 4.89 49 Industrials 43.27 43.27 0.00 56.73 17.81 27.13 6.99 20.99 43.92 3.33 15.43 9.60 7.60 85 Consumer Discretionary 34.64 34.64 0.00 65.36 21.39 29.55 8.54 27.53 33.18 2.75 14.67 9.92 4.50 36 Consumer Staples 52.13 52.13 0.00 47.87 11.43 23.87 4.54 13.70 41.61 3.85 7.49 11.91 18.50 52 Health Care 10.19 10.19 0.00 89.81 11.98 NA 34.73 1.06 NA 0.98 1.37 28.95 5.32 87 Financials 62.90 62.90 0.00 37.10 8.01 22.90 4.14 9.80 56.05 4.00 5.52 10.64 28.35 73 Information Technology 41.61 41.61 0.00 58.39 23.13 13.70 2.49 42.57 10.06 1.49 0.95 4.71 2.05 9 Telecom. Services 24.72 22.89 0.28 75.28 29.35 17.13 3.89 55.04 16.89 4.59 2.13 5.49 1.61 31 Utilities EXHIBIT 5-17 Common-Size Balance Sheet Statistics for the S&P 500: Grouped by S&P/MSCI GICS Sector (in percent except No. of Observations; data for 2005) 205 c05.indd 205 9/17/08 11:33:26 AM 9.07 Accts payable 0.50 46.33 46.84 Total liabilities Preferred stock Common equity Total equity 38.28 37.52 0.76 61.72 20.18 21.02 8.80 35.70 36.82 38.90 38.76 0.14 61.10 18.78 25.48 7.12 24.83 36.41 4.07 10.21 17.92 7.91 49 Industrials LT long term, PP&E property, plant, and equipment. Source: Based on data from Compustat. 17.84 53.16 LT debt 19.00 54.84 PP&E Current liabilities 27.14 Current assets 2.73 10.82 5.32 2.98 Inventories Other current 14.30 11.83 Receivables 9.16 30 Materials 7.56 29 Energy Cash No. observations Panel B. Mean Data 42.36 42.25 0.11 57.64 19.05 27.71 10.46 25.38 40.18 3.74 19.36 12.46 10.19 85 Consumer Discretionary 35.33 35.32 0.01 64.67 23.51 28.66 9.82 30.77 36.35 3.09 15.54 9.92 7.45 36 Consumer Staples 51.12 50.94 0.18 48.88 14.83 25.50 8.75 16.76 44.62 4.08 9.23 12.96 19.55 52 Health Care 19.50 18.60 0.93 80.50 18.16 NA 35.09 1.92 NA 1.09 6.88 34.02 10.49 87 Financials 59.95 59.89 0.06 40.05 10.60 23.99 7.03 13.05 56.71 4.60 6.51 12.78 33.43 73 Information Technology 34.26 34.22 0.04 65.74 31.00 13.56 2.76 48.53 11.59 2.49 0.94 5.16 3.32 9 Telecom. Services 23.17 22.57 0.60 76.83 31.94 18.92 4.53 57.48 18.60 6.44 2.62 6.78 2.85 31 Utilities 206 International Financial Statement Analysis E XAMPLE 5 - 7 Cross - Sectional Common - Size Analysis Jason Lu is examining four companies in the computer industry to evaluate their relative nancial position as reected on their balance sheet. He has compiled the following vertical common-size data for Dell, Hewlett-Packard Co., Gateway, and Apple Computer. Cross-Sectional Analysis, Consolidated Balance Sheets (in percent of total assets) Company DELL HPQ GTW AAPL Fiscal year 3 Feb 2006 31 Oct 2005 31 Dec 2005 30 Sep 2005 Assets Current assets: Cash and cash equivalents 30.47 17.99 21.99 30.22 Short-term investments 8.72 0.02 8.50 41.30 Accounts receivable, net 7.75 17.69 16.11 17.97 Financing receivables, net 5.90 NA NA NA Inventories 2.49 8.89 11.42 1.43 11.34 13.03 22.06 8.48 Total current assets Other current assets 76.62 56.05 81.94 89.17 Property, plant, and equipment, net 8.68 8.34 4.33 7.07 Investments 11.64 9.70 0.00 0.00 Long-term nancing receivables, net 1.41 NA NA NA Other assets 1.65 25.91 13.73 3.76 100.00 100.00 100.00 100.00 15.40 Total Assets Liabilities and Stockholders Equity Current liabilities: Accounts payable 42.58 13.22 39.66 Short-term debt 0.00 2.37 2.60 0.00 26.34 25.10 23.60 14.76 Accrued and other Total current liabilities 68.92 40.69 65.86 30.16 Long-term debt 2.18 4.39 15.62 0.00 Other liabilities 11.03 6.84 2.98 5.20 0.00 0.00 0.00 0.00 82.13 51.92 84.46 35.36 17.87 48.08 15.54 64.64 Commitments and contingent liabilities Total liabilities Stockholders equity Total stockholders equity Source: Based on data from Bloomberg. HPQ Hewlett-Packard Co., GTW NA not available. c05.indd c05.indd 206 Gateway, APPL Apple Computer, 9/17/08 11:33:27 AM Chapter 5 Understanding the Balance Sheet 207 From this data, Lu learns the following: All four companies have a high level of cash, consistent with the information technology sector. Dell and Apple have a much higher than normal balance in cash and investments combined. This may reect their business models, which have generated large operating cash ows in recent years. Apple has the lowest level of accounts receivable. Further research is necessary to learn if this is related to Apples cash sales through retail stores or if the company has been selling/factoring receivables to a greater degree than the other companies. Dell and Apple both have an extraordinarily low level of inventory. Both utilize a just-in-time inventory system and rely on suppliers to hold inventory until needed. Additional scrutiny of the footnotes accompanying their annual reports reveals that Dell includes some in-transit inventory in other current assets and that Apple regularly makes purchase commitments that are not currently recorded as inventory and uses contract manufacturers to assemble and test some nished products. Dell has a smaller relative amount of purchase commitments. Hewlett-Packard has similar purchase commitments to Apple, and all of the companies make some use of contract manufacturers, but no mention is made of them about the extent that inventory may be understated through such use. Overall, it appears that the inventory levels may be understated somewhat for Dell and Apple but that, all things considered, they have been more efcient at managing inventory than Hewlett-Packard or Gateway. All four companies have a level of property, plant, and equipment below that of the sector, with Gateway having the lowest level. Hewlett-Packard has a large amount of other assets. Further analysis reveals that this represents purchased intangibles, particularly goodwill from acquisitions. Dell and Gateway have a large amount of accounts payable. Due to Dells high level of cash and investments, this is likely not a problem for Dell; however, it could indicate that Gateway could have difculty in paying suppliers. An analysis of Gateways cash ows would be warranted. Consistent with the industry, Dell, Hewlett-Packard, and Apple have very low levels of long-term debt. Gateway has a high level relative to the industry, which warrants further examination to assess the companys nancial risk. 5.2. Balance Sheet Ratios The second technique permitting comparison across time (time-series analysis) and across companies (cross-sectional analysis) is ratio analysis. In ratio analysis, the analyst may examine the level and trend of a ratio in relation to past values of the ratio for the company, thereby providing information on changes in the nancial position of a company over time. The analyst may also compare a ratio against the values of the ratio for comparable companies, thereby providing information on the nancial position of a company in relation to that of its peer group. So-called balance sheet ratios are those involving balance sheet items only. Balance sheet ratios fall under the heading of liquidity ratios (measuring the companys ability to meet its short-term obligations) or solvency ratios (measuring the companys ability to meet long-term and other obligations). The use of these ratios along with other balance sheet ratios and ratios combining balance sheet data c05.indd 207 9/17/08 11:33:43 AM 208 International Financial Statement Analysis EXHIBIT 5-18 Balance Sheet Ratios Liquidity Ratios Calculation Measurement Current Current assets Current liabilities Ability to meet current liabilities Quick (acid test) (Cash Marketable securities Receivables) Current liabilities Ability to meet current liabilities Cash (Cash Marketable securities) Current liabilities Ability to meet current liabilities Long-term debt to equity Total long-term debt Financial risk and nancial leverage Debt to equity Total debt Total equity Financial risk and nancial leverage Total debt Total debt Total assets Financial risk and nancial leverage Financial leverage Total assets Solvency Ratios Total equity Total equity Financial risk and nancial leverage with other nancial statement data are discussed in a later chapter. Exhibit 5-18 summarizes the calculation and interpretation of selected balance sheet ratios. Some have questioned the usefulness of nancial statement analysis in a world where capital markets are said to be efcient. After all, they say, an efcient market is forward looking, whereas the analysis of nancial statements is a look at the past. However, the value of nancial analysis is that it enables the analyst to gain insights that can assist in making forward-looking projections required by an efcient market. Financial ratios serve the following purposes: They provide insights into the microeconomic relationships within a company that help analysts project earnings and free cash ow (which is necessary to determine entity value and creditworthiness). They provide insights into a companys nancial exibility, which is its ability to obtain the cash required to meet nancial obligations or to make asset acquisitions, even if unexpected circumstances should develop. Financial exibility requires a company to possess nancial strength (a level and trend of nancial ratios that meet or exceed industry norms), lines of credit, or assets that can be easily used as a means of obtaining cash, either by their outright sale or by using them as collateral. They provide a means of evaluating managements ability. Key performance ratios can serve as quantitative measures for ranking managements ability relative to a peer group. EXAMPLE 5-8 Ratio Analysis For the following ratio questions, refer to the balance sheet information for Roche Group presented in Exhibit 5-7. c05.indd c05.indd 208 9/17/08 11:33:53 AM Chapter 5 209 Understanding the Balance Sheet 1. The current ratio for Roche Group at 31 December 2005 is closest to A. 1.29. B. 1.86. C. 1.97. D. 3.75. 2. Using the balance sheet information presented in Exhibit 5-7 for Roche Group, which one of the following ratios increased in 2005 relative to 2004? A. Current ratio B. Total debt ratio C. Debt-to-equity ratio D. Financial leverage ratio Solution to 1. D is correct. The current ratio (current assets (CHF35,626 CHF9,492). current liabilities) is 3.75 Solution to 2. A is correct. The current ratio (current assets current liabilities) increased from 2.93 (CHF29,679 CHF10,134) in 2004 to 3.75 (CHF35,626 CHF9,492) in 2005. The total debt ratio declined from 43.1 percent in 2004 to 39.8 percent in 2005; the debt-to-equity ratio declined from 75.6 percent in 2004 to 66.2 percent in 2005; and the nancial leverage ratio declined from 1.756 in 2004 to 1.662 in 2005. Financial ratio analysis is limited by: The use of alternative accounting methods. Accounting methods play an important role in the interpretation of nancial ratios. It should be remembered that ratios are usually based on data taken from nancial statements. Such data are generated via accounting procedures that might not be comparable among companies because companies have latitude in the choice of accounting methods. This lack of consistency across companies makes comparability difcult to analyze and limits the usefulness of ratio analysis. Some accounting alternatives currently found include the following: FIFO or LIFO inventory valuation methods. Cost or equity methods of accounting for unconsolidated associates. Straight-line or accelerated consumption pattern methods of depreciation. Capitalized or operating lease treatment. The homogeneity of a companys operating activities. Many companies are diversied with divisions operating in different industries. This makes it difcult to nd comparable industry ratios to use for comparison purposes. It is better to examine industry-specic ratios by lines of business. The need to determine whether the results of the ratio analysis are mutually consistent. One set of ratios might show a problem, and another set might indicate that this problem is short term in nature. The need to use judgment. The analyst must use judgment when performing ratio analysis. A key issue is whether a ratio for a company is within a reasonable range for an industry, with this range being determined by the analyst. Although nancial ratios are used to help assess the growth potential and risk of a business, they cannot be used alone to directly value a company or determine its creditworthiness. The entire operation of the business must be examined, and the external economic and industry setting in which it is operating must be considered when interpreting nancial ratios. c05.indd 209 9/17/08 11:33:55 AM 210 International Financial Statement Analysis 6 . SUMMARY The starting place for analyzing a company is typically the balance sheet. It provides users such as creditors or investors with information regarding the sources of nance available for projects and infrastructure. At the same time, it normally provides information about the future earnings capacity of a companys assets as well as an indication of cash ows implicit in the receivables and inventories. The balance sheet has many limitations, especially relating to the measurement of assets and liabilities. The lack of timely recognition of liabilities and, sometimes, assets, coupled with historical costs as opposed to fair value accounting for all items on the balance sheet, implies that the nancial analyst must make numerous adjustments to determine the economic net worth of the company. The balance sheet discloses what an entity owns (assets) and what it owes (liabilities) at a specic point in time, which is why it is also referred to as the statement of nancial position. Equity represents the portion belonging to the owners or shareholders of a business. Equity is the residual interest in the assets of an entity after deducting its liabilities. The value of equity is increased by any generation of new assets by the business itself or by prots made during the year and is decreased by losses or withdrawals in the form of dividends. The analyst must understand the structure and format of the balance sheet in order to evaluate the liquidity, solvency, and overall nancial position of a company. Key points are: The report format of the balance sheet lists assets, liabilities, and equity in a single column. The account format follows the pattern of the traditional general ledger accounts, with assets at the left and liabilities and equity at the right of a central dividing line. The balance sheet should distinguish between current and noncurrent assets and between current and noncurrent liabilities unless a presentation based on liquidity provides more relevant and reliable information. Assets expected to be liquidated or used up within one year or one operating cycle of the business, whichever is greater, are classied as current assets. Assets not expected to be liquidated or used up within one year or one operating cycle of the business, whichever is greater, are classied as noncurrent assets. Liabilities expected to be settled or paid within one year or one operating cycle of the business, whichever is greater, are classied as current liabilities. Liabilities not expected to be settled or paid within one year or one operating cycle of the business, whichever is greater, are classied as noncurrent liabilities. Asset and liability values reported on a balance sheet may be measured on the basis of fair value or historical cost. Historical cost values may be quite different from economic values. Balance sheets must be evaluated critically in light of accounting policies applied in order to answer the question of how the values relate to economic reality and to each other. The notes to nancial statements are an integral part of the U.S. GAAP and IFRS nancial reporting processes. They provide important required detailed disclosures, as well as other information provided voluntarily by management. This information can be invaluable when determining whether the measurement of assets is comparable to other entities being analyzed. Tangible assets are long-term assets with physical substance that are used in company operations. Intangible assets are amounts paid by a company to acquire certain rights that are not represented by the possession of physical assets. A company should assess whether the useful life of an intangible asset is nite or innite and, if nite, the length of its life. c05.indd 210 9/17/08 11:33:58 AM Chapter 5 Understanding the Balance Sheet 211 Under IFRS and U.S. GAAP, goodwill should be capitalized and tested for impairment annually. Goodwill is not amortized. Financial instruments are contracts that give rise to both a nancial asset of one entity and a nancial liability of another entity. Financial instruments come in a variety of instruments, including derivatives, hedges, and marketable securities. There are ve potential components that comprise the owners equity section of the balance: contributed capital, minority interest, retained earnings, treasury stock, and accumulated comprehensive income. The statement of changes in equity reects information about the increases or decreases to a companys net assets or wealth. Ratio analysis is used by analysts and managers to assess company performance and status. Another valuable analytical technique is common-size (relative) analysis, which is achieved through the conversion of all balance sheet items to a percentage of total assets. P RACTICE PROBLEMS 1. Resources controlled by a company as a result of past events are A. equity. B. assets. C. liabilities. 2. Equity equals A. Assets Liabilities. B. Liabilities Assets. C. Assets Liabilities. 3. Distinguishing between current and noncurrent items on the balance sheet and presenting a subtotal for current assets and liabilities is referred to as A. the report format. B. the account format. C. a classied balance sheet. 4. All of the following are current assets except A. cash. B. goodwill. C. inventories. 5. Debt due within one year is considered A. current. B. preferred. C. long term. 6. Money received from customers for products to be delivered in the future is recorded as A. revenue and an asset. B. an asset and a liability. C. revenue and a liability. c05.indd 211 9/17/08 11:33:59 AM 212 International Financial Statement Analysis 7. The carrying value of inventories reects A. their original cost. B. their current value. C. the lower of original cost or net realizable value. 8. When a company pays its rent in advance, its balance sheet will reect a reduction in A. assets and liabilities. B. liabilities and shareholders equity. C. one category of assets and an increase in another. 9. Accrued liabilities are A. balanced against an asset. B. expenses that have been paid. C. expenses that have been reported on the income statement. 10. The initial measurement of goodwill is A. not subject to management discretion. B. based on an acquisitions purchase price. C. based on the acquired companys book value. 11. Dening total asset turnover as revenue divided by average total assets, all else equal, impairment write-downs of long-lived assets owned by a company will most likely result in an increase for that company in A. the debt-to-equity ratio but not the total asset turnover. B. the total asset turnover but not the debt-to-equity ratio. C. both the debt-to-equity ratio and the total asset turnover. 12. For nancial assets classied as trading securities, how are unrealized gains and losses reected in shareholders equity? A. They are not recognized. B. As an adjustment to paid-in capital. C. They ow through income into retained earnings. 13. For nancial assets classied as available for sale, how are unrealized gains and losses reected in shareholders equity? A. They are not recognized. B. They ow through retained earnings. C. As a separate line item (other comprehensive income). 14. For nancial assets classied as held to maturity, how are unrealized gains and losses reected in shareholders equity? A. They are not recognized. B. They ow through retained earnings. C. As a separate line item (valuation gains/losses). 15. Under IFRS, the minority interest in consolidated subsidiaries is presented on the balance sheet A. as a long-term liability. B. separately, but as a part of shareholders equity. C. as a mezzanine item between liabilities and shareholders equity. c05.indd c05.indd 212 9/17/08 11:33:59 AM Chapter 5 Understanding the Balance Sheet 213 16. Retained earnings are a component of A. liabilities. B. minority interest. C. owners equity. 17. When a company buys shares of its own stock to be held in treasury, it records a reduction in A. both assets and liabilities. B. both assets and shareholders equity. C. assets and an increase in shareholders equity. 18. A common-size analysis of the balance sheet is most likely to signal investors that the company A. has increased sales. B. is using assets efciently. C. is becoming more leveraged. 19. An investor concerned whether a company can meet its near-term obligations is most likely to calculate the A. current ratio. B. debt-to-equity ratio. C. return on total capital. 20. The most stringent test of a companys liquidity is its A. cash ratio. B. quick ratio. C. current ratio. 21. An investor worried that a company may go bankrupt would most likely examine its A. current ratio. B. return on equity. C. debt-to-equity ratio. 22. Using the information presented in Exhibit 5-8 in the chapter, the quick ratio for Sony Corp. on 31 March 2005 is closest to A. 0.44. B. 0.81. C. 0.84. 23. Applying common-size analysis to the Sony Corp. balance sheets presented in Exhibit 5-8, which one of the following line items increased in 2005 relative to 2004? A. Goodwill B. Securities investments and other C. Deferred insurance acquisition costs 24. Using the information presented in Exhibit 5-8, the nancial leverage ratio for Sony Corp. on 31 March 2005 is closest to A. 2.30. B. 2.81. C. 3.31. c05.indd c05.indd 213 9/17/08 11:33:59 AM c05.indd c05.indd 214 9/17/08 11:34:00 AM CHAPTER 6 U NDERSTANDING THE CASH FLOW STATEMENT Thomas R. Robinson, CFA CFA Institute Charlottesville, Virginia Hennie van Greuning, CFA World Bank Washington, DC Elaine Henry, CFA University of Miami Miami, Florida Michael A. Broihahn, CFA Barry University Miami, Florida L EARNING OUTCOMES After completing this chapter, you will be able to do the following: Compare and contrast cash ows from operating, investing, and nancing activities and classify cash ow items as relating to one of those three categories given a description of the items. Describe how noncash investing and nancing activities are reported. 215 c06.indd 215 9/17/08 11:34:53 AM 216 International Financial Statement Analysis Compare and contrast the key differences in cash ow statements prepared under international nancial reporting standards (IFRS) and U.S. generally accepted accounting principles (U.S. GAAP). Explain the difference between the direct and indirect method of presenting cash from operating activities and the arguments in favor of each method. Describe how the cash ow statement is linked to the income statement and the balance sheet. Explain the steps in the preparation of direct and indirect cash ow statements, including how cash ows can be computed using income statement and balance sheet data. Analyze and interpret a cash ow statement using both total currency amounts and common-size cash ow statements. Explain and compute free cash ow to the rm, free cash ow to equity, and other cash ow ratios. 1 . INTRODUCTION The cash ow statement provides information about a companys cash receipts and cash payments during an accounting period, showing how these cash ows link the ending cash balance to the beginning balance shown on the companys balance sheet. The cash-based information provided by the cash ow statement contrasts with the accrual-based information from the income statement. For example, the income statement reects revenues when earned rather than when cash is collected; in contrast, the cash ow statement reects cash receipts when collected as opposed to when the revenue was earned. A reconciliation between reported income and cash ows from operating activities provides useful information about when, whether, and how a company is able to generate cash from its operating activities. Although income is an important measure of the results of a companys activities, cash ow is also essential. As an extreme illustration, a hypothetical company that makes all sales on account, without regard to whether it will ever collect its accounts receivable, would report healthy sales on its income statement and might well report signicant income; however, with zero cash inow, the company would not survive. The cash ow statement also provides a reconciliation of the beginning and ending cash on the balance sheet. In addition to information about cash generated (or, alternatively, cash used) in operating activities, the cash ow statement provides information about cash provided (or used) in a companys investing and nancing activities. This information allows the analyst to answer such questions as: Does the company generate enough cash from its operations to pay for its new investments, or is the company relying on new debt issuance to nance them? Does the company pay its dividends to common stockholders using cash generated from operations, from selling assets, or from issuing debt? Answers to these questions are important because, in theory, generating cash from operations can continue indenitely, but generating cash from selling assets, for example, is possible only as long as there are assets to sell. Similarly, generating cash from debt nancing is possible only as long as lenders are willing to lend, and the lending decision depends on expectations that the company will ultimately have adequate cash to repay its obligations. In summary, information about the sources and uses of cash helps creditors, investors, and other statement users evaluate the companys liquidity, solvency, and nancial exibility. c06.indd 216 9/17/08 11:34:54 AM Chapter 6 Understanding the Cash Flow Statement 217 This chapter explains how cash ow activities are reected in a companys cash ow statement. The chapter is organized as follows: Section 2 describes the components and format of the cash ow statement, including the classication of cash ows under international nancial reporting standards (IFRS) and U.S. generally accepted accounting principles (GAAP) and the direct and indirect formats for presenting the cash ow statement. Section 3 discusses the linkages of the cash ow statement with the income statement and balance sheet and the steps in the preparation of the cash ow statement. Section 4 demonstrates the analysis of cash ow statements, including the conversion of an indirect cash ow statement to the direct method and how to use common-size cash ow analysis, free cash ow measures, and cash ow ratios used in security analysis. Section 5 summarizes the chapter. Finally, practice problems in CFA Institute multiple-choice format are provided. 2 . COMPONENTS AND FORMAT OF THE CASH FLOW STATEMENT The analyst needs to be able to extract and interpret information on cash ows from nancial statements prepared according to any allowable format. The basic components and allowable formats of the cash ow statement are well established. The cash ow statement has subsections relating specic items to the operating, investing, and nancing activities of the company. Two presentation formats are available: the direct and the indirect. The following discussion presents these topics in greater detail. 2.1. Classication of Cash Flows and Noncash Activities All companies engage in operating, investing, and nancing activities. These activities are the classications used in the cash ow statement under both IFRS and U.S. GAAP. Under IFRS, International Accounting Standard No. 7, (IAS No. 7), Cash Flow Statements, provides that cash ows are categorized as follows:1 Operating activities include the companys day-to-day activities that create revenues, such as selling inventory and providing services. Cash inows result from cash sales and from collection of accounts receivable. Examples include cash receipts from the provision of services and royalties, commissions, and other revenue. To generate revenue, companies undertake activities such as manufacturing inventory, purchasing inventory from suppliers, and paying employees. Cash outows result from cash payments for inventory, salaries, taxes, and other operating-related expenses and from paying accounts payable. Additionally, operating activities include cash receipts and payments related to securities held for dealing or trading purposes (as opposed to being held for investment, as discussed below). Investing activities include purchasing and selling investments. Investments include property, plant, and equipment; intangible assets; other long-term assets; and both long-term and short-term investments in the equity and debt (bonds and loans) issued by other companies. 1 IAS No. 7 became effective on 1 January 1994. c06.indd 217 9/17/08 11:34:55 AM 218 International Financial Statement Analysis For this purpose, investments in equity and debt securities exclude: (a) any securities considered cash equivalents (very short-term, highly liquid securities) and (b) dealing or trading securities, the purchase and sale of which are considered operating activities even for companies where this is not a primary business activity. Cash inows in the investing category include cash receipts from the sale of nontrading securities; property, plant, and equipment; intangibles; or other long-term assets. Cash outows include cash payments for the purchase of these assets. Financing activities include obtaining or repaying capital, such as equity and long-term debt. The two primary sources of capital are shareholders and creditors. Cash inows in this category include cash receipts from issuing stock (common or preferred) or bonds and cash receipts from borrowing. Cash outows include cash payments to repurchase stock (e.g., treasury stock), to pay dividends, and to repay bonds and other borrowings. Note that indirect borrowing using accounts payable is not considered a nancing activitysuch borrowing would be classied as an operating activity. EXAMPLE 6-1 Net Cash Flow from Investing Activities A company recorded the following in Year 1: Proceeds from issuance of long-term debt $300,000 Purchase of equipment $200,000 Loss on sale of equipment Proceeds from sale of equipment Equity in earnings of afliate $70,000 $120,000 $10,000 On the Year 1 statement of cash ows, the company would report net cash ow from investing activities closest to A. $150,000. B. $80,000. C. $200,000. D. $300,000. Solution. The only two items that would affect the investing section are the purchase of equipment and the proceeds from sale of equipment. The loss on sale of equipment and the equity in earnings of afliate affect net income but are not investing cash ows. The issuance of debt is a nancing cash ow. B is correct: ($200,000) $120,000 ($80,000). Under IFRS, there is some exibility in reporting some items of cash ow, particularly interest and dividends. IAS No. 7 notes that while for a nancial institution interest paid and received would normally be classied as operating activities, for other entities, alternative classications may be appropriate. For this reason, under IFRS, interest received may be classied either as an operating activity or as an investing activity. Under IFRS, interest c06.indd c06.indd 218 9/17/08 11:34:55 AM Chapter 6 Understanding the Cash Flow Statement 219 paid may be classied as either an operating activity or as a nancing activity. Furthermore, under IFRS, dividends received may be classied as either an operating activity or an investing activity. On the other hand, dividends paid may be classied as either an operating activity or a nancing activity. Companies must use a consistent classication from year to year and disclose where the amounts are reported. Under U.S. GAAP, this discretion is not permitted: Interest received and paid is reported as operating activities for all companies.2 Under U.S. GAAP, dividends received are always reported as operating activities and dividends paid are always reported as nancing activities. EXAMPLE 6-2 Operating versus Financing Cash Flows On 31 December 2006, a company issued a $30,000, 90-day note at 8 percent to pay for inventory purchased that day and issued $110,000 long-term debt at 11 percent annually to pay for new equipment purchased that day. Which of the following most accurately reects the combined effect of both transactions on the companys cash ows for the year ended 31 December 2006 under U.S. GAAP? Cash ow from A. operations increases $30,000. B. nancing increases $110,000. C. operations decreases $30,000. D. nancing decreases $110,000. Solution. C is correct because the increase in inventories would decrease cash ow from operations. The issuance of both short-term and long-term debt is part of nancing activities. Equipment purchased is an investing activity. Note that because no interest was paid or received in this example, the answer would be the same under IFRS. Companies may also engage in noncash investing and nancing transactions. A noncash transaction is any transaction that does not involve an inow or outow of cash. For example, if a company exchanges one nonmonetary asset for another nonmonetary asset, no cash is involved. Similarly, no cash is involved when a company issues common stock either for dividends or in connection with conversion of a convertible bond or convertible preferred stock. Because no cash is involved in noncash transactions (by denition), these transactions are not incorporated in the cash ow statement. However, any signicant noncash transaction is required to be disclosed, either in a separate note or a supplementary schedule to the cash ow statement. 2.2. A Summary of Differences between IFRS and U.S. GAAP As highlighted in the previous section, there are some differences in cash ow statements prepared under IFRS and U.S. GAAP that the analyst should be aware of when comparing the cash ow statements of companies using U.S. GAAP or IFRS. The key differences are 2 See Financial Accounting Standard No. 95, Statement of Cash Flows. This was originally issued in 1987 and modied somewhat in recent years. c06.indd 219 9/17/08 11:35:01 AM 220 International Financial Statement Analysis EXHIBIT 6-1 Cash Flow Statements: Differences between IFRS and U.S. GAAP Topic IFRS U.S. GAAP Interest received Operating or investing Operating Interest paid Operating or nancing Operating Dividends received Operating or investing Operating Dividends paid Operating or nancing Financing Bank overdrafts Considered part of cash equivalents Not considered part of cash and cash equivalents and classied as nancing Taxes paid Generally operating, but a portion can be allocated to investing or nancing if it can be specically identied with these categories Operating Format of statement Direct or indirect; direct is encouraged Direct or indirect; direct is encouraged. If direct is used, a reconciliation of net income and operating cash ow must also be provided Disclosures Tax cash ows must be separately disclosed in the cash ow statement Interest and taxes paid must be disclosed in footnotes if not presented on the statement of cash ows Classication of Cash Flows: Sources: IAS No. 7, FAS No. 95, and Similarities and Differences: A Comparison of IFRS and U.S. GAAP, PricewaterhouseCoopers, October 2004, available at www.pwc.com. summarized in Exhibit 6-1. In short, the IASB allows more exibility in the reporting of items such as interest paid or received and dividends paid or received, and in how income tax expense is classied. U.S. GAAP classies interest and dividends received from investments as operating activities, whereas IFRS allows companies to classify those items as either operating or investing cash ows. Likewise, U.S. GAAP classies interest expense as an operating activity, even though the principal amount of the debt issued is classied as a nancing activity. IFRS allows companies to classify interest expense as either an operating activity or a nancing activity. U.S. GAAP classies dividends paid to stockholders as a nancing activity, whereas IFRS allows companies to classify dividends paid as either an operating activity or a nancing activity. U.S. GAAP classies all income tax expenses as an operating activity. IFRS also classies income tax expense as an operating activity, unless the tax expense can be specically identied with an investing or nancing activity (e.g., the tax effect of the sale of a discontinued operation could be classied under investing activities). Under either of the two sets of standards, companies currently have a choice of formats for presenting cash ow statements, as discussed in the next section. c06.indd c06.indd 220 9/17/08 11:35:04 AM Chapter 6 Understanding the Cash Flow Statement 221 2.3. Direct and Indirect Cash Flow Formats for Reporting Operating Cash Flow There are two acceptable formats for reporting cash ow from operations (also known as cash ow from operating activities or operating cash ow), dened as the net amount of cash provided from operating activities: the direct and the indirect methods. The amount of operating cash ow is identical under both methods; only the presentation format of the operating cash ow section differs. The presentation format of the cash ows from investing and nancing is exactly the same, regardless of which method is used to present operating cash ows. The direct method shows the specic cash inows and outows that result in reported cash ow from operating activities. It shows each cash inow and outow related to a companys cash receipts and disbursements, adjusting income statement items to remove the effect of accruals. In other words, the direct method eliminates any impact of accruals and shows only cash receipts and cash payments. The primary argument in favor of the direct method is that it provides information on the specic sources of operating cash receipts and payments in contrast to the indirect method, which shows only the net result of these receipts and payments. Just as information on the specic sources of revenues and expenses is more useful than knowing only the net resultnet incomethe analyst gets additional information from a direct-format cash ow statement. The additional information is useful in understanding historical performance and in predicting future operating cash ows. The indirect method shows how cash ow from operations can be obtained from reported net income as the result of a series of adjustments. The indirect format begins with net income. To reconcile net income with operating cash ow, adjustments are made for noncash items, for nonoperating items, and for the net changes in operating accruals. The main argument for the indirect approach is that it shows the reasons for differences between net income and operating cash ows. (It may be noted, however, that the differences between net income and operating cash ows are equally visible on an indirect-format cash ow statement and in the supplementary reconciliation required if the company uses the direct method.) Another argument for the indirect method is that it mirrors a forecasting approach that begins by forecasting future income and then derives cash ows by adjusting for changes in balance sheet accounts that occur due to the timing differences between accrual and cash accounting. Under IFRS, IAS No. 7 encourages the use of the direct method but permits either. Similarly, under U.S. GAAP, the Financial Accounting Standards Board (FASB) in Financial Accounting Standard No. 95 encourages the use of the direct method but allows companies to use the indirect method. Under FAS No. 95, if the direct method is presented, footnote disclosure must also be provided of the indirect method. If the indirect method is chosen, no direct-format disclosures are required. As a result, few U.S. companies present the direct format for operating cash ows. Many users of nancial statements prefer the direct format, particularly analysts and commercial lenders, because of the importance of information about operating receipts and payments to assessing a companys nancing needs and capacity to repay existing obligations. In 1987, at the time the FASB was adopting FAS No. 95, some companies argued that it is less costly to adjust net income to operating cash ow, as in the indirect format, than it is to report gross operating cash receipts and payments, as in the direct format. With subsequent progress in accounting systems and technology, it is not clear that this argument remains valid. CFA Institute has advocated that standard setters require the use of the direct c06.indd c06.indd 221 9/17/08 11:35:05 AM 222 International Financial Statement Analysis format for the main presentation of the cash ow statement, with indirect cash ows as supplementary disclosure.3 2.3.1. An Indirect-Format Cash Flow Statement Prepared under IFRS Exhibit 6-2 presents cash ow statements prepared under IFRS from Roche Groups annual report for the scal years ended 31 December 2005 and 2004, which show the use of the indirect method. Roche is a leading international health care company based in Switzerland.4 EXHIBIT 6-2 Roche Group: Consolidated Cash Flow Statements (CHF millions) Fiscal Years Ended 31 December 2005 2004 6,730 7,063 Cash Flows from Operating Activities Net income Add back nonoperating (income) expense: Income from associated companies Financial income Financing costs Exceptional income from bond conversion and redemption Income taxes Discontinued businesses (1) (678) 382 2,224 12 43 (369) 602 (872) 1,865 (2,337) Operating prot 8,669 5,995 Depreciation of property, plant, and equipment 1,302 1,242 Amortization of goodwill Amortization of intangible assets Impairment of long-term assets Changes in group organization 572 1,011 1,000 66 39 199 Major legal cases 356 Expenses for dened-benet postemployment plans 313 532 Expenses for equity-settled equity compensation plans 364 169 Other adjustments 445 (335) Cash generated from continuing operations Operating cash ows generated from discontinued businesses Cash generated from operations (Increase) decrease in working capital 12,526 (5) 9,413 335 12,521 9,748 488 227 3 A Comprehensive Business Reporting Model: Financial Reporting for Investors, CFA Institute Centre for Financial Market Integrity, October 2005, p. 27. 4 The cash ow statement presented here includes a reconciliation of net income to cash generated from operations, which Roche Group reported in the footnotes to the nancial statement rather than on the statement itself. c06.indd 222 9/17/08 11:35:05 AM Chapter 6 223 Understanding the Cash Flow Statement Fiscal Years Ended 31 December 2005 2004 Vitamin case payments (82) (66) Major legal cases (98) (65) Payments made for dened-benet postemployment plans (303) (653) Utilization of restructuring provisions (119) (163) Utilization of other provisions (310) (128) Other operating cash ows (125) (75) (1,997) (1,490) 9,975 7,335 (3,319) (2,344) (349) (191) 353 196 Income taxes paid Total Cash Flows from Operating Activities Cash Flows from Investing Activities Purchase of property, plant, and equipment Purchase of intangible assets Disposal of property, plant, and equipment Disposal of intangible assets Disposal of products Acquisitions of subsidiaries and associated companies Divestments of discontinued businesses and associated companies Interest and dividends received Sales of marketable securities Purchases of marketable securities Other investing cash ows Total Cash Flows from Investing Activities 2 12 56 431 (233) (1,822) 2,913 696 383 255 9,859 4,965 (15,190) (4,281) (161) (5,686) 64 (2,019) Cash Flows from Financing Activities Proceeds from issue of long-term debt instruments 2,565 Repayment of long-term debt instruments (1,178) (3,039) Increase (decrease) in other long-term debt (1,083) (1,156) Transactions in own equity instruments Increase (decrease) in short-term borrowings Interest and dividends paid Exercises of equity-settled equity compensation plans Genentech and Chugai share repurchases Other nancing cash ows Total Cash Flows from Financing Activities Net effect of currency translation on cash and cash equivalents 779 237 (422) (939) (1,983) (1,971) 1,090 (2,511) (38) (2,781) 643 (1,699) 61 (7,863) (124) Increase (Decrease) in Cash and Cash Equivalents 1,623 (2,671) Cash and cash equivalents at 1 January 2,605 5,276 Cash and Cash Equivalents on 31 December c06.indd 223 115 4,228 2,605 9/17/08 11:35:06 AM 224 International Financial Statement Analysis In the cash ows from operating activities section of Roches cash ow statement, the company reconciles its net income to net cash provided by operating activities. Under IFRS, payments for interest and taxes are disclosed in the body of the cash ow statement. Note that Roche discloses the income taxes paid (CHF 1,997 million in 2005) as a separate item in the cash ows from operating activities section. Separate disclosure of this is not useful if an analyst is trying to assess the impact on cash ow of changes in tax rates (income tax expense provided on the income statement does not reect the ow of cash due to prepaid and deferred items). Roche reports its interest paid in the cash ows from nancing activities section, showing a total of CHF 1,983 million in interest and dividends paid in 2005. As noted earlier under U.S. GAAP, interest paidor the reconciliation adjustment for the net change in interest payablemust be reported in the operating section of the cash ow statement. Furthermore, U.S. GAAP does not require that interest and taxes paid be disclosed as separate line items on the cash ow statement; however, it does require that these amounts be provided in a supplemental note. Roche reports its dividends and interest received (CHF 383 million in 2005) in the cash ows from investing activities section. Under U.S. GAAP, investment income received (or the reconciliation adjustment for the net change in investment income receivable) must be reported in the operating section of the cash ow statement. 2.3.2. A Direct-Format Cash Flow Statement Prepared under IFRS Exhibit 6-3 presents a direct-method format cash ow statement prepared under IFRS for Telefnica Group, a diversied telecommunications company based in Madrid.5 Note that in this format of the cash ow statement, the cash received from customers, as well as other operating items, is clearly shown. The analyst can then contrast the change in revenues from the income statement with the change in cash received from customers. An increase in revenues coupled with a decrease in cash received from customers could signal collection problems. However, in the case of Telefnica Group, cash received from customers has increased. 2.3.3. Illustrations of Cash Flow Statements Prepared under U.S. GAAP Previously, we presented a cash ow statement prepared under IFRS. In this section, we illustrate cash ow statements prepared under U.S. GAAP. This section presents the cash ow statements of two companies, Tech Data Corporation and Wal-Mart. Tech Data reports its operating activities using the direct method, whereas Wal-Mart reports its operating activities using the more common indirect method. Tech Data Corporation is a leading distributor of information technology products. Exhibit 6-4 on page 226 presents comparative cash ow statements from the companys annual report for the scal years ended 31 January 2005 and 2004.6 Tech Data Corporation prepares its cash ow statements under the direct method. In the cash ows from operating activities section of Tech Datas cash ow statements, the company identies the amount of cash it received from customers, $19.7 billion for 2005, and the amount of cash that it paid to suppliers and employees, $19.6 billion for 2005. Net cash provided by operating activities of $106.9 million was adequate to cover the companys investing activities, primarily purchases of property and equipment ($25.9 million) and software 5 Excludes supplemental cash ow reconciliation provided at the bottom of the original cash ow statement by the company. 6 Under U.S. GAAP, companies present three years of the cash ow statement. For purposes of presentation and comparison with the IFRS statements presented above, only two years are presented here. c06.indd 224 9/17/08 11:35:06 AM Chapter 6 225 Understanding the Cash Flow Statement EXHIBIT 6-3 Telefnica Group: Consolidated Cash Flow Statements for Years Ended 31 December ( millions) 2005 2004 44,353.14 36,367.10 (30,531.54) (24,674.10) Cash Flows from Operating Activities Cash received from customers Cash paid to suppliers and employees Dividends received Net interest and other nancial expenses paid 70.58 (1,520.00) 71.24 (1,307.11) Taxes paid (1,233.04) Net Cash from Operating Activities 11,139.14 10,131.13 (326.00) 113.20 241.27 Cash Flows from Investing Activities Proceeds on disposals of property, plant, and equipment and intangible assets Payments on investments in property, plant, and equipment and intangible assets Proceeds on disposals of companies, net of cash, and cash equivalents disposed Payments on investments in companies, net of cash, and cash equivalents acquired (4,423.22) 501.59 (6,571.40) (3,488.15) 531.98 (4,201.57) Proceeds on nancial investments not included under cash equivalents 147.61 31.64 Payments made on nancial investments not included under cash equivalents (17.65) (76.35) Interest received on short-term investments not included under cash equivalents 625.18 1,139.51 32.67 13.51 Capital grants received Net Cash Used in Investing Activities (9,592.02) (5,808.16) Dividends paid (2,768.60) (2,865.81) Proceeds from issue of stock (2,054.12) (1,938.56) Cash Flows from Financing Activities Proceeds on issue of debentures and bonds 875.15 572.99 Proceeds on loans, credits, and promissory notes 16,533.96 10,135.11 Cancellation of debentures and bonds (3,696.52) (1,790.57) Repayments of loans, credits, and promissory notes (9,324.54) (8,049.77) (434.67) (3,936.61) Net Cash from Financing Activities Effect of foreign exchange rate changes on collections and payments 165.73 Effect of changes in consolidation methods and other nonmonetary effects 9.62 Net Increase (Decrease) in Cash and Cash Equivalents during the Year Cash and cash equivalents at beginning of year Cash and Cash Equivalents at End of Year c06.indd 225 74.18 (36.76) 1,287.80 423.78 914.35 490.57 2,202.15 914.35 9/17/08 11:35:07 AM 226 International Financial Statement Analysis EXHIBIT 6-4 Tech Data Corporation and Subsidiaries: Consolidated Cash Flow Statements, Years Ended 31 January ($ thousands) 2005 2004 Cash received from customers $19,745,283 $17,390,674 Cash paid to suppliers and employees Cash Flows from Operating Activities: (19,571,824) (17,027,162) Interest paid (18,837) (17,045) Income taxes paid (47,677) (43,233) Net Cash Provided by Operating Activities 106,945 303,234 Cash Flows from Investing Activities Acquisition of businesses, net of cash acquired Proceeds from sale of property and equipment 5,130 (203,010) 4,484 Expenditures for property and equipment (25,876) (31,278) Software development costs (17,899) (21,714) Net Cash Used in Investing Activities (38,645) (251,518) Cash Flows from Financing Activities Proceeds from the issuance of common stock 32,733 28,823 (11,319) (138,039) Principal payments on long-term debt (9,214) (1,492) Net Cash Provided by (Used in) Financing Activities 12,200 (110,708) 5,755 10,602 86,255 (48,390) Net repayments on revolving credit loans Effect of exchange rate changes on cash Net Increase (Decrease) in Cash and Cash Equivalents Cash and cash equivalents at beginning of year 108,801 157,191 $195,056 $108,801 $162,460 $104,147 Depreciation and amortization 55,472 55,084 Provision for losses on accounts receivable 13,268 29,214 Deferred income taxes (3,616) 7,369 Cash and Cash Equivalents at End of Year Reconciliation of net income to net cash provided by operating activities: Net income Adjustments to reconcile net income to net cash provided by operating activities: Changes in operating assets and liabilities, net of acquisitions: Accounts receivable (44,305) (15,699) (119,999) (140,203) (32,193) 14,713 Accounts payable 55,849 300,350 Accrued expenses and other liabilities 20,000 (51,741) Inventories Prepaid and other assets Total adjustments Net cash provided by operating activities c06.indd 226 (55,515) $106,945 199,087 $303,234 9/17/08 11:35:07 AM Chapter 6 227 Understanding the Cash Flow Statement development ($17.9 million). In 2005, the company issued $32.7 million of common stock, providing net cash from nancing activities of $12.2 million after its debt repayments. Overall, the companys cash increased by $86.3 million, from $108.8 million at the beginning of the year to $195.1 million at the end of the year. Whenever the direct method is used, FAS No. 95 mandates a disclosure note and schedule that reconciles net income with the net cash ow from operating activities. Tech Data shows this reconciliation at the bottom of its consolidated statements of cash ows. The disclosure note and reconciliation schedule are exactly the information that would have been presented in the body of the cash ow statement if the company had elected instead to use the indirect method. Wal-Mart is a global retailer that conducts business under the names of Wal-Mart and Sams Club. Exhibit 6-5 presents the comparative cash ow statements from the companys annual report for the scal years ended 31 January 2005 and 2004.7 Wal-Mart prepares its cash ow statements under the indirect method. In the cash ows from operating activities section of Wal-Marts cash ow statement, the company reconciles its net income of $10.3 billion to net cash provided by operating activities of $15 billion. Whenever the indirect method is used, U.S. GAAP mandates a supplemental note that discloses how much cash was paid for interest and income taxes. Wal-Mart discloses the amount of cash paid for income tax ($5.6 billion), interest ($1.2 billion), and capital lease obligations (i.e., the interest expense component of the capital lease payments) at the bottom of its cash ow statements. EXHIBIT 6-5 Wal-Mart Cash Flow Statements, Fiscal Years Ended 31 January ($ millions) 2005 2004 $10,267 $ 8,861 Cash Flows from Operating Activities Income from continuing operations Adjustments to reconcile net income to net cash provided by operating activities: 4,405 3,852 Deferred income taxes Depreciation and amortization 263 177 Other operating activities 378 173 (304) 373 Changes in certain assets and liabilities, net of effects of acquisitions: Decrease (increase) in accounts receivable (2,635) (1,973) Increase in accounts payable Increase in inventories 1,694 2,587 Increase in accrued liabilities 976 1,896 15,044 15,946 50 15,044 15,996 Net cash provided by operating activities of continuing operations Net cash provided by operating activities of discontinued operations Net Cash Provided by Operating Activities (Continued ) 7 Under U.S. GAAP, companies present three years of the cash ow statement. For purposes of presentation and comparison with the IFRS statements presented above, only two years are presented here. c06.indd 227 9/17/08 11:35:08 AM 228 International Financial Statement Analysis EXHIBIT 6-5 (Continued ) 2005 2004 Payments for property and equipment (12,893) (10,308) Investment in international operations (315) (38) Cash Flows from Investing Activities Proceeds from the disposal of xed assets 953 481 1,500 (96) 78 Proceeds from the sale of McLane Other investing activities Net cash used in investing activities of continuing operations (12,351) (8,287) Net cash used in investing activities discontinued operations (25) (12,351) (8,312) Net Cash Used in Investing Activities Cash Flows from Financing Activities Increase in commercial paper 544 Proceeds from issuance of long-term debt 688 5,832 4,099 Purchase of company stock (4,549) (5,046) Dividends paid (2,214) (1,569) Payment of long-term debt (2,131) (3,541) (204) (305) Payment of capital lease obligations Other nancing activities 113 Net Cash Used in Financing Activities (2,609) 111 (5,563) Effect of exchange rate changes on cash 205 320 Net Increase in Cash and Cash Equivalents 289 2,441 5,199 2,758 Cash and Cash Equivalents at End of Year Cash and cash equivalents at beginning of year $5,488 $5,199 Income tax paid $5,593 $4,358 1,163 1,024 377 252 Interest paid Capital lease obligations incurred 3 . THE CASH FLOW STATEMENT: LINKAGES AND PREPARATION The indirect format of the cash ow statement demonstrates that changes in balance sheet accounts are an important factor in determining cash ows. The next section addresses the linkages between the cash ow statement and other nancial statements. 3.1. Linkages of the Cash Flow Statement with the Income Statement and Balance Sheet Recall the accounting equation that summarizes the balance sheet: Assets c06.indd c06.indd 228 Liabilities Owners equity 9/17/08 11:35:09 AM Chapter 6 229 Understanding the Cash Flow Statement Cash is an asset. The statement of cash ows ultimately shows the change in cash during an accounting period. The beginning and ending balances of cash are shown on the companys balance sheets for the previous and current years, and the bottom of the cash ow statement reconciles beginning cash with ending cash. For example, the Roche Groups cash ow statement for 2005, presented in Exhibit 6-2, shows that operating, investing, and nancing activities during the year imply a CHF 1,623 increase in cash and cash equivalents, which is the amount by which end-of-year cash and cash equivalents (CHF 4,228) exceeds beginningof-year cash and cash equivalents (CHF 2,605). The relationship, stated in general terms, is as shown below. Beginning Balance Sheet on 31 December 20X6 Beginning cash Statement of Cash Flows for Year Ended 31 December 20X7 Ending Balance Sheet on 31 December 20X7 Less: Cash payments Ending cash Plus: Cash receipts (for operating, investing, (from operating, investing, and nancing and nancing activities) activities) In the case of cash held in foreign currencies, there would also be an impact from changes in exchange rates. The body of the cash ow statement shows why the change in cash occurred; in other words, it shows the companys operating, investing, and nancing activities (as well as the impact of foreign currency translation). The beginning and ending balance sheet values of cash and cash equivalents are linked through the cash ow statement. The linkage is similar to the one that relates net income and dividends as shown in the income statement to the beginning and ending values of retained earnings in the owners equity section of the balance sheet, as shown below. Beginning Balance Sheet on 31 December 20X6 Beginning retained earnings Statement of Owners Equity for Year Ended 31 December 20X7 Plus: Net income or minus net loss from the income statement for year ended 31 December 20X7 Minus: Dividends Ending Balance Sheet on 31 December 20X7 Ending retained earnings A companys operating activities are reported on an accrual basis in the income statement, and any differences between the accrual basis and the cash basis of accounting for an operating transaction result in an increase or decrease in some (usually) short-term asset or liability on the balance sheet. For example, if revenue reported using accrual accounting is higher than the cash actually collected, the result will be an increase in accounts receivable. If expenses reported using accrual accounting are lower than cash actually paid, the result will be a decrease in accounts payable. A companys investing activities typically relate to the long-term asset section of the balance sheet, and its nancing activities typically relate to the equity and long-term debt sections of the balance sheet. Each item on the balance sheet is also related to the income c06.indd c06.indd 229 9/17/08 11:35:09 AM 230 International Financial Statement Analysis statement and/or cash ow statement through the change in the beginning and ending balance. Consider, for example, accounts receivable: Beginning Balance Sheet on 31 December 20X6 Income Statement for Year Ended 31 December 20X7 Statement of Cash Flows for Year Ended 31 December 20X7 Ending Balance Sheet on 31 December 20X7 Beginning accounts receivable Plus: Revenues Minus: Cash collected from customers Ending accounts receivable Knowing any three of these four items makes it easy to compute the fourth. For example, if you know beginning accounts receivable, revenues, and cash collected from customers, you can easily compute ending accounts receivable. Understanding these interrelationships between the balance sheet, income statement, and cash ow statement is useful in not only understanding the companys nancial health but also in detecting accounting irregularities. The next section demonstrates the preparation of cash ow information based on income statement and balance sheet information. 3.2. Steps in Preparing the Cash Flow Statement The preparation of the cash ow statement uses data from both the income statement and the comparative balance sheets. As noted earlier, companies often only disclose indirect operating cash ow information, whereas analysts prefer direct-format information. Understanding how cash ow information is put together will enable you to take an indirect statement apart and recongure it in a more useful manner. The following demonstration of how a cash ow statement is prepared uses the income statement and the comparative balance sheets for Acme Corporation (a ctitious retail company) shown in Exhibits 6-6 and 6-7. EXHIBIT 6-6 Acme Corporation Income Statement, Year Ended 31 December 2006 ($ thousands) Revenue $23,598 Cost of goods sold 11,456 Gross prot 12,142 Salary and wage expense 4,123 Depreciation expense 1,052 Other operating expenses 3,577 Total operating expenses 8,752 Operating prot 3,390 Other revenues (expenses): Gain on sale of equipment Interest expense Income before tax Income tax expense Net income c06.indd 230 205 (246) (41) 3,349 1,139 $ 2,210 9/17/08 11:35:10 AM Chapter 6 231 Understanding the Cash Flow Statement EXHIBIT 6-7 Acme Corporation Comparative Balance Sheets, 31 December 2006 and 2005 ($ thousands) 2006 Cash 2005 $1,011 $1,163 Net Change $(152) Accounts receivable 1,012 957 55 Inventory 3,984 3,277 707 155 178 6,162 5,575 587 510 510 Buildings 3,680 3,680 Equipment* 8,798 8,555 243 (3,443) (2,891) (552) (309) Prepaid expenses Total current assets Land Less: accumulated depreciation Total long-term assets Total assets Accounts payable (23) 9,545 9,854 $15,707 $15,429 278 $3,588 $3,325 263 Salary and wage payable 85 75 10 Interest payable 62 74 (12) 55 50 5 Other accrued liabilities Income tax payable 1,126 1,104 22 Total current liabilities 4,916 4,628 288 Long-term debt 3,075 3,575 (500) Common stock 3,750 4,350 (600) Retained earnings Total liabilities and equity 3,966 2,876 1,090 $15,707 $15,429 278 *During 2006, Acme purchased new equipment for a total cost of $1,300. No items impacted retained earnings other than net income and dividends. The rst step in preparing the cash ow statement is to determine the total cash ows from operating activities. The direct method of presenting cash from operating activities will be illustrated rst, followed by the indirect method. Cash ows from investing activities and from nancing activities are identical under either method. 3.2.1. Operating Activities: Direct Method We rst determine how much cash Acme received from its customers, followed by how much cash was paid to suppliers and to employees as well as how much cash was paid for other operating expenses, interest, and income taxes. 3.2.1.1. Cash Received from Customers The income statement for Acme reported revenue of $23,598 (in thousands) for the year ended 31 December 2006. To determine the cash receipts from its customers, it is necessary to adjust this revenue amount by the net c06.indd c06.indd 231 9/17/08 11:35:10 AM 232 International Financial Statement Analysis change in accounts receivable for the year. If accounts receivable increase during the year, revenue on an accrual basis is higher than cash receipts from customers, and vice versa. For Acme Corporation, accounts receivable increased by $55, so cash received from customers was $23,543, as follows: Revenue Less: Increase in accounts receivable Cash received from customers $23,598 (55) $23,543 Cash received from customers affects the accounts receivable account as follows: Beginning accounts receivable Plus revenue Minus cash collected from customers Ending accounts receivable $957 23,598 (23,543) $1,012 The accounts receivable account information can also be presented as follows: Beginning accounts receivable $957 Plus revenue 23,598 Minus ending accounts receivable (1,012) Cash collected from customers EXAMPLE 6-3 $23,543 Computing Cash Received from Customers Blue Bayou, an advertising company, reported revenues of $50 million, total expenses of $35 million, and net income of $15 million in the most recent year. If accounts receivable decreased by $12 million, how much cash did the company receive from customers? A. $62 million B. $50 million C. $38 million D. $15 million Solution. A is correct. Revenues of $50 million plus the decrease in accounts receivable of $12 million equals $62 million cash received from customers. The decrease in accounts receivable means that the company received more in cash than the amount of revenue it reported. Cash received from customers is sometimes referred to as cash collections from customers or cash collections. c06.indd 232 9/17/08 11:35:11 AM Chapter 6 233 Understanding the Cash Flow Statement 3.2.1.2. Cash Paid to Suppliers For Acme, the cash paid to suppliers was $11,900, determined as follows: Cost of goods sold $11,456 Plus: Increase in inventory Equals purchases from suppliers Less: Increase in accounts payable Cash paid to suppliers 707 $12,163 (263) $11,900 There are two pieces to this calculation: the amount of inventory purchased and the amount paid for it. To determine purchases from suppliers, cost of goods sold is adjusted for the change in inventory. If inventory increased during the year, then purchases during the year exceeded cost of goods sold, and vice versa. Acme reported cost of goods sold of $11,456 for the year ended 31 December 2006. For Acme Corporation, inventory increased by $707, so purchases from suppliers was $12,163. Purchases from suppliers affects the inventory account, as shown below: Beginning inventory Plus purchases Minus cost of goods sold Ending inventory $3,277 12,163 (11,456) $3,984 Acme purchased $12,163 of inventory from suppliers this year, but is this the amount of cash that Acme paid to its suppliers during the year? Not necessarily. Acme may not have yet paid for all of these purchases and may yet owe for some of the purchases made this year. In other words, Acme may have paid less cash to its suppliers than the amount of this years purchases, in which case Acmes liability (accounts payable) will have increased by the difference. Alternatively, Acme may have paid even more to its suppliers than the amount of this years purchases, in which case Acmes accounts payable will have decreased. Therefore, once purchases have been determined, cash paid to suppliers can be calculated by adjusting purchases for the change in accounts payable. If the company made all purchases for cash, then accounts payable would not change and cash outows would equal purchases. If accounts payable increased during the year, then purchases on an accrual basis are higher than they are on a cash basis, and vice versa. In this example, Acme made more purchases than it paid in cash, so the balance in accounts payable has increased. For Acme, the cash paid to suppliers was $11,900, determined as follows: Purchases from suppliers Less: Increase in accounts payable Cash paid to suppliers $12,163 (263) $11,900 The amount of cash paid to suppliers is reected in the accounts payable account, as shown below: Beginning accounts payable Plus purchases Minus cash paid to suppliers Ending accounts payable c06.indd c06.indd 233 $3,325 12,163 (11,900) $3,588 9/17/08 11:35:14 AM 234 International Financial Statement Analysis EXAMPLE 6-4 Computing Cash Paid to Suppliers Orange Beverages Plc., a manufacturer of tropical drinks, reported cost of goods sold for the year of $100 million. Total assets increased by $55 million, but inventory declined by $6 million. Total liabilities increased by $45 million, but accounts payable decreased by $2 million. How much cash did the company pay to its suppliers during the year? A. $110 million B. $108 million C. $104 million D. $96 million Solution. D is correct. Cost of goods sold of $100 million less the decrease in inventory of $6 million equals purchases from suppliers of $94 million. The decrease in accounts payable of $2 million means that the company paid $96 million in cash ($94 million plus $2 million). 3.2.1.3. Cash Paid to Employees To determine the cash paid to employees, it is necessary to adjust salary and wage expense by the net change in salary and wage payable for the year. If salary and wage payable increased during the year, then salary and wage expense on an accrual basis is higher than the amount of cash paid for this expense, and vice versa. For Acme, salary and wage payable increased by $10, so cash paid for salary and wages was $4,113, as follows: Salary and wage expense Less: Increase in salary and wage payable Cash paid to employees $4,123 (10) $4,113 The amount of cash paid to employees is reected in the salary and wage payable account, as shown below: Beginning salary and wages payable $75 Plus salary and wage expense 4,123 Minus cash paid to employees (4,113) Ending salary and wages payable $85 3.2.1.4. Cash Paid for Other Operating Expenses To determine the cash paid for other operating expenses, it is necessary to adjust the other operating expenses amount on the income statement by the net changes in prepaid expenses and accrued expense liabilities for the year. If prepaid expenses increased during the year, other operating expenses on a cash basis were higher than on an accrual basis, and vice versa. Likewise, if accrued expense liabilities increased during the year, other operating expenses on a cash basis were lower than c06.indd c06.indd 234 9/17/08 11:35:14 AM Chapter 6 235 Understanding the Cash Flow Statement on an accrual basis, and vice versa. For Acme Corporation, the amount of cash paid for operating expenses in 2006 was $3,532, as follows: Other operating expenses $3,577 Less: Decrease in prepaid expenses (23) Less: Increase in other accrued liabilities (22) Cash paid for other operating expenses EXAMPLE 6-5 Expenses $3,532 Computing Cash Paid for Other Operating Black Ice, a sportswear manufacturer, reported other operating expenses of $30 million. Prepaid insurance expense increased by $4 million, and accrued utilities payable decreased by $7 million. Insurance and utilities are the only two components of other operating expenses. How much cash did the company pay in other operating expenses? A. $41 million B. $33 million C. $27 million D. $19 million Solution. A is correct. Other operating expenses of $30 million plus the increase in prepaid insurance expense of $4 million plus the decrease in accrued utilities payable of $7 million equals $41 million. 3.2.1.5. Cash Paid for Interest The company is either subject to U.S. GAAP, which requires that interest expense be included in operating cash ows, or it is subject to IFRS, which gives companies the option to treat interest expense in this manner. To determine the cash paid for interest, it is necessary to adjust interest expense by the net change in interest payable for the year. If interest payable increases during the year, then interest expense on an accrual basis is higher than the amount of cash paid for interest, and vice versa. For Acme Corporation, interest payable decreased by $12 and cash paid for interest was $258, as follows: Interest expense $246 Plus: Decrease in interest payable Cash paid for interest 12 $258 Alternatively, cash paid for interest may also be determined by an analysis of the interest payable account, as shown below: Beginning interest payable $74 Plus interest expense 246 Minus cash paid for interest Ending interest payable c06.indd c06.indd 235 (258) $62 9/17/08 11:35:18 AM 236 International Financial Statement Analysis 3.2.1.6. Cash Paid for Income Taxes To determine the cash paid for income taxes, it is necessary to adjust the income tax expense amount on the income statement by the net changes in taxes receivable, taxes payable, and deferred income taxes for the year. If taxes receivable or deferred tax assets increase during the year, income taxes on a cash basis will be higher than on an accrual basis, and vice versa. Likewise, if taxes payable or deferred tax liabilities increase during the year, income tax expense on a cash basis will be lower than on an accrual basis, and vice versa. For Acme Corporation, the amount of cash paid for income taxes in 2006 was $1,134, as follows: Income tax expense $1,139 Less: Increase in income tax payable Cash paid for income taxes (5) $1,134 3.2.2. Investing Activities: Direct Method The second and third steps in preparing the cash ow statement are to determine the total cash ows from investing activities and from nancing activities. The presentation of this information is identical, regardless of whether the direct or indirect method is used for operating cash ows. Investing cash ows are always presented using the direct method. Purchases and sales of equipment were the only investing activities undertaken by Acme in 2006, as evidenced by the fact that the amounts reported for land and buildings were unchanged during the year. An informational note in Exhibit 6-7 tells us that Acme purchased new equipment in 2006 for a total cost of $1,300. However, the amount of equipment shown on Acmes balance sheet increased by only $243 (ending balance of $8,798 minus beginning balance of $8,555); therefore, Acme must have also sold some equipment during the year. To determine the cash inow from the sale of equipment, we analyze the equipment and accumulated depreciation accounts as well as the gain on the sale of equipment from Exhibits 6-6 and 6-7. The historical cost of the equipment sold was $1,057. This amount is determined as follows: Beginning balance equipment (from balance sheet) Plus equipment purchased (from informational note) Minus ending balance equipment (from balance sheet) Equals historical cost of equipment sold $8,555 1,300 (8,798) $1,057 The accumulated depreciation on the equipment sold was $500, determined as follows: Beginning balance accumulated depreciation (from balance sheet) Plus depreciation expense (from income statement) Minus ending balance accumulated depreciation (from balance sheet) Equals accumulated depreciation on equipment sold $2,891 1,052 (3,443) $500 The historical cost information, accumulated depreciation information, and information from the income statement about the gain on the sale of equipment can be used to determine the cash received from the sale. Historical cost of equipment sold (calculated above) Less accumulated depreciation on equipment sold (calculated above) $1,057 (500) Equals: Book value of equipment sold 557 Plus: Gain on sale of equipment (from the income statement) 205 Equals: Cash received from sale of equipment c06.indd c06.indd 236 $762 9/17/08 11:35:21 AM Chapter 6 237 Understanding the Cash Flow Statement EXAMPLE 6-6 of Equipment Computing Cash Received from the Sale Copper, Inc., a brewery and restaurant chain, reported a gain on the sale of equipment of $12 million. In addition, the companys income statement shows depreciation expense of $8 million and the cash ow statement shows capital expenditure of $15 million, all of which was for the purchase of new equipment. Balance sheet item 12/31/2005 12/31/2006 Change Equipment $100 million $109 million $9 million $30 million $36 million $6 million Accumulated depreciationequipment Using the above information from the comparative balance sheets, how much cash did the company receive from the equipment sale? A. $16 million B. $9 million C. $6 million D. $3 million Solution. A is correct. Selling price (cash inow) minus book value equals gain or loss on sale; therefore, gain or loss on sale plus book value equals selling price (cash inow). The amount of gain is given, $12 million. To calculate the book value of the equipment sold, nd the historical cost of the equipment and the accumulated depreciation on the equipment. Beginning balance of equipment of $100 million plus equipment purchased of $15 million minus ending balance of equipment of $109 million equals historical cost of equipment sold, or $6 million. Beginning accumulated depreciation on equipment of $30 million plus depreciation expense for the year of $8 million minus ending balance of accumulated depreciation of $36 million equals accumulated depreciation on the equipment sold, or $2 million. Therefore, the book value of the equipment sold was $6 million minus $2 million, or $4 million. Because the gain on the sale of equipment was $12 million, the amount of cash received must have been $16 million. 3.2.3. Financing Activities: Direct Method As with investing activities, nancing activities are always presented using the direct method. 3.2.3.1. Long-Term Debt and Common Stock The change in long-term debt, based on the beginning and ending balance sheets in Exhibit 6-7, was a decrease of $500. Absent other information, this indicates that Acme retired $500 of long-term debt. Retiring long-term debt is a cash outow relating to nancing activities. Similarly, the change in common stock during 2006 was a decrease of $600. Absent other information, this indicates that Acme repurchased $600 of its common stock. Repurchase of common stock is also a cash outow related to nancing activity. c06.indd c06.indd 237 9/17/08 11:35:21 AM 238 International Financial Statement Analysis 3.2.3.2. Dividends Recall the following relationship: Beginning retained earnings Net income Dividends Ending retained earnings Based on this relationship, the amount of cash dividends paid in 2006 can be determined from an analysis of retained earnings, as follows: Beginning balance of retained earnings (from the balance sheet) $2,876 Plus net income (from the income statement) 2,210 Minus ending balance of retained earnings (from the balance sheet) (3,966) Equals dividends paid $1,120 3.2.4. Overall Statement of Cash Flows: Direct Method Exhibit 6-8 summarizes the information about Acmes operating, investing, and nancing cash ows in the statement of cash ows. At the bottom of the statement, the total net change in cash is shown to be a decrease of $152 (from $1,163 to $1,011). This can also be seen on the comparative balance sheet in Exhibit 6-7. The cash provided by operating activities of $2,606 was adequate to cover the net cash used in investing activities of $538; however, the companys debt repayments, cash payments for dividends, and repurchase of common stock (i.e., its nancing activities) of $2,220 resulted in an overall decrease of $152. EXHIBIT 6-8 Acme Corporation Cash Flow Statement (Direct Method) for Year Ended 31 December 2006 ($ thousands) Cash Flow from Operating Activities Cash received from customers $23,543 Cash paid to suppliers (11,900) Cash paid to employees (4,113) Cash paid for other operating expenses (3,532) Cash paid for interest Cash paid for income tax Net cash provided by operating activities (258) (1,134) 2,606 Cash Flow from Investing Activities Cash received from sale of equipment Cash paid for purchase of equipment Net cash used for investing activities 762 (1,300) (538) Cash Flow from Financing Activities Cash paid to retire long-term debt Cash paid to retire common stock (500) (600) Cash paid for dividends (1,120) Net cash used for nancing activities (2,220) Net decrease in cash (152) Cash balance, 31 December 2005 Cash balance, 31 December 2006 c06.indd 238 1,163 $1,011 9/17/08 11:35:30 AM Chapter 6 Understanding the Cash Flow Statement 239 3.2.5. Overall Statement of Cash Flows: Indirect Method Using the alternative approach to reporting cash from operating activities, the indirect method, we will present the same amount of cash provided by operating activities. Under this approach, we reconcile Acmes net income of $2,210 to its operating cash ow of $2,606. To perform this reconciliation, net income is adjusted for the following: (a) any nonoperating activities; (b) any noncash expenses; and (c) changes in operating working capital items. The only nonoperating activity in Acmes income statement, the sale of equipment, resulted in a gain of $205. This amount is removed from the operating cash ow section; the cash effects of the sale are shown in the investing section. Acmes only noncash expense was depreciation expense of $1,052. Under the indirect method, depreciation expense must be added back to net income because it was a noncash deduction in the calculation of net income. Changes in working capital accounts include increases and decreases in the current operating asset and liability accounts. The changes in these accounts arise from applying accrual accounting; that is, recognizing revenues when they are earned and expenses when they are incurred instead of when the cash is received or paid. To make the working capital adjustments under the indirect method, any increase in a current operating asset account is subtracted from net income while a net decrease is added to net income. As described above, the increase in accounts receivable, for example, resulted from Acme recording income statement revenue higher than the amount of cash received from customers; therefore, to reconcile back to operating cash ow, that increase in accounts receivable must be deducted from net income. For current operating liabilities, a net increase is added to net income while a net decrease is subtracted from net income. As described above, the increase in wages payable, for example, resulted from Acme recording income statement expenses higher than the amount of cash paid to employees. Exhibit 6-9 presents a tabulation of the most common types of adjustments that are made to net income when using the indirect method to determine net cash ow from operating activities. EXHIBIT 6-9 Adjustments to Net Income Using the Indirect Method Additions Noncash Items Depreciation expense of tangible assets Amortization expense of intangible assets Depletion expense of natural resources Amortization of bond discount Nonoperating Losses Loss on sale or write down of assets Loss on retirement of debt Loss on investments accounted for under the equity method Increase in Deferred Income Tax Liability Changes in Working Capital Resulting from Accruing Higher Expenses than Cash Payments, or Lower Revenues than Cash Receipts Increase in current operating liabilities (e.g., accounts payable and accrued expense liabilities) Decrease in current operating assets (e.g., accounts receivable, inventory, and prepaid expenses) (Continued ) c06.indd 239 9/17/08 11:35:31 AM 240 International Financial Statement Analysis EXHIBIT 6-9 (Continued ) Subtractions Noncash Items (e.g., Amortization of Bond Premium) Nonoperating Items Gain on sale of assets Gain on retirement of debt Income on investments accounted for under the equity method Decrease in Deferred Income Tax Liability Changes in Working Capital Resulting from Accruing Lower Expenses than Cash Payments, or Higher Revenues than Cash Receipts Decrease in current operating liabilities (e.g., accounts payable and accrued expense liabilities) Increase in current operating assets (e.g., accounts receivable, inventory, and prepaid expenses) Accordingly, for Acme Corporation, the $55 increase in accounts receivable and the $707 increase in inventory are subtracted from net income while the $23 decrease in prepaid expenses is added to net income. For Acmes current liabilities, the increases in accounts payable, salary and wage payable, income tax payable, and other accrued liabilities ($263, $10, $5, and $22, respectively) are added to net income while the $12 decrease in interest payable is subtracted from net income. Exhibit 6-10 presents the cash ow statement for Acme Corporation under the indirect method by using the information that we have determined from our analysis of the income statement and the comparative balance sheets. Note that the investing and nancing sections are identical to the statement of cash ows prepared using the direct method. EXHIBIT 6-10 Acme Corporation Cash Flow Statement (Indirect Method) Year Ended 31 December 2006 ($ thousands) Cash Flow from Operating Activities Net income Depreciation expense Gain on sale of equipment Increase in accounts receivable Increase in inventory $2,210 1,052 (205) (55) (707) Decrease in prepaid expenses 23 Increase in accounts payable 263 Increase in salary and wage payable Decrease in interest payable Increase in income tax payable Increase in other accrued liabilities Net cash provided by operating activities c06.indd c06.indd 240 10 (12) 5 22 2,606 9/17/08 11:35:31 AM Chapter 6 241 Understanding the Cash Flow Statement Cash Flow from Investing Activities Cash received from sale of equipment Cash paid for purchase of equipment 762 (1,300) Net cash used for investing activities (538) Cash Flow from Financing Activities Cash paid to retire long-term debt (500) Cash paid to retire common stock (600) Cash paid for dividends (1,120) Net cash used for nancing activities (2,220) Net decrease in cash (152) Cash balance, 31 December 2005 1,163 Cash balance, 31 December 2006 $1,011 EXAMPLE 6-7 Adjusting Net Income to Compute Operating Cash Flow Based on the following information for Pinkerly Inc., what are the total adjustments that the company would make to net income in order to derive operating cash ow? Year Ended Income Statement Item Net income Depreciation 12/31/2006 $ 30 million $7 million Balance sheet item 12/31/2005 12/31/2006 Change Accounts receivable $15 million $30 million $15 million Inventory $16 million $13 million ($3 million) Accounts payable $10 million $20 million $10 million A. Add $5 million. B. Add $29 million. C. Subtract $ 5 million. D. Subtract $29 million. Solution. A is correct. To derive operating cash ow, the company would make the following adjustments to net income: add depreciation (a noncash expense) of $7 million; add the decrease in inventory of $3 million; add the increase in accounts payable of $10 million; and subtract the increase in accounts receivable of $15 million. Total additions would be $20 million, and total subtractions would be $15 million for net additions of $5 million. c06.indd 241 9/17/08 11:35:32 AM 242 International Financial Statement Analysis 3.3. Conversion of Cash Flows from the Indirect to the Direct Method An analyst may desire to review direct-format operating cash ow to review trends in cash receipts and payments (such as cash received from customers or cash paid to suppliers). If a direct-format statement is not available, cash ows from operating activities reported under the indirect method can be converted to the direct method. Accuracy of conversion depends on adjustments using data available in published nancial reports. The method described here is sufciently accurate for most analytical purposes. The three-step conversion process is demonstrated for Acme Corporation in Exhibit 6-11. Referring again to Exhibits 6-6 and 6-7 for Acme Corporations income statement and balance sheet information, begin by disaggregating net income of $2,210 into total revenues and total expenses (Step 1). Next, remove any nonoperating and noncash items (Step 2). For Acme, we EXHIBIT 6-11 Conversion from the Indirect to the Direct Method Step 1 Total revenues $23,803 Aggregate all revenue and all expenses Total expenses 21,593 Net income $ 2,210 Step 2 Total revenue less noncash item revenues: Remove all noncash items from aggregated revenues and expenses and break out remaining items into relevant cash ow items ($23,803 $205) Revenue $23,598 $23,598 Total expenses less noncash item expenses: ($21,593 $1,052) Cost of goods sold $20,541 $11,456 Salary and wage expenses 4,123 Other operating expenses 3,577 Interest expense Income tax expense Total Step 3 a Convert accrual amounts to cash ow amounts by adjusting for working capital changes b c 1,139 $20,541 Cash received from customers $23,543 Cash paid to suppliers 11,900 Cash paid to employees 4,113 d e f 246 Cash paid for other operating expenses Cash paid for interest Cash paid for income tax 3,532 258 1,134 Calculations for Step 3 a Revenue of $23,598 less increase in accounts receivable of $55. b Cost of goods sold of $11,456 plus increase in inventory of $707 less increase in accounts payable of $263. c Salary and wage expense of $4,123 less increase in salary and wage payable of $10. d Other operating expenses of $3,577 less decrease in prepaid expenses of $23 less increase in other accrued liabilities of $22. e Interest expense of $246 plus decrease in interest payable of $12. f Income tax expense of $1,139 less increase in income tax payable of $5. c06.indd 242 9/17/08 11:35:38 AM Chapter 6 Understanding the Cash Flow Statement 243 therefore remove the nonoperating gain on the sale of equipment of $205 and the noncash depreciation expense of $1,052. Then, convert accrual amounts of revenues and expenses to cash ow amounts of receipts and payments by adjusting for changes in working capital accounts (Step 3). The results of these adjustments are the items of information for the direct format of operating cash ows. These line items are shown as the results of Step 3. 4 . CASH FLOW STATEMENT ANALYSIS The analysis of a companys cash ows can provide useful information for understanding a companys business and earnings and for predicting its future cash ows. This section describes tools and techniques for analyzing the statement of cash ows, including the analysis of major sources and uses of cash, cash ow, common-size analysis, conversion of the cash ow statement from the indirect method to the direct method, and computation of free cash ow and cash ow ratios. 4.1. Evaluation of the Sources and Uses of Cash Evaluation of the cash ow statement should involve an overall assessment of the sources and uses of cash between the three main categories as well as an assessment of the main drivers of cash ow within each category, as follows: 1. Evaluate where the major sources and uses of cash ow are between operating, investing, and nancing activities. 2. Evaluate the primary determinants of operating cash ow. 3. Evaluate the primary determinants of investing cash ow. 4. Evaluate the primary determinants of nancing cash ow. Step 1: The major sources of cash for a company can vary with its stage of growth. For a mature company, it is desirable to have the primary source of cash be operating activities. Over the long term, a company must generate cash from its operating activities. If operating cash ow were consistently negative, a company would need to borrow money or issue stock (nancing activities) to fund the shortfall. Eventually, these providers of capital need to be repaid from operations or they will no longer be willing to provide capital. Cash generated from operating activities can either be used in investing or nancing activities. If the company has good opportunities to grow the business or other investment opportunities, it is desirable to use the cash in investing activities. If the company does not have protable investment opportunities, the cash should be returned to capital providers, a nancing activity. For a new or growth stage company, operating cash ow may be negative for some period of time as it invests in inventory and receivables (extending credit to new customers) in order to grow the business. This cannot sustain itself over the long term, so eventually the cash must start to come primarily from operating activities so that capital can be returned to the providers of capital. Finally, it is desirable that operating cash ows are sufcient to cover capital expenditures (in other words, the company has free cash ow as discussed further below). In summary, major points to consider at this step are: What are the major sources and uses of cash ow? Is operating cash ow positive and sufcient to cover capital expenditures? c06.indd 243 9/17/08 11:35:39 AM 244 International Financial Statement Analysis Step 2: Turning to the operating section, the analysts should examine the most signicant determinants of operating cash ow. Some companies need to raise cash for use in operations (to hold receivables, inventory, etc.), while occasionally a companys business model generates cash ow (e.g., when cash is received from customers before it needs to be paid out to suppliers). Under the indirect method, the increases and decreases in receivables, inventory, payables, and so on can be examined to determine whether the company is using or generating cash in operations and why. It is also useful to compare operating cash ow with net income. For a mature company, because net income includes noncash expenses (depreciation and amortization), it is desirable that operating cash ow exceeds net income. The relationship between net income and operating cash ow is also an indicator of earnings quality. If a company has large net income but poor operating cash ow, it may be a sign of poor earnings quality. The company may be making aggressive accounting choices to increase net income but not be generating cash for its business. You should also examine the variability of both earnings and cash ow and consider the impact of this variability on the companys risk as well as the ability to forecast future cash ows for valuation purposes. In summary: What are the major determinants of operating cash ow? Is operating cash ow higher or lower than net income? Why? How consistent are operating cash ows? Step 3: Within the investing section, you should evaluate each line item. Each line item represents either a source or use of cash. This enables you to understand where the cash is being spent (or received). This section will tell you how much cash is being invested for the future in property, plant, and equipment; how much is used to acquire entire companies; and how much is put aside in liquid investments, such as stocks and bonds. It will also tell you how much cash is being raised by selling these types of assets. If the company is making major capital investments, you should consider where the cash is coming from to cover these investments (e.g., is the cash coming from excess operating cash ow or from the nancing activities described in Step 4?). Step 4: Within the nancing section, you should examine each line item to understand whether the company is raising capital or repaying capital and what the nature of its capital sources are. If the company is borrowing each year, you should consider when repayment may be required. This section will also present dividend payments and repurchases of stock that are alternative means of returning capital to owners. Example 6-8 provides an example of a cash ow statement evaluation. EXAMPLE 6-8 Analysis of the Cash Flow Statement Derek Yee, CFA, is preparing to forecast cash ow for Groupe Danone as an input into his valuation model. He has asked you to evaluate the historical cash ow statement of Groupe Danone, which is presented in Exhibit 6-12. Groupe Danone prepares its nancial statements in conformity with International Financial Reporting Standards as adopted by the European Union. c06.indd 244 9/17/08 11:35:39 AM Chapter 6 245 Understanding the Cash Flow Statement EXHIBIT 6-12 Groupe Danone: Consolidated Financial Statements, Consolidated Statements of Cash Flows, Years Ended 31 December ( millions) 2004 2005 Net income 449 1,464 Minority interests in net income of consolidated subsidiaries 189 207 Net income from discontinued operations (47) (504) Net income (loss) of afliates 550 (44) Depreciation and amortization 481 478 Dividends received from afliates Other ows Cash Flows Provided by Operations 45 45 (93) 70 1,574 1,716 (Increase) decrease in inventories (70) (17) (Increase) decrease in trade accounts receivable (27) (87) Increase (decrease) in trade accounts payable 143 123 Changes in other working capital items 74 112 Net change in current working capital 120 131 1,694 1,847 Cash Flows Provided by Operating Activities Capital expenditures (520) (607) Purchase of businesses and other investments net of cash and cash equivalent acquired (98) (636) Proceeds from the sale of businesses and other investments net of cash and cash equivalent disposed of 650 (Increase) decrease in long-term loans and other long-term assets 130 (134) Changes in cash and cash equivalents of discontinued operations 52 30 214 312 38 61 Purchases of treasury stock (net of disposals) (213) (558) Dividends (456) (489) Increase (decrease) in noncurrent nancial liabilities (290) (715) Increase (decrease) in current nancial liabilities (536) (191) (Increase) decrease in marketable securities (415) (210) (1,872) (2,102) Cash Flows Provided by Investing Activities Increase in capital and additional paid-in capital Cash ows used in nancing activities Effect of exchange rate changes on cash and cash equivalents 1,659 (21) 53 15 110 Cash and cash equivalents at beginning of period 451 466 Cash and Cash Equivalents at End of Period 466 576 Interest 152 172 Income tax 439 424 Increase (Decrease) in Cash and Cash Equivalents Supplemental Disclosures: Cash paid during the year: c06.indd 245 9/17/08 11:35:41 AM 246 International Financial Statement Analysis Yee would like answers to the following questions: What are the major sources of cash for Groupe Danone? What are the major uses of cash for Groupe Danone? What is the relationship between net income and cash ow from operating activities? Is cash ow from operating activities sufcient to cover capital expenditures? Other than capital expenditures, is cash being used or generated in investing activities? What types of nancing cash ows does Groupe Danone have? Solution. The major categories of cash ows can be summarized as follows ( millions): 2004 2005 Cash ows from operating activities 1,694 1,847 Cash ows from investing activities 214 312 Cash ows from nancing activities Exchange rate effects on cash Increase in cash (1,872) (2,102) (21) 53 15 110 The primary source of cash for Groupe Danone is operating activities. The secondary source of cash is investing activities. Most of this cash ow is being spent in nancing activities. The fact that the primary source of cash is from operations is a good sign. Additionally, operating cash ow exceeds net income in both yearsa good sign. Operating cash ows is much higher than capital expenditures, indicating that the company can easily fund capital expenditures from operations. The company has generated investing cash ows by selling business and investments in the two years presented. In the nancing category, Groupe Danone is spending cash by repurchasing its own stock, paying dividends, and paying down debt. This could be an indicator that the company lacks investment opportunities and is, therefore, returning cash to the providers of capital. 4.2. Common-Size Analysis of the Statement of Cash Flows In common-size analysis of a companys income statement, each income and expense line item is expressed as a percentage of net revenues (net sales). For the common-size balance sheet, each asset, liability, and equity line item is expressed as a percentage of total assets. For the common-size cash ow statement, there are two alternative approaches. The rst approach is to express each line item of cash inow (outow) as a percentage of total inows (outows) of cash, and the second approach is to express each line item as a percentage of net revenue. Exhibit 6-13 demonstrates the total cash inows/total outows method for Acme Corporation. Under this approach, each of the cash inows is expressed as a percentage of the total cash inows, whereas each of the cash outows is expressed as a percentage of the total c06.indd c06.indd 246 9/17/08 11:35:50 AM Chapter 6 247 Understanding the Cash Flow Statement EXHIBIT 6-13 Acme Corporation: Common-Size Cash Flow Statement, Year Ended 31 December 2006 Panel A. Direct Format for Operating Cash Flow Inows Receipts from customers Percentage of Total Inows $23,543 Sale of equipment Total 762 $24,305 Outows Payments to suppliers 96.86% 3.14 100.00% Percentage of Total Outows $11,900 48.66% Payments to employees 4,113 16.82 Payments for other operating expenses 3,532 14.44 258 1.05 Payments for income tax 1,134 4.64 Purchase of equipment 1,300 5.32 500 2.04 600 2.45 1,120 4.58 Payments for interest Retirement of long-term debt Retirement of common stock Dividend payments Total $24,457 100.00% Panel B. Indirect Format for Operating Cash Flow Inows Operations Sale of equipment Total Percentage of Total Inows $2,606 762 $3,368 Outows Purchase of equipment Retirement of long-term debt Retirement of common stock Dividend payments Total 77.38% 22.62 100.00% Percentage of Total Outows 1,300 36.93% 500 14.20 600 17.05 1,120 31.82 $3,520 100.00% cash outows. In Panel A, Acmes common-size statement is based on a cash ow statement using the direct method of presenting operating cash ows. Operating cash inows and outows are separately presented on the cash ow statement and, therefore, the common-size cash ow statement shows each of these operating inows (outows) as a percentage of total inows (outows). In Panel B, Acmes common-size statement is based on a cash ow statement using the indirect method of presenting operating cash ows. When a cash ow statement has been presented using the indirect method, operating cash inows and outows are not separately presented; therefore, the common-size cash ow statement shows only the net operating cash ows as a percentage of total inows or outows, depending on whether the net amount c06.indd c06.indd 247 9/17/08 11:35:58 AM 248 International Financial Statement Analysis EXHIBIT 6-14 Acme Corporation: Common-Size Cash Flow Statement: Indirect Format, Year Ended 31 December 2006 Percentage of Net Revenue Cash Flow from Operating Activities Net income Depreciation expense Gain on sale of equipment Increase in accounts receivable Increase in inventory $2,210 1,052 9.37 4.46 (205) (0.87) (55) (0.23) (707) (3.00) Decrease in prepaid expenses 23 0.10 Increase in accounts payable 263 1.11 Increase in salary and wage payable Decrease in interest payable Increase in income tax payable Increase in other accrued liabilities Net Cash Provided by Operating Activities 10 0.04 (12) (0.05) 5 0.02 22 0.09 2,606 11.04 Cash Flow from Investing Activities Cash received from sale of equipment Cash paid for purchase of equipment Net Cash Used for Investing Activities 762 3.23 (1,300) (5.51) (538) (2.28) (500) (2.12) Cash Flow from Financing Activities Cash paid to retire long-term debt Cash paid to retire common stock (600) (2.54) Cash paid for dividends (1,120) (4.75) Net Cash Used for Financing Activities (2,220) (9.41) Net Decrease in Cash $(152) (0.64) was an in- or out- cash ow. Because Acmes net operating cash ow is positive, it is shown as a percentage of total inows. Exhibit 6-14 demonstrates the net revenue common-size cash ow statement for Acme Corporation. Under the net revenue approach, each line item in the cash ow statement is shown as a percentage of net revenue. The common-size statement in this exhibit has been developed based on Acmes cash ow statement using the indirect method for operating cash ows. Each line item of the reconciliation between net income and net operating cash ows is expressed as a percentage of net revenue. The common-size format makes it easier to see trends in cash ow rather than just looking at the total amount. This method is also useful to the analyst in forecasting future cash ows because individual items in the commonsize statement (e.g., depreciation, xed capital expenditures, debt borrowing, and repayment) are expressed as a percentage of net revenue. Thus, once the analyst has forecast revenue, the common-size statement provides a basis for forecasting cash ows. c06.indd 248 9/17/08 11:35:59 AM Chapter 6 249 Understanding the Cash Flow Statement EXAMPLE 6-9 Analysis of a Common-Size Cash Flow Statement Andrew Potter is examining an abbreviated common-size cash ow statement based on net revenues for Dell, which is reproduced below: Period Ending: 3 Feb 2006 28 Jan 2005 Net income 6.39% 6.18% Depreciation 0.70 Net income adjustments 30 Jan 2004 31 Jan 2003 1 Feb 2002 6.38% 5.99% 4.00% 0.68 0.63 0.60 0.77 0.93 0.56 0.92 0.61 4.57 Accounts receivable 1.84 0.00 1.96 0.54 0.71 Inventory 0.21 0.00 0.13 0.06 0.36 Other operating activities 0.54 4.49 0.34 0.50 0.20 Cash owsoperating activities Changes in operating activities Liabilities 3.22 Net Cash FlowOperating 8.66% 0.00 10.79% 5.19 4.04 8.86% 9.99% 1.98 12.18% Cash owsinvesting activities Capital expenditures 1.30 1.07 0.79 0.86 0.97 Investments 8.24 3.64 4.88 3.04 6.28 Other investing activities 0.00 0.00 1.12 0.00 0.00 Net Cash FlowsInvesting 6.94% 4.71% 6.79% 3.90% 7.25% Sale and purchase of stock 11.14 6.36 3.34 5.72 8.68 0.00 0.00 0.00 0.01 Cash owsnancing activities Other nancing activities 0.00 Net Cash FlowsFinancing 11.14% 6.36% 3.34% 5.72% 8.67% Effect of exchange rate 0.35 1.15 1.48 1.30 0.33 Net Cash Flow 4.10% 0.87% 0.21% 1.67% 4.07% Based on the information in the above exhibit, address the following: 1. Characterize the importance of A. depreciation. B. capital expenditures. 2. Contrast Dells operating cash ow as a percentage of revenue with Dells net prot margin (on a cash basis). 3. Identify Dells major use of its positive operating cash ow. c06.indd 249 9/17/08 11:35:59 AM 250 International Financial Statement Analysis Solution to 1. A. Dell has very little depreciation expense (less than 1 percent), which is added back to determine operating cash ow. B. Dells level of capital expenditures is relatively small, less than 1 percent of revenues in most years, but this increased in the most recent year. This is consistent with Dells low amount of depreciation. Solution to 2. Dells operating cash ow as a percentage of revenue is consistently much higher than net prot margin. Dells business model appears to generate cash ow instead of requiring working capital, as many companies do. Dell collects cash ow customers, on average, sooner than cash is paid out to suppliers. Solution to 3. Most of Dells operating cash ow has been used to repurchase large amounts of its own stock (nancing activities). 4.3. Free Cash Flow to the Firm and Free Cash Flow to Equity In the initial evaluation of the cash ow statement above, it was mentioned that it is desirable that operating cash ows are sufcient to cover capital expenditures. The excess of operating cash ow over capital expenditures is known generically as free cash ow. For purposes of valuing a company or its equity securities, an analyst may want to determine a more precise free cash ow measure, such as free cash ow to the rm (FCFF) or free cash ow to equity (FCFE). FCFF is the cash ow available to the companys suppliers of debt and equity capital after all operating expenses (including income taxes) have been paid and necessary investments in working capital and xed capital have been made. FCFF can be computed starting with net income as8 FCFF NI NCC Int(1Tax rate) FCInv WCInv where NI NCC Int FCInv WCInv Net income Noncash charges (such as depreciation and amortization) Interest expense Capital expenditures (xed capital, such as equipment) Working capital expenditures The reason for adding back interest is that FCFF is the cash ow available to the suppliers of debt capital as well as equity capital. Conveniently, FCFF can also be computed from cash ow from operating activities as FCFF CFO Int(1 Tax rate) FCInv CFO represents cash ow from operating activities under U.S. GAAP or under IFRS where the company has chosen to place interest expense in operating activities. Under IFRS, if 8 See Stowe, Robinson, Pinto, and McLeavey (2002) for a detailed discussion of free cash ow computations. c06.indd 250 9/17/08 11:36:11 AM Chapter 6 251 Understanding the Cash Flow Statement the company has placed interest and dividends received in investing activities, these should be added back to CFO to determine FCFF. Additionally, if dividends paid were subtracted in the operating section, these should be added back in to compute FCFF. The computation of FCFF for Acme Corporation (based on the data from Exhibits 6-6, 6-7, and 6-8) is as follows: CFO Plus: Interest paid times (1 income tax rate) {$258 [1 ($1,139 $3,349)]} Less: Net investments in xed capital ($1,300 $762) FCFF $2,606 170 (538) $2,238 FCFE is the cash ow available to the companys common stockholders after all operating expenses and borrowing costs (principal and interest) have been paid and necessary investments in working capital and xed capital have been made. FCFE can be computed as FCFE CFO FCInv Net borrowing Net debt repayment The computation of FCFE for Acme Corporation (based on the data from Exhibits 6-6, 6-7, and 6-8) is as follows: CFO Less: Net investments in xed capital [$1,300 Less: Debt repayment FCFE $762] $2,606 (538) (500) $1,568 Positive FCFE means that the company has an excess of operating cash ow over amounts needed for investments for the future and repayment of debt. This cash would be available for distribution to owners. 4.4. Cash Flow Ratios The statement of cash ows provides information that can be analyzed over time to obtain a better understanding of the past performance of a company and its future prospects. This information can also be effectively used to compare the performance and prospects of different companies in an industry and of different industries. There are several ratios based on cash ow from operating activities that are useful in this analysis. These ratios generally fall into cash ow performance (protability) ratios and cash ow coverage (solvency) ratios. Exhibit 6-15 on page 252 summarizes the calculation and interpretation of some of these ratios. EXAMPLE 6-10 A Cash Flow Analysis of Comparables Andrew Potter is comparing the cash-ow-generating ability of Dell with that of several other computer manufacturers: Hewlett Packard, Gateway, and Apple. He collects the following information: c06.indd 251 9/17/08 11:36:14 AM 252 International Financial Statement Analysis Operating Cash Flow Revenue 2005 2004 2003 DELL 8.66% 10.79% 8.86% HPQ 9.26% 6.37% 8.29% GTW 0.65% 11.89% 2.15% AAPL 18.20% 11.28% 4.66% 2005 2004 2003 DELL 20.89% 24.97% 21.10% HPQ 10.46% 6.75% 8.33% GTW 1.35% 22.84% 3.22% AAPL 25.87% 12.57% 4.41% Average Total Assets AAPL Apple, GTW Gateway, HPQ Hewlett Packard. What is Potter likely to conclude about the relative cash-ow-generating ability of these companies? Solution. Dell has consistently generated operating cash ow relative to both revenue and assets. Hewlett Packard also has a good level of operating cash ow relative to revenue, but its operating cash ow is not as strong as Dell relative to assets. This is likely due to Dells lean business model and lack of a need for large amounts of property, plant, and equipment. Gateway has poor operating cash ow on both measures. Apple has dramatically improved its operating cash ow over the three years and in 2005 had the strongest operating cash ow of the group. EXHIBIT 6-15 Cash Flow Ratios Performance Ratios What It Measures Cash ow to revenue CFO Net revenue Cash generated per dollar of revenue Cash return on assets CFO Average total assets Cash generated from all resources Cash return on equity CFO Average shareholders equity Cash generated from owner resources Cash to income CFO Cash generating ability of operations Cash ow per share (CFO Preferred dividends) number of common shares outstanding Operating cash ow on a per-share basis Coverage Ratios Calculation What It Measures Debt coverage CFO Interest coverage c06.indd 252 Calculation (CFO Interest paid paid) Interest paid Operating income Financial risk and nancial leverage Total debt Taxes Ability to meet interest obligations 9/17/08 11:36:15 AM Chapter 6 Understanding the Cash Flow Statement 253 Reinvestment CFO assets Debt payment CFO Cash paid for long-term debt repayment Ability to pay debts with operating cash ows Dividend payment CFO Ability to pay dividends with operating cash ows Investing and nancing CFO Cash outows for investing and nancing activities Cash paid for long-term Dividends paid Ability to acquire assets with operating cash ows Ability to acquire assets, pay debts, and make distributions to owners 5 . SUMMARY The cash ow statement provides important information about a companys cash receipts and cash payments during an accounting period as well as information about a companys operating, investing, and nancing activities. Although the income statement provides a measure of a companys success, cash and cash ow are also vital to a companys long-term success. Information on the sources and uses of cash helps creditors, investors, and other statement users evaluate the companys liquidity, solvency, and nancial exibility. Key concepts are as follows: Cash ow activities are classied into three categories: operating activities, investing activities, and nancing activities. Signicant noncash transaction activities (if present) are reported by using a supplemental disclosure note to the cash ow statement. The cash ow statement under IFRS is similar to U.S. GAAP; however, IFRS permits greater discretion in classifying some cash ow items as operating, investing, or nancing activities. Companies can use either the direct or the indirect method for reporting their operating cash ow: The direct method discloses operating cash inows by source (e.g., cash received from customers, cash received from investment income) and operating cash outows by use (e.g., cash paid to suppliers, cash paid for interest) in the operating activities section of the cash ow statement. The indirect method reconciles net income to net cash ow from operating activities by adjusting net income for all noncash items and the net changes in the operating working capital accounts. The cash ow statement is linked to a companys income statement and comparative balance sheets and is constructed from the data on those statements. Although the indirect method is most commonly used by companies, the analyst can generally convert it to the direct format by following a simple three-step process. The analyst can use common-size statement analysis for the cash ow statement. Two prescribed approaches are the total cash inows/total cash outows method and the percentage of net revenues method. The cash ow statement can be used to determine FCFF and FCFE. The cash ow statement may also be used in nancial ratios measuring a companys protability, performance, and nancial strength. c06.indd 253 9/17/08 11:36:22 AM 254 International Financial Statement Analysis P RACTICE PROBLEMS 1. The three major classications of activities in a cash ow statement are A. inows, outows, and balances. B. beginning balance, ending balance, and change. C. operating, investing, and nancing. 2. The sale of a building for cash would be classied as what type of activity on the cash ow statement? A. Operating B. Investing C. Financing 3. Which of the following is an example of a nancing activity on the cash ow statement under U.S. GAAP? A. Payment of dividends B. Receipt of dividends C. Payment of interest 4. A conversion of a face value $1 million convertible bond for $1 million of common stock would most likely be A. reported as a $1 million nancing cash outow and inow. B. reported as supplementary information to the cash ow statement. C. reported as a $1 million nancing cash outow and a $1 million investing cash inow. 5. Interest expense may be classied as an operating cash ow A. under U.S. GAAP, but may be classied as either operating or investing cash ows under IFRS. B. under IFRS, but may be classied as either operating or investing cash ows under U.S. GAAP. C. under U.S. GAAP, but may be classied as either operating or nancing cash ows under IFRS. 6. Tax cash ows A. must be separately disclosed in the cash ow statement under IFRS only. B. must be separately disclosed in the cash ow statement under U.S. GAAP only. C. are not separately disclosed in the cash ow statement under IFRS or U.S. GAAP. 7. Which of the following components of the cash ow statement may be prepared under the indirect method under both IFRS and U.S. GAAP? A. Operating B. Investing C. Financing 8. Which of the following is most likely to appear in the operating section of a cash ow statement under the indirect method under U.S. GAAP? A. Net income B. Cash paid for interest C. Cash paid to suppliers c06.indd c06.indd 254 9/17/08 11:36:22 AM Chapter 6 255 Understanding the Cash Flow Statement 9. Red Road Company, a consulting company, reported total revenues of $100 million, total expenses of $80 million, and net income of $20 million in the most recent year. If accounts receivable increased by $10 million, how much cash did the company receive from customers? A. $110 million B. $90 million C. $30 million 10. Green Glory Corp., a garden supply wholesaler, reported cost of goods sold for the year of $80 million. Total assets increased by $55 million, including an increase of $5 million in inventory. Total liabilities increased by $45 million, including an increase of $2 million in accounts payable. How much cash did the company pay to its suppliers during the year? A. $90 million B. $83 million C. $77 million 11. Purple Fleur S.A., a retailer of oral products, reported cost of goods sold for the year of $75 million. Total assets increased by $55 million, but inventory declined by $6 million. Total liabilities increased by $45 million, and accounts payable increased by $2 million. How much cash did the company pay to its suppliers during the year? A. $85 million B. $79 million C. $67 million 12. White Flag, a womens clothing manufacturer, reported wage expense of $20 million. The beginning balance of wages payable was $3 million, and the ending balance of wages payable was $1 million. How much cash did the company pay in wages? A. $24 million B. $23 million C. $22 million 13. An analyst gathered the following information from a companys 2004 nancial statements ($ millions): Year Ended 31 December 2003 2004 Net sales 245.8 254.6 Cost of goods sold 168.3 175.9 Accounts receivable 73.2 68.3 Inventory 39.0 47.8 Accounts payable 20.3 22.9 Based only on the information above, the companys 2004 statement of cash ows prepared using the direct method would include amounts ($ millions) for cash received from customers and cash paid to suppliers, respectively, that are closest to: Cash Received from Customers A. 249.7 182.1 B. 259.5 169.7 C. c06.indd c06.indd 255 Cash Paid to Suppliers 259.5 182.1 9/17/08 11:36:23 AM 256 International Financial Statement Analysis 14. Golden Cumulus Corp., a commodities trading company, reported interest expense of $19 million and taxes of $6 million. Interest payable increased by $3 million, and taxes payable decreased by $4 million. How much cash did the company pay for interest and taxes? A. $22 million for interest and $2 million for taxes B. $16 million for interest and $2 million for taxes C. $16 million for interest and $10 million for taxes 15. An analyst gathered the following information from a companys 2005 nancial statements ($ millions): Balances as of Year Ended 31 December Retained earnings Accounts receivable Inventory Accounts payable 2004 120 38 45 36 2005 145 43 48 29 The company declared and paid cash dividends of $10 million in 2005 and recorded depreciation expense in the amount of $25 million for 2005. The companys 2005 cash ow from operations ($ millions) was closest to A. 25. B. 35. C. 45. 16. Silverago Incorporated, an international metals company, reported a loss on the sale of equipment of $2 million. In addition, the companys income statement shows depreciation expense of $8 million and the cash ow statement shows capital expenditure of $10 million, all of which was for the purchase of new equipment. Using the following information from the comparative balance sheets, how much cash did the company receive from the equipment sale? Balance Sheet Item Equipment Accumulated depreciationequipment 12/31/2005 $100 million $40 million 12/31/2006 $105 million $46 million Change $5 million $6 million A. $6 million B. $5 million C. $1 million 17. Jaderong Plinkett Stores reported net income of $25 million, which equals the companys comprehensive income. The company has no outstanding debt. Using the following information from the comparative balance sheets ($ millions), what should the company report in the nancing section of the statement of cash ows? Balance Sheet Item Common stock Additional paid-in capital common stock Retained earnings Total stockholders equity c06.indd c06.indd 256 12/31/2005 $100 12/31/2006 $102 Change $2 $100 $100 $300 $140 $115 $357 $40 $15 $57 9/17/08 11:36:23 AM Chapter 6 257 Understanding the Cash Flow Statement A. Issuance of common stock $42 million; dividends paid of $10 million B. Issuance of common stock $38 million; dividends paid of $10 million C. Issuance of common stock $42 million; dividends paid of $40 million 18. Based on the following information for Pinkerly Inc., what are the total net adjustments that the company would make to net income in order to derive operating cash ow? Year Ended Income Statement Item Net income Depreciation 12/31/2006 $20 million $2 million Balance Sheet Item 12/31/2005 12/31/2006 Change Accounts receivable $25 million $22 million ($3 million) Inventory $10 million $14 million $4 million Accounts payable $8 million $13 million $5 million A. Add $6 million B. Add $8 million C. Subtract $6 million 19. The rst step in evaluating the cash ow statement should be to examine A. individual investing cash ow items. B. individual nancing cash ow items. C. the major sources and uses of cash. 20. Which of the following would be valid conclusions from an analysis of the cash ow statement for Telefnica Group presented in Exhibit 6-3? A. The company does not pay dividends. B. The primary use of cash is nancing activities. C. The primary source of cash is operating activities. 21. Which is an appropriate method of preparing a common-size cash ow statement? A. Begin with net income and show the items that reconcile net income and operating cash ows. B. Show each line item on the cash ow statement as a percentage of net revenue. C. Show each line item on the cash ow statement as a percentage of total cash outows. 22. Which of the following is an appropriate method of computing free cash ow to the rm? A. Add operating cash ows plus capital expenditures and deduct after-tax interest payments. B. Add operating cash ows plus after-tax interest payments and deduct capital expenditures. C. Deduct both after-tax interest payments and capital expenditures from operating cash ows. c06.indd c06.indd 257 9/17/08 11:36:24 AM 258 International Financial Statement Analysis 23. An analyst has calculated a ratio using as the numerator the sum of operating cash ow, interest, and taxes, and as the denominator the amount of interest. What is this ratio, what does it measure, and what does it indicate? A. This ratio is an interest coverage ratio, measuring a companys ability to meet its interest obligations and indicating a companys solvency. B. This ratio is an effective tax ratio, measuring the amount of a companys operating cash ow used for taxes, and indicating a companys efciency in tax management. C. This ratio is an operating protability ratio, measuring the operating cash ow generated accounting for taxes and interest, and indicating a companys liquidity. c06.indd c06.indd 258 9/17/08 11:36:24 AM CHAPTER 7 F INANCIAL ANALYSIS TECHNIQUES Thomas R. Robinson, CFA CFA Institute Charlottesville, Virginia Hennie van Greuning, CFA World Bank Washington, DC Elaine Henry, CFA University of Miami Miami, Florida Michael A. Broihahn, CFA Barry University Miami, Florida L EARNING OUTCOMES After completing this chapter, you will be able to do the following: Identify the analytical phases, sources of information, and output of nancial analysis. Differentiate between computation and analysis of ratios, and explain key questions that should be addressed in ratio analysis. 259 c07.indd 259 9/17/08 11:37:15 AM 260 International Financial Statement Analysis Demonstrate and explain the use of ratio analysis, common-size nancial statements, and graphs in company analysis and the value, purposes, and limitations of ratio analysis. Explain the common classications of ratios and compute, analyze, and interpret activity, liquidity, solvency, protability, and valuation ratios. Explain how ratios are related and how to evaluate a company using a combination of different ratios. Demonstrate the application of DuPont analysis (the decomposition of return on equity). Describe how ratios are useful in equity analysis. Describe how ratios are useful in credit analysis. Discuss segment reporting requirements and compute, analyze, and interpret segment ratios. Describe how the results of common-size and ratio analysis can be used to model/forecast earnings. 1 . INTRODUCTION Financial analysis applies analytical tools to nancial data to assess a companys performance and trends in that performance. In essence, an analyst converts data into nancial metrics that assist in decision making. Analysts seek to answer such questions as: How successfully has the company performed, relative to its own past performance and relative to its competitors? How is the company likely to perform in the future? Based on expectations about future performance, what is the value of this company or the securities it issues? A primary source of data is a companys nancial reports, including the nancial statements, footnotes, and managements discussion and analysis. This text focuses on data presented in nancial reports prepared under International Financial Reporting Standards (IFRS) and U.S. generally accepted accounting principles (U.S. GAAP). However, even nancial reports prepared under these standards do not contain all the information needed to perform effective nancial analysis. Although nancial statements do contain data about the past performance of a company (its income and cash ows) as well as its current nancial condition (assets, liabilities, and owners equity), such statements may not provide some important nonnancial information nor do they forecast future results. The nancial analyst must be capable of utilizing nancial statements in conjunction with other information in order to reach valid conclusions and make projections. Accordingly, an analyst will most likely need to supplement the information found in a companys nancial reports with industry and economic data. The purpose of this chapter is to describe various techniques used to analyze a companys nancial statements. Financial analysis of a company may be performed for a variety of reasons, such as valuing equity securities, assessing credit risk, conducting due diligence related to an acquisition, or assessing a subsidiarys performance. This text will describe the techniques common to any nancial analysis and then discuss more specic aspects for the two most common categories: equity analysis and credit analysis. Equity analysis incorporates an owners perspective, either for valuation or performance evaluation. Credit analysis incorporates a creditors (such as a banker or bondholder) perspective. In either case, there is a need to gather and analyze information to make a decision (ownership or credit); the focus of analysis varies due to the differing interests of owners and creditors. Both equity and credit analysis assess the entitys ability to generate and grow earnings and cash ow, as well as any associated risks. Equity analysis usually places a greater emphasis on growth, whereas credit analysis usually places a greater c07.indd 260 9/17/08 11:37:16 AM Chapter 7 Financial Analysis Techniques 261 emphasis on risks. The difference in emphasis reects the different fundamentals of these types of investments: The value of a companys equity generally increases as the companys earnings and cash ow increase, whereas the value of a companys debt has an upper limit.1 The balance of this chapter is organized as follows: Section 2 recaps the framework for nancial statements and the place of nancial analysis techniques within it. Section 3 provides a description of analytical tools and techniques. Section 4 explains how to compute, analyze, and interpret common nancial ratios. Sections 4 through 8 explain the use of ratios and other analytical data in equity analysis, debt analysis, segment analysis, and forecasting, respectively. Section 9 summarizes the key points of the chapter. Practice problems in the CFA Institute multiple-choice format conclude the chapter. 2 . THE FINANCIAL ANALYSIS PROCESS In nancial analysis, as in any business task, a clear understanding of the end goal and the steps required to get there is essential. In addition, the analyst needs to know the typical questions to address when interpreting nancial data and how to communicate the analysis and conclusions. 2.1. The Objectives of the Financial Analysis Process Due to the variety of reasons for performing nancial analysis, the numerous available techniques, and the often substantial amount of data, it is important that the analytical approach be tailored to the specic situation. Prior to embarking on any nancial analysis, the analyst should clarify purpose and context, and clearly understand the following: What is the purpose of the analysis? What questions will this analysis answer? What level of detail will be needed to accomplish this purpose? What data are available for the analysis? What are the factors or relationships that will inuence the analysis? What are the analytical limitations, and will these limitations potentially impair the analysis? Having claried the purpose and context of the analysis, the analyst can select the techniques (e.g., ratios) that will best assist in making a decision. Although there is no single approach to structuring the analysis process, a general framework is set forth in Exhibit 7-1.2 The steps in this process were discussed in more detail in an earlier chapter. The primary focus of this chapter is on Phases 3 and 4, processing and analyzing data. 2.2. Distinguishing between Computations and Analysis An effective analysis encompasses both computations and interpretations. A well-reasoned analysis differs from a mere compilation of various pieces of information, computations, 1 The upper limit is equal to the undiscounted sum of the principal and remaining interest payments (i.e., the present value of these contractual payments at a zero percent discount rate). 2 Components of this framework have been adapted from van Greuning and Bratanovic (2003, p. 300) and Benninga and Sarig (1997, pp. 134156). c07.indd 261 9/17/08 11:37:16 AM 262 International Financial Statement Analysis EXHIBIT 7-1 A Financial Statement Analysis Framework Phase Sources of Information Output 1. Articulate the purpose and context of the analysis The nature of the analysts function, such as evaluating an equity or debt investment or issuing a credit rating. Statement of the purpose or objective of analysis. Communication with client or superior on needs and concerns. A list (written or unwritten) of specic questions to be answered by the analysis. Institutional guidelines related to developing specic work product. Nature and content of report to be provided. Timetable and budgeted resources for completion. 2. Collect input data Financial statements, other nancial data, questionnaires, and industry/ economic data. Discussions with management, suppliers, customers, and competitors. Organized nancial statements. Financial data tables. Completed questionnaires, if applicable. Company site visits (e.g., to production facilities or retail stores). 3. Process data Data from the previous phase. Adjusted nancial statements. Common-size statements. Ratios and graphs. Forecasts. 4. Analyze/interpret the processed data Input data as well as processed data. Analytical results. 5. Develop and communicate conclusions and recommendations (e.g., with an analysis report) Analytical results and previous reports. Analytical report answering questions posed in Phase 1. 6. Follow up Information gathered by periodically repeating above steps as necessary to determine whether changes to holdings or recommendations are necessary. Institutional guidelines for published reports. Recommendation regarding the purpose of the analysis, such as whether to make an investment or grant credit. Updated reports and recommendations. tables, and graphs by integrating the data collected into a cohesive whole. Analysis of past performance, for example, should address not only what happened but also why it happened and whether it advanced the companys strategy. Some of the key questions to address include: What aspects of performance are critical for this company to successfully compete in this industry? How well did the companys performance meet these critical aspects? (This is established through computation and comparison with appropriate benchmarks, such as the companys own historical performance or competitors performance.) c07.indd 262 9/17/08 11:37:17 AM Chapter 7 263 Financial Analysis Techniques What were the key causes of this performance, and how does this performance reect the companys strategy? (This is established through analysis.) If the analysis is forward looking, additional questions include: What is the likely impact of an event or trend? (Established through interpretation of analysis.) What is the likely response of management to this trend? (Established through evaluation of quality of management and corporate governance.) What is the likely impact of trends in the company, industry, and economy on future cash ows? (Established through assessment of corporate strategy and through forecasts.) What are the recommendations of the analyst? (Established through interpretation and forecasting of results of analysis.) What risks should be highlighted? (Established by an evaluation of major uncertainties in the forecast.) Example 7-1 demonstrates how a companys nancial data can be analyzed in the context of its business strategy and changes in that strategy. An analyst must be able to understand the why behind the numbers and ratios, not just what the numbers and ratios are. EXAMPLE 7-1 Performance Change in Strategy Reected in Financial Motorola (NYSE: MOT) and Nokia (NYSE: NOK) engage in the design, manufacture, and sale of mobility products worldwide. Selected nancial data for 2003 through 2005 for these two competitors are given below. Selected Financial Data for Motorola ($ millions) Years ended 31 December Net sales Operating earnings 2005 2004 2003 36,843 31,323 23,155 4,696 3,132 1,273 Selected Financial Data for Nokia Corporation ( millions) Years ended 31 December Net sales Operating prot 2005 2004 2003 34,191 29,371 29,533 4,639 4,326 4,960 Source: Motorola 10-K and Nokia 20-F, both led 2 March 2006. Although the raw numbers for Motorola and Nokia are not directly comparable because Motorola reports in U.S. dollars and Nokia in euros, the relative changes can be compared. Motorola reported a 35 percent increase in net sales from 2003 to 2004 and a further increase in 2005 of approximately 18 percent. Also, the companys operating earnings more than doubled from 2003 to 2004 and grew another 50 percent in 2005. Over the 2003 to 2004 time period, industry leader Nokia reported a decrease in both sales and operating prots, although sales growth was about 16 percent in 2005. c07.indd 263 9/17/08 11:37:17 AM 264 International Financial Statement Analysis What caused Motorolas dramatic growth in sales and operating prots? One of the most important factors was the introduction of new products, such as the stylish RAZR cell phone in 2004. Motorolas 2005 10-K indicates that more than 23 million RAZRs had been sold since the product was launched. The handset segment represents 54 percent of the companys 2004 sales and nearly 58 percent of 2005 sales, so the impact on sales and protability of the successful product introduction was signicant. The introduction of branded, differentiated products not only increased demand but also increased the potential for higher pricing. The introduction of the new products was one result of the companys strategic shift to develop a consumer marketing orientation as a complement to its historically strong technological position. Analysts often need to communicate the ndings of their analysis in a written report. Their reports should, therefore, communicate how conclusions were reached and why recommendations were made. For example, a report might present the following:3 The purpose of the report, unless it is readily apparent. Relevant aspects of the business context: Economic environment (country, macro economy, sector). Financial and other infrastructure (accounting, auditing, rating agencies). Legal and regulatory environment (and any other material limitations on the company being analyzed). Evaluation of corporate governance. Assessment of nancial and operational data. Conclusions and recommendations (including risks and limitations to the analysis). An effective storyline and well-supported conclusions and recommendations are normally enhanced by using 3 to 10 years of data, as well as analytic techniques appropriate to the purpose of the report. 3 . ANALYSIS TOOLS AND TECHNIQUES The tools and techniques presented in this section facilitate evaluations of company data. Evaluations require comparisons. It is difcult to say that a companys nancial performance was good without clarifying the basis for comparison. In assessing a companys ability to generate and grow earnings and cash ow, and the risks related to those earnings and cash ows, the analyst draws comparisons to other companies (cross-sectional analysis) and over time (trend or time-series analysis). For example, an analyst may wish to compare the protability in 2004 of Dell and Gateway. These companies differ signicantly in size, so comparing net income in raw dollars 3 The nature and content of reports will vary depending on the purpose of the analysis and the ultimate recipient of the report. For an example of the contents of an equity research report, see Stowe, Robinson, Pinto, and McLeavey (2002, pp. 2228). c07.indd 264 9/17/08 11:37:24 AM Chapter 7 265 Financial Analysis Techniques is not useful. Instead, ratios (which express one number in relation to another) and commonsize nancial statements can remove size as a factor and enable a more relevant comparison. The analyst may also want to examine Dells performance relative to its own historic performance. Again, the raw dollar amounts of sales or net income may not highlight signicant changes. However, using ratios (see Example 7-2), horizontal nancial statements, and graphs can make such changes more apparent. The following paragraphs describe the tools and techniques of ratio analysis in more detail. EXAMPLE 7-2 Ratio Analysis Dell computer reported the following data for three recent scal years: Fiscal Year Ended (FYE) Net Income (millions of US$) 1/31/2003 $2,122 1/30/2004 $2,645 1/28/2005 $3,043 Overall net income has grown steadily over the three-year period. Net income for FYE 2005 is 43 percent higher than net income in 2003, which is a good sign. However, has protability also steadily increased? We can obtain some insight by looking at the net prot margin (net income divided by revenue) for each year. Fiscal Year Ended Net Prot Margin 1/31/2003 5.99% 1/30/2004 6.38% 1/28/2005 6.18% The net prot margin indicates that protability improved from FY2003 to FY2004 but deteriorated slightly from FY2004 to FY2005. Further analysis is needed to determine the cause of the protability decline and assess whether this decline is likely to persist in future years. 3.1. Ratios There are many relationships between nancial accounts and between expected relationships from one point in time to another. Ratios are a useful way of expressing these relationships. Ratios express one quantity in relation to another (usually as a quotient). Notable academic research has examined the importance of ratios in predicting stock returns (Ou and Penman, 1989b; Abarbanell and Bushee, 1998) or credit failure (Altman, 1968; Ohlson, 1980; Hopwood et al., 1994). This research has found that nancial statement c07.indd c07.indd 265 9/17/08 11:37:27 AM 266 International Financial Statement Analysis ratios are effective in selecting investments and in predicting nancial distress. Practitioners routinely use ratios to communicate the value of companies and securities. Several aspects of ratio analysis are important to understand. First, the computed ratio is not the answer. The ratio is an indicator of some aspect of a companys performance, telling what happened but not why it happened. For example, an analyst might want to answer the question: Which of two companies was more protable? The net prot margin, which expresses prot relative to revenue, can provide insight into this question. Net prot margin is calculated by dividing net income by revenue:4 Net income __________ Revenue Assume Company A has 100,000 of net income and 2 million of revenue, and thus a net prot margin of 5 percent. Company B has 200,000 of net income and 6 million of revenue, and thus a net prot margin of 3.33 percent. Expressing net income as a percentage of revenue claries the relationship: For each 100 of revenue, Company A earns 5 in net income, while Company B earns only 3.33 for each 100 of revenue. So, we can now answer the question of which company was more protable in percentage terms: Company A was more protable, as indicated by its higher net prot margin of 5 percent. We also note that Company A was more protable despite the fact that Company B reported higher absolute amounts of net income and revenue. However, this ratio by itself does not tell us why Company A has a higher prot margin. Further analysis is required to determine the reason (perhaps higher relative sales prices or better cost control). Company size sometimes confers economies of scale, so the absolute amounts of net income and revenue are useful in nancial analysis. However, ratios reduce the effect of size, which enhances comparisons between companies and over time. A second important aspect of ratio analysis is that differences in accounting policies (across companies and across time) can distort ratios, and a meaningful comparison may, therefore, involve adjustments to the nancial data. Third, not all ratios are necessarily relevant to a particular analysis. The ability to select a relevant ratio or ratios to answer the research question is an analytical skill. Finally, as with nancial analysis in general, ratio analysis does not stop with computation; interpretation of the result is essential. In practice, differences in ratios across time and across companies can be subtle, and interpretation is situation specic. 3.1.1. The Universe of Ratios There are no authoritative bodies specifying exact formulas for computing ratios or providing a standard, comprehensive list of ratios. Formulas and even names of ratios often differ from analyst to analyst or from database to database. The number of different ratios that can be created is practically limitless. There are, however, widely accepted ratios that have been found to be useful. Section 4 of this chapter will focus primarily on these broad classes and commonly accepted denitions of key ratios. However, the analyst should be aware that different ratios may be used in practice and that certain industries have unique ratios tailored to the characteristics of that industry. When faced with an unfamiliar ratio, the analyst can 4 The term sales is often used interchangeably with the term revenues. Other times it is used to refer to revenues derived from sales of products versus services. Furthermore, the income statement usually reects revenues or sales after returns and allowances (e.g., returns of products or discounts offered after a sale to induce the customer to not return a product). Additionally, in some countries, including the United Kingdom, the term turnover is used in the sense of revenue. c07.indd 266 9/17/08 11:37:32 AM Chapter 7 267 Financial Analysis Techniques examine the underlying formula to gain insight into what the ratio is measuring. For example, consider the following ratio formula: Operating income _______________ Average total assets Never having seen this ratio, an analyst might question whether a result of 12 percent is better than 8 percent. The answer can be found in the ratio itself. The numerator is operating income and the denominator is average total assets, so the ratio can be interpreted as the amount of operating income generated per unit of assets. For every 100 of average total assets, generating 12 of operating income is better than generating 8 of operating income. Furthermore, it is apparent that this particular ratio is an indicator of protability (and, to a lesser extent, efciency in use of assets in generating operating prots). When facing a ratio for the rst time, the analyst should evaluate the numerator and denominator to assess what the ratio is attempting to measure and how it should be interpreted. This is demonstrated in Example 7-3. EXAMPLE 7-3 Interpreting a Financial Ratio An insurance company reports that its combined ratio is determined by dividing losses and expenses incurred by net premiums earned. It reports the following combined ratios: 2005 Combined ratio 2004 2003 2002 2001 90.1% 104.0% 98.5% 104.1% 101.1% Explain what this ratio is measuring and compare and contrast the results reported for each of the years shown in the chart. What other information might an analyst want to review before concluding on this information? Solution. The combined ratio is a protability measure. The ratio is explaining how much the costs (losses and expenses) were for every dollar of revenue (net premiums earned). The underlying formula indicates that a lower ratio is better. The 2005 ratio of 90.1 percent means that for every dollar of net premiums earned, the costs were $.901, yielding a gross prot of $.099. Ratios greater than 100 percent indicate an overall loss. A review of the data indicates that there does not seem to be a consistent trend in this ratio. Prots were achieved in 2005 and 2003. The results for 2004 and 2002 show the most signicant losses at 104 percent. The analyst would want to discuss this data further with management and understand the characteristics of the underlying business. He or she would want to understand why the results are so volatile. The analyst would also want to determine what ratio should be used as a benchmark. The operating income/average total assets ratio shown above is one of many versions of the return on assets (ROA) ratio. Note that there are other ways of specifying this formula based on how assets are dened. Some nancial ratio databases compute ROA using the ending value of assets rather than average assets. In limited cases, one may also see beginning c07.indd c07.indd 267 9/17/08 11:37:33 AM 268 International Financial Statement Analysis assets in the denominator. Which one is right? It depends upon what you are trying to measure and the underlying company trends. If the company has a stable level of assets, the answer will not differ greatly under the three measures of assets (beginning, average, and ending). If, however, the assets are growing (or shrinking), the results will differ. When assets are growing, operating income divided by ending assets may not make sense because some of the income would have been generated before some assets were purchased, and this would understate the companys performance. Similarly, if beginning assets are used, some of the operating income later in the year may have been generated only because of the addition of assets; therefore, the ratio would overstate the companys performance. Because operating income occurs throughout the period, it generally makes sense to use some average measure of assets. A good general rule is that when an income statement or cash ow statement number is in the numerator of a ratio and a balance sheet number is in the denominator, then an average should be used for the denominator. It is generally not necessary to use averages when only balance sheet numbers are used in both the numerator and denominator because both are determined as of the same date. However, as we shall see later, there are occasions when even balance sheet data may be averages, e.g., in analyzing the components of return on equity (ROE), which is dened as net income divided by average shareholders equity. If an average is used, there is also judgment required as to what average should be used. For simplicity, most ratio databases use a simple average of the beginning and end-of-year balance sheet amounts. If the companys business is seasonal so that levels of assets vary by interim period (semiannual or quarterly), then it may be benecial to take an average over all interim periods, if available (if the analyst is working within a company and has access to monthly data, this can also be used). 3.1.2. Value, Purposes, and Limitations of Ratio Analysis The value of ratio analysis is that it enables the equity or credit analyst to evaluate past performance, assess the current nancial position of the company, and gain insights useful for projecting future results. As noted previously, the ratio itself is not the answer but an indicator of some aspect of a companys performance. Financial ratios provide insights into: Microeconomic relationships within a company that help analysts project earnings and free cash ow. A companys nancial exibility, or ability to obtain the cash required to grow and meet its obligations, even if unexpected circumstances develop. Managements ability. There are also limitations to ratio analysis: The homogeneity of a companys operating activities. Companies may have divisions operating in many different industries. This can make it difcult to nd comparable industry ratios to use for comparison purposes. The need to determine whether the results of the ratio analysis are consistent. One set of ratios may indicate a problem, whereas another set may prove that the potential problem is only short term in nature. The need to use judgment. A key issue is whether a ratio for a company is within a reasonable range. Although nancial ratios are used to help assess the growth potential and risk of a company, they cannot be used alone to directly value a company or its securities, or to determine its creditworthiness. The entire operation of the company must be examined, c07.indd 268 9/17/08 11:37:39 AM Chapter 7 Financial Analysis Techniques 269 and the external economic and industry setting in which it is operating must be considered when interpreting nancial ratios. The use of alternative accounting methods. Companies frequently have latitude when choosing certain accounting methods. Ratios taken from nancial statements that employ different accounting choices may not be comparable unless adjustments are made. Some important accounting considerations include the following: FIFO (rst in, rst out), LIFO (last in, rst out), or average cost inventory valuation methods (IFRS no longer allow LIFO). Cost or equity methods of accounting for unconsolidated afliates. Straight-line or accelerated methods of depreciation. Capital or operating lease treatment. The expanding use of IFRS and the planned convergence between U.S. GAAP and IFRS seeks to make the nancial statements of different companies comparable and so overcome some of these difculties. Nonetheless, there will remain accounting choices that the analyst must consider. 3.1.3. Sources of Ratios Ratios may be computed using data directly from companies nancial statements or from a database such as Reuters, Bloomberg, Baseline, FactSet, or Thomson Financial. These databases are popular because they provide easy access to many years of historical data so that trends over time can be examined. They also allow for ratio calculations based on periods other than the companys scal year, such as for the trailing 12 months (TTM) or most recent quarter (MRQ). Analysts should be aware that the underlying formulas may differ by vendor. The formula used should be obtained from the vendor, and the analyst should determine whether any adjustments are necessary. Furthermore, database providers often exercise judgment when classifying items. For example, operating income may not appear directly on a companys income statement, and the vendor may use judgment to classify income statement items as operating or nonoperating. Variation in such judgments would affect any computation involving operating income. It is, therefore, a good practice to use the same source for data when comparing different companies or when evaluating the historical record of a single given company. Analysts should verify the consistency of formulas and data classications of the data source. Analysts should also be mindful of the judgments made by a vendor in data classications and refer back to the source nancial statements until they are comfortable that the classications are appropriate. Systems are under development that collect nancial data from regulatory lings and can automatically compute ratios. The eXtensible Business Reporting Language (XBRL) is a mechanism that attaches smart tags to nancial information (e.g., total assets), so that software can automatically collect the data and perform desired computations. The organization developing XBRL (www.xbrl.org) is a worldwide nonprot consortium of organizations, including the International Accounting Standards Board. Analysts can compare a subject company to similar (peer) companies in these databases or use aggregate industry data. For nonpublic companies, aggregate industry data can be obtained from such sources as Annual Statement Studies by the Risk Management Association or Dun & Bradstreet. These publications provide industry data with companies sorted into quartiles. Twenty-ve percent of companies ratios fall within the lowest quartile, 25 percent have ratios between the lower quartile and median value, and so on. Analysts can then determine a companys relative standing in the industry. c07.indd 269 9/17/08 11:37:40 AM 270 International Financial Statement Analysis 3.2. Common-Size Analysis Common-size analysis involves expressing nancial data, including entire nancial statements, in relation to a single nancial statement item, or base. Items used most frequently as the bases are total assets or revenue. In essence, common-size analysis creates a ratio between every nancial statement item and the base item. Common-size analysis was demonstrated in chapters for the income statement, balance sheet, and cash ow statement. In this section, we present common-size analysis of nancial statements in greater detail and include further discussion of their interpretation. 3.2.1. Common-Size Analysis of the Balance Sheet A vertical5 common-size balance sheet, prepared by dividing each item on the balance sheet by the same periods total assets and expressing the results as percentages, highlights the composition of the balance sheet. What is the mix of assets being used? How is the company nancing itself? How does one companys balance sheet composition compare with that of peer companies, and what is behind any differences? A horizontal common-size balance sheet, prepared by computing the increase or decrease in percentage terms of each balance sheet item from the prior year, highlights items that have changed unexpectedly or have unexpectedly remained unchanged. For example, Exhibit 7-2 presents a vertical common-size (partial) balance sheet for a hypothetical company in two different time periods. In this example, receivables have increased from 35 percent to 57 percent of total assets. What are possible reasons for such an increase? The increase might indicate that the company is making more of its sales on a credit basis rather than a cash basis, perhaps in response to some action taken by a competitor. Alternatively, the increase in receivables as a percentage of assets may have occurred because of a change in another current asset category, for example, a decrease in the level of inventory; the analyst would then need to investigate why that asset category had changed. Another possible reason for the increase in receivables as a percentage of assets is that the company has lowered its credit standards, relaxed its collection procedures, or adopted more aggressive revenue recognition policies. The analyst can turn to other comparisons and ratios (e.g., comparing the rate of growth in accounts receivable with the rate of growth in sales to help determine which explanation is most likely). EXHIBIT 7-2 Vertical Common-Size (Partial) Balance Sheet for a Hypothetical Company Period 1 % of Total Assets Period 2 % of Total Assets Cash 25 15 Receivables 35 57 Inventory 35 20 Fixed assets, net of depreciation Total assets 5 8 100 100 5 The term vertical analysis is used to denote a common-size analysis using only one reporting period or one base nancial statement, whereas horizontal analysis can refer either to an analysis comparing a specic nancial statement with prior or future time periods or to a cross-sectional analysis of one company with another. c07.indd 270 9/17/08 11:37:40 AM Chapter 7 271 Financial Analysis Techniques 3.2.2. Common-Size Analysis of the Income Statement A vertical common-size income statement divides each income statement item by revenue, or sometimes by total assets (especially in the case of nancial institutions). If there are multiple revenue sources, a decomposition of revenue in percentage terms is useful. For example, Exhibit 7-3 presents a hypothetical companys vertical common-size income statement in two different time periods. Revenue is separated into the companys four services, each shown as a percentage of total revenue. In this example, revenues from Service A have become a far greater percentage of the companys total revenue (45 percent in Period 2). What are possible reasons for and implications of this change in business mix? Did the company make a strategic decision to sell more of Service A, perhaps because it is more protable? Apparently not, because the companys earnings before interest, taxes, depreciation, and amortization (EBITDA) declined from 53 percent of sales to 45 percent, so other possible explanations should be examined. In addition, we note from the composition of operating expenses that the main reason for this decline in protability is that salaries and employee benets have increased from 15 percent to 25 percent of total revenue. Are more highly compensated employees required for Service A? Were higher training costs incurred in order to increase Service A revenues? If the analyst wants to predict future performance, the causes of these changes must be understood. In addition, Exhibit 7-3 shows that the companys income tax as a percentage of sales has declined dramatically (from 15 percent to 8 percent). Furthermore, as a percentage of earnings before tax (EBT) (usually the more relevant comparison), taxes have decreased from 36 percent to 23 percent. Is Service A provided in a jurisdiction with lower tax rates? If not, what is the explanation? EXHIBIT 7-3 Vertical Common-Size Income Statement for Hypothetical Company Period 1 % of Total Revenue Period 2 % of Total Revenue Revenue source: Service A 30 45 Revenue source: Service B 23 20 Revenue source: Service C 30 30 Revenue source: Service D 17 5 100 100 Salaries and employee benets 15 25 Administrative expenses 22 20 Total revenue Operating expenses (excluding depreciation) Rent expense 10 10 EBITDA 53 45 4 4 49 41 7 7 42 34 Depreciation and amortization EBIT Interest paid EBT Income tax provision 15 8 Net income 27 26 EBIT c07.indd 271 earnings before interest and tax. 9/17/08 11:37:41 AM 272 International Financial Statement Analysis The observations based on Exhibit 7-3 summarize the issues that can be raised through analysis of the vertical common-size income statement. 3.2.3. Cross-Sectional Analysis As noted previously, ratios and common-size statements derive part of their meaning through comparison to some benchmark. Cross-sectional analysis (sometimes called relative analysis) compares a specic metric for one company with the same metric for another company or group of companies, allowing comparisons even though the companies might be of signicantly different sizes and/or operate in different currencies. Exhibit 7-4 presents a vertical common-size (partial) balance sheet for two hypothetical companies at the same point in time. Company 1 is clearly more liquid (liquidity is a function of how quickly assets can be converted into cash) than Company 2, which has only 12 percent of assets available as cash, compared with the highly liquid Company 1, where cash is 38 percent of assets. Given that cash is generally a relatively low-yielding asset and thus not a particularly efcient use of the balance sheet, why does Company 1 hold such a large percentage of total assets in cash? Perhaps the company is preparing for an acquisition, or maintains a large cash position as insulation from a particularly volatile operating environment. Another issue highlighted by the comparison in this example is the relatively high percentage of receivables in Company 2s assets, which (as discussed in section 3.2.1) may indicate a greater proportion of credit sales, overall changes in asset composition, lower credit or collection standards, or aggressive accounting policies. 3.2.4. Trend Analysis6 When looking at nancial statements and ratios, trends in the data, whether they are improving or deteriorating, are as important as the current absolute or relative levels. Trend analysis provides important information regarding historical performance and growth and, given a sufciently long history of accurate seasonal information, can be of great assistance as a planning and forecasting tool for management and analysts. Exhibit 7-5A presents a partial balance sheet for a hypothetical company over ve periods. The last two columns of the table show the changes for Period 5 compared with Period 4, expressed both in absolute currency (in this case, dollars) and in percentages. A small percentage EXHIBIT 7-4 Vertical Common-Size (Partial) Balance Sheet for Two Hypothetical Companies Assets Company 1 % of Total Assets Company 2 % of Total Assets Cash 38 12 Receivables 33 55 Inventory 27 24 Fixed assets net of depreciation 1 2 Investments 1 7 Total Assets 100 100 6 In nancial statement analysis, the term trend analysis usually refers to comparisons across time periods of 3 to 10 years not involving statistical tools. This differs from the use of the term in the quantitative methods portion of the CFA curriculum, where trend analysis refers to statistical methods of measuring patterns in time-series data. c07.indd 272 9/17/08 11:37:41 AM Chapter 7 273 Financial Analysis Techniques EXHIBIT 7-5A Partial Balance Sheet for a Hypothetical Company over Five Periods Period 1 2 3 4 5 Change 4 to 5 ($ million) 39 29 27 19 16 3 15.8% Investments 1 7 7 6 4 2 33.3% Receivables 44 41 37 67 79 12 17.9% Inventory 15 25 36 25 27 2 8% 1 2 6 9 8 1 11.1% 100 105 112 126 133 8 5.6% Assets ($ millions) Cash Fixed assets net of depreciation Total assets Change 4 to 5 (%) change could hide a signicant currency change and vice versa, prompting the analyst to investigate the reasons despite one of the changes being relatively small. In this example, the largest percentage change was in investments, which decreased by 33.3 percent.7 However, an examination of the absolute currency amount of changes shows that investments changed by only $2 million, and the more signicant change was the $12 million increase in receivables. Another way to present data covering a period of time is to show each item in relation to the same item in a base year (i.e., a horizontal common-size balance sheet). Exhibit 7-5B presents the same partial balance sheet as in Exhibit 7-5A but with each item indexed relative to the same item in Period 1. For example, in Period 2, the company had $29 million cash, which is 75 percent of the amount of cash it had in Period 1, or expressed as an index relative to Period 1, 75 ($29/$39 0.75 100 75). Presenting data this way highlights signicant changes. In this example, we see easily that the company has less than half the amount of cash in Period 1, four times the amount of investments, and eight times the amount of property, plant, and equipment. An analysis of horizontal common-size balance sheets highlights structural changes that have occurred in a business. Past trends are obviously not necessarily an accurate predictor of the future, especially when the economic or competitive environment changes. An examination of past trends is more valuable when the macroeconomic and competitive environments are relatively stable and when the analyst is reviewing a stable or mature business. However, even in less stable contexts, historical analysis can serve as a basis for developing expectations. Understanding past trends is helpful in assessing whether these trends are likely to continue or if the trend is likely to change direction. One measure of success is for a company to grow at a rate greater than the rate of the overall market in which it operates. Companies that grow slowly may nd themselves unable to attract equity capital. Conversely, companies that grow too quickly may nd that their administrative and management information systems cannot keep up with the rate of expansion. 3.2.5. Relationships among Financial Statements Trend data generated by a horizontal common-size analysis can be compared across nancial statements. For example, the growth rate of assets for the hypothetical company in 7 Percentage change is calculated as: (Ending value (Ending value/Beginning value) 1. c07.indd 273 Beginning value)/Beginning value, or equivalently, 9/17/08 11:37:42 AM 274 International Financial Statement Analysis EXHIBIT 7-5B Horizontal Common-Size (Partial) Balance Sheet for a Hypothetical Company over Five Periods, with Each Item Expressed Relative to the Same Item in Period One Period Assets 1 2 3 4 5 Cash 1.00 0.75 0.69 0.48 0.41 Investments 1.00 7.35 6.74 6.29 4.00 Receivables 1.00 0.93 0.84 1.52 1.79 Inventory 1.00 1.68 2.40 1.68 1.78 Fixed assets net of depreciation 1.00 2.10 5.62 8.81 8.00 Total assets 1.00 1.05 1.12 1.26 1.33 Exhibit 7-5 can be compared with the companys growth in revenue over the same period of time. If revenue is growing more quickly than assets, the company may be increasing its efciency (i.e., generating more revenue for every dollar invested in assets). As another example, consider the following year-over-year percentage changes for a hypothetical company: Revenue Net income Operating cash ow Total assets 20% 25% 10% 30% Net income is growing faster than revenue, which indicates increasing protability. However, the analyst would need to determine whether the faster growth in net income resulted from continuing operations or from nonoperating, nonrecurring items. In addition, the 10 percent decline in operating cash ow despite increasing revenue and net income clearly warrants further investigation because it could indicate a problem with earnings quality (perhaps aggressive reporting of revenue). Finally, the fact that assets have grown faster than revenue indicates the companys efciency may be declining. The analyst should examine the composition of the increase in assets and the reasons for the changes. Example 7-4 provides a recent example of a company where comparisons of trend data from different nancial statements can indicate aggressive accounting policies. EXAMPLE 7-4 Use of Comparative Growth Information8 Sunbeam, a U.S. company, brought in new management to turn the company around during July 1996. For the following year, 1997, the following common-size trends were apparent: Revenue Inventory Receivables 19% 58% 38% 8 Adapted from Robinson and Munter (2004, pp. 215). c07.indd 274 9/17/08 11:37:43 AM Chapter 7 275 Financial Analysis Techniques It is generally more desirable to observe inventory and receivables growing at a slower (or similar) rate to revenue growth. Receivables growing faster than revenue can indicate operational issues, such as lower credit standards or aggressive accounting policies for revenue recognition. Similarly, inventory growing faster than revenue can indicate an operational problem with obsolescence or aggressive accounting policies, such as an improper overstatement of inventory to increase prots. In this case, the explanation lay in aggressive accounting policies. Sunbeam was later charged by the U.S. Securities and Exchange Commission (SEC) with improperly accelerating the recognition of revenue and engaging in other practices, such as billing customers for inventory prior to shipment. 3.3. The Use of Graphs as an Analytical Tool Graphs facilitate comparison of performance and nancial structure over time, highlighting changes in signicant aspects of business operations. In addition, graphs provide the analyst (and management) with a visual overview of risk trends in a business. Graphs may also be used effectively to communicate the analysts conclusions regarding nancial condition and risk management aspects. Exhibit 7-6 presents the information from Exhibit 7-5A in a stacked column format. The graph makes the signicant decline in cash and growth in receivables (both in absolute terms and as a percentage of assets) readily apparent. Choosing the appropriate graph to communicate the most signicant conclusions of a nancial analysis is a skill. In general, pie graphs are most useful to communicate the composition of a total value (e.g., assets over a limited amount of time, say one or two periods). Line graphs are useful when the focus is on the change in amount for a limited number of EXHIBIT 7-6 Stacked Column Graph of Asset Composition of Hypothetical Company over Five Periods 160 140 120 Fixed assets net of depreciation 100 Inventory 80 Receivables 60 40 Investments 20 Cash 0 1 c07.indd 275 2 3 4 5 9/17/08 11:37:45 AM 276 International Financial Statement Analysis EXHIBIT 7-7 Line Graph of Growth of Assets of Hypothetical Company over Five Periods 90 Cash 80 70 Investments 60 50 Receivables 40 Inventory 30 20 Fixed assets net of depreciation 10 0 1 2 3 4 5 items over a relatively longer time period. When the composition and amounts, as well as their change over time, are all important, a stacked column graph can be useful. When comparing Period 5 with Period 4, the growth in receivables appears to be within normal bounds, but when comparing Period 5 with earlier periods, the dramatic growth becomes apparent. In the same manner, a simple line graph will also illustrate the growth trends in key nancial variables. Exhibit 7-7 presents the information from Exhibit 7-5 as a line graph, illustrating the growth of assets of a hypothetical company over ve periods. The steady decline in cash, volatile movements of inventory, and dramatic growth of receivables is clearly illustrated. 3.4. Regression Analysis When analyzing the trend in a specic line item or ratio, frequently it is possible simply to visually evaluate the changes. For more complex situations, regression analysis can help identify relationships (or correlation) between variables. For example, a regression analysis could relate a companys sales to gross domestic product (GDP) over time, providing insight into whether the company is cyclical. In addition, the statistical relationship between sales and GDP could be used as a basis for forecasting sales. Other examples of such relationships are the relation between a companys sales and inventory over time, or the relation between hotel occupancy and a companys hotel revenues. In addition to providing a basis for forecasting, regression analysis facilitates identication of items or ratios that are not behaving as expected, given historical statistical relationships. 4 . COMMON RATIOS USED IN FINANCIAL ANALYSIS In the previous section, we focused on ratios resulting from common-size analysis. In this section, we expand the discussion to include other commonly used nancial ratios and the broad classes into which they are categorized. There is some overlap with common-size nancial c07.indd 276 9/17/08 11:37:47 AM Chapter 7 Financial Analysis Techniques 277 EXHIBIT 7-8 Categories of Financial Ratios Category Description Activity Activity ratios measure how efciently a company performs day-to-day tasks, such as the collection of receivables and management of inventory. Liquidity Liquidity ratios measure the companys ability to meet its short-term obligations. Solvency Solvency ratios measure a companys ability to meet long-term obligations. Subsets of these ratios are also known as leverage and long-term debt ratios. Protability Protability ratios measure the companys ability to generate protable sales from its resources (assets). Valuation Valuation ratios measure the quantity of an asset or ow (e.g., earnings) associated with ownership of a specied claim (e.g., a share or ownership of the enterprise). statement ratios. For example, a common indicator of protability is the net prot margin, which is calculated as net income divided by sales. This ratio appears on a common-size vertical income statement. Other ratios involve information from multiple nancial statements or even data from outside the nancial statements. Due to the large number of ratios, it is helpful to think about ratios in terms of broad categories based on what aspects of performance a ratio is intended to detect. Financial analysts and data vendors use a variety of categories to classify ratios. The category names and the ratios included in each category can differ. Common ratio categories include activity, liquidity, solvency, and protability. These categories are summarized in Exhibit 7-8. Each category measures a different aspect of analysis, but all are useful in evaluating a companys overall ability to generate cash ows from operating its business and the associated risks. These categories are not mutually exclusive; some ratios are useful in measuring multiple aspects of the business. For example, an activity ratio measuring how quickly a company collects accounts receivable is also useful in assessing the companys liquidity because collection of revenues increases cash. Some protability ratios also reect the operating efciency of the business. In summary, analysts appropriately use certain ratios to evaluate multiple aspects of the business. Analysts also need to be aware of variations in industry practice in the calculation of nancial ratios. In the text that follows, alternative views on ratio calculations are often provided. 4.1. Interpretation and Context Financial ratios can only be interpreted in the context of other information, including benchmarks. In general, the nancial ratios of a company are compared with those of its major competitors (cross-sectional and trend analysis) and to the companys prior periods (trend analysis). The goal is to understand the underlying causes of divergence between a companys ratios and those of the industry. Even ratios that remain consistent require understanding c07.indd 277 9/17/08 11:37:48 AM 278 International Financial Statement Analysis because consistency can sometimes indicate accounting policies selected to smooth earnings. An analyst should evaluate nancial ratios based on the following: 1. Company goals and strategy. Actual ratios can be compared with company objectives to determine whether objectives are being attained and whether the results are consistent with the companys strategy. 2. Industry norms (cross-sectional analysis). A company can be compared with others in its industry by relating its nancial ratios to industry norms or to a subset of the companies in an industry. When industry norms are used to make judgments, care must be taken because: Many ratios are industry specic, and not all ratios are important to all industries. Companies may have several different lines of business. This will cause aggregate nancial ratios to be distorted. It is better to examine industry-specic ratios by lines of business. Differences in accounting methods used by companies can distort nancial ratios. Differences in corporate strategies can affect certain nancial ratios. 3. Economic conditions. For cyclical companies, nancial ratios tend to improve when the economy is strong and weaken during recessions. Therefore, nancial ratios should be examined in light of the current phase of the business cycle. The following sections discuss activity, liquidity, solvency, and protability ratios in turn. Selected valuation ratios are presented later in the section on equity analysis. 4.2. Activity Ratios Activity ratios are also known as asset utilization ratios or operating efciency ratios. This category is intended to measure how well a company manages various activities, particularly how efciently it manages its various assets. Activity ratios are analyzed as indicators of ongoing operational performancehow effectively assets are used by a company. These ratios reect the efcient management of both working capital and longer-term assets. As noted, efciency has a direct impact on liquidity (the ability of a company to meet its short-term obligations), so some activity ratios are also useful in assessing liquidity. 4.2.1. Calculation of Activity Ratios Exhibit 7-9 presents the most commonly used activity ratios. The exhibit shows the numerator and denominator of each ratio. Activity ratios measure how efciently the company utilizes assets. They generally combine information from the income statement in the numerator with balance sheet items in the denominator. Because the income statement measures what happened during a period whereas the balance sheet shows the condition only at the end of the period, average balance sheet data are normally used for consistency. For example, to measure inventory management efciency, cost of goods sold (from the income statement) is divided by average inventory (from the balance sheet). Most databases, such as Bloomberg and Baseline, use this averaging convention when income statement and balance sheet data are combined. These databases typically average only two points: the beginning of the year and the end of the year. The examples that follow based on annual nancial statements illustrate that practice. However, some analysts prefer to average more observations if they are available, especially if the business is seasonal. If a semiannual report is prepared, an average can be taken over three data c07.indd 278 9/17/08 11:37:48 AM Chapter 7 279 Financial Analysis Techniques EXHIBIT 7-9 Denitions of Commonly Used Activity Ratios Activity Ratios Numerator Denominator Inventory turnover Cost of goods sold Average inventory Days of inventory on hand (DOH) Number of days in period Inventory turnover Receivables turnover Revenue Average receivables Days of sales outstanding (DSO) Number of days in period Receivables turnover Payables turnover Purchases Average trade payables Number of days of payables Number of days in period Payables turnover Working capital turnover Revenue Average working capital Fixed asset turnover Revenue Average net xed assets Total asset turnover Revenue Average total assets points (beginning, middle, and end of year). If quarterly data are available, a ve-point average can be computed (beginning of year and end of each quarterly period) or a four-point average using the end of each quarterly period. Note that if the companys year ends at a low or high point for inventory for the year, there can still be bias in using three or ve data points, because the beginning and end of year occur at the same time of the year and are effectively double counted. Because cost of goods sold measures the cost of inventory that has been sold, this ratio measures how many times per year the entire inventory was theoretically turned over, or sold. (We say that the entire inventory was theoretically sold because in practice companies do not generally sell out their entire inventory.) If, for example, a companys cost of goods sold for a recent year was 120,000 and its average inventory was 10,000, the inventory turnover ratio would be 12. The company theoretically turns over (i.e., sells) its entire inventory 12 times per year (i.e., once a month). (Again, we say theoretically because in practice the company likely carries some inventory from one month into another.) Turnover can then be converted to days of inventory on hand (DOH) by dividing inventory turnover into the number of days in the accounting period. In this example, the result is a DOH of 30.42 (365/12), meaning that, on average, the companys inventory was on hand for about 30 days, or, equivalently, the company kept on hand about 30 days worth of inventory, on average, during the period. Activity ratios can be computed for any annual or interim period, but care must be taken in the interpretation and comparison across periods. For example, if the same company had cost of goods sold for the rst quarter (90 days) of the following year of 35,000 and average inventory of 11,000, the inventory turnover would be 3.18 times. However, this turnover rate is 3.18 times per quarter, which is not directly comparable to the 12 times per year in the preceding year. In this case, we can annualize the quarterly inventory turnover rate by multiplying the quarterly turnover by 4 (12 months/3 months; or by 4.06, using 365 days/ 90 days) for comparison to the annual turnover rate. So, the quarterly inventory turnover is equivalent to a 12.72 annual inventory turnover (or 12.91 if we annualize the ratio using a 90-day quarter and a 365-day year). To compute the DOH using quarterly data, we can use the quarterly turnover rate and the number of days in the quarter for the numeratoror, we can use the annualized turnover rate and 365 days; either results in DOH of around 28.3, c07.indd 279 9/17/08 11:37:49 AM 280 International Financial Statement Analysis with slight differences due to rounding (90/3.18 28.30 and 365/12.91 28.27). Another time-related computational detail is that for companies using a 52/53-week annual period and for leap years, the actual days in the year should be used rather than 365. In some cases, an analyst may want to know how many days of inventory are on hand at the end of the year rather than the average for the year. In this case, it would be appropriate to use the year-end inventory balance in the computation rather than the average. If the company is growing rapidly or if costs are increasing rapidly, analysts should consider using cost of goods sold just for the fourth quarter in this computation because the cost of goods sold of earlier quarters may not be relevant. Example 7-5 further demonstrates computation of activity ratios using Hong Kong Exchangelisted Lenovo Group Limited. EXAMPLE 7-5 Computation of Activity Ratios Ya-Wen Yang would like to evaluate how efcient Lenovo Group Limited is at collecting its trade accounts receivable on average during the scal year ended 31 March 2005. Yang has gathered the following information from Lenovos annual and interim reports: HK$ in Thousands Trade receivables as of 31 March 2004 1,230,944 Trade receivables as of 31 March 2005 851,337 Revenue for year ended 31 March 2005 22,554,678 What is Lenovos receivables turnover and number of days of sales outstanding (DSO) for the scal year ended 31 March 2005? Solution: Receivables turnover DSO Revenue/Average receivables 22,554,678/[(1,230,944 851,337)/2] 22,554,678/1,041,140.50 21.6634 times Number of days in period/Receivables turnover 365/21.6634 16.85 days On average, it took Lenovo 16.85 days to collect receivables during the scal year ended 31 March 2005. 4.2.2 Interpretation of Activity Ratios In this section, we discuss the activity ratios that were dened in Exhibit 7-9. Inventory turnover and DOH. Inventory turnover lies at the heart of operations for many entities. It indicates the resources (money) tied up in inventory (i.e., the carrying costs) and can, therefore, be used to indicate inventory management effectiveness. The higher the inventory turnover ratio, the shorter the period that inventory is held and so c07.indd c07.indd 280 9/17/08 11:37:49 AM Chapter 7 281 Financial Analysis Techniques the lower DOH. In general, inventory turnover (and DOH) should be benchmarked against industry norms. A high inventory turnover ratio relative to industry norms might indicate highly effective inventory management. Alternatively, a high inventory turnover ratio (and commensurately low DOH) could possibly indicate the company does not carry adequate inventory, so shortages could potentially hurt revenue. To assess which explanation is more likely, the analyst can compare the companys revenue growth with that of the industry. Slower growth combined with higher inventory turnover could indicate inadequate inventory levels. Revenue growth at or above the industrys growth supports the interpretation that the higher turnover reects greater inventory management efciency. A low inventory turnover ratio (and commensurately high DOH) relative to the rest of the industry could be an indicator of slow-moving inventory, perhaps due to technological obsolescence or a change in fashion. Again, comparing the companys sales growth with the industry can offer insight. Receivables turnover and DSO. The number of DSO represents the elapsed time between a sale and cash collection, reecting how fast the company collects cash from customers it offers credit. Although limiting the numerator to sales made on credit would be more appropriate, credit sales information is not always available to analysts; therefore, revenue as reported in the income statement is generally used as an approximation. A relatively high receivables turnover ratio (and commensurately low DSO) might indicate highly efcient credit and collection. Alternatively, a high receivables turnover ratio could indicate that the companys credit or collection policies are too stringent, suggesting the possibility of sales being lost to competitors offering more lenient terms. A relatively low receivables turnover ratio would typically raise questions about the efciency of the companys credit and collections procedures. As with inventory management, comparison of the companys sales growth relative to the industry can help the analyst assess whether sales are being lost due to stringent credit policies. In addition, comparing the companys estimates of uncollectible accounts receivable and actual credit losses with past experience and with peer companies can help assess whether low turnover reects credit management issues. Companies often provide details of receivables aging (how much receivables have been outstanding by age). This can be used along with DSO to understand trends in collection, as demonstrated in Example 7-6. EXAMPLE 7-6 Evaluation of an Activity Ratio Ya-Wen Yang has computed the average DSO for scal years ended 31 March 2004 and 2005: 2005 Days of sales outstanding 2004 16.85 14.05 Yang would like to better understand why, on average, it took almost 17 days to collect receivables in 2005 versus 14 days in 2004. He collects accounts receivable aging c07.indd c07.indd 281 9/17/08 11:37:55 AM 282 International Financial Statement Analysis information from Lenovos annual reports and computes the percentage of accounts receivable by days outstanding. This information is presented below: 31 March 2005 HK$000 Percent 31 March 2004 HK$000 Percent 31 March 2003 HK$000 Percent 0 30 days 588,389 69.11% 944,212 76.71% 490,851 88.68% 31 60 days 56,966 6.69% 84,481 6.86% 27,213 4.92% 6190 days 40,702 4.78% 20,862 1.69% 10,680 1.93% Over 90 days 165,280 19.41% 181,389 14.74% 24,772 4.48% Total 851,337 100.00% 1,230,944 100.00% 553,516 100.00% From these data, it appears that over the past three years there has been a trend of fewer receivables due within 30 days and more due for periods of longer than 90 days. Lenovos footnotes disclose that general trade customers are provided with 30-day credit terms but that systems integration customers (consulting jobs) are given 180 days. Furthermore, the footnotes reveal that consulting revenues increased dramatically over the 2003 to 2004 period. In the third quarter of scal year ending 31 March 2005, Lenovo spun off its systems integration business to another company, retaining a small percentage interest. Yang concludes that the higher DSO in scal year ending 31 March 2005 appears to be due to the higher revenue in systems integration, which has longer credit terms. Yang may further surmise that DSO should drop in the next scal year since this business has been spun off. Payables turnover and the number of days of payables. The number of days of payables reects the average number of days the company takes to pay its suppliers, and the payables turnover ratio measures how many times per year the company theoretically pays off all its creditors. For purposes of calculating these ratios, an implicit assumption is that the company makes all its purchases using credit. If the amount of purchases is not directly available, it can be computed as cost of goods sold plus ending inventory less beginning inventory. Alternatively, cost of goods sold is sometimes used as an approximation of purchases. A payables turnover ratio that is high (low days payable) relative to the industry could indicate that the company is not making full use of available credit facilities; alternatively, it could result from a company taking advantage of early payment discounts. An excessively low turnover ratio (high days payable) could indicate trouble making payments on time, or alternatively, exploitation of lenient supplier terms. This is another example where it is useful to look simultaneously at other ratios. If liquidity ratios indicate that the company has sufcient cash and other short-term assets to pay obligations and yet the days payable ratio is relatively high, the analyst would favor the lenient supplier credit and collection policies as an explanation. Working capital turnover. Working capital is dened as current (expected to be consumed or converted into cash within one year) assets minus current liabilities. Working capital c07.indd 282 9/17/08 11:37:57 AM Chapter 7 283 Financial Analysis Techniques turnover indicates how efciently the company generates revenue with its working capital. For example, a working capital turnover ratio of 4.0 indicates that the company generates 4 of revenue for every 1 of working capital. A high working capital turnover ratio indicates greater efciency (i.e., the company is generating a high level of revenues relative to working capital). For some companies, working capital can be near zero or negative, rendering this ratio incapable of being interpreted. The following two ratios are more useful in those circumstances. Fixed asset turnover. This ratio measures how efciently the company generates revenues from its investments in xed assets. Generally, a higher xed-asset turnover ratio indicates more efcient use of xed assets in generating revenue. A low ratio can indicate inefciency, a capital-intensive business environment, or a new business not yet operating at full capacityin which case the analyst will not be able to link the ratio directly to efciency. In addition, asset turnover can be affected by factors other than a companys efciency. The xed-asset turnover ratio would be lower for a company whose assets are newer (and, therefore, less depreciated and so reected in the nancial statements at a higher carrying value) than the ratio for a company with older assets (that are thus more depreciated and so reected at a lower carrying value). The xed-asset ratio can be erratic because, although revenue may have a steady growth rate, increases in xed assets may not follow a smooth pattern; so, every year-to-year change in the ratio does not necessarily indicate important changes in the companys efciency. Total asset turnover. The total asset turnover ratio measures the companys overall ability to generate revenues with a given level of assets. A ratio of 1.20 would indicate that the company is generating 1.20 of revenues for every 1 of average assets. A higher ratio indicates greater efciency. Because this ratio includes both xed and current assets, inefcient working capital management can distort overall interpretations. It is, therefore, helpful to analyze working capital and xed-asset turnover ratios separately. A low asset turnover ratio can be an indicator of inefciency or of relative capital intensity of the business. The ratio also reects strategic decisions by management: for example, the decision whether to use a more labor-intensive (and less capital-intensive) approach to its business or a more capital-intensive (and less labor-intensive) approach. When interpreting activity ratios, the analysts should examine not only the individual ratios but also the collection of relevant ratios to determine the overall efciency of a company. Example 7-7 demonstrates the evaluation of activity ratios, both narrow (e.g., number of days inventory) and broad (total asset turnover) for a Taiwanese semiconductor manufacturer. EXAMPLE 7-7 Evaluation of Activity Ratios United Microelectronics Corp. (UMC) is a semiconductor foundry company based in Taiwan. As part of an analysis of managements operating efciency, an analyst collects the following activity ratios from Bloomberg: Ratio 2004 2003 2002 2001 DOH 35.68 40.70 40.47 48.51 DSO 45.07 58.28 51.27 76.98 0.35 0.28 0.23 0.22 Total asset turnover c07.indd 283 9/17/08 11:38:04 AM 284 International Financial Statement Analysis These ratios indicate that the company has improved on all three measures of activity over the four-year period. The company has fewer DOH, is collecting receivables faster, and is generating a higher level of revenues relative to total assets. The overall trend is good, but thus far, the analyst has only determined what happened. A more important question is why the ratios improved, because understanding good changes as well as bad ones facilitates judgments about the companys future performance. To answer this question, the analyst examines company nancial reports as well as external information about the industry and economy. In examining the annual report, the analyst notes that in the fourth quarter of 2004, the company experienced an inventory correction and that the company recorded an allowance for the decline in market value and obsolescence of inventory of TWD 1,786,493, or about 15 percent of year-end inventory value (compared with about a 5.9 percent allowance in the prior year). This reduction in the value of inventory accounts for a large portion of the decline in DOH from 40.7 in 2003 to 35.68 in 2004. Management claims that this inventory obsolescence is a short-term issue; analysts can watch DOH in future interim periods to conrm this assertion. In any event, all else being equal, the analyst would likely expect DOH to return to a level closer to 40 days going forward. More positive interpretations can be drawn from the total asset turnover. The analyst nds that the companys revenues increased more than 35 percent while total assets only increased by about 6 percent. Based on external information about the industry and economy, the analyst attributes the increased revenues largely to the recovery of the semiconductor industry in 2004. However, management was able to achieve this growth in revenues with a comparatively modest increase in assets, leading to an improvement in total asset turnover. Note further that part of the reason for the modest increase in assets is lower DOH and DSO. 4.3. Liquidity Ratios Liquidity analysis, which focuses on cash ows, measures a companys ability to meet its short-term obligations. Liquidity measures how quickly assets are converted into cash. Liquidity ratios also measure the ability to pay off short-term obligations. In day-to-day operations, liquidity management is typically achieved through efcient use of assets. In the medium term, liquidity in the nonnancial sector is also addressed by managing the structure of liabilities. (See discussion on nancial sector below.) The level of liquidity needed differs from one industry to another. A particular companys liquidity position may also vary according to the anticipated need for funds at any given time. Judging whether a company has adequate liquidity requires analysis of its historical funding requirements, current liquidity position, anticipated future funding needs, and options for reducing funding needs or attracting additional funds (including actual and potential sources of such funding). Larger companies are usually better able to control the level and composition of their liabilities than smaller companies. Therefore, they may have more potential funding sources, including public capital and money markets. Greater discretionary access to capital markets also reduces the size of the liquidity buffer needed relative to companies without such access. c07.indd 284 9/17/08 11:38:06 AM Chapter 7 285 Financial Analysis Techniques Contingent liabilities, such as letters of credit or nancial guarantees, can also be relevant when assessing liquidity. The importance of contingent liabilities varies for the nonbanking and banking sector. In the nonbanking sector, contingent liabilities (usually disclosed in the footnotes to the companys nancial statements) represent potential cash outows, and when appropriate, should be included in an assessment of a companys liquidity. In the banking sector, contingent liabilities represent potentially signicant cash outows that are not dependent on the banks nancial condition. Although outows in normal market circumstances typically may be low, a general macroeconomic or market crisis can trigger a substantial increase in cash outows related to contingent liabilities because of the increase in defaults and business bankruptcies that often accompany such events. In addition, such crises are usually characterized by diminished levels of overall liquidity, which can further exacerbate funding shortfalls. Therefore, for the banking sector, the effect of contingent liabilities on liquidity warrants particular attention. 4.3.1. Calculation of Liquidity Ratios Common liquidity ratios are presented in Exhibit 7-10. These liquidity ratios reect a companys position at a point in time and, therefore, typically use data from the ending balance sheet rather than averages. The current, quick, and cash ratios reect three measures of a companys ability to pay current liabilities. Each uses a progressively stricter denition of liquid assets. The defensive interval ratio measures how long a company can pay its daily cash expenditures using only its existing liquid assets, without additional cash ow coming in. This ratio is similar to the burn rate often computed for start-up internet companies in the late 1990s or for biotechnology companies. The numerator of this ratio includes the same liquid assets used in the quick ratio, and the denominator is an estimate of daily cash expenditures. To obtain daily cash expenditures, the total of cash expenditures for the period is divided by the number of days in the period. Total cash expenditures for a period can be approximated by summing all expenses on the income statementsuch as cost of goods sold; selling, general, and administrative expenses; and research and development expensesand then subtracting any noncash expenses, such as depreciation and amortization. (Typically, taxes are not included.) EXHIBIT 7-10 Denitions of Commonly Used Liquidity Ratios Liquidity Ratios Numerator Denominator Current ratio Current assets Current liabilities Quick ratio Cash short-term marketable investments receivables Current liabilities Cash ratio Cash short-term marketable investments Current liabilities Defensive interval ratio Cash short-term marketable investments receivables Daily cash expenditures Additional Liquidity Measure Cash conversion cycle (net operating cycle) c07.indd 285 DOH DSO number of days of payables 9/17/08 11:38:14 AM 286 International Financial Statement Analysis The cash conversion cycle, a nancial metric not in ratio form, measures the length of time required for a company to go from cash (invested in its operations) to cash received (as a result of its operations). During this period of time, the company needs to nance its investment in operations through other sources (i.e., through debt or equity). 4.3.2. Interpretation of Liquidity Ratios In this section, we discuss the interpretation of the ve basic liquidity ratios presented in Exhibit 7-10. Current ratio. This ratio expresses current assets (assets expected to be consumed or converted into cash within one year) in relation to current liabilities (liabilities falling due within one year). A higher ratio indicates a higher level of liquidity (i.e., a greater ability to meet short-term obligations). A current ratio of 1.0 would indicate that the book value of its current assets exactly equals the book value of its current liabilities. A lower ratio indicates less liquidity, implying a greater reliance on operating cash ow and outside nancing to meet short-term obligations. Liquidity affects the companys capacity to take on debt. The current ratio implicitly assumes that inventories and accounts receivable are indeed liquid (which is presumably not the case when related turnover ratios are low). Quick ratio. The quick ratio is more conservative than the current ratio because it includes only the more liquid current assets (sometimes referred to as quick assets) in relation to current liabilities. Like the current ratio, a higher quick ratio indicates greater liquidity. The quick ratio reects the fact that certain current assetssuch as prepaid expenses, some taxes, and employee-related prepaymentsrepresent costs of the current period that have been paid in advance and cannot usually be converted back into cash. This ratio also reects the fact that inventory might not be easily and quickly converted into cash, and furthermore, that a company would probably not be able to sell all of its inventory for an amount equal to its carrying value, especially if it were required to sell the inventory quickly. In situations where inventories are illiquid (as indicated, for example, by low inventory turnover ratios), the quick ratio may be a better indicator of liquidity than the current ratio. Cash ratio. The cash ratio normally represents a reliable measure of an individual entitys liquidity in a crisis situation. Only highly marketable short-term investments and cash are included. In a general market crisis, the fair value of marketable securities could decrease signicantly as a result of market factors, in which case even this ratio might not provide reliable information. Defensive interval ratio. This ratio measures how long the company can continue to pay its expenses from its existing liquid assets without receiving any additional cash inow. A defensive interval ratio of 50 would indicate that the company can continue to pay its operating expenses for 50 days before running out of quick assets, assuming no additional cash inows. A higher defensive interval ratio indicates greater liquidity. If a companys defensive interval ratio is very low relative to peer companies or to the companys own history, the analyst would want to ascertain whether there is sufcient cash inow expected to mitigate the low defensive interval ratio. Cash conversion cycle (net operating cycle). This metric indicates the amount of time that elapses from the point when a company invests in working capital until the point at which the company collects cash. In the typical course of events, a merchandising company acquires inventory on credit, incurring accounts payable. The company then sells that inventory on credit, increasing accounts receivable. Afterwards, it pays out cash to settle its accounts payable, and it collects cash in settlement of its accounts receivable. The time between the outlay of cash and the collection of cash is called the cash conversion cycle. A shorter cash conversion cycle indicates greater liquidity. The short cash conversion cycle implies that the company needs c07.indd c07.indd 286 9/17/08 11:38:14 AM Chapter 7 287 Financial Analysis Techniques to nance its inventory and accounts receivable for only a short period of time. A longer cash conversion cycle indicates lower liquidity; it implies that the company must nance its inventory and accounts receivable for a longer period of time, possibly indicating a need for a higher level of capital to fund current assets. Example 7-8 demonstrates the advantages of a short cash conversion cycle as well as how a companys business strategies are reected in nancial ratios. EXAMPLE 7-8 Evaluation of Liquidity Ratios An analyst is evaluating the liquidity of Dell and nds that Dell provides a computation of the number of days of receivables, inventory, and accounts payable, as well as the overall cash conversion cycle, as follows: Fiscal Year Ended 28 Jan 2005 30 Jan 2004 31 Jan 2003 32 31 28 DSO DOH 4 3 70 68 (37) Equals: Cash conversion cycle 3 73 Less: Number of days of payables (36) (37) The minimal DOH indicates that Dell maintains lean inventories, which is attributable to key aspects of the companys business modelnamely, the company does not build a computer until it is ordered. Furthermore, Dell has a sophisticated just-in-time manufacturing system. In isolation, the increase in number of days payable (from 68 days in 2003 to 73 days in 2005) might suggest an inability to pay suppliers; however, in Dells case, the balance sheet indicates that the company has almost $10 billion of cash and short-term investments, which would be more than enough to pay suppliers sooner if Dell chose to do so. Instead, Dell takes advantage of the favorable credit terms granted by its suppliers. The overall effect is a negative cash cycle, a somewhat unusual result. Instead of requiring additional capital to fund working capital as is the case for most companies, Dell has excess cash to invest for about 37 days (reected on the balance sheet as short-term investments) on which it is earning, rather than paying, interest. For comparison, the analyst computes the cash conversion cycle for three of Dells competitors: Fiscal Year 2004 2003 2002 HP Compaq 27 37 61 Gateway (7) (9) (3) (40) (41) (40) Apple The analyst notes that of the group, only HP Compaq has to raise capital for working capital purposes. Dell is outperforming HP Compaq and Gateway on this metric, its negative cash conversion cycle of minus 37 days indicating stronger liquidity than either of those two competitors. Apple, however, is slightly more liquid than Dell, evidenced by its slightly more negative cash conversion cycle, and Apple also has a similarly stable negative cash conversion cycle. c07.indd 287 9/17/08 11:38:15 AM 288 International Financial Statement Analysis 4.4. Solvency Ratios Solvency refers to a companys ability to fulll its long-term debt obligations. Assessment of a companys ability to pay its long-term obligations (i.e., to make interest and principal payments) generally includes an in-depth analysis of the components of its nancial structure. Solvency ratios provide information regarding the relative amount of debt in the companys capital structure and the adequacy of earnings and cash ow to cover interest expenses and other xed charges (such as lease or rental payments) as they come due. Analysts seek to understand a companys use of debt for several main reasons. One reason is that the amount of debt in a companys capital structure is important for assessing the companys risk and return characteristics, specically its nancial leverage. Leverage is a magnifying effect that results from the use of xed costscosts that stay the same within some range of activityand can take two forms: operating leverage and nancial leverage. Operating leverage results from the use of xed costs in conducting the companys business. Operating leverage magnies the effect of changes in sales on operating income. Protable companies may use operating leverage because when revenues increase, with operating leverage, their operating income increases at a faster rate. The explanation is that, although variable costs will rise proportionally with revenue, xed costs will not. When nancing a rm (i.e., raising capital for it), the use of debt constitutes nancial leverage because interest payments are essentially xed nancing costs. As a result of interest payments, a given percent change in EBIT results in a larger percent change in earnings before taxes (EBT). Thus, nancial leverage tends to magnify the effect of changes in EBIT on returns owing to equity holders. Assuming that a company can earn more on the funds than it pays in interest, the inclusion of some level of debt in a companys capital structure may lower a companys overall cost of capital and increase returns to equity holders. However, a higher level of debt in a companys capital structure increases the risk of default and results in higher borrowing costs for the company to compensate lenders for assuming greater credit risk. Starting with Modigliani and Miller (1958, 1963), a substantial amount of research has focused on a companys optimal capital structure and the subject remains an important one in corporate nance. In analyzing nancial statements, an analyst aims to understand levels and trends in a companys use of nancial leverage in relation to past practices and the practices of peer companies. Analysts also need to be aware of the relationship between operating leverage and nancial leverage. The greater a companys use of operating leverage, the greater the risk of the operating income stream available to cover debt payments; operating leverage can thus limit a companys capacity to use nancial leverage. A companys relative solvency is fundamental to valuation of its debt securities and its creditworthiness. Finally, understanding a companys use of debt can provide analysts with insight into the companys future business prospects because managements decisions about nancing often signal their beliefs about a companys future. 4.4.1. Calculation of Solvency Ratios Solvency ratios are primarily of two types. Debt ratios, the rst type, focus on the balance sheet and measure the amount of debt capital relative to equity capital. Coverage ratios, the second type, focus on the income statement and measure the ability of a company to cover its debt payments. All of these ratios are useful in assessing a companys solvency and, therefore, in evaluating the quality of a companys bonds and other debt obligations. Exhibit 7-11 describes commonly used solvency ratios. The rst three of the debt ratios presented use total debt in the numerator. The denition of total debt used in these c07.indd c07.indd 288 9/17/08 11:38:25 AM Chapter 7 289 Financial Analysis Techniques EXHIBIT 7-11 Denitions of Commonly Used Solvency Ratios Solvency Ratios Numerator Denominator Debt-to-assets ratioa Total debtb Total assets Debt-to-capital ratio Total debtb Total debtb Debt-to-equity ratio b Total debt Total shareholders equity Financial leverage ratio Average total assets Average total equity Interest coverage EBIT Interest payments Fixed charge coverage EBIT Debt ratios Total shareholders equity Coverage ratios lease payments Interest payments lease payments a Total debt ratio is another name sometimes used for this ratio. In this chapter, we take total debt in this context to be the sum of interest-bearing short-term and long-term debt. b ratios varies among informed analysts and nancial data vendors, with some using the total of interest-bearing short-term and long-term debt, excluding liabilities such as accrued expenses and accounts payable. (For calculations in this chapter, we use this denition.) Other analysts use denitions that are more inclusive (e.g., all liabilities) or restrictive (e.g., long-term debt only, in which case the ratio is sometimes qualied as long-term, as in long-term debt-to-equity ratio). If using different denitions of total debt materially changes conclusions about a companys solvency, the reasons for the discrepancies warrant further investigation. 4.4.2. Interpretation of Solvency Ratios In this section, we discuss the interpretation of the basic solvency ratios presented in Exhibit 7-11. Debt-to-assets ratio. This ratio measures the percentage of total assets nanced with debt. For example, a debt-to-assets ratio of 0.40 or 40 percent indicates that 40 percent of the companys assets are nanced with debt. Generally, higher debt means higher nancial risk and thus weaker solvency. Debt-to-capital ratio. The debt-to-capital ratio measures the percentage of a companys capital (debt plus equity) represented by debt. As with the previous ratio, a higher ratio generally means higher nancial risk and thus indicates weaker solvency. Debt-to-equity ratio. The debt-to-equity ratio measures the amount of debt capital relative to equity capital. Interpretation is similar to the preceding two ratios (i.e., a higher ratio indicates weaker solvency). A ratio of 1.0 would indicate equal amounts of debt and equity, which is equivalent to a debt-to-capital ratio of 50 percent. Alternative denitions of this ratio use the market value of stockholders equity rather than its book value (or use the market values of both stockholders equity and debt). Financial leverage ratio. This ratio (often called simply the leverage ratio) measures the amount of total assets supported for each one money unit of equity. For example, a value of 3 for this ratio means that each 1 of equity supports 3 of total assets. The higher the nancial leverage ratio, the more leveraged the company is in the sense of using debt and other liabilities to nance assets. This ratio is often dened in terms of average total assets and c07.indd 289 9/17/08 11:38:26 AM 290 International Financial Statement Analysis average total equity and plays an important role in the DuPont decomposition of return on equity that will be presented in section 4.6.2. Interest coverage. This ratio measures the number of times a companys EBIT could cover its interest payments. A higher interest coverage ratio indicates stronger solvency, offering greater assurance that the company can service its debt (i.e., bank debt, bonds, notes) from operating earnings. Fixed charge coverage. This ratio relates xed charges, or obligations, to the cash ow generated by the company. It measures the number of times a companys earnings (before interest, taxes, and lease payments) can cover the companys interest and lease payments.9 Similar to the interest coverage ratio, a higher xed charge coverage ratio implies stronger solvency, offering greater assurance that the company can service its debt (i.e., bank debt, bonds, notes, and leases) from normal earnings. The ratio is sometimes used as an indication of the quality of the preferred dividend, with a higher ratio indicating a more secure preferred dividend. Example 7-9 demonstrates the use of solvency ratios in evaluating the creditworthiness of a company. EXAMPLE 7-9 Evaluation of Solvency Ratios A credit analyst is evaluating the solvency of Alcatel (now known as Alcatel-Lucent) as of the beginning of 2005. The following data are gathered from the companys 2005 annual report (in millions): 2004 2003 Total equity 4,389 4,038 Accrued pension 1,144 1,010 Other reserves 2,278 3,049 Total nancial debt 4,359 5,293 Other liabilities 6,867 7,742 19,037 21,132 Total assets The analyst concludes that, as used by Alcatel in its 2005 annual report, total nancial debt consists of noncurrent debt and the interest-bearing, borrowed portion of current liabilities. 1. A. Calculate the companys nancial leverage ratio for 2004. B. Interpret the nancial leverage ratio calculated in Part A. 2. A. What are the companys debt-to-assets, debt-to-capital, and debt-to-equity ratios for the two years? B. Is there any discernable trend over the two years? 9 For computing this ratio, an assumption sometimes made is that one-third of the lease payment amount represents interest on the lease obligation and that the rest is a repayment of principal on the obligation. For this variant of the xed charge coverage ratio, the numerator is EBIT plus one-third of lease payments and the denominator is interest payments plus one-third of lease payments. c07.indd 290 9/17/08 11:38:26 AM Chapter 7 Financial Analysis Techniques 291 Solutions to 1: A. Average total assets was (19,037 21,132)/2 20,084.50 and average total equity was (4,389 4,038)/2 4,213.5. Thus, nancial leverage was 20,084.50/4,213.5 4.77. B. For 2004, every 1 in total equity supported 4.77 in total assets, on average. Solutions to 2: A. Debt-to-assets for 2003 5,293/21,132 25.05% Debt-to-assets for 2004 4,359/19,037 22.90% Debt-to-capital for 2003 5,293/(5,293 4,038) 56.72% Debt-to-capital for 2004 4,359/(4,359 4,389) 49.83% Debt-to-equity for 2003 5,293/4,038 1.31 Debt-to-equity for 2004 4,359/4,389 0.99 B. On all three metrics, the companys level of debt has declined. This decrease in debt as part of the companys capital structure indicates that the companys solvency has improved. From a creditors perspective, higher solvency (lower debt) indicates lower risk of default on obligations. 4.5. Protability Ratios The ability to generate prot on capital invested is a key determinant of a companys overall value and the value of the securities it issues. Consequently, many equity analysts would consider protability to be a key focus of their analytical efforts. Protability reects a companys competitive position in the market, and by extension, the quality of its management. The income statement reveals the sources of earnings and the components of revenue and expenses. Earnings can be distributed to shareholders or reinvested in the company. Reinvested earnings enhance solvency and provide a cushion against short-term problems. 4.5.1. Calculation of Protability Ratios Protability ratios measure the return earned by the company during a period. Exhibit 7-12 provides the denitions of a selection of commonly used protability ratios. Return-on-sales protability ratios express various subtotals on the income statement (e.g., gross prot, operating prot, net prot) as a percentage of revenue. Essentially, these ratios constitute part of a common-size income statement discussed earlier. Return on investment protability ratios measure income relative to assets, equity, or total capital employed by the company. For operating ROA, returns are measured as operating income (i.e., prior to deducting interest on debt capital). For ROA and ROE, returns are measured as net income (i.e., after deducting interest paid on debt capital). For return on common equity, returns are measured as net income minus preferred dividends (because preferred dividends are a return to preferred equity). c07.indd 291 9/17/08 11:38:32 AM 292 International Financial Statement Analysis EXHIBIT 7-12 Denitions of Commonly Used Protability Ratios Protability Ratios Numerator Denominator Gross prot margin Gross prot Revenue Operating prot margin Operating income11 Revenue Pretax margin EBT (earnings before tax but after interest) Revenue Net prot margin Net income Revenue Operating ROA Operating income Average total assets ROA Net income Average total assets Return on total capital EBIT Short- and long-term debt and equity ROE Net income Average total equity Return on common equity Net incomePreferred dividends Average common equity Return on Sales 10 Return on Investment 4.5.2. Interpretation of Protability Ratios In the following, we discuss the interpretation of the protability ratios presented in Exhibit 7-12. For each of the protability ratios, a higher ratio indicates greater protability. Gross prot margin. Gross prot margin indicates the percentage of revenue available to cover operating and other expenditures. Higher gross prot margin indicates some combination of higher product pricing and lower product costs. The ability to charge a higher price is constrained by competition, so gross prots are affected by (and usually inversely related to) competition. If a product has a competitive advantage (e.g., superior branding, better quality, or exclusive technology), the company is better able to charge more for it. On the cost side, higher gross prot margin can also indicate that a company has a competitive advantage in product costs. Operating prot margin. Operating prot is calculated as gross margin minus operating costs. So, an operating margin increasing faster than the gross margin can indicate improvements in controlling operating costs, such as administrative overheads. In contrast, a declining operating prot margin could be an indicator of deteriorating control over operating costs. Pretax margin. Pretax income (also called earnings before tax) is calculated as operating prot minus interest, so this ratio reects the effects on protability of leverage and other 10 Sales is being used as a synonym for revenue. Some analysts use EBIT as a shortcut representation of operating income. Note that EBIT, strictly speaking, includes nonoperating items such as dividends received and gains and losses on investment securities. Of utmost importance is that the analyst compute ratios consistently whether comparing different companies or analyzing one company over time. 11 c07.indd 292 9/17/08 11:38:35 AM Chapter 7 Financial Analysis Techniques 293 (nonoperating) income and expenses. If a companys pretax margin is rising primarily as a result of increasing nonoperating income, the analyst should evaluate whether this increase reects a deliberate change in a companys business focus and, therefore, the likelihood that the increase will continue. Net prot margin. Net prot, or net income, is calculated as revenue minus all expenses. Net income includes both recurring and nonrecurring components. Generally, the net prot margin adjusted for nonrecurring items offers a better view of a companys potential future protability. ROA. ROA measures the return earned by a company on its assets. The higher the ratio, the more income is generated by a given level of assets. Most databases compute this ratio as: Net income _______________ Average total assets The problem with this computation is net income is the return to equity holders, whereas assets are nanced by both equity holders and creditors. Interest expense (the return to creditors) has already been subtracted in the numerator. Some analysts, therefore, prefer to add back interest expense in the numerator. In such cases, interest must be adjusted for income taxes because net income is determined after taxes. With this adjustment, the ratio would be computed as: Net income Interest expense (1 Tax rate) ___________________________________ Average total assets Alternatively, some analysts elect to compute ROA on a pre-interest and pretax basis as: Operating income of EBIT ______________________ Average total assets As noted, returns are measured prior to deducting interest on debt capital (i.e., as operating income or EBIT). This measure reects the return on all assets invested in the company, whether nanced with liabilities, debt, or equity. Whichever form of ROA is chosen, the analyst must use it consistently in comparisons to other companies or time periods. Return on total capital. Return on total capital measures the prots a company earns on all of the capital that it employs (short-term debt, long-term debt, and equity). As with ROA, returns are measured prior to deducting interest on debt capital (i.e., as operating income or EBIT). ROE. ROE measures the return earned by a company on its equity capital, including minority equity, preferred equity, and common equity. As noted, return is measured as net income (i.e., interest on debt capital is not included in the return on equity capital). A variation of ROE is return on common equity, which measures the return earned by a company only on its common equity. Both ROA and ROE are important measures of protability and will be explored in more detail below. As with other ratios, protability ratios should be evaluated individually and as a group to gain an understanding of what is driving protability (operating versus nonoperating activities). Example 7-10 demonstrates the evaluation of protability ratios and the use of managements discussion that accompanies nancial statements to explain the trend in ratios. c07.indd c07.indd 293 9/17/08 11:38:36 AM 294 International Financial Statement Analysis EXAMPLE 7-10 Evaluation of Protability Ratios. An analyst is evaluating the protability of DaimlerChrysler (NYSE: DCX) over a recent three-year period and collects the following protability ratios: 2004 Gross prot margin 2003 2002 19.35% 19.49% 18.99% Operating prot margin 3.19% 2.83% 3.35% Pretax margin 2.49% 0.44% 4.06% Net prot margin 1.74% 0.33% 3.15% DCXs 2003 annual report indicates that revenue declined in 2003. Furthermore, managements discussion of results in that report notes the following: General administrative expenses of 5.4 billion remained virtually at on the prior-year level. General administrative expenses as a percentage of revenues were 3.9 percent in 2003 and 3.6 percent in 2002, reecting the limited variability of these expenses. Slightly higher personnel expenses, primarily caused by higher net periodic pension and postretirement benet costs, resulted in a moderate increase of general administrative expenses. 1. Contrast gross prot margins and operating prot margins over 2002 to 2004. 2. Explain the decline in operating prot margin in 2003. 3. Explain why the pretax margin might decrease to a greater extent than the operating prot margin in 2003. 4. Compare and contrast net prot margins and pretax margins over 2002 to 2004. Solution to 1. Gross margin improved from 2002 to 2003 as a result of some combination of price increases and/or cost control. However, gross margin declined slightly in 2004. Operating prot margin, on the other hand, declined from 2002 to 2003, and then improved in 2004. Solution to 2. The decline in operating prot from 3.35 percent in 2002 to 2.83 percent in 2003 appears to be the result of DCXs operating leverage, discussed in managements discussion. Revenue declined in 2003 but, according to management, general administrative expenses were virtually at compared with 2002. These expenses thus increased as a proportion of revenue in 2003, lowering the operating prot margin. This is an example of the effects of xed cost on protability. In general, as revenues rise, to the extent that costs remain xed, operating margins should increase. However, if revenue declines, the opposite occurs. Solution to 3. Pretax margin was down substantially in 2003, indicating that the company may have had some nonoperating losses or high interest expense in that year. A review of the companys nancial statement footnotes conrms that the cause was nonoperating losses: Specically, the company had a signicant impairment loss on investments in 2003. Solution to 4. Net prot margin followed the same pattern as pretax margin, declining substantially in 2003, then improving in 2004 but not reaching 2002 levels. In the absence of major variation in the applicable tax rates, this would be the expected as net income is EBT (1 tax rate). c07.indd 294 9/17/08 11:38:36 AM Chapter 7 295 Financial Analysis Techniques 4.6. Integrated Financial Ratio Analysis In prior sections, the text presented separately activity, liquidity, solvency, and protability ratios. In the following, we illustrate the importance of examining a portfolio of ratios, not a single ratio or category of ratios in isolation, to ascertain the overall position and performance of a company. Experience shows that the information from one ratio category can be helpful in answering questions raised by another category and that the most accurate overall picture comes from integrating information from all sources. Section 4.6.1 provides some introductory examples of such analysis, and section 4.6.2 shows how return on equity can be analyzed into components related to prot margin, asset utilization (activity), and nancial leverage. 4.6.1. The Overall Ratio Picture: Examples This section presents two simple illustrations to introduce the use of a portfolio of ratios to address an analytical task. Example 7-11 shows how the analysis of a pair of activity ratios resolves an issue concerning a companys liquidity. Example 7-12 shows that examining the overall ratios of multiple companies can assist an analyst in drawing conclusions about their relative performances. EXAMPLE 7-11 A Portfolio of Ratios An analyst is evaluating the liquidity of a Canadian manufacturing company and obtains the following liquidity ratios: 2005 2004 2003 Current ratio 2.1 1.9 1.6 Quick ratio 0.8 0.9 1.0 The ratios present a contradictory picture of the companys liquidity. Based on the increase in its current ratio from 1.6 to 2.1, the company appears to have strong and improving liquidity; however, based on the decline of the quick ratio from 1.0 to 0.8, its liquidity appears to be deteriorating. Because both ratios have exactly the same denominator, current liabilities, the difference must be the result of changes in some asset that is included in the current ratio but not in the quick ratio (e.g., inventories). The analyst collects the following activity ratios: DOH 55 45 30 DSO 24 28 30 The companys DOH has deteriorated from 30 days to 55 days, meaning that the company is holding increasingly greater amounts of inventory relative to sales. The decrease in DSO implies that the company is collecting receivables faster. If the proceeds from these collections were held as cash, there would be no effect on either the current ratio or the quick ratio. However, if the proceeds from the collections were used to purchase inventory, there would be no effect on the current ratio and a decline in the quick ratio (i.e., the pattern shown in this example). Collectively, the ratios suggest that liquidity is declining and that the company may have an inventory problem that needs to be addressed. c07.indd 295 9/17/08 11:38:52 AM 296 International Financial Statement Analysis EXAMPLE 7-12 A Comparison of Two Companies (1). An analyst collects the following information for two companies: 2005 2004 2003 2002 76.69 89.09 147.82 187.64 4.76 4.10 2.47 1.95 Anson Industries Inventory turnover DOH Receivables turnover 10.75 9.33 11.14 7.56 DSO 33.95 39.13 32.77 48.29 4.62 4.36 4.84 4.22 75.49 86.56 Accounts payable turnover Days payable 78.97 83.77 Cash from operations/Total liabilities 31.41% 11.15% 4.04% 8.81% ROE 5.92% 1.66% 1.62% 0.62% ROA 3.70% 1.05% 1.05% 0.39% Net prot margin (Net income/Revenue) 3.33% 1.11% 1.13% 0.47% Total asset turnover (Revenue/Average assets) 1.11 0.95 0.93 0.84 Leverage (Average assets/Average equity) 1.60 1.58 1.54 1.60 9.19 9.08 7.52 14.84 39.73 40.20 48.51 24.59 8.35 7.01 6.09 5.16 43.73 52.03 59.92 70.79 Clarence Corporation Inventory turnover DOH Receivables turnover DSO Accounts payable turnover 6.47 6.61 7.66 6.52 Days payable 56.44 55.22 47.64 56.00 Cash from operations/Total liabilities 13.19% 16.39% 15.80% 11.79% ROE 9.28% 6.82% 3.63% 6.75% ROA 4.64% 3.48% 1.76% 3.23% Net prot margin (Net income/Revenue) 4.38% 3.48% 1.60% 2.34% Total asset turnover (Revenue/Average assets) 1.06 1.00 1.10 1.38 Leverage (Average assets/Average equity) 2.00 1.96 2.06 2.09 Which of the following choices best describes reasonable conclusions an analyst might make about the companies efciency? A. Over the past four years, Anson has shown greater improvement in efciency than Clarence, as indicated by its total asset turnover ratio increasing from 0.84 to 1.11. c07.indd 296 9/17/08 11:38:59 AM Chapter 7 Financial Analysis Techniques 297 B. In 2004, Ansons DOH of only 4.76 indicated that it was less efcient at inventory management than Clarence, which had DOH of 39.73. C. In 2004, Clarences receivables turnover of 8.35 times indicated that it was more efcient at receivables management than Anson, which had receivables turnover of 10.75. D. Over the past four years, Clarence has shown greater improvement in efciency than Anson, as indicated by its net prot margin of 4.38 percent. Solution. A is correct. Over the past four years, Anson has shown greater improvement in efciency than Clarence, as indicated by its total asset turnover ratio increasing from 0.84 to 1.11. Over the same period of time, Clarences total asset turnover ratio has declined from 1.38 to 1.06. Choice B is incorrect because it misinterprets DOH. Choice C is incorrect because it misinterprets receivables turnover. Choice D is incorrect because net prot margin is not an indicator of efciency. 4.6.2. DuPont Analysis: The Decomposition of ROE As noted earlier, ROE measures the return a company generates on its equity capital. To understand what drives a companys ROE, a useful technique is to decompose ROE into its component parts. (Decomposition of ROE is sometimes referred to as DuPont analysis because it was developed originally at that company.) Decomposing ROE involves expressing the basic ratio (i.e., net income divided by average shareholders equity) as the product of component ratios. Because each of these component ratios is an indicator of a distinct aspect of a companys performance that affects ROE, the decomposition allows us to evaluate how these different aspects of performance affected the companys protability as measured by ROE.12 Decomposing ROE is useful in determining the reasons for changes in ROE over time for a given company and for differences in ROE for different companies in a given time period. The information gained can also be used by management to determine which areas they should focus on to improve ROE. This decomposition will also show why a companys overall protability, measured by ROE, is a function of its efciency, operating protability, taxes, and use of nancial leverage. DuPont analysis shows the relationship between the various categories of ratios discussed in this chapter and how they all inuence the return to the investment of the owners. Analysts have developed several different methods of decomposing ROE. The decomposition presented here is one of the most commonly used and the one found in popular research databases, such as Bloomberg. Return on equity is calculated as: ROE Net income ______________________ Average shareholders equity 12 For purposes of analyzing ROE, this method usually uses average balance sheet factors; however, the math will work out if beginning or ending balances are used throughout. For certain purposes, these alternative methods may be appropriate. See Stowe et al. (2002, pp. 8588). c07.indd 297 9/17/08 11:39:11 AM 298 International Financial Statement Analysis The decomposition of ROE makes use of simple algebra and illustrates the relationship between ROE and ROA. Expressing ROE as a product of only two of its components, we can write: Average total assets Net income Net income ______________________ ROE ______________________ _______________ Average shareholders equity Average total assets Average shareholders equity (7-1a) which can be interpreted as: ROE ROA Leverage In other words, ROE is a function of a companys ROA and its use of nancial leverage (leverage for short, in this discussion). A company can improve its ROE by improving ROA or making more effective use of leverage. Consistent with the denition given earlier, leverage is measured as average total assets divided by average shareholders equity. If a company had no leverage (no liabilities), its leverage ratio would equal 1.0 and ROE would exactly equal ROA. As a company takes on liabilities, its leverage increases. As long as a company is able to borrow at a rate lower than the marginal rate it can earn investing the borrowed money in its business, the company is making an effective use of leverage and ROE would increase as leverage increases. If a companys borrowing cost exceeds the marginal rate it can earn on investing, ROE would decline as leverage increased because the effect of borrowing would be to depress ROA. Using the data from Example 7-12 for Anson Industries, an analyst can examine the trend in ROE and determine whether the increase from an ROE of 0.625 percent in 2002 to 5.925 percent in 2005 is a function of ROA or the use of leverage: Leverage ROE ROA 2005 5.92% 3.70% 1.60 2004 1.66% 1.05% 1.58 2003 1.62% 1.05% 1.54 2002 0.62% 0.39% 1.60 Over the four-year period, the companys leverage factor was relatively stable. The primary reason for the increase in ROE is the increase in protability measured by ROA. Just as ROE can be decomposed, the individual components such as ROA can be decomposed. Further decomposing ROA, we can express ROE as a product of three component ratios: Net income _______________________ Averages shareholders equity Revenue _______________ Revenue Average total assets Average total assets ______________________ Average shareholders equity Net income __________ (7-1b) which can be interpreted as: ROE Net prot margin Asset turnover Leverage The rst term on the right-hand side of this equation is the net prot margin, an indicator of protability: how much income a company derives per one money unit (e.g., euro or dollar) of sales. The second term on the right is the asset turnover ratio, an indicator of c07.indd c07.indd 298 9/17/08 11:39:15 AM Chapter 7 299 Financial Analysis Techniques efciency: how much revenue a company generates per one money unit of assets. Note that ROA is decomposed into these two components: net prot margin and asset turnover. A companys ROA is a function of protability (net prot margin) and efciency (asset turnover). The third term on the right-hand side of Equation 7-1b is a measure of nancial leverage, an indicator of solvency: the total amount of a companys assets relative to its equity capital. This decomposition illustrates that a companys ROE is a function of its net prot margin, its efciency, and its leverage. Again, using the data from Example 7-12 for Anson Industries, the analyst can evaluate in more detail the reasons behind the trend in ROE:13 ROE Net Prot Margin Asset Turnover Leverage 2005 5.92% 3.33% 1.11 1.60 2004 1.66% 1.11% 0.95 1.58 2003 1.62% 1.13% 0.93 1.54 2002 0.62% 0.47% 0.84 1.60 This further decomposition conrms that increases in protability (measured here as net prot margin) are indeed an important contributor to the increase in ROE over the fouryear period. However, Ansons asset turnover has also increased steadily. The increase in ROE is, therefore, a function of improving protability and improving efciency. As noted above, ROE decomposition can also be used to compare the ROEs of peer companies, as demonstrated in Example 7-13. EXAMPLE 7-13 A Comparison of Two Companies (2) Referring to the data for Anson Industries and Clarence Corporation in Example 7-12, which of the following choices best describes reasonable conclusions an analyst might make about the companies ROE? A. Ansons inventory turnover of 76.69 indicates it is more protable than Clarence. B. The main drivers of Clarences superior ROE in 2004 are its greater use of debt nancing and higher net prot margin. C. The main driver of Clarences superior ROE in 2004 is its more efcient use of assets. D. Ansons days payable of 78.97 indicates it is more protable than Clarence. Solution. B is correct. The main driver of Clarences superior ROE (9.29 percent compared with only 5.94 percent for Anson) in 2004 is its greater use of debt nancing (leverage of 2.00 compared with Ansons leverage of 1.60) and higher net prot margin (4.38 percent compared with only 3.33 percent for Anson). A and D are incorrect because neither inventory turnover nor days payable is an indicator of protability. C is incorrect because Clarence has less-efcient use of assets than Anson, indicated by turnover of 1.06 for Clarence compared with Ansons turnover of 1.11. 13 Please note that ratios are expressed in terms of two decimal places and are rounded. Therefore, ROE may not be the exact product of the three ratios. c07.indd 299 9/17/08 11:39:19 AM 300 International Financial Statement Analysis To separate the effects of taxes and interest, we can further decompose the net prot margin and write: Net income ______________________ Average shareholder equity Net income __________ EBT EBIT _____ _______ EBT EBIT Revenue Average total assets ______________________ Average shareholders equity Revenue _______________ Average total assets (7-1c) which can be interpreted as: ROE Tax burden Interest burden EBIT margin Asset turnover Leverage This ve-way decomposition is the one found in nancial databases such as Bloomberg. The rst term on the right-hand side of this equation measures the effect of taxes on ROE. Essentially, it reects one minus the average tax rate, or how much of a companys pretax prots it gets to keep. This can be expressed in decimal or percentage form. So, a 30 percent tax rate would yield a factor of 0.70 or 70 percent. A higher value for the tax burden implies that the company can keep a higher percentage of its pretax prots, indicating a lower tax rate. A decrease in the tax burden ratio implies the opposite (i.e., a higher tax rate leaving the company with less of its pretax prots). The second term on the right-hand side captures the effect of interest on ROE. Higher borrowing costs reduce ROE. Some analysts prefer to use operating income instead of EBIT for this factor and the following one (consistency is required!). In such a case, the second factor would measure both the effect of interest expense and nonoperating income. The third term on the right-hand side captures the effect of operating margin (if operating income is used in the numerator) or EBIT margin (if EBIT is used) on ROE. In either case, this factor primarily measures the effect of operating protability on ROE. The fourth term on the right-hand side is again the asset turnover ratio, an indicator of the overall efciency of the company (i.e., how much revenue it generates per unit of assets). The fth term on the right-hand side is the nancial leverage ratio described abovethe total amount of a companys assets relative to its equity capital. This decomposition expresses a companys ROE as a function of its tax rate, interest burden, operating protability, efciency, and leverage. An analyst can use this framework to determine what factors are driving a companys ROE. The decomposition of ROE can also be useful in forecasting ROE based upon expected efciency, protability, nancing activities, and tax rates. The relationship of the individual factors, such as ROA to the overall ROE, can also be expressed in the form of an ROE tree to study the contribution of each of the ve factors, as shown in Exhibit 7-13 for Anson Industries.14 Exhibit 7-13 shows that Ansons ROE of 5.92 percent in 2005 can be decomposed into ROA of 3.7 percent and leverage of 1.60. ROA can further be decomposed into a net prot margin of 3.33 percent and total asset turnover of 1.11. Net prot margin can be decomposed into a tax burden of 0.70 (an average tax rate of 30 percent), an interest burden of 0.90, and an EBIT margin of 5.29 percent. Overall ROE is decomposed into ve components. Example 7-14 demonstrates how the ve-component decomposition can be used to determine reasons behind the trend in a companys ROE. 14 Note that a breakdown of net prot margin was not provided in Example 7-12, but is added here. c07.indd 300 9/17/08 11:39:24 AM Chapter 7 301 Financial Analysis Techniques EXHIBIT 7-13 DuPont Analysis of Anson Industries ROE: 2005 Return on Equity: Net income Average shareholders equity = 5.92% Return on Assets: Net income Average total assets = 3.7% Net Profit Margin: Net income Revenues = 3.33% Tax Burden: Net income EBT = 0.70 Interest Burden: EBT EBIT = 0.90 EXAMPLE 7-14 Leverage: Average total assets Average shareholders equity = 1.60 Total Asset Turnover: Revenues Average total assets = 1.11 EBIT Margin: EBIT Revenues = 5.29% Five-Way Decomposition of ROE An analyst examining BP PLC (BP) wishes to understand the factors driving the trend in ROE over a recent three-year period. The analyst obtains the following data from Bloomberg and ascertains that Bloomberg has included nonoperating income in the interest burden factor: 2004 ROE Tax burden 2003 2002 20.62% 14.42% 10.17% 64.88% 62.52% 60.67% 130.54% 112.60% 130.50% EBIT margin 6.51% 6.40% 4.84% Asset turnover 1.55 1.38 1.19 Leverage 2.42 2.32 2.24 Interest burden What might the analyst conclude? Solution. Because the tax burden reects the relation of after-tax prots to pretax profits, the increase from 60.67 percent to 64.88 percent indicates that taxes declined as c07.indd 301 9/17/08 11:39:24 AM 302 International Financial Statement Analysis a percentage of pretax prots. This decline in average tax rates could be due to lower tax rates from new legislation or revenue in a lower tax jurisdiction. An interest burden factor greater than 100 percent means that nonoperating income exceeded interest expense in all three years. Operating margin (EBIT margin) improved, particularly from 2002 to 2003, indicating the companys operations were more protable. The companys efciency (asset turnover) increased each year as did its leverage. Overall, the trend in ROE (doubling in three years) did not result from a single aspect of the companys performance, but instead was a function of lower average tax rates, increasing operating prots, greater efciency, and increased use of leverage. Additional research on the causes of the various changes is required in order to develop expectations about the companys future performance. The most detailed decomposition of ROE that we have presented is a ve-way decomposition. Nevertheless, an analyst could further decompose individual components of a veway analysis. For example, EBIT margin (EBIT/Revenue) could be further decomposed into a nonoperating component (EBIT/Operating income) and an operating component (Operating income/Revenues). The analyst can also examine which other factors contributed to these ve components. For example, an improvement in efciency (total asset turnover) may have resulted from better management of inventory (DOH) or better collection of receivables (DSO). 5 . EQUITY ANALYSIS One application of nancial analysis is to select securities as part of the equity portfolio management process. Analysts are interested in valuing a security to assess its merits for inclusion or retention in a portfolio. The valuation process has several steps, including:15 1. 2. 3. 4. 5. Understanding the business and the existing nancial prole. Forecasting company performance. Selecting the appropriate valuation model. Converting forecasts to a valuation. Making the investment decision. Financial analysis assists in providing the core information to complete the rst two steps of this valuation process: understanding the business and forecasting performance. Fundamental equity analysis involves evaluating a companys performance and valuing its equity in order to assess its relative attractiveness as an investment. Analysts use a variety of methods to value a companys equity, including valuation ratios (e.g., the price-to-earnings or P/E ratio), discounted cash ow approaches, and residual income approaches (ROE compared with the cost of capital), among others. The following section addresses the rst of these approachesthe use of valuation ratios. 15 Stowe et al. (2002, p. 6). c07.indd 302 9/17/08 11:39:28 AM Chapter 7 303 Financial Analysis Techniques 5.1. Valuation Ratios Valuation ratios have long been used in investment decision making. A well-known example is the P/E ratioprobably the most widely used indicator in discussing the value of equity securitieswhich relates share price to the earnings per share (EPS). Additionally, some analysts use other market multiples, such as price to book value (P/B) and price to cash ow (P/CF). The following sections explore valuation ratios and other quantities related to valuing equities. 5.1.1. Calculation of Valuation Ratios and Related Quantities Exhibit 7-14 describes the calculation of some common valuation ratios and related quantities. The P/E ratio expresses the relationship between the price per share and the amount of earnings attributable to a single share. In other words, the P/E ratio tells us how much an investor in common stock pays per dollar of current earnings. EXHIBIT 7-14 Denitions of Selected Valuation Ratios and Related Quantities Numerator Denominator Price per share Earnings per share Valuation ratios P/E P/CF Price per share Cash ow per share P/S Price per share Sales per share P/B Price per share Book value per share Basic EPS Net income minus preferred dividends Weighted average number of ordinary shares outstanding Diluted EPS Adjusted income available for ordinary shares, reecting conversion of dilutive securities Weighted average number of ordinary and potential ordinary shares outstanding Cash ow per share Cash ow from operations Average number of shares outstanding EBITDA per share EBITDA Average number of shares outstanding Dividends per share Common dividends declared Weighted average number of ordinary shares outstanding Dividend payout ratio Common share dividends Net income attributable to common shares Retention rate (b) Net income attributable to common shares Common share dividends Net income attributable to common shares Sustainable growth rate b Per-Share Quantities Dividend-Related Quantities c07.indd 303 ROE 9/17/08 11:39:31 AM 304 International Financial Statement Analysis Because P/E ratios are calculated using net income, the ratios can be sensitive to nonrecurring earnings or one-off earnings events. In addition, because net income is generally considered to be more susceptible to manipulation than are cash ows, analysts may use price to cash ow as an alternative measureparticularly in situations where earnings quality may be an issue. EBITDA per share, because it is calculated using income before interest, taxes, and depreciation, can be used to eliminate the effect of different levels of xed asset investment across companies. It facilitates comparison between companies in the same sector but at different stages of infrastructure maturity. Price to sales is calculated in a similar manner and is sometimes used as a comparative price metric when a company does not have positive net income. Another price-based ratio that facilitates useful comparisons of companies stock prices is price to book value, or P/B, which is the ratio of price to book value per share. This ratio is often interpreted as an indicator of market judgment about the relationship between a companys required rate of return and its actual rate of return. Assuming that book values reect the fair values of the assets, a price to book ratio of one can be interpreted as an indicator that the companys future returns are expected to be exactly equal to the returns required by the market. A ratio greater than one would indicate that the future protability of the company is expected to exceed the required rate of return, and values of this ratio less than one indicate that the company is not expected to earn excess returns.16 5.1.2. Interpretation of Earnings per Share Exhibit 7-14 presented a number of per-share quantities that can be used in valuation ratios. In the following, we discuss the interpretation of one such critical quantity, EPS. EPS is simply the amount of earnings attributable to each share of common stock. In isolation, EPS does not provide adequate information for comparison of one company with another. For example, assume that two companies have only common stock outstanding and no dilutive securities outstanding. In addition, assume the two companies have identical net income of $10 million, identical book equity of $100 million and, therefore, identical profitability (10 percent, using ending equity in this case for simplicity). Furthermore, assume that Company A has 100 million weighted average common shares outstanding, whereas Company B has 10 million weighted average common shares outstanding. So, Company A will report EPS of $0.10 per share, and Company B will report EPS of $1 per share. The difference in EPS does not reect a difference in protabilitythe companies have identical prots and protability. The difference reects only a different number of common shares outstanding. Analysts should understand in detail the types of EPS information that companies report: Basic EPS provides information regarding the earnings attributable to each share of common stock. International Accounting Standards (IAS) No. 33 contains the international principles for the determination and presentation of EPS. This standard applies to entities whose shares are publicly traded or in the process of being issued in public securities markets, and other entities that choose to disclose EPS. U.S. Financial Accounting Standards Board Statement No. 128 contains the standards for computing and presenting EPS. To calculate basic EPS, the weighted average number of shares outstanding during the period is rst calculated. The weighted average number of shares consists of the number of 16 For more detail on valuation ratios as used in equity analysis, see Stowe et al. (2002). c07.indd 304 9/17/08 11:39:31 AM Chapter 7 Financial Analysis Techniques 305 ordinary shares outstanding at the beginning of the period, adjusted by those bought back or issued during the period, multiplied by a time-weighting factor. Accounting standards generally require the disclosure of basic as well as diluted EPS (diluted EPS includes the effect of all the companys securities whose conversion or exercise would result in a reduction of basic EPS; dilutive securities include convertible debt, convertible preferred, warrants, and options). Basic EPS and diluted EPS must be shown with equal prominence on the face of the income statement for each class of ordinary share. Disclosure includes the amounts used as the numerators in calculating basic and diluted EPS, and a reconciliation of those amounts to the companys prot or loss for the period. Because both basic and diluted EPS are presented in a companys nancial statements, an analyst does not need to calculate these measures for reported nancial statements. Understanding the calculations is, however, helpful for situations requiring an analyst to calculate expected future EPS. To calculate diluted EPS, earnings are adjusted for the after-tax effects assuming conversion, and the following adjustments are made to the weighted number of shares: The weighted average number of shares for basic EPS, plus those that would be issued on conversion of all dilutive potential ordinary shares. Potential ordinary shares are treated as dilutive when their conversion would decrease net prot per share from continuing ordinary operations. These shares are deemed to have been converted into ordinary shares at the beginning of the period or, if later, at the date of the issue of the shares. Options, warrants (and their equivalents), convertible instruments, contingently issuable shares, contracts that can be settled in ordinary shares or cash, purchased options, and written put options should be considered. 5.1.3. Dividend-Related Quantities In the following, we discuss the interpretation of the dividend-related quantities presented in Exhibit 7-14. These quantities play a role in some present value models for valuing equities. Dividend payout ratio. The dividend payout ratio measures the percentage of earnings that the company pays out as dividends to shareholders. The amount of dividends per share tends to be relatively xed because any reduction in dividends has been shown to result in a disproportionately large reduction in share price. Because dividend amounts are relatively xed, the dividend payout ratio tends to uctuate with earnings. Therefore, conclusions about a companys dividend payout policies should be based on examination of payout over a number of periods. Optimal dividend policy, similar to optimal capital structure, has been examined in academic research and continues to be a topic of signicant interest in corporate nance. Retention rate. The retention rate is the complement of the payout ratio (i.e., 1 payout ratio). Whereas the payout ratio measures the percentage of earnings that a company pays out as dividends, the retention rate is the percentage of earnings that a company retains. It is simply one minus the payout ratio. (Note that both the dividend payout ratio and retention rate are both percentages of earnings. The difference in terminologyratio versus rate versus percentagereects common usage rather than any substantive differences.) Sustainable growth rate. A companys sustainable growth rate is viewed as a function of its protability (measured as ROE) and its ability to nance itself from internally generated funds (measured as the retention rate). A higher ROE and a higher retention rate result in a higher sustainable growth rate. This calculation can be used to estimate a companys growth rate, a factor commonly used in equity valuation. c07.indd 305 9/17/08 11:39:32 AM 306 International Financial Statement Analysis 5.2. Industry-Specic Ratios As stated earlier in this chapter, a universally accepted denition and classication of ratios does not exist. The purpose of ratios is to serve as indicators of important aspects of a companys performance and value. Aspects of performance that are considered important in one industry may be irrelevant in another, and industry-specic ratios reect these differences. For example, companies in the retail industry may report same-store sales changes because, in the retail industry, it is important to distinguish between growth that results from opening new stores and growth that results from generating more sales at existing stores. Industryspecic metrics can be especially important to the value of equity in early stage industries, where companies are not yet protable. In addition, regulated industriesespecially in the nancial sectoroften are required to comply with specic regulatory ratios. For example, the banking sectors liquidity and cash reserve ratios provide an indication of banking liquidity and reect monetary and political requirements. Banking capital adequacy requirements, although not perfect, do relate banks solvency requirements directly to their specic levels of risk exposure. Exhibit 7-15 presents some industry-specic and task-specic ratios.17 5.3. Research on Ratios in Equity Analysis Some ratios should be expected to be particularly useful in equity analysis. The end product of equity analysis is often a valuation and investment recommendation. Theoretical valuation models are useful in selecting ratios that would be useful in this process. For example, a companys P/B is theoretically linked to ROE, growth, and the required return. ROE is also a primary determinate of residual income in a residual income valuation model. In both cases, higher ROE relative to the required return denotes a higher valuation. Similarly, prot margin is related to justied price-to-sales (P/S) ratios. Another common valuation method involves forecasts of future cash ows that are discounted back to the present. Trends in ratios can be useful in forecasting future earnings and cash ows (e.g., trends operating prot margin and collection of customer receivables). Future growth expectations are a key component of all of these valuation models. Trends may be useful in assessing growth prospects (when used in conjunction with overall economic and industry trends). The variability in ratios and common-size data can be useful in assessing risk, an important component of the required rate of return in valuation models. A great deal of academic research has focused on the use of these fundamental ratios in evaluating equity investments. A classic study, Ou and Penman (1989a,b), found that ratios and common-size metrics generated from accounting data were useful in forecasting earnings and stock returns. Ou and Penman examined a variety of 68 such metrics and found that these variables could be reduced to a more parsimonious list and combined in a statistical model that was particularly useful for selecting investments. These variables included: Percentage change in current ratio. Percentage change in quick ratio. Percentage change in inventory turnover. 17 These are provided for illustrative purposes only. There are many other industry-specic ratios that are outside the scope of this text. Resources such as Standard and Poors Industry Surveys present useful ratios for each industry. c07.indd 306 9/17/08 11:39:32 AM Chapter 7 307 Financial Analysis Techniques EXHIBIT 7-15 Denitions of Some Common Industry and Task-Specic Ratios Ratios Numerator Denominator Coefcient of variation of operating income Standard deviation of operating income Average operating income Coefcient of variation of net income Standard deviation of net income Average net income Coefcient of variation of revenues Standard deviation of revenue Average revenue Capital adequacybanks Various components of capital Risk-weighted assets, market risk exposure, and level of operational risk assumed Monetary reserve requirement Reserves held at central bank Specied deposit liabilities Liquid asset requirement Approved readily marketable securities Specied deposit liabilities Net interest margin Net interest income Total interest-earning assets Same (or comparable) store sales Average revenue growth year over year for stores open in both periods Not applicable Sales per square foot (meter) Revenue Total retail space in feet or meters Revenue per employee Revenue Total number of employees Net Income per employee Net income Total number of employees Average daily rate Room revenue Number of rooms sold Occupancy rate Number of rooms sold Number of rooms available Business Risk Ratios Financial Sector Ratios Retail Ratios Service Companies Hotel Inventory/total assets (a common-size measure) and the percentage change in this metric. Percentage change in inventory. Percentage change in sales. Percentage change in depreciation. Change in dividend per share. Percentage change in depreciation to plant assets ratio. ROE. Change in ROE. Percentage change in capital expenditures to total assets ratio (contemporaneously and lagged). Debt-to-equity ratio and the percentage change in this ratio. Percentage change in total asset turnover. c07.indd 307 9/17/08 11:39:33 AM 308 International Financial Statement Analysis ROA. Gross margin. Pretax margin. Sales to total cash. Percentage change in total assets. Cash ow to debt. Working capital to total assets. Operating ROA. Repayment of long-term debt to total long-term debt. Cash dividend to cash ows. Subsequent studies have also demonstrated the use of ratios in evaluation of equity investments and valuation. Lev and Thiagarajan (1993) examined fundamental nancial variables used by analysts to assess whether they are useful in security valuation. They found that fundamental variables add about 70 percent to the explanatory power of earnings alone in predicting excess returns (stock returns in excess of those expected). The fundamental variables they found useful included percentage changes in inventory and receivables relative to sales, gross margin, sales per employee, and the change in bad debts relative to the change in accounts receivable, among others. Abarbanell and Bushee (1997) found some of the same variables useful in predicting future accounting earnings. Abarbanell and Bushee (1998) devised an investment strategy using these same variables and found that they can generate excess returns under this strategy. Piotroski (2000) used nancial ratios to supplement a value investing strategy and found that he can generate signicant excess returns. Variables used by Piotroski include ROA, cash ow ROA, change in ROA, change in leverage, change in liquidity, change in gross margin, and change in inventory turnover. This research shows that in addition to being useful in evaluating the past performance of a company, ratios can be useful in predicting future earnings and equity returns. 6 . CREDIT ANALYSIS Credit risk is the risk of loss caused by a counterpartys or debtors failure to make a promised payment. For example, credit risk with respect to a bond is the risk that the obligor (the issuer of the bond) is not able to pay interest and principal according to the terms of the bond indenture (contract). Credit analysis is the evaluation of credit risk. Approaches to credit analysis vary and, as with all nancial analysis, depend on the purpose of the analysis and the context in which it is done. Credit analysis for specic types of debt (e.g., acquisition nancing and other highly leveraged nancing) often involves projections of period-by-period cash ows similar to projections made by equity analysts. Whereas the equity analyst may discount projected cash ows to determine the value of the companys equity, a credit analyst would use the projected cash ows to assess the likelihood of a company complying with its nancial covenants in each period and paying interest and principal as due.18 The analysis would also include expectations about asset sales and renancing options open to the company. 18 Financial covenants are clauses in bond indentures relating to the nancial condition of the bond issuer. c07.indd 308 9/17/08 11:39:33 AM Chapter 7 Financial Analysis Techniques 309 Credit analysis may relate to the borrowers credit risk in a particular transaction or to its overall creditworthiness. In assessing overall creditworthiness, one general approach is credit scoring, a statistical analysis of the determinants of credit default. Another general approach to credit analysis is the credit rating process that is used, for example, by credit rating agencies to assess and communicate the probability of default by an issuer on its debt obligations (e.g., commercial paper, notes, and bonds). A credit rating can be either long term or short term and is an indication of the rating agencys opinion of the creditworthiness of a debt issuer with respect to a specic debt security or other obligation. Where a company has no debt outstanding, a rating agency can also provide an issuer credit rating that expresses an opinion of the issuers overall capacity and willingness to meet its nancial obligations. The following sections review research on the use of ratios in credit analysis and the ratios commonly used in credit analysis. 6.1. The Credit Rating Process The rating process involves both the analysis of a companys nancial reports as well as a broad assessment of a companys operations. The credit rating process includes many of the following procedures:19 Meeting with management, typically including the chief nancial ofcer, to discuss, for example, industry outlook, overview of major business segments, nancial policies and goals, distinctive accounting practices, capital spending plans, and nancial contingency plans. Tours of major facilities, time permitting. Meeting of a ratings committee where the analysts recommendations are voted on, after considering factors that include: Business risk, including the evaluation of: Operating environment. Industry characteristics (e.g., cyclicality and capital intensity). Success factors and areas of vulnerability. Companys competitive position, including size and diversication. Financial risk, including: The evaluation of capital structure, interest coverage, and protability using ratio analysis. The examination of debt covenants. Evaluation of management. Monitoring of publicly distributed ratingsincluding reconsideration of ratings due to changing conditions. In assigning credit ratings, rating agencies emphasize the importance of the relationship between a companys business risk prole and its nancial risk. The companys business risk prole determines the level of nancial risk appropriate for any rating category.20 When analyzing nancial ratios, rating agencies normally investigate deviations of ratios from the median ratios of the universe of companies for which such ratios have been calculated and also use the median ratings as an indicator for the ratings grade given to 19 Based on Standard & Poors Corporate Ratings Criteria (2006). Standard & Poors Corporate Ratings Criteria (2006), p. 23. 20 c07.indd 309 9/17/08 11:39:34 AM 310 International Financial Statement Analysis EXHIBIT 7-16 Selected Credit Ratios Used by Standard & Poors Credit Ratio Numeratora Denominatorb EBIT interest coverage EBIT Gross interest (prior to deductions for capitalized interest or interest income) EBITDA interest coverage EBITDA Gross interest (prior to deductions for capitalized interest or interest income) Funds from operations to total debt FFO (net income adjusted for noncash items) Total debt Free operating cash ow to total debt CFO (adjusted) less capital expenditures Total debt Total debt to EBITDA Total debt EBITDA Return on capital EBIT Capital Average equity (common and preferred stock) and short-term portions of debt, noncurrent deferred taxes, minority interest Total debt to total debt plus equity Total debt Total debt plus equity FFO, funds from operations; CFO, cash ow from operations. a Emphasis is on earnings from continuing operations. b Note that both the numerator and denominator denitions are adjusted from ratio to ratio and may not correspond to the denitions used in this chapter. Source: Based on data from Standard & Poors Corporate Ratings Criteria (2006), p. 43. a specic debt issuer. This so-called universe of rated companies changes constantly, and any calculations are obviously affected by economic factors as well as by mergers and acquisitions. International ratings include the inuence of country and economic risk factors. Exhibit 7-16 presents key nancial ratios used by Standard & Poors in evaluating industrial companies. Note that before calculating ratios, rating agencies make certain adjustments to reported nancials such as adjusting debt to include off-balance sheet debt in a companys total debt. 6.2. Research on Ratios in Credit Analysis A great deal of academic and practitioner research has focused on determining which ratios are useful in assessing the credit risk of a company, including the risk of bankruptcy. One of the earliest studies examined individual ratios to assess their ability to predict failure of a company up to ve years in advance. Beaver (1967) found that six ratios could correctly predict company failure one year in advance 90 percent of the time and ve years in advance at least 65 percent of the time. The ratios found effective by Beaver were cash ow-to-total debt, ROA, total debt-to-total assets, working capital-to-total assets, the current ratio, and the no-credit interval ratio (the length of time a company could go without borrowing). Altman (1968) and Altman, Haldeman, and Narayanan (1977) found that nancial ratios could be combined in an effective model for predicting bankruptcy. Altmans initial work involved creation of a Z-score that was able to correctly predict nancial distress. The Z-score was computed as c07.indd 310 9/17/08 11:39:34 AM Chapter 7 Financial Analysis Techniques Z 311 1.2 (Current assets Current liabilities)/Total assets 1.4 (Retained earnings/Total assets) 3.3 (EBIT/Total assets) 0.6 (Market value of stock/Book value of liabilities) 1.0 (Sales/Total assets) In his initial study, a Z-score of lower than 1.81 predicted failure and the model was able to accurately classify 95 percent of companies studied into a failure group and a nonfailure group. The original model was designed for manufacturing companies. Subsequent renements to the models allow for other company types and time periods. Generally, the variables found to be useful in prediction include protability ratios, coverage ratios, liquidity ratios, capitalization ratios, and earnings variability (Altman 2000). Similar research has been performed on the ability of ratios to predict bond ratings and bond yields. For example, Ederington, Yawitz, and Roberts (1987) found that a small number of variables (total assets, interest coverage, leverage, variability of coverage, and subordination status) were effective in explaining bond yields. Similarly, Ederington (1986) found that nine variables in combination could correctly classify more than 70 percent of bond ratings. These variables included ROA, long-term debt to assets, interest coverage, cash ow to debt, variability of coverage and cash ow, total assets, and subordination status. These studies have shown that ratios are effective in evaluating credit risk, bond yields, and bond ratings. 7 . BUSINESS AND GEOGRAPHIC SEGMENTS Analysts often need to evaluate the performance underlying business segments (subsidiary companies, operating units, or simply operations in different geographic areas) to understand in detail the company as a whole. Unfortunately, companies are not required to provide full nancial statements for segments for which all of the traditional ratios can be computed. Publicly traded companies are required to provide limited segment information under both IFRS and U.S. GAAP. 7.1. IAS 14 Requirements Under IAS 14 (Segment Reporting), disclosures are required for reportable segments. U.S. GAAP requirements are similar to IFRS but less detailed. One noticeable omission under U.S. GAAP is the disclosure of segment liabilities. A reportable segment is dened as a business or geographical segment where both of the following apply: The majority (greater than 50 percent) of its revenue is earned externally. Its income from sales, segment result, or assets is greater than or equal to 10 percent of the appropriate total amount of all segments. A business segment is a distinguishable component of a company that is engaged in providing an individual product or service or a group of related products or services and that is subject to risks and returns that are different from those of other business segments. A geographical segment is a distinguishable component of a company that is engaged in providing products or services within a particular economic environment. c07.indd 311 9/17/08 11:39:35 AM 312 International Financial Statement Analysis Different business and geographical segments should be identied. A companys business and geographical segments for external reporting purposes should be those organizational units for which information is reported to the board of directors and to the chief executive ofcer. If a companys internal organizational and management structure and its system of internal nancial reporting to the board of directors and the chief executive ofcer are not based on individual products, services, groups of related products or services, nor on geography, the directors and management of the company should choose either business segments or geographical segments as the companys primary segment reporting format, based on their assessment of which type of segment reects the primary source of the companys risks and returns. Under this standard, most entities would identify their business and geographical segments as the organizational units for which information is reported to the nonexecutive board of directors and senior management. If the total revenue from external customers for all reportable segments combined is less than 75 percent of the total company revenue, additional reportable segments should be identied until the 75 percent level is reached. Small segments might be combined as one if they share a substantial number of factors that dene a business or geographical segment, or they might be combined with a similar signicant reportable segment. If they are not separately reported or combined, they are included as an unallocated reconciling item. The company must identify a primary segment reporting format (either business or geographical) with the other segment used for the secondary reporting format. The dominant source and nature of risks and returns govern whether a companys primary segment reporting format will be its business segments or its geographical segments. The companys internal organization and management structure, and its system of internal nancial reporting to the board of directors and the chief executive ofcer, are normally the basis for identifying the predominant source and nature of risks and differing rates of return facing the company. For each primary segment, the following should be disclosed: Segment revenue, distinguishing between revenue to external customers and revenue from other segments. Segment result (segment revenue minus segment expenses). Carrying amount of segment assets. Segment liabilities. Cost of property, plant, and equipment, and intangible assets acquired. Depreciation and amortization expense. Other noncash expenses. Share of the net prot or loss of an investment accounted for under the equity method. Reconciliation between the information of reportable segments and the consolidated nancial statements in terms of segment revenue, result, assets, and liabilities. For each secondary segment, the following should be disclosed: Revenue from external customers. Carrying amount of segment assets. Cost of property, plant, and equipment, and intangible assets acquired. Other required disclosures are as follows: Revenue of any segment whereby the external revenue of the segment is greater than or equal to 10 percent of company revenue but that is not a reportable segment (because a majority of its revenue is from internal transfers). c07.indd 312 9/17/08 11:39:35 AM Chapter 7 313 Financial Analysis Techniques Basis of pricing intersegment transfers. Changes in segment accounting policies. Types of products and services in each business segment. Composition of each geographical segment. 7.2. Segment Ratios Based on the limited segment information that companies are required to present, a variety of useful ratios can be computed, as shown in Exhibit 7-17. The segment margin measures the operating protability of the segment relative to revenues, whereas the segment ROA measures the operating protability relative to assets. Segment turnover measures the overall efciency of the segment: how much revenue is generated per unit of assets. The segment debt ratio examines the level of liabilities (hence solvency) of the segment. Example 7-15 demonstrates the evaluation of segment ratios. EXHIBIT 7-17 Denitions of Segment Ratios Segment Ratios Numerator Denominator Segment margin Segment prot (loss) Segment revenue Segment turnover Segment revenue Segment assets Segment ROA Segment prot (loss) Segment assets Segment debt ratio Segment liabilities Segment assets EXAMPLE 7-15 The Evaluation of Segment Ratios The following information relates to the business segments of Nokia for 2004 in millions of euros. Evaluate the performance of the segments using the segment margin, segment ROA, and segment turnover. Revenue Mobile Phones Multimedia Enterprise Solutions Networks Operating Prot Segment Assets 18,429 3,768 3,758 3,636 179 787 806 199 210 6,367 878 3,055 Segment Margin Mobile Phones Multimedia Enterprise Solutions Networks c07.indd 313 Segment ROA Segment Turnover 20.45% 100.27% 4.90 4.92% 22.74% 4.62 24.69% 94.76% 3.84 13.79% 28.74% 2.08 9/17/08 11:39:36 AM 314 International Financial Statement Analysis Solution. Mobile Phones is the best performing segment with the highest segment margin, segment ROA, and efciency. Networks is the second highest in terms of protability but lowest in efciency (the ability to generate revenue from assets). Enterprise Solutions is not protable; however, it is the smallest segment and may still be in the development stage. 8 . MODEL BUILDING AND FORECASTING Analysts often need to forecast future nancial performance. For example, EPS forecasts of analysts are widely followed by Wall Street. Analysts use data about the economy, industry, and company in arriving at a companys forecast. The results of an analysts nancial analysis, including common-size and ratio analysis, are integral to this process, along with the judgment of the analysts. Based on forecasts of growth and expected relationships among the nancial statement data, the analyst can build a model (sometimes referred to as an earnings model) to forecast future performance. In addition to budgets, pro forma nancial statements are widely used in nancial forecasting within companies, especially for use by senior executives and boards of directors. Last but not least, these budgets and forecasts are also used in presentations to credit analysts and others in obtaining external nancing. For example, based on a revenue forecast, an analyst may budget expenses based on expected common-size data. Forecasts of balance sheet and cash ow statements can be derived from expected ratio data, such as DSO. Forecasts are not limited to a single point estimate but should involve a range of possibilities. This can involve several techniques: Sensitivity analysis. Also known as what if analysis, sensitivity analysis shows the range of possible outcomes as specic assumptions are changed; this could, in turn, inuence nancing needs or investment in xed assets. Scenario analysis. This type of analysis shows the changes in key nancial quantities that result from given (economic) events, such as the loss of customers, the loss of a supply source, or a catastrophic event. If the list of events is mutually exclusive and exhaustive and the events can be assigned probabilities, the analyst can evaluate not only the range of outcomes but also standard statistical measures such as the mean and median value for various quantities of interest. Simulation. This is computer-generated sensitivity or scenario analysis based on probability models for the factors that drive outcomes. Each event or possible outcome is assigned a probability. Multiple scenarios are then run using the probability factors assigned to the possible values of a variable. 9 . SUMMARY Financial analysis techniques, including common-size and ratio analysis, are useful in summarizing nancial reporting data and evaluating the performance and nancial position of a company. The results of nancial analysis techniques provide important inputs into security valuation. Key facets of nancial analysis include the following: c07.indd 314 9/17/08 11:39:39 AM Chapter 7 Financial Analysis Techniques 315 Common-size nancial statements and nancial ratios remove the effect of size, allowing comparisons of a company with peer companies (cross-sectional analysis) and comparison of a companys results over time (trend or time-series analysis). Activity ratios measure the efciency of a companys operations, such as collection of receivables or management of inventory. Major activity ratios include inventory turnover, days of inventory on hand, receivables turnover, days of sales outstanding, payables turnover, number of days of payables, working capital turnover, xed asset turnover, and total asset turnover. Liquidity ratios measure the ability of a company to meet short-term obligations. Major liquidity ratios include the current ratio, quick ratio, cash ratio, and defensive interval ratio. Solvency ratios measure the ability of a company to meet long-term obligations. Major solvency ratios include debt ratios (including the debt-to-assets ratio, debt-to-capital ratio, debt-to-equity ratio, and nancial leverage ratio) and coverage ratios (including interest coverage and xed charge coverage). Protability ratios measure the ability of a company to generate prots from revenue and assets. Major protability ratios include return on sales ratios (including gross prot margin, operating prot margin, pretax margin, and net prot margin) and return on investment ratios (including operating ROA, ROA, ROE, and return on common equity). Ratios can also be combined and evaluated as a group to better understand how they t together and how efciency and leverage are tied to protability. ROE can be analyzed as the product of the net prot margin, asset turnover, and nancial leverage. Ratio analysis is useful in the selection and valuation of debt and equity securities and is a part of the credit rating process. Ratios can also be computed for business segments to evaluate how units within a business are doing. The results of nancial analysis provide valuable inputs into forecasts of future earnings and cash ow. P RACTICE PROBLEMS 1. Comparison of a companys nancial results to other peer companies for the same time period is called A. horizontal analysis. B. time-series analysis. C. cross-sectional analysis. 2. In order to assess a companys ability to fulll its long-term obligations, an analyst would most likely examine A. activity ratios. B. liquidity ratios. C. solvency ratios. 3. Which ratio would a company most likely use to measure its ability to meet short-term obligations? A. Current ratio B. Payables turnover C. Gross prot margin c07.indd 315 9/17/08 11:39:41 AM 316 International Financial Statement Analysis 4. Which of the following ratios would be most useful in determining a companys ability to cover its debt payments? A. ROA B. Total asset turnover C. Fixed charge coverage 5. John Chan is interested in assessing both the efciency and liquidity of Spherion PLC. Chan has collected the following data for Spherion: 2005 2004 2003 Days of inventory on hand 32 34 40 Days of sales outstanding 28 25 23 Number of days of payables 40 35 35 Based on this data, what is Chan least likely to conclude? A. Inventory management has contributed to improved liquidity. B. Management of payables has contributed to improved liquidity. C. Management of receivables has contributed to improved liquidity. 6. Marcus Lee is examining the solvency of Apex Manufacturing and has collected the following data (in millions of euros): 2005 2004 2003 Total debt 2,000 1,900 1,750 Total equity 4,000 4,500 5,000 Which of the following would be the most appropriate conclusion for Lee? A. The company is becoming increasingly less solvent, as evidenced by the increase in its debt-to-equity ratio from 0.35 to 0.50 from 2003 to 2005. B. The company is becoming less liquid, as evidenced by the increase in its debt-toequity ratio from 0.35 to 0.50 from 2003 to 2005. C. The company is becoming increasingly more liquid, as evidenced by the increase in its debt-to-equity ratio from 0.35 to 0.50 from 2003 to 2005. 7. With regard to the data in Problem 6, what would be a reasonable explanation of these nancial results? A. The decline in the companys equity results from a decline in the market value of this companys common shares. B. The increase of 250 in the companys debt from 2003 to 2005 indicates that lenders are viewing the company as increasingly creditworthy. C. The decline in the companys equity indicates that the company may be incurring losses on its operations, paying dividends greater than income, and/or repurchasing shares. 8. Linda Roper observes a decrease in a companys inventory turnover. Which of the following would explain this trend? A. The company installed a new inventory management system, allowing more efcient inventory management. c07.indd c07.indd 316 9/17/08 11:39:41 AM Chapter 7 317 Financial Analysis Techniques B. Due to problems with obsolescent inventory last year, the company wrote off a large amount of its inventory at the beginning of the period. C. The company installed a new inventory management system but experienced some operational difculties resulting in duplicate orders being placed with suppliers. 9. Which of the following would best explain an increase in receivables turnover? A. The company adopted new credit policies last year and began offering credit to customers with weak credit histories. B. Due to problems with an error in its old credit scoring system, the company had accumulated a substantial amount of uncollectible accounts and wrote off a large amount of its receivables. C. To match the terms offered by its closest competitor, the company adopted new payment terms now requiring net payment within 30 days rather than 15 days, which had been its previous requirement. 10. Brown Corporation had an average days sales outstanding of 19 days in 2005. Brown wants to decrease its collection period in 2006 to match the industry average of 15 days. Credit sales in 2005 were $300 million, and Brown expects credit sales to increase to $390 million in 2006. To achieve Browns goal of decreasing the collection period, the change in the average accounts receivable balance from 2005 to 2006 that must occur is closest to A. $1.22 million. B. $0.42 million. C. $0.42 million. 11. An analyst gathered the following data for a company: 2003 2004 2005 19.8% 20.0% 22.0% Return on total assets 8.1% 8.0% 7.9% Total asset turnover 2.0 2.0 2.1 ROE Based only on the information above, the most appropriate conclusion is that, over the period 2003 to 2005, the companys A. net prot margin and nancial leverage have decreased. B. net prot margin and nancial leverage have increased. C. net prot margin has decreased but its nancial leverage has increased. 12. A decomposition of ROE for Integra SA is as follows: 2005 ROE 2004 18.90% 0.70 0.75 Interest burden 0.90 0.90 EBIT margin 10.00% 10.00% Asset turnover 1.50 1.40 Leverage c07.indd c07.indd 317 18.90% Tax burden 2.00 2.00 9/17/08 11:39:42 AM 318 International Financial Statement Analysis Which of the following choices best describes reasonable conclusions an analyst might make based on this ROE decomposition? A. Protability and the liquidity position both improved in 2005. B. The higher average tax rate in 2005 offset the improvement in protability, leaving ROE unchanged. C. The higher average tax rate in 2005 offset the improvement in efciency, leaving ROE unchanged. 13. A decomposition of ROE for Company A and Company B is as follows: Company A Company B 2005 2005 2004 26.46% ROE 2004 18.90% 26.33% 18.90% Tax burden 0.7 0.75 0.75 0.75 Interest burden 0.9 0.9 0.9 0.9 EBIT margin 7.00% Asset turnover 1.5 10.00% 1.4 13.00% 1.5 10.00% 1.4 Leverage 4 2 2 2 Which of the following choices best describes reasonable conclusions an analyst might make based on this ROE decomposition? A. Company As ROE is higher than Company Bs in 2005, but the difference between the two companies ROE is very small and was mainly the result of Company As increase in its nancial leverage. B. Company As ROE is higher than Company Bs in 2005, apparently reecting a strategic shift by Company A to a product mix with higher prot margins. C. Company As ROE is higher than Company Bs in 2005, which suggests that Company A may have purchased new, more efcient equipment. 14. Rent-A-Center reported the following information related to total debt and shareholders equity in its 2003 annual report. As of 31 December 2003 2002 2001 2000 1999 Total debt 698,000 521,330 702,506 741,051 847,160 Stockholders equity 794,830 842,400 405,378 309,371 206,690 ($ thousands) What would an analysts most appropriate conclusion be based on this data? A. The companys solvency improved from 1999 to 2002. B. The companys solvency improved from 2002 to 2003. C. The data suggest the company increased debt in 2002. c07.indd c07.indd 318 9/17/08 11:39:43 AM Chapter 7 319 Financial Analysis Techniques 15. Frank Collins observes the following data for two companies: Company A Revenue $4,500 $6,000 $50 $1,000 $40,000 $60,000 Net income Current assets Total assets Company B $100,000 $700,000 Current liabilities $10,000 $50,000 Total debt $60,000 $150,000 Shareholders equity $30,000 $500,000 Which of the following choices best describes reasonable conclusions that Collins might make about the two companies ability to pay their current and long-term obligations? A. Company As current ratio of 4.0x indicates it is more liquid than Company B, whose current ratio is only 1.2x, but Company B is more solvent, as indicated by its lower debt-to-equity ratio. B. Company As current ratio of 25 percent indicates it is less liquid than Company B, whose current ratio is 83 percent, and Company A is also less solvent, as indicated by a debt-to-equity ratio of 200 percent compared with Company Bs debt-to-equity ratio of only 30 percent. C. Company As current ratio of 4.0x indicates it is more liquid than Company B, whose current ratio is only 1.2x, and Company A is also more solvent, as indicated by a debt-to-equity ratio of 200 percent compared with Company Bs debt-to-equity ratio of only 30 percent. Use the following information to answer Problems 16 through 19. The data below appear in the ve-year summary of a major international company. A business combination with another major manufacturer took place in 2003. The term turnover in this nancial data is a synonym for revenue. 2000 Financial statements 2001 2002 2003 2004 GBP m GBP m GBP m GBP m GBP m 4,390 3,624 3,717 8,167 11,366 844 700 704 933 1,579 Income statements Turnover (i.e., revenue) Prot before interest and taxation (EBIT) Net interest payable Taxation Minorities Prot for the year 80 54 98 163 188 186 195 208 349 579 94 99 105 125 167 484 352 293 296 645 (Continued ) c07.indd 319 9/17/08 11:39:43 AM 320 International Financial Statement Analysis (Continued ) 2000 2001 2002 2003 2004 3,510 3,667 4,758 10,431 11,483 316 218 290 561 682 Balance sheets Fixed assets Current asset investments, cash at bank and in hand Other current assets 558 514 643 1,258 1,634 4,384 4,399 5,691 12,250 13,799 602 1,053 1,535 3,523 3,707 Other creditors and provisions (current) 1,223 1,054 1,102 2,377 3,108 Total liabilities 1,825 2,107 2,637 5,900 6,815 Net assets 2,559 2,292 3,054 6,350 6,984 Shareholders funds 2,161 2,006 2,309 5,572 6,165 398 286 745 778 819 2,559 2,292 3,054 6,350 6,984 53 5 71 85 107 864 859 975 1,568 2,292 Total assets Interest bearing debt (long term) Equity minority interests Capital employed Cash ow Working capital movements Net cash inow from operating activities 16. The companys total assets at year-end 1999 were GBP 3,500 million. Which of the following choices best describes reasonable conclusions an analyst might make about the companys efciency? A. Comparing 2004 with 2000, the companys efciency improved, as indicated by a total asset turnover ratio of 0.86 compared with 0.64. B. Comparing 2004 with 2000, the companys efciency deteriorated, as indicated by its current ratio. C. Comparing 2004 with 2000, the companys efciency deteriorated due to asset growth faster than turnover (i.e., revenue) growth. 17. Which of the following choices best describes reasonable conclusions an analyst might make about the companys solvency? A. Comparing 2004 with 2000, the companys solvency improved, as indicated by an increase in its debt-to-assets ratio from 0.14 to 0.27. B. Comparing 2004 with 2000, the companys solvency deteriorated, as indicated by a decrease in interest coverage from 10.6 to 8.4. C. Comparing 2004 with 2000, the companys solvency improved, as indicated by the growth in its prots to GBP 645 million. 18. Which of the following choices best describes reasonable conclusions an analyst might make about the companys liquidity? A. Comparing 2004 with 2000, the companys liquidity improved, as indicated by an increase in its debt-to-assets ratio from 0.14 to 0.27. c07.indd 320 9/17/08 11:39:44 AM Chapter 7 Financial Analysis Techniques 321 B. Comparing 2004 with 2000, the companys liquidity deteriorated, as indicated by a decrease in interest coverage from 10.6 to 8.4. C. Comparing 2004 with 2000, the companys liquidity improved, as indicated by an increase in its current ratio from 0.71 to 0.75. 19. Which of the following choices best describes reasonable conclusions an analyst might make about the companys protability? A. Comparing 2004 with 2000, the companys protability improved, as indicated by an increase in its debt-to-assets ratio from 0.14 to 0.27. B. Comparing 2004 with 2000, the companys protability deteriorated, as indicated by a decrease in its net prot margin from 11.0 percent to 5.7 percent. C. Comparing 2004 with 2000, the companys protability improved, as indicated by the growth in its shareholders equity to GBP 6,165 million. 20. In general, a creditor would consider a decrease in which of the following ratios to be positive news? A. Interest coverage (times interest earned) B. Debt to total assets C. Return on assets 21. Assuming no changes in other variables, which of the following would decrease ROA? A. A decrease in the effective tax rate B. A decrease in interest expense C. An increase in average assets 22. What does the P/E ratio measure? A. The multiple that the stock market places on a companys EPS. B. The relationship between dividends and market prices. C. The earnings for one common share of stock. c07.indd c07.indd 321 9/17/08 11:39:45 AM c07.indd c07.indd 322 9/17/08 11:39:45 AM CHAPTER 8 I NTERNATIONAL STANDARDS CONVERGENCE Thomas R. Robinson, CFA CFA Institute Charlottesville, Virginia Hennie van Greuning, CFA World Bank Washington, DC Elaine Henry, CFA University of Miami Miami, Florida Michael A. Broihahn, CFA Barry University Miami, Florida L EARNING OUTCOMES After completing this chapter, you will be able to do the following: State and explain key aspects of the International Financial Reporting Standards (IFRS) framework as they pertain to the objectives and qualitative characteristics of nancial statements. 323 c08.indd 323 9/17/08 11:40:45 AM 324 International Financial Statement Analysis Identify and explain the major international accounting standards for each asset and liability category on the balance sheet, and the key differences from U.S. generally accepted accounting principles (GAAP). Identify and explain the major international accounting standards for major revenue and expense categories on the income statement, and the key differences from U.S. GAAP. Identify and explain the major differences between international and U.S. GAAP accounting standards concerning the treatment of interest and dividends on the cash ow statement. Interpret the effect of differences between international and U.S. GAAP accounting standards on the balance sheet, income statement, and the statement of changes in equity for some commonly used nancial ratios. 1 . INTRODUCTION The International Accounting Standards Board (IASB) is the standard-setting body of the International Accounting Standards Committee (IASC) Foundation. The objectives of the IASC Foundation are to develop a single set of global nancial reporting standards and to promote the use of those standards. In accomplishing these objectives, the IASC Foundation explicitly aims to bring about convergence between national standards and international standards. Around the world, many national accounting standard setters have adopted, or are in the process of adopting, the standards issued by the IASB: International Financial Reporting Standards, or IFRS.1 Over the past few years, convergence between IFRS and U.S. generally accepted accounting principles (U.S. GAAP), which are issued by the Financial Accounting Standards Board (FASB), has increased signicantly. The two accounting standards boards now issue joint exposure drafts for a number of standards. In February 2006, the FASB and IASB published a memorandum of understanding outlining a road map for convergence over the next several years. The IFRS Framework for the Preparation and Presentation of Financial Statements (referred to here as the Framework) was introduced earlier. In this chapter, we review certain key aspects of the Framework. Section 2 provides an overview of the Framework. Sections 3, 4, and 5 provide additional descriptions of the IFRS relevant to each of the nancial statements, noting some of the differences currently remaining between IFRS and U.S. GAAP. Section 6 summarizes the standard setters agenda for convergence. Section 7 describes the effect on selected nancial ratios of current differences between U.S. and international standards. Section 8 provides a summary of key concepts, and practice problems in the CFA multiplechoice format conclude the chapter. A note of caution: The stated objective of the IASB/FASB convergence project is to eliminate differences between IFRS and U.S. GAAP. The convergence project implies that frequent changes to accounting standards are bound to continue for a number of years. Because a detailed comparison of current differences between IFRS and U.S. GAAP would 1 International accounting standards also include standards with a numbering system identied as IAS (International Accounting Standards), which were issued by the board of the IASC prior to the formation of the IASB in 2001 and the handover of standard-setting functions from the IASCs board to the IASB. c08.indd 324 9/17/08 11:40:46 AM Chapter 8 International Standards Convergence 325 be of limited practical value, this chapter aims to present basic principles and issues. Analysts should be aware of resources available to nd the timeliest information on IFRS, including the web site of the IASB (www.iasb.org) and the website of the FASB (www.fasb.org). 2 . THE IFRS FRAMEWORK The IFRS Framework, which is currently being re-examined as part of the international convergence project, was originally published in 1989 and was designed to assist the IASB in developing standards as well as to assist users of nancial statements in interpreting the information contained therein. The Framework sets forth the concepts that underlie the preparation and presentation of nancial statements and provides guidance on the denition, recognition, and measurement of the elements from which nancial statements are constructed. In addition, the Framework discusses the concepts of capital and capital maintenance. 2.1. Key Aspects of the IFRS Framework The objectives of nancial statements, as stated in the Framework, are to provide information about the nancial position, performance, and changes in nancial position of an entity; this information should be useful to a wide range of users for the purpose of making economic decisions.2 The denition, therefore, covers the balance sheet (including the statement of changes in equity), income statement, and cash ow statement. To achieve the objective of providing useful information, nancial statements should have certain characteristics. Recent IASB updates emphasize the following qualitative characteristics related to the usefulness of information in nancial statements: Relevance Predictive value Faithful representation (an emphasis on economic substance over form, reliability, and completeness) Neutrality (absence of bias) Veriability Financial statements provide information on the nancial position and performance of an entity by grouping the effects of transactions and other events into the following ve broad classes or elements: Balance Sheet Elements (Financial Position) Assets: Resources controlled by an entity as a result of past events and from which future economic benets are expected to ow to the entity. Liabilities: Present obligations of an entity arising from past events, the settlement of which is expected to result in an outow of resources from the entity. Equity: Assets less liabilities (for companies, shareholders equity), which is the residual interest in the assets of the entity. 2 Framework for the Preparation and Presentation of Financial Statements, IASC, 1989, adopted by IASB 2001, paragraph 12. c08.indd 325 9/17/08 11:40:47 AM 326 International Financial Statement Analysis Income Statement Elements (Performance) Income: Increases in economic benets that result in an increase in equity, other than increases resulting from contributions by owners. The increases in economic benets may be in the form of inows of assets, enhancements to assets, or decreases in liabilities. Income includes both revenues and gains. Revenues are income from the ordinary activities of the entity (e.g., the sale of products). Gains result from activities other than ordinary activities (e.g., the sale of equipment no longer needed). Expenses: Decreases in economic benets that result in decreases in equity, other than decreases because of distributions to owners. The decreases in economic benets may be in the form of outows of assets, depletions of assets, or increases in liabilities. (Expenses include losses as well as those items normally thought of as expenses, such as the cost of goods sold or wages.) Changes in these ve basic elements are portrayed in the statement of cash ow and the statement of changes in equity. 2.2. Challenges in Financial Statement Preparation: Timing and Amounts Two key challenges for preparers of nancial statements are determining when to recognize nancial events and how to measure the nancial effect of these events. Recognition is the process of incorporating into the nancial statement an item that meets the denition of a nancial statement element (i.e., assets, liabilities, equity, income, and expenses) and satises the criteria for recognition. The IFRS criteria for recognition of an item are that it should be recognized in the nancial statements if: It is probable that any future economic benet associated with the item will ow to or from the entity. The item has a cost or value that can be measured with reliability. Measurement is the process of determining the monetary effect of nancial events and thus the amounts that are to be recognized and presented in the nancial statements. In meeting the challenges of recognition and measurement, nancial statement preparers employ judgment about appropriate methodsmany of which are constrained by IFRS requirements to use specic methodsand the estimation of relevant parameters. Such judgments and estimates can vary across companies and across time; therefore, analysts should develop awareness of the potential effect of these variations on nancial statements. 3 . THE BALANCE SHEET A number of standards, including the Framework described above, apply to the majority of the components of the balance sheet. These include standards describing requirements for companies adopting international nancial standards for the rst time,3 requirements for presenting 3 IFRS No. 1. c08.indd 326 9/17/08 11:40:47 AM Chapter 8 International Standards Convergence 327 nancial statements under international nancial standards,4 and accounting for changes in accounting principles and estimates.5 Other standards apply more directly to specic components of the balance sheet. The sections below describe the key aspects of the standards relevant to each component of the balance sheet. 3.1. Marketable Securities The international standards of accounting for marketable securities, contained in IAS No. 39, require that companies recognize securities initially at fair market value; for investments in marketable securities, this is typically the cost to acquire securities. The fair market value of securities changes over time, and the central issue in accounting for securities is: Should securities continue to be presented at cost or adjusted as changes occur in their fair market value? Under the accounting standards, the answer depends on how the security is categorized. Securities with xed maturities and payments (e.g., bonds) that the company intends to hold until maturity (and has the ability to do so) can be categorized as held to maturity. Held-to-maturity securities are presented at their original cost, updated for any amortization of discount or premium. A debt security purchased for an amount greater than its principal value is said to have been purchased at a premium; if purchased for an amount less than its principal value it is said to have been purchased at a discount. Any premium or discount is amortized (i.e., reduced) over the remaining life of the security so that at maturity, the value of the security in the accounting records equals the principal value. Securities that do not have xed maturities (e.g., equity) and bonds that a company does not intend to hold until maturity are presented at their fair market value, and the reported value continues to be adjusted as changes occur in the fair market value. Such changes in a securitys fair market value during an accounting period, assuming the security is not sold, give rise to unrealized gains or losses. An unrealized gain results from an increase in a securitys value over the accounting period, and an unrealized loss results from a decrease in a securitys value. If the security is sold, the gain or loss is said to be realized. When securities are sold, a company realizes a gain (loss) if the sale price is greater than (less than) the value of the security in the companys books. The accounting for unrealized holding gains or losses differs for held-for-trading securities (trading securities) versus available-for-sale securities. Trading securities are simply those securities that the company intends to trade, and available-for-sale securities are those that do not fall into any other category. The category trading securities also includes derivatives. Unrealized holding gains or losses on trading securities are recorded in the income statement. Unrealized holding gains or losses on available-for-sale securities are recorded in equity (as part of other comprehensive income) until the securities are sold. So, both trading and available-for-sale securities are valued at market value, but only the unrealized holding gains or losses on trading securities ow directly through the income statement. As a result, the performance of trading securities portfolios is more transparently reected in the nancial statements. Exhibit 8-1 summarizes the different categories of marketable securities and their accounting treatment. 4 IAS No. 1. IAS No. 8. 5 c08.indd 327 9/17/08 11:40:48 AM 328 International Financial Statement Analysis EXHIBIT 8-1 Categories of Marketable Securities and Accounting Treatment Category How Measured Unrealized and Realized Gains and Losses Income (Interest and Dividends) Reported Held to maturity Amortized cost Unrealized: not reported In income statement Realized: reported in income statement Trading Fair value Unrealized: reported in income statement In income statement Realized: reported in income statement Available for sale Fair value Unrealized: reported in equity In income statement Realized: reported in income statement EXAMPLE 8-1 Accounting for Marketable Securities Assume a company has the following portfolio of marketable securities: Value at Fiscal Year-End 2005 Value at Fiscal Year-End 2006 Held to maturity $10,000,000 $10,000,000 Held for trading $5,000,000 $5,500,000 Available for sale $8,000,000 $7,000,000 Category 1. What amount of unrealized holding gains or losses would the company report in total? 2. How much unrealized holding gains or losses would the company report in its income statement? Solution to 1. The total amount of unrealized holding gains or losses that the company would report is determined by comparing the end-of-period value of held-for-trading and available-for-sale securities with their values as reported at the end of the previous period. In this example, the company would report a total of $500,000 as unrealized holding losses, calculated as the value of the held-for-trading and available-for-sale securities at the end of the period ($12,500,000) minus their value at the beginning of the period ($13,000,000). Solution to 2. The company would report an unrealized holding gain of $500,000 in its income statement. The change in the market value of the available-for-sale securities (the unrealized loss of $1,000,000) would not be reported in the income statement. Instead, it would be shown as part of comprehensive income. c08.indd 328 9/17/08 11:40:48 AM Chapter 8 International Standards Convergence 329 An analyst should obtain an understanding of managements rationale for categorizing securities as trading securities or as available for sale. The performance of trading securities portfolios is more transparently reected in the nancial statements because the income statement shows both income (interest and dividends) and changes in value, whether realized or unrealized. In contrast, with available-for-sale securities, there is an asymmetrical treatment of income and changes in value. This asymmetrical treatment can cause an unsophisticated user of nancial statements to misinterpret the performance of a companys marketable securities portfolio. It is possible, for example, that unrealized losses could accumulate in equity without affecting the income statement. An additional standard relevant to marketable securities is the requirement that risk exposures arising from nancial instruments be disclosed; requirements include specied minimum qualitative and quantitative disclosures about credit risk, liquidity risk, and market risk.6 Qualitative disclosures require a description of managements objectives, policies, and processes for managing those risks. Quantitative disclosures refer to the provision of information regarding the extent to which an entity is exposed to risk. Together, these disclosures provide an overview of the entitys use of nancial instruments and the resulting risk exposures. 3.2. Inventories The chapter on balance sheets describes various methods by which companies determine the cost of goods in inventory. Unlike U.S. GAAP, International Accounting Standards7 require that the choice of the accounting method used to value inventories should be based upon the order in which products are sold, relative to when they are put into inventory. Therefore, whenever possible, the cost of a unit of inventory should be assigned by specic identication of the units costs. In many cases, however, it is necessary to use a formula to calculate inventory costs. International standards permit the use of two alternative formulas for assigning the cost of inventory: (1) weighted average cost, in which the cost per unit of inventory is determined as a weighted average of the cost of all units of inventory; and (2) rst in, rst out (FIFO), in which it is assumed that the costs associated with the rst units purchased (rst in) are considered to be the cost of the rst units sold (rst out). Unlike U.S. GAAP, international standards do not allow the use of the LIFO (last in, rst out) method to calculate the cost of inventory because the method is not considered a faithful model of inventory ows. The IASB has noted that the use of LIFO is often tax driven because this method results in lower taxable income during periods of rising prices; however, they concluded that tax considerations do not provide a conceptual basis for selecting an appropriate treatment. Like U.S. GAAP, international standards require inventory to be reported at the lower of cost or net realizable value. However, IFRS permits the reversal of inventory write-downs, but no such provision exists in U.S. GAAP. 3.3. Property, Plant, and Equipment The international standards of accounting for property, plant, and equipment, contained in IAS No. 16, require companies to recognize these assets initially at cost. 6 IFRS No. 7. IAS No. 2. 7 c08.indd 329 9/17/08 11:40:55 AM 330 International Financial Statement Analysis Like U.S. GAAP, international standards allow property, plant, and equipment to be reported in the nancial statements at cost less accumulated depreciation. Depreciation is the systematic allocation of the cost of the asset over its useful life, and accumulated depreciation is the cumulative amount of depreciation expense recorded in relation to the asset. Unlike U.S. GAAP, International Accounting Standards allow another alternative: reporting property, plant, and equipment at a revalued amount. When property, plant, and equipment are revalued, they are reported in the nancial statements at fair value as of the revaluation date, less accumulated depreciation subsequent to the revaluation. Any revaluation increase is reported as part of equity, unless it is reversing a previous revaluation decrease. (The reason for this is that the previous decrease was reported as a reduction in the companys net income.) Any revaluation decrease is reported in prot and loss unless it is reversing a previous revaluation increase. 3.4. Long-Term Investments The overall IFRS Framework for accounting for a companys investments in the securities of another company is based on the extent of control that the investing company has on the investee company. In the discussion of marketable securities above, it was assumed that the equity investment gave the investing company no control over the investee. As discussed, in such cases, the investments are designated as trading or available for sale and reected at fair value. If, however, an equity investment did give the investing company some control over the investee, the accounting standards require a different treatment. The specic treatment depends on the amount of control. If an investor owns 20 percent or more of the voting power of an investee, such an ownership stake would provide signicant inuence, where signicant inuence is dened as power to participate in nancial and operating policy decisions of the investee but is not control or joint control over those policies.8 When an investor has signicant inuence, international standards require that the investment be reported using the equity method of accounting. The equity method of accounting means that the investor reports its pro rata share of the investees prots as an increase in the amount of investment. If an investor owns more than 50 percent of the voting power of the investee, such an ownership stake would provide signicant control and the investees nancial statements would be consolidated with those of the investor. Consolidation roughly means that the investees assets, liabilities, and income are combined into those of the investor. Note: The IFRS standard on business combinations is an active agenda item of the convergence project and is, therefore, subject to change during coming years. When an investor shares the ownership of an investee, as in a joint venture, control is shared and the investor would account for the investment using either the proportionate consolidation method or the equity method. Proportionate consolidation roughly means that the investors nancial statements include its proportionate share of the investees assets, liabilities, and income. Exhibit 8-2 summarizes the different levels of control associated with each level of ownership and the accounting treatment used in each situation. 8 IAS No. 28. c08.indd 330 9/17/08 11:40:56 AM Chapter 8 331 International Standards Convergence EXHIBIT 8-2 Accounting Treatment for Different Levels of an Investors Percentage Ownership in an Investee and Related Extent of Control Extent of Control Percent Ownership Accounting Treatment IFRS Reference Signicant inuence 2050% Equity accounting IAS No. 28 Control More than 50% Business combinations/ consolidation IAS No. 27/IFRS No. 3/SIC 12 Joint control Shared Joint ventures/proportionate consolidation or equity accounting IAS No. 31/SIC 13 SIC Standing Interpretations Committee. Like U.S. GAAP, international standards use extent of control as a factor determining whether an investee should be consolidated. U.S. GAAP differs from IFRS in that it allows a dual model: one model based on extent of voting control, and one model based on an alternative assessment of economic control. The model based on economic control depends rst on the economic substance of the investee and second on the investors economic interests in the investee (liability for the investees losses and opportunity to benet from the investees gains). Unlike U.S. GAAP, international standards permit that interests in joint ventures may be accounted for using the proportionate consolidation method or the equity method,9 whereas U.S. GAAP requires the equity method of accounting. 3.5. Goodwill IFRS denes goodwill as the amount an acquirer pays to buy another company, minus the fair value of the net identiable assets acquired. Goodwill is intended to represent future economic benets arising from assets that are not capable of being individually identied and separately recognized. Goodwill is considered an intangible asset (i.e., an asset without physical substance). Whereas some intangible assetsso-called identiable intangible assets, such as patents and trademarkscan be bought and sold individually, goodwill cannot. Goodwill is an unidentiable intangible. Under IFRS No. 3, goodwill is capitalized as an asset and tested for impairment annually. Impairment means diminishment in value. Impairment of goodwill is a noncash expense; however, the impairment of goodwill does affect reported net income. When impairment of goodwill is charged against income in the current period, current reported income decreases. This charge against income also leads to reduced net assets and reduced shareholders equity, but potentially improved return on assets, asset turnover ratios, return on equity, and equity turnover ratios because equity, the denominator in these ratios, is smaller. Even if the market reacts indifferently to an impairment write-off, an analyst should understand the implications of a goodwill write-off and, more generally, evaluate whether reported goodwill has been impaired. Example 8-2 presents a partial goodwill impairment footnote for Prudential PLC. 9 IAS No. 31. c08.indd 331 9/17/08 11:40:56 AM 332 International Financial Statement Analysis EXAMPLE 8-2 Goodwill Impairment Testing Susan Lee is examining the nancial statements of Prudential PLC and notes that the income statement shows a goodwill impairment charge of 120 million. Lee nds the following footnote to Prudentials nancial statements. Prudential PLC 2005 Annual Report Footnote H1 Impairment testing Goodwill does not generate cash ows independently of other groups of assets and thus is assigned to cash generating units (CGUs) for the purposes of impairment testing. These CGUs are based upon how management monitors the business and represent the lowest level to which goodwill can be allocated on a reasonable basis. An allocation of the Groups goodwill to CGUs is shown below: 2005 2004 ( millions) ( millions) M&G 1,153 1,153 120 Venture investment subsidiaries of the PAC with-prots fund 607 784 Other 188 188 1,948 2,245 Japan life company Other represents goodwill amounts allocated across cash generating units in Asia and US operations. These goodwill amounts are not individually material. There are no other intangible assets with indenite useful lives other than goodwill. Assessment of whether goodwill may be impaired With the exception of M&G and venture investment subsidiaries of the PAC with-prots fund the goodwill in the balance sheet relates to acquired life businesses. The Company routinely compares the aggregate of net asset value and acquired goodwill on an IFRS basis of acquired life business with the value of the business as determined using the EEV methodology, as described in section D1. Any excess of IFRS over EEV carrying value is then compared with EEV basis value of current and projected future new business to determine whether there is any indication that the goodwill in the IFRS balance sheet may be impaired. Goodwill is tested for impairment by comparing the CGUs carrying amount, excluding any goodwill, with its recoverable amount. M&G The recoverable amount for the M&G CGU has been determined by calculating its value in use. This has been calculated by aggregating the present value of future c08.indd c08.indd 332 9/17/08 11:40:57 AM Chapter 8 International Standards Convergence 333 cash ows expected to be derived from the component businesses of M&G (based upon management projections) and its current surplus capital. The discounted cash ow valuation has been based on a three-year plan prepared by M&G, and approved by the directors of Prudential plc, and cash ow projections for later years. As a cross check to the discounted cash ow analysis, a review was undertaken of publicly available information for companies engaged in businesses comparable to the component businesses, including reported market prices for such companies shares. In addition, a review was undertaken of publicly available terms of transactions involving companies comparable to the component businesses. In particular, comparison has been made of the valuation multiples implied by the discounted cash ow analysis to current trading multiples of companies comparable to the component businesses, as well as to multiples achieved in precedent transactions. The value in use is particularly sensitive to a number of key assumptions, as follows: (i) The assumed growth rate on forecast cash ows beyond the terminal year of the budget. A growth rate of 2.5 per cent has been used to extrapolate beyond the plan period. (ii) The risk discount rate. Differing discount rates have been applied in accordance with the nature of the individual component businesses. For retail and institutional business a risk discount rate of 12 per cent has been applied. This represents the average implied discount rate for comparable UK listed asset managers calculated by reference to risk-free rates, equity risk premiums of 5 per cent and an average beta factor for relative market risk of comparable UK listed asset managers. A similarly granular approach has been applied for the other component businesses of M&G. (iii) That asset management contracts continue on similar terms. Management believes that any reasonable change in the key assumptions would not cause the carrying amount of M&G to exceed its recoverable amount. Japanese life company As noted above, the entire goodwill relating to the Japanese life operation of 120 million has been deemed to be impaired following impairment testing carried out in 2005. This testing was based on a recoverable amount for the Japanese company that was determined by calculating its value in use based on net present value cash ow projections. Such projections reected existing business over the expected duration of the contracts and expected new business. A risk discount rate of 5 per cent was applied to the projected cash ows. On the basis of the results of this exercise it was determined that all goodwill held in relation to the Japanese business should be written off in 2005. c08.indd 333 9/17/08 11:41:09 AM 334 International Financial Statement Analysis PAC with-prots fund venture investment subsidiaries The recoverable amount for the ventures entities controlled by the Group through PPM Capital has been determined on a portfolio CGU basis by aggregating fair values calculated for each entity less costs to sell these entities. The fair value of each entity is calculated by PPM Capital in accordance with the International Private Equity and Venture Capital Valuation Guidelines which set out industry best practice for determining the fair value of private equity investments. The guidelines require that an enterprise value is calculated for each investment, typically using an appropriate multiple applied to the Companys maintainable earnings. All amounts relating to nancial instruments ranking higher in a liquidation than those controlled by PPM Capital are then deducted from the enterprise value and a marketability discount applied to the result to give a fair value attributable to the instruments controlled by PPM Capital. The marketability discount ranges from 10 per cent to 30 per cent, depending on PPM Capitals level of control over a realization process. Management believes that any reasonable change in the key assumptions would not give rise to an impairment charge. 1. What operating unit resulted in a goodwill impairment charge, and how was the charge computed? 2. For the operating unit identied in Part 1, would an analyst anticipate subsequent goodwill impairments? Solution to 1. The entire impairment charge for 2005 was related to the Japanese life company operating unit. The loss was determined by projecting future cash ows for this unit and discounting them at a rate of 5 percent. Solution to 2. Because the impairment charge for 2005 represented all of the goodwill of the Japanese life company operating unit, subsequent goodwill impairments for this operating unit should not occur. Because goodwill can signicantly inuence the comparability of nancial statements between companies using different accounting methods, analysts sometimes make certain goodwill-related adjustments to a companys nancial statements. The objective of such adjustments is to remove any distortion that goodwill and its recognition, amortization, and impairment might create. Adjustments include the following: Subtracting goodwill from assets and use of this adjusted data to compute nancial ratios. Excluding goodwill impairment charges from income and use of this adjusted data when reviewing operating trends. Evaluating future business acquisitions by taking into account the purchase price paid relative to the net assets and earnings prospects of the acquired company. If the amount an acquirer pays to buy another company is less than the fair value of the net identiable assets acquired, it is not recognized as negative goodwill. Instead, a gain is recognized. However, before any gain is recognized, the acquirer should reassess the cost of c08.indd 334 9/17/08 11:41:22 AM Chapter 8 International Standards Convergence 335 acquisition and the fair values attributed to the acquirees identiable assets, liabilities, and contingent liabilities. As noted, goodwill arises in connection with acquisitions. Several other aspects of international accounting for acquisitions may be noted. Under the purchase method of accounting,10 the acquisition price must be allocated to all of the acquired companys identiable tangible and intangible assets, liabilities, and contingent liabilities. The assets and liabilities of the acquired entity are combined into the nancial statements of the acquiring company at their fair values on the acquisition date. Because the acquirers assets and liabilities, measured at their historical costs, are combined with the acquired companys assets and liabilities, measured at their fair market value on the acquisition date, the acquirers pre- and postmerger balance sheets are often not easily compared. Furthermore, under the purchase method, the income statement and the cash ow statements include the operating performance of the acquiree from the date of the acquisition forward. Operating results prior to the acquisition are not restated and remain the same as historically reported by the acquirer. Consequently, although the nancial statements of the acquirer will reect the reality of the acquisition, they will not be comparable before and after the acquisition. 3.6. Intangible Assets Other than Goodwill IAS No. 38 includes standards for reporting certain intangible assets other than goodwill. These intangible assets are referred to as identiable intangible assets. Identiable intangible assets arise either from contractual or other legal rights, or must be capable of being separated from the company and sold, transferred, licensed, rented, or exchanged. The standards for reporting identiable intangible assets, contained in IAS No. 38, provide that an intangible asset is recognizedat costif it is probable that the future economic benets attributable to the asset will ow to the company and if the cost of the asset can be measured reliably. Only those intangibles that have been purchased or manufactured (in limited instances) may be recognized as assets. Internally produced items, such as customer lists, are not recognized as assets. Given that it meets the criteria for recognition, an intangible asset with a nite useful life is amortized on a systematic basis over the best estimate of its useful life. In other words, the cost of the identiable intangible asset is allocated systematically over the assets useful life. If the identiable intangible asset does not have a nite useful life, it is not amortized. Instead, the asset is tested at least annually for impairment as with goodwill. Testing for impairment involves evaluating whether the current value of an asset is materially lower than its carrying value. Like U.S. GAAP, international standards allow identiable intangibles to be reported in the nancial statements at cost less amortization and less any impairment charges. Unlike U.S. GAAP, international accounting standards allow another alternative: reporting identiable intangible assets at a revalued amount. When identiable intangible assets are revalued, they are reported in the nancial statements at fair value as of the revaluation date, less accumulated amortization subsequent to the revaluation. Any revaluation increase is reported as part of equity, unless it is reversing a previous revaluation decrease. Any revaluation decrease is reported in prot and loss unless it is reversing a previous revaluation increase. U.S. GAAP prohibits revaluations. Companies also have intangible assets that accounting rules do not include as items that can be recorded in nancial statements; these intangible assets include management skill, 10 IFRS No. 3. c08.indd 335 9/17/08 11:41:30 AM 336 International Financial Statement Analysis a positive corporate culture, trademarks, name recognition, a good reputation, proprietary products, and so forth. However, the costs related to these intangible assetssuch as training, advertising, and researchmust be expensed. An analyst must be aware of the potential value of such unrecorded assets. 3.7. Provisions (Nonnancial Liabilities) Nonnancial liabilities include provisions, which are liabilities of uncertain timing or amount, such as warranty obligations, and contingent liabilities, which are liabilities contingent on the occurrence of some event. The standards for reporting nonnancial liabilities, contained in IAS No. 37, provide that a company should recognize nonnancial liabilities when it has a present obligation as a result of a past event and the company can reliably estimate the cost to settle the obligation. The amount recognized as a nonnancial liability should be the best estimate, as of the balance sheet date, of the cost that will be required to settle the obligation. 4 . THE INCOME STATEMENT A number of standards, including the Framework (described above), apply to the majority of the components of the income statement. These include standards describing requirements for companies adopting international nancial standards for the rst time, requirements for presenting nancial statements under international nancial standards, and accounting for changes in accounting principles and estimates.11 Other standards apply more directly to specic components of the income statement. The sections below describe the key aspects of the standards relevant to each component in the same order as the components described in the chapter discussing the income statement. 4.1. Revenue Recognition: General The IASB Framework denes income as including both revenue and gains. In IAS No. 18, revenue is dened as the gross inow of economic benets during the period, arising in the ordinary course of activities, or resulting in increases in equity other than contributions by equity participants. IAS No. 18 addresses how revenue is to be measured, namely, at the fair value of consideration received. The standard also addresses the timing of revenue recognition. Some criteria for recognizing revenue are common to both the sale of goods and the provision of services: It must be possible to reliably measure the amount of revenue and costs of the transaction, and it must be probable that economic benets of the transaction will ow to the seller. In addition, to recognize revenue from the sale of goods, it is necessary that the risks and rewards of ownership pass to the buyer and that the seller not have continued control over the goods sold. To recognize revenue from the provision of services, it is necessary that the stage of completion of the service can be measured reliably. U.S. GAAP denes revenue in terms of actual or expected cash ows, and, for revenue recognition, U.S. GAAP focuses extensively on realization and earned status. U.S. GAAP also 11 IFRS No. 1, IAS No. 1, and IAS No. 8, respectively. c08.indd 336 9/17/08 11:41:31 AM Chapter 8 International Standards Convergence 337 provides more extensive guidance than IFRS regarding industry-specic issues. Despite such differences, the key principles are similar in U.S. GAAP and IFRS. 4.2. Revenue Recognition for Construction Contracts IAS No. 11 deals with the recognition of construction contract revenue and costsin particular, the allocation of contract revenue and costs to the accounting periods in which construction work is performed. The standard applies to the accounting for construction contracts in the nancial statements of contractors. A construction contract is a contract specically negotiated for the construction of an asset or a combination of assets that are closely interrelated or interdependent in terms of their design, technology, and function, or their ultimate purpose or use. Construction contracts include those for the construction or restoration of assets and the restoration of the environment. When the outcome of a construction contract can be estimated reliably, revenue and costs (and, therefore, prot) should be recognized based on the stage of completion (percentage of completion method). When the outcome of a contract cannot be reliably estimated, revenue should be recognized to the extent that it is probable to recover contract costs. This requirement differs from U.S. GAAP, which requires that the completed contract method be used in such cases. 4.3. Cost of Sales Two international accounting standards, IAS No. 2 (accounting for the cost of inventories) and IAS No. 18 (revenue recognition), have an effect on cost of sales. As noted, under international standards, LIFO is not an acceptable method for the valuation of inventory. Consequently, nancial statements prepared according to U.S. GAAP may differ signicantly from those prepared under IFRS. U.S. GAAP does, however, require that companies using LIFO disclose the information required to enable a user of nancial statements to adjust the inventory and cost of sales gures to a basis comparable with nancial statements prepared using IFRS. 4.4. Administrative Expenses (Including Employee Benets) Administrative (or operating) expenses typically include overheads related to employee costs. The IASB Framework denes expenses to include losses because expenses are decreases in economic benets that result in a decrease in equity. The inclusion of losses as expenses contrasts with U.S. GAAP, which differentiates expenses from losses by restricting the term expenses to refer to those outows (of cash or the equivalent) that relate to the entitys ongoing primary business operations. One type of administrative expense with specic international accounting principles is the expense related to employee benets, such as salaries, bonuses, postemployment benets, and termination benets. Recognition and measurement principles, as well as the disclosure requirements, are provided in IAS No. 19. IFRS No. 2 deals with equity compensation benets, such as share options. 4.5. Depreciation Expenses As discussed above, depreciation is the process of recognizing the costs of xed assets over time by systematically decreasing the assets value and reporting a commensurate expense on c08.indd c08.indd 337 9/17/08 11:41:31 AM 338 International Financial Statement Analysis the income statement. The term depletion is used for this process when the asset is a natural resource, and the term amortization is used for this process when the asset is an intangible asset. The cost of acquiring land is not depreciated. International standards require companies to review the depreciation method applied to an asset at least at each nancial year-end. If there has been a signicant change in the expected pattern of consumption of the future economic benets embodied in the asset, companies must change the depreciation method to reect the changed pattern. Similar to U.S. GAAP, such a change is accounted for as a change in accounting estimate12 and thus reected on future nancial statements. Various depreciation methods exist, including the straight-line method, which allocates evenly the cost of a long-lived asset over its estimated useful life, and accelerated methods, which allocate a greater proportion of the assets cost in the earlier years of its useful life, thus accelerating the timing of the depreciation expense. In choosing the appropriate depreciation method, IFRS requires: The depreciable amount is allocated on a systematic basis over the useful life. The method used must reect the pattern of expected consumption. Whether the straight-line depreciation method or an accelerated method is used, the method complies with IFRS only if it reects the pattern of the expected consumption of the assets. 4.6. Finance Costs In general, borrowing costsdened as interest and other costs incurred by an entity in connection with the borrowing of fundsare expensed in the period incurred. IFRS offers an alternative to expensing borrowing costs immediately. When borrowing costs are incurred in connection with the acquisition, construction, or production of an asset that takes a long time to be ready for its intended use, such borrowing costs can be added to the total cost of the asset.13 In other words, rather than expensing these costs immediately, a company has the alternative to capitalize these borrowing costs and depreciate them over time. This topic is an item on the list of IASBs short-term convergence projects as of December 2006. U.S. GAAP requires the capitalization of interest costs for assets that take a substantial time to complete. 4.7. Income Tax Expense IAS No. 12 prescribes the accounting treatment for income taxes and specically addresses issues relating to the carrying amount of assets as well as transactions and other events of the current period, which are recognized in the entitys nancial statements. As with U.S. GAAP, international standards provide for the accounting treatment when differences exist between accounting methods allowed by the relevant taxing authority and accounting methods allowed for nancial statement reporting (i.e., IFRS). Where differences exist between methods allowable by taxing authorities and by IFRS, differences will exist between taxable prot and nancial statement pretax prot (also referred to as accounting 12 IAS No. 8. IAS No. 23. 13 c08.indd 338 9/17/08 11:41:31 AM Chapter 8 International Standards Convergence 339 prot). Such differences give rise to differences in the value of a companys assets and liabilities recorded in its nancial statements (balance sheet) and the tax bases of those assets and liabilities. In turn, these differences can result in future taxes payable or receivable, so-called deferred tax liabilities and deferred tax assets. The primary differences between U.S. GAAP and IFRS are attributable to differences in exceptions to the application of the principles (i.e., differences in the scope of coverage of the principles). 4.8. Nonrecurring Items Nonrecurring items generally include discontinued operations, accounting changes, and unusual or infrequent items. As noted, analysts typically nd it useful to break reported earnings down into recurring and nonrecurring components. Recurring earnings are viewed as permanent or sustainable, whereas nonrecurring earnings are considered to be somewhat random and unsustainable. Therefore, analysts often exclude the effects of nonrecurring items when performing a short-term analysis of an entity (e.g., estimating next years earnings). However, even so-called nonrecurring events, such as sales of a part of a business, tend to recur from time to time, so analysts may include some average (per year) amount of nonrecurring items for longer-term analyses. IFRS and U.S. GAAP differ in their treatment of these issues, although as with other areas, convergence is occurring.14 For discontinued operations, IFRS changed to align with U.S. GAAP. IFRS No. 5 generally converges with SFAS No. 144. The new international guidance, like the U.S. standards, requires that discontinued operations be reported when a company disposes of one of its business components (or when the component is being held for sale) and will no longer have management involvement. For accounting changes, U.S. GAAP changed to align with IFRS. SFAS No. 154, issued in June 2005, generally converges with IAS No. 8. Changes in accounting principles are accounted for retrospectively, and changes in accounting estimates are accounted for prospectively. For extraordinary items, convergence has not yet been achieved. U.S. GAAP continues to allow extraordinary items (i.e., items that are both unusual in nature and infrequent in occurrence) to be reported separately from net income. Unlike U.S. GAAP, IFRS do not distinguish between items that are and are not likely to recur. Furthermore, IFRS do not permit any items to be classied as extraordinary items. However, IFRS do require the disclosure of all material information that is relevant to understanding a companys performance. The analyst generally can use this information, together with information from outside sources, to estimate amounts of recurring and nonrecurring items. 5 . THE CASH FLOW STATEMENT Both international standards and U.S. GAAP require that a statement of cash ows be included among a companys full set of nancial statements (FASB Statement No. 95, Statement of Cash Flows, and IAS No. 7, Cash Flow Statements) showing the changes in cash and cash equivalents over an accounting period. 14 This topic is discussed in D. Herrmann and I. P. N. Hauge, Convergence: In Search of the Best, Journal of Accountancy online edition, January 2006: www.aicpa.org/PUBS/JOFA/jan2006/herrmann.htm. c08.indd 339 9/17/08 11:41:32 AM 340 International Financial Statement Analysis EXHIBIT 8-3 Statement of Cash Flows: Classication of Interest and Dividends under International and U.S. Standards Category Classication in IFRS vs. U.S. GAAP Cash ows from OPERATING activities Cash from principal revenue-producing activities of the entity (i.e., cash receipts from customers less cash payments to suppliers and employees). Interest received IFRS alternatives: operating or investing section U.S. GAAP: mandated operating section Dividends received IFRS alternatives: operating or investing section U.S. GAAP: mandated operating section Interest paid IFRS alternatives: operating or nancing section U.S. GAAP: mandated operating section Dividends paid (IFRS only) IFRS alternatives: operating or nancing section Cash ows from INVESTING activities Purchases of long-term assets and other investments not included in cash equivalents; proceeds on sale. Interest received (IFRS only) IFRS alternatives: operating or investing section Dividends received (IFRS only) IFRS alternatives: operating or investing section Cash ows from FINANCING activities Cash from issuance or repayment of equity capital and/or long-term debt. Dividends paid IFRS alternatives: operating or nancing section U.S. GAAP: mandated nancing section Interest paid IFRS alternatives: operating or nancing section Both sets of standards require that the cash ow statement include sections covering operating, investing, and nancing activities of the company. The differences between international and U.S. standards arise in the classication of certain cash ows. International standards allow companies to report cash inows from interest and dividends as either operating or investing activities and cash outows for interest and dividends as either operating or nancing activities (see Exhibit 8-3). In contrast, U.S. standards require the following: Interest and dividends received are classied as inows from operating activities; interest paid is classied as an outow for operating activities; and dividends paid are classied as nancing activities. 6 . STANDARD SETTERS AGENDA FOR CONVERGENCE As noted in the introduction to this chapter, in February 2006, the FASB and IASB published a memorandum of understanding outlining a road map for convergence over the next several years. This section summarizes the standard setters agenda for convergence over the period 2006 to 2008. By 2008, the IASB and FASB aim to conclude whether any major differences should be eliminated in the following topics for short-term convergence, and if so, to complete the work to do so: fair value option (allow companies to report nancial assets and liabilities at c08.indd 340 9/17/08 11:41:32 AM Chapter 8 341 International Standards Convergence fair value on a contract-by-contract basis, converging to IFRS); borrowing costs (eliminate alternative to expense immediately when in connection with longer-term projects, converging to U.S. GAAP); research and development; impairment; segment reporting; subsequent events; and income taxes. Topics that are already on an active agenda for IASB and/or FASB include business combinations, consolidations, fair value measurement guidance, liabilities and equity distinctions, performance reporting, postretirement benets (including pensions), and revenue recognition. Joint IASB and FASB goals for 2008 have been established for each of these topics. 7 . EFFECT OF DIFFERENCES BETWEEN ACCOUNTING STANDARDS As we note throughout this chapter, differences between international and U.S. accounting standards are decreasing as convergence between the two sets of standards occurs. Differences that do exist have an effect on commonly used nancial ratios. We discuss several major differences here. If comparing a U.S. company that uses LIFO accounting with an international company for whom this method is not allowable, an analyst will make adjustments. Specically, using nancial statement note disclosures, the analyst will adjust the U.S. companys prots (gross, operating, and net), ending inventory, and total assets. These adjustments will affect certain protability, solvency, liquidity, and activity ratios. For comparison purposes, inventory is adjusted from LIFO to FIFO by adding the LIFO reserve to the LIFO inventory value on the balance sheet. Under U.S. GAAP, a company must disclose the LIFO reserve amount in the nancial statement notes if the LIFO method is followed. In addition, cost of goods sold is adjusted from LIFO to FIFO by subtracting the net increase in the LIFO reserve that occurred during the scal year. Example 8-3 illustrates a LIFO to FIFO conversion. EXAMPLE 8-3 and Ratios LIFO Effects on Financial Statements Buccaneer Corporation prepares its nancial statements (Exhibits 8-4 and 8-5) in accordance with U.S. GAAP and uses the LIFO inventory method. During the year, Buccaneers LIFO reserve increased from $40 million to $64 million. The income tax rate is 30 percent. EXHIBIT 8-4 Income Statement and Balance Sheet under LIFO and FIFO Inventory Accounting ($ millions) Account LIFO Method LIFO to FIFO Adjustment FIFO Method Sales 1,800.0 Cost of sales 1,060.0 (24.0) 1,036.0 Gross prot 740.0 24.0 764.0 Operating expenses 534.0 534.0 Income before taxes c08.indd 341 1,800.0 206.0 24.0 230.0 9/17/08 11:41:33 AM 342 International Financial Statement Analysis Account LIFO Method LIFO to FIFO Adjustment FIFO Method Income taxes 61.8 (7.2) 69.0 Net income 144.2 (16.8) 161.0 Cash 80.0 80.0 Inventory 356.0 64.0 420.0 Other current assets 344.0 344.0 Fixed assets, net 1,120.0 1,120.0 Total assets 1,900.0 64.0 1,964.0 Current liabilities 200.0 200.0 Noncurrent liabilities 424.0 19.2 443.2 Common stock 840.0 840.0 Retained earnings 436.0 Total liabilities and equity 44.8 480.8 1,900.0 64.0 1,964.0 The net increase in Buccaneers LIFO reserve during the scal year was $24 million ($64 million $40 million). To adjust from LIFO to FIFO, the net increase in the LIFO reserve must be subtracted from the LIFO reported cost of sales. (A net decrease in the LIFO reserve during the year would be added to LIFO reported cost of sales in a LIFO to FIFO conversion.) Accordingly, because reported gross prots are $24 million higher after the FIFO conversion, income tax expense will increase by $7.2 million ($24 million 30% income tax rate), resulting in an increase to net income of $16.8 million. For the balance sheet conversion, the year-end LIFO reserve of $64 million is added to the LIFO reported inventory, resulting in an increase of $64 million to both inventory and total assets under FIFO. In addition, the deferred income tax liabilities will increase by $19.2 million ($64 million 30% income tax rate), and retained earnings will increase by $44.8 million ($64 million 70% aftertax retention). Comparative selected protability, solvency, liquidity, and activity ratios for Buccaneer Corporation under the two inventory methods are given in Exhibit 8-5. EXHIBIT 8-5 Financial Ratios under LIFO and FIFO Inventory Accounting Ratio Formula LIFO Method FIFO Method Net prot margin Net sales 8.01% 8.94% Financial leverage Total assets Total equity 1.489 1.487 Current ratio Current assets liabilities 3.90 4.22 Inventory turnover c08.indd 342 Net income Cost of sales inventory 2.98 turns 2.47 turns Current Ending 9/17/08 11:41:36 AM Chapter 8 343 International Standards Convergence If comparing an IFRS company with a U.S. company that reports extraordinary items separately from net income but reports certain unusual items as part of operating income, an analyst will examine the nancial statement notes to identify similar items that have received different reporting treatment. If comparing an IFRS company, which has written up the value of its intangible or tangible long-term assets, with a U.S. company, an analyst will eliminate the effect of the write-ups in calculating asset-based ratios. Example 8-4 illustrates a revaluation adjustment conversion. EXAMPLE 8-4 Analyst Adjustments to Revaluations in IFRS/U.S. GAAP Comparisons Aramis Ltd. prepares its nancial statements in accordance with IFRS. During the current year, Aramis revalued its xed assets upward by a total of 75 million to better reect its present fair market value. The analyst must reverse the revaluation adjustments that Aramis has made if Aramis is to be compared with a company that complies with U.S. GAAP. For Aramis, the analyst will reduce both xed assets and other equity by the upward revaluation of 75 million. Exhibit 8-6 shows these adjustments. EXHIBIT 8-6 Analyst Adjustments to Revaluation ( millions) Account Unadjusted Reversal of Revaluation Post-Adjustment Sales 1,700.0 1,700.0 Cost of sales 1,040.0 1,040.0 Gross prot 660.0 660.0 Operating expenses 475.0 475.0 Income before taxes 185.0 185.0 Income taxes 74.0 74.0 Net income 111.0 111.0 1,150.0 (75.0) 1,075.0 Inventory 310.0 310.0 Other current assets 120.0 120.0 20.0 20.0 1,600.0 (75.0) 1,525.0 Noncurrent liabilities 370.0 370.0 Current liabilities 225.0 225.0 Contributed capital 550.0 550.0 455.0 (75.0) 380.0 1,600.0 (75.0) 1,525.0 Fixed assets, net Cash Total assets Earned and other equity Total liabilities and equity c08.indd 343 9/17/08 11:41:48 AM 344 International Financial Statement Analysis Selected comparative performance ratios for Aramis under the two approaches are given in Exhibit 8-7. EXHIBIT 8-7 Financial Ratios Pre- and Post-Adjustment Ratio Formula Unadjusted Post-adjustment Return on assets Net income Total assets 6.94% 7.28% Return on equity Net income Total equity 11.04% 11.94% Asset turnover Net sales Total assets 1.063 turns 1.115 turns Equity turnover Net sales Total equity 1.692 turns 1.828 turns Financial leverage Total assets 1.592 1.640 Total equity 8 . SUMMARY The IASB is the standard-setting body of the IASC Foundation. The objectives of the IASC Foundation are to develop a single set of global nancial reporting standards and to promote the use of those standards. In accomplishing these objectives, the IASC Foundation explicitly aims to bring about convergence between national standards and international standards. Many national accounting standard setters have adopted, or are in the process of adopting, the IFRS. This chapter discussed both the IFRS Framework and the IFRS standards for reporting accounting items on the balance sheet, income statement, and cash ow statement. Key points include the following: The objectives of nancial statements, as stated in the Framework, are to provide information about the nancial position, performance, and changes in nancial position of an entity; this information should be useful to a wide range of users for the purpose of making economic decisions. To achieve the objective of providing useful information, nancial statements should have the following qualitative characteristics: relevance, predictive value, faithful representation, neutrality, and veriability. Financial statements provide information on the nancial position and performance of an entity by grouping the effects of transactions and other events into the following ve broad elements: assets, liabilities, equity, income, and expenses. Both IFRS and U.S. GAAP require companies to present basic nancial statements: balance sheet, income statement, statement of cash ows, and statement of changes in equity. One major difference between IFRS and U.S. GAAP affecting all three statements involves inventories: U.S. GAAP allows the LIFO method for inventory costing, whereas IFRS does not. Another major balance sheet difference between IFRS and U.S. GAAP is that IFRS allows companies to revalue property, plant, and equipment as well as intangible assets. Accounting for investments is another area of difference: IFRS uses a voting control model to determine need for consolidation, whereas U.S. GAAP uses a dual model based on voting control and economic control. c08.indd 344 9/17/08 11:41:57 AM Chapter 8 International Standards Convergence 345 An important difference between IFRS and U.S. GAAP is the treatment of some nonrecurring items. IFRS does not permit any items to be classied as extraordinary items. International standards allow companies to report cash inows from interest and dividends as relating to either operating or investing activities, and cash outows for interest and dividends as relating to either operating or nancing activities. Convergence between IFRS and U.S. GAAP has increased signicantly over the past few years and is continuing. Analysts should know how to make nancial statement adjustments to better compare IFRS reporting companies with those companies reporting under U.S. GAAP. P RACTICE PROBLEMS 1. According to the IFRS Framework, which of the following is a qualitative characteristic related to the usefulness of information in nancial statements? A. Neutrality B. Timeliness C. Accrual basis 2. Under the IFRS Framework, changes in the elements of nancial statements are most likely portrayed in the A. balance sheet. B. income statement. C. cash ow statement. 3. Under IASB standards, which of the following categories of marketable securities is most likely to incur an asymmetrical treatment of income and changes in value? A. Held for trading B. Held to maturity C. Available for sale 4. According to IASB standards, which of the following inventory methods is most preferred? A. Specic identication B. Weighted average cost C. First in, rst out (FIFO) 5. According to IASB standards, which of the following inventory methods is not acceptable? A. Weighted average cost B. First in, rst out (FIFO) C. Last in, rst out (LIFO) 6. Under IASB standards, inventory write-downs are A. not allowed. B. allowed but not reversible. C. allowed and subject to reversal. c08.indd 345 9/17/08 11:41:59 AM 346 International Financial Statement Analysis 7. According to IASB standards, property, plant, and equipment revaluations are A. not allowed. B. allowed for decreases only. C. allowed for both increases and decreases. 8. Under IASB standards, a joint venture interest is accounted for by using A. consolidation. B. the equity method or consolidation. C. the equity method or proportionate consolidation. 9. Under IASB standards, goodwill A. may be written off when acquired. B. is subject to an annual impairment test. C. is amortized over its expected useful life. 10. Under IASB standards, negative goodwill A. must be recorded as a gain. B. is prorated to the noncurrent assets. C. is accounted for as an extraordinary item. 11. Under IASB standards, an identiable intangible asset with an indenite life A. may be written off when acquired. B. is amortized over a 20-year period. C. is accounted for in the same manner as goodwill. 12. Under IASB standards, identiable intangible assets are A. only revalued downward, with the decrease reported to prot and loss. B. revalued upward and reported to equity when reversing a previous revaluation decrease. C. revalued upward and reported to prot and loss when reversing a previous revaluation decrease. 13. Under IASB standards, when the outcome of a construction contract cannot be estimated reliably, revenue and costs should be A. recognized by using the completed contract method. B. recognized by using the percentage of completion contract method. C. recognized to the extent that it is probable to recover contract costs. 14. Under IASB standards, xed asset depreciation methods must be A. rational and systematic. B. rational and reviewed at least annually. C. systematic and reect the pattern of expected consumption. 15. Under IASB standards, cash inows for the receipt of interest and dividends are A. operating cash ows. B. either operating or investing cash ows. C. either investing or nancing cash ows. c08.indd c08.indd 346 9/17/08 11:41:59 AM Chapter 8 International Standards Convergence 347 16. Under IASB standards, cash outows for the payment of interest are A. operating cash ows. B. either investing or nancing cash ows. C. either operating or nancing cash ows. 17. Under IASB standards, cash outows for the payment of dividends are A. nancing cash ows. B. either operating or investing cash ows. C. either operating or nancing cash ows. 18. When comparing a U.S. company that uses LIFO accounting with an IFRS company that uses FIFO accounting, an analyst will A. make no adjustment if the adjustment data are unavailable. B. adjust either company to achieve comparability with the other. C. adjust the U.S. company to achieve comparability with the IFRS company. 19. When comparing a U.S. company with an IFRS company that has written up the value of its intangible assets, an analyst will eliminate the effect of the write-ups in calculating the A. gross margin. B. earnings per share. C. nancial leverage multiplier. c08.indd c08.indd 347 9/17/08 11:42:00 AM c08.indd c08.indd 348 9/17/08 11:42:00 AM CHAPTER 9 F INANCIAL STATEMENT ANALYSIS: APPLICATIONS Thomas R. Robinson, CFA CFA Institute Charlottesville, Virginia Hennie van Greuning, CFA World Bank Washington, DC Elaine Henry, CFA University of Miami Miami, Florida Michael A. Broihahn, CFA Barry University Miami, Florida L EARNING OUTCOMES After completing this chapter, you will be able to do the following: Evaluate a companys past nancial performance and explain how a companys strategy is reected in past nancial performance. Prepare a basic projection of a companys future net income and cash ow. 349 c09.indd 349 9/17/08 11:42:33 AM 350 International Financial Statement Analysis Describe the role of nancial statement analysis in assessing the credit quality of a potential debt investment. Discuss the use of nancial statement analysis in screening for potential equity investments. Determine and justify appropriate analyst adjustments to a companys nancial statements to facilitate comparison with another company. 1 . INTRODUCTION This chapter presents several important applications of nancial statement analysis. Among the issues we will address are the following: What are the key questions to address in evaluating a companys past nancial performance? How can an analyst approach forecasting a companys future net income and cash ow? How can nancial statement analysis be used to evaluate the credit quality of a potential xed-income investment? How can nancial statement analysis be used to screen for potential equity investments? How can differences in accounting methods affect nancial ratio comparisons between companies, and what are some adjustments analysts make to reported nancials in the interests of comparability? Prior to undertaking any analysis, an analyst should explore the purpose and context of the analysis because purpose and context guide further decisions about the approach, the tools, the data sources, and the format in which to report results of the analysis, and also suggest which aspects of the analysis are most important. The analyst should then be able to formulate the key questions that the analysis must address. The questions will suggest the data the analyst needs to collect to objectively address the questions. The analyst then processes and analyzes the data to answer these questions. Conclusions and decisions based on the analysis are communicated in a format appropriate to the context, and follow-up is undertaken as required. Although this chapter will not formally present applications as a series of steps, the process just described is generally applicable. Section 2 describes the use of nancial statement analysis to evaluate a companys past nancial performance, and section 3 describes basic approaches to projecting a companys future nancial performance. Section 4 presents the use of nancial statement analysis in assessing the credit quality of a potential debt investment. Section 5 concludes the survey of applications by describing the use of nancial statement analysis in screening for potential equity investments. Analysts often encounter situations in which they must make adjustments to a companys reported nancial results to increase their accuracy or comparability with the nancials of other companies. Section 6 illustrates several typical types of analyst adjustments. Section 7 summarizes the chapter, and practice problems in the CFA Institute multiple-choice format conclude the chapter. c09.indd 350 9/17/08 11:42:34 AM Chapter 9 Financial Statement Analysis: Applications 351 2 . APPLICATION: EVALUATING PAST FINANCIAL PERFORMANCE Analysts often analyze a companys past nancial performance to determine the comparability of companies for a market-based valuation,1 to provide a basis for a forward-looking analysis of the company, or to obtain information for evaluating the companys management. An evaluation of a companys past performance addresses not only what happened (i.e., how the company performed) but also why it happenedthe causes behind the performance and how the performance reects the companys strategy. Evaluative judgments assess whether the performance is better or worse, compared with a relevant benchmark such as the companys own historical performance, a competitors performance, or market expectations. Some of the key analytical questions include: How have corporate measures of protability, efciency, liquidity, and solvency changed over the period being analyzed? Why? How do the level and trend in a companys protability, efciency, liquidity, and solvency compare with the corresponding results of other companies in the same industry? What explains any differences? What aspects of performance are critical for a company to successfully compete in its industry, and how did the company perform relative to those critical performance aspects? What are the companys business model and strategy, and how did they inuence the companys performance as reected, for example, in its sales growth, efciency, and protability? Data available to answer these questions include the companys (and its competitors) nancial statements, materials from the companys investor relations department, corporate press releases, and nonnancial statement regulatory lings, such as proxies. Useful data also include industry information (e.g., from industry surveys, trade publications, and government sources), consumer information (e.g., from consumer satisfaction surveys), and information that is gathered by the analyst rsthand (e.g., through on-site visits). Processing the data will typically involve creating common-size nancial statements, calculating nancial ratios, and reviewing or calculating industry-specic metrics. Example 9-1 illustrates the effects of strategy on performance and the use of basic economic reasoning in interpreting results. EXAMPLE 9-1 A Change in Strategy Reected in a Change in Financial Performance In analyzing the historical performance of Motorola (NYSE: MOT) as of the beginning of 2006, an analyst might refer to the information presented in Exhibit 9-1. Panel A presents selected data for Motorola from 2003 to 2005. Panel B presents an excerpt from 1 Stowe, Robinson, Pinto, and McLeavey (2002) describe market-based valuation as using price multiples ratios of a stocks market price to some measure of value per share (e.g., price-to-earnings ratios). Although the valuation method may be used independently of an analysis of a companys past nancial performance, such an analysis may explain reasons for differences in companies price multiples. c09.indd c09.indd 351 9/17/08 11:42:34 AM 352 International Financial Statement Analysis the segment footnote, giving data for Motorolas mobile device business segment (the segment that manufactures and sells cellular phones). Panel C presents excerpts from the Management Discussion and Analysis (MD&A) describing the results of the segment. Looking back to 1996, Motorola was the market leader with its StarTAC cellular phone, but since 1998, Nokia had become the largest player in the global mobile phone market. The mood inside Motorola was grim in early 2003. Nokia, whose candy bar phone designs were all the rage, had snatched Motorolas No. 1 worldwide market share (Fortune, 12 June 2006, p. 126). Following the arrival of new CEO Edward Zander at the end of 2003, Motorola radically revamped its strategy for new products: Design leads, and engineering follows (Business Week, 8 August 2005, p. 68). Motorolas strategy thereafter evolved to include a strong consumer marketing orientation to complement its historically strong technological position. The company launched 60 new products in 2004, an important one of which was the RAZR cellular phone with an ultra-thin prole that served to differentiate it from competitors offerings. The successful introduction of new products in 2004 enabled the company to gain market share and increase protability. The changes at Motorola extended beyond the product strategy. An article in Barrons noted that in addition to the shift in product strategy, Motorola has undergone a nancial overhaul. . . . The company has reduced the percentage of working capital to sales to less than 12 percent from about 22 percent, a sign of increased efciency (Barrons, 25 July 2005, p. 23). EXHIBIT 9-1 Selected Data for Motorola (Years Ended 31 December) ($ millions) 2005 2004 2003 $36,843 $31,323 $23,155 11,777 10,354 7,503 4,696 3,132 1,273 35,649 30,922 26,809 Panel A. Data for Motorola Net sales Gross margin Operating earnings Total assets Panel B. Data for Motorolas Mobile Device Segment from Segment Footnote Net sales 21,455 17,108 11,238 Operating earnings 2,198 1,728 511 Assets 7,548 5,442 3,900 Panel C. Excerpt from MD&A 2004 c09.indd 352 Our wireless handset business had a very strong year in 2004, reected by a 53% increase in net sales, a 257% increase in operating earnings and increased market share. The increase in net sales was driven by an increase in unit shipments, which increased 39% in 2004 compared to 2003, and improved ASP [average selling price], which increased 15% in 2004 compared to 2003. . . . This increase in net sales, accompanied by process improvements in the supply chain and benets from ongoing cost reduction activities resulted in increased gross margin, which drove the increase in overall operating earnings for the business. . . . 9/17/08 11:42:36 AM Chapter 9 2005 Financial Statement Analysis: Applications 353 Net sales increased by $4.3 billion, or 25%, to $21.5 billion and operating earnings increased by 27% to $2.2 billion. We shipped 146 million handsets in 2005, up 40% from 2004. . . . The increase in unit shipments was attributed to an increase in the size of the total market and a gain in the segments market share. The gain in market share reected strong demand for GSM handsets and consumers desire for the segments compelling products that combine innovative style leading technology. The segment had increased net sales in all regions of the world as a result of an improved product portfolio, strong market growth in emerging markets, and high replacement sales in more mature markets. Average selling price (ASP) decreased approximately 10% compared to 2004, driven primarily by a higher percentage of lower-tier, lower-priced handsets in the overall sales mix. Source: Motorolas 2005 10-K led 2 March 2006 and 2004 10-K led 4 March 2005. Using the information provided, address the following: 1. Typically, products that are differentiated either through recognizable brand names, proprietary technology, or both can be sold at a higher price than commodity products. A. In general, would the selling prices of differentiated products be more directly reected in a companys operating prot margin or gross prot margin? B. Does Motorolas segment footnote (Panel B) reect a successful differentiation strategy in its mobile devices business? C. Based on the excerpts from Motorolas MD&A (Panel C), compare and contrast the drivers of the growth in sales in Motorolas mobile device business in 2005 with the drivers in 2004. 2. The Barrons article refers to working capital as a percentage of sales, an indicator of efciency. A. In general, what other ratios indicate a companys efciency? B. Does the nancial data for Motorola shown in this example reect increased efciency? Solutions to 1: A. Sales of differentiated products at premium prices would generally be reected more directly in the gross prot margin, increasing it, all else equal. The effect of premium pricing generally would also be reected in a higher operating margin. However, expenditures on advertising and/or research in support of differentiating features mean that the effect on operating prot margins is often weaker than the effect on gross prot margins. B. Although Motorolas segment footnote does not include information on gross margins by segment, it does include sufcient information for calculating operating prot margins, which should also be positively correlated with premium pricing. Dividing operating earnings by net sales, we nd that operating margins in the mobile devices business increased from 4.5 percent ($511/11,238) in 2003 to 10.1 percent ($1,728/17,108) in 2004 and 10.2 percent ($2,198/21,455) in 2005. The data indicate successful results from the differentiation strategy in 2004, but no further meaningful improvement in 2005. c09.indd 353 9/17/08 11:42:49 AM 354 International Financial Statement Analysis C. In both years, the MD&A attributes sales growth to an increase in Motorolas share of the handset market. The 2005 MD&A explicitly mentions growth of the total wireless handset market as another factor in sales growth for that year. The 2004 results beneted from both a 39 percent increase in units sales (compared with 2003) and a 15 percent increase in ASP. The sources of growth shifted somewhat from 2004 to 2005. Lower-tier, lower-price handsets became a larger part of Motorolas product mix in 2005, and ASP declined by 10 percent. Because sales grew by 25.4 percent [ (21,455 17,108)/17,108] in 2005, it is clear, however, that the growth in handset unit sales more than overcame the decline in ASP. Solutions to 2: A. Other ratios that indicate a companys efciency include asset turnover, xedasset turnover, working capital turnover, receivables turnover, and inventory turnover. In addition, efciency is indicated by days of inventory on hand, days of sales outstanding, and days of payables. B. Yes, they do indicate increased efciency. The data given permit the calculation of one efciency ratio, total asset turnover. Motorolas total asset turnover improved from 0.864 (23,155/26,809) for 2003 to 1.013 (31,323/30,922) for 2004 to 1.033 (36,843/35,649) for 2005. In calculating nancial statement ratios, an analyst needs to be aware of the potential impact of companies reporting under different accounting standards, such as U.S. generally accepted accounting principles (U.S. GAAP) and International Financial Reporting Standards (IFRS). Furthermore, even within a given set of accounting standards, companies still have discretion to choose among acceptable methods and also must make certain estimates even when applying the same method. Therefore, it may be useful to make selected adjustments to a companys nancial statement data in order to facilitate comparisons with other companies or with the industry overall. Examples of such analyst adjustments will be discussed in section 6. Example 9-2 illustrates how differences in accounting standards can affect nancial ratio comparisons. EXAMPLE 9-2 Comparisons The Effect of U.S. GAAP versus IFRS on ROE Despite convergence between U.S. GAAP and IFRS, differences remain. Non-U.S. companies that use IFRS (or any other acceptable body of accounting standards) and le with the U.S. Securities and Exchange Commission (because their shares or depositary receipts based on their shares trade in the United States) are required to reconcile their net income and shareholders equity accounts to U.S. GAAP. In comparing the historical performance of Motorola and Nokia, you have prepared Exhibit 9-2 to evaluate whether the difference in accounting standards affects the comparison of the two companies return on equity (ROE). Panel A presents selected data for Motorola for 2004 and 2005, and Panel B presents data for Nokia under IFRS and under U.S. GAAP. c09.indd 354 9/17/08 11:43:02 AM Chapter 9 355 Financial Statement Analysis: Applications EXHIBIT 9-2 Data for Motorola and Nokia for an ROE Calculation (Years Ended 31 December) 2005 2004 U.S. GAAP ($ millions) ($ millions) Net income 4,599 2,191 16,676 13,331 ( millions) ( millions) 3,616 3,192 12,155 14,231 3,582 3,343 12,558 14,576 Panel A: Selected Data for Motorola Shareholders equity Panel B: Selected Data for Nokia Corporation IFRS Net income Shareholders equity U.S. GAAP Net income Shareholders equity Source: Motorola s 10-K and Nokias 20-F, both led 2 March 2006. Does the difference in accounting standards affect the ROE comparison? Solution. Motorolas return on average shareholders equity for 2005 at 30.7 percent [net income of $4,599 divided by average shareholders equity, calculated as ($16,676 $13,331)/2] was higher than Nokias, whether calculated under IFRS or U.S. GAAP. The difference in accounting standards does not affect the conclusion, though it does affect the magnitude of the difference in protability. Under IFRS, Nokias ROE was 27.4 percent [net income of 3,616 divided by average shareholders equity, calculated as (12,155 14,231)/2]. Under U.S. GAAP, Nokias ROE was slightly lower at 26.4 percent [net income of 3,582 divided by average shareholders equity, calculated as (12,558 14,576)/2]. Results of the calculations are summarized in the following table: Panel A: Motorola U.S. GAAP Return on average shareholders equity 30.7% Panel B: Nokia Corporation IFRS Return on average shareholders equity 27.4% U.S. GAAP Return on average shareholders equity c09.indd 355 26.4% 9/17/08 11:43:08 AM 356 International Financial Statement Analysis In Example 9-2, Nokias ROE for 2005 under IFRS and U.S. GAAP differed only slightly. In some cases, the effect of applying IFRS and U.S. GAAP on ROE and other protability ratios can be substantial. For example, the Swiss drug company Novartis, which has undertaken historically numerous business combinations, shows a return on average shareholders equity of 19.0 percent in 2005 under IFRS compared with 13.7 percent under U.S. GAAP; the differences are largely due to differences in accounting for business combinations.2 Research indicates that for most non-U.S. companies ling with the U.S. Securities and Exchange Commission (SEC), differences between U.S. GAAP and home-country GAAP net income average around 1 to 2 percent of market value of equity, but with large variation.3 Comparison of the levels and trends in the companys performance provide information for statements about how the company performed. The companys management presents its view about causes underlying its performance in the MD&A section of its annual report and during periodic conference calls. To gain additional understanding on the causes underlying a companys performance, an analyst can review industry information or seek additional sources of information. The results of an analysis of past performance provide a basis for reaching conclusions and making recommendations. For example, an analysis undertaken as the basis for a forward-looking study might result in conclusions about whether a companys future performance is likely to reect continuation of recent historical trends or not. As another example, an analysis to support a market-based valuation of a company might focus on whether the companys better (worse) protability and growth outlook compared with the peer group median justify its relatively high (low) valuation, as judged by market multiples such as priceto-earnings ratio (P/E), market-to-book ratio (MV/BV), and total invested capital to earnings before interest, taxes, depreciation, and amortization (TIC/EBITDA).4 As another example, an analysis undertaken as a component of an evaluation of the companys management might result in conclusions about whether the company has grown as fast as another company, or as the industry overall, and whether the company has maintained protability while growing. 3 . APPLICATION: PROJECTING FUTURE FINANCIAL PERFORMANCE In some cases, evaluating a companys past performance provides a basis for forward-looking analyses. An evaluation of a companys environment and history may persuade the analyst that historical data constitute a valid basis for such analyses and that the analysts projections may be based on the continuance of past trends, perhaps with some adjustments. Alternatively, in the case of a major acquisition or divestiture, a start-up company, or a company operating in a volatile industry, past performance may be less relevant to future performance. Projections of future nancial performance are used in determining the value of a company or of its equity component. Projections of future nancial performance are also used in 2 Henry and Yang (2006). Pownall and Schipper (1999). Home country GAAP can refer to IFRS in addition to non-IFRS GAAP other than U.S. GAAP. 4 Total invested capital is the sum of market value of common equity, book value of preferred equity, and face value of debt. 3 c09.indd 356 9/17/08 11:43:19 AM Chapter 9 Financial Statement Analysis: Applications 357 credit analysisparticularly in project nance or acquisition nanceto determine whether a companys cash ows will be adequate to pay the interest and principal on its debt and to evaluate whether a company will likely be in compliance with its nancial covenants. Sources of data for analysts projections include some or all of the following: the companys projections; the companys previous nancial statements; industry structure and outlook; and macroeconomic forecasts. Projections of a companys near-term performance may be used as an input to marketbased valuation (valuation based on price multiples). Such projections may involve projecting next years sales and using the common-size income statement to project major expense items or particular margins on sales (e.g., gross prot margin or operating prot margin). More complex projections of a companys future performance involve developing a more detailed analysis of components across multiple periodsfor example, projections of sales and gross margin by product line, projection of operating expenses based on historical patterns, and projection of interest expense based on requisite debt funding, interest rates, and applicable taxes. Furthermore, a projection should include sensitivity analyses related to the major assumptions. 3.1. Projecting Performance: An Input to Market-Based Valuation One application of nancial statement analysis involves projecting a companys near-term performance as an input to market-based valuation. For example, one might project a companys sales and prot margin to estimate earnings per share (EPS) and then apply a projected P/E to establish a target price for a companys stock. Analysts often take a top-down approach to projecting a companys sales.5 First, industry sales are projected based on their historical relation with some macroeconomic indicator or indicators such as real gross domestic product. In researching the automobile industry, for example, the analyst may nd that the industrys annual domestic unit automobile sales (numbers of cars sold in domestic markets) bears a relation to annual changes in real GDP. Regression analysis is often used in establishing the parameters of such relations. Other factors in projecting sales may include consumer income or tastes, technological developments, and the availability of substitute products or services. After industry sales are projected, a companys market share is projected. Company-level market share projections may be based on historical market share and a forward-looking assessment of the companys competitive position. The companys sales are then estimated as its projected market share multiplied by projected total industry sales. After developing a sales forecast for a company, an analyst can choose among various methods for forecasting income and cash ow. One decision is the level of detail in forecasts. For example, separate forecasts may be made for individual expense items or for more aggregated expense items, such as total operating expenses. Rather than stating a forecast in terms of expenses, the forecast might be stated in terms of a forecasted prot margin (gross, operating, or net). The net prot margin, in contrast to the gross or operating prot margins, is affected by nancial leverage and tax rates, which are subject to managerial and legal/regulatory revisions; therefore, historical data may sometimes be more relevant for projecting gross or operating margins. Whatever the margin used, the forecasted amount of prot for a given period is the product of the forecasted amount of sales and the forecast of the selected prot margin. 5 The discussion in this paragraph is indebted to Benninga and Sarig (1997). c09.indd 357 9/17/08 11:43:19 AM 358 International Financial Statement Analysis As Example 9-3 illustrates, for relatively mature companies operating in nonvolatile product markets, historical information on operating prot margins can provide a useful starting point for forecasting future operating prots (at least over short forecasting horizons). For a new or relatively volatile business, or one with signicant xed costs (which can magnify the volatility of operating margins), historical operating prot margins are typically less reliable for projecting future margins. EXAMPLE 9-3 Using Historical Operating Prot Margins to Forecast Operating Prot One approach to projecting operating prot is to determine a companys average operating prot margin over the previous three years and apply that margin to a forecast of the companys sales. Consider the following three companies: Johnson & Johnson (JNJ). This U.S. health care conglomerate founded in 1887 had 2005 sales of around $50.5 billion from its three main businesses: pharmaceuticals, medical devices and diagnostics, and consumer products. BHP Billiton (BHP). This company, with group headquarters in Australia and secondary headquarters in London, is the worlds largest natural resources company, reporting revenue of approximately US$32 billion for the scal year ended June 2006. The company mines, processes, and markets coal, copper, nickel, iron, bauxite, and silver and also has substantial petroleum operations. TomTom. This Dutch company, which went public on the Amsterdam Stock Exchange in 2005, provides personal navigation products and services in Europe, North America, and Australia. The companys revenues for 2005 were 720 million, an increase of 275 percent from 2004 and more than 18 times greater than revenues in 2003. Address the following problems: 1. For each of the three companies given, state and justify whether the suggested forecasting method would be a reasonable starting point for projecting future operating prot. 2. Assume the suggested approach was applied to each of the three companies based on the realized level of sales provided. Consider the following additional information: JNJ: For the three years prior to 2005, JNJs average operating prot margin was approximately 26.6 percent. The companys actual operating prot for 2005 was $13.4 billion. BHP: For the three years prior to the year ending June 2006, BHPs average operating prot margin was approximately 22.5 percent, based on data from Thompson Financial. The companys actual operating prot for the year ended June 2006, excluding prots from a jointly controlled entity, was $9.7 billion. TomTom: Over the three years prior to 2005, TomToms average operating prot margin was approximately 23.5 percent. The companys actual operating prot for 2005 was 195 million. c09.indd 358 9/17/08 11:43:20 AM Chapter 9 Financial Statement Analysis: Applications 359 Using the additional information given, state and justify whether actual results supported the usefulness of the stable operating margin assumption. Solution to 1: JNJ: Because JNJ is an established company with diversied operations across relatively stable businesses, the suggested approach to projecting the companys operating prot might provide a reasonable starting point. BHP: Because commodity prices tend to be volatile and the mining industry is relatively capital intensive, the suggested approach to projecting BHPs operating prot would probably not have provided a useful starting point. TomTom: A new company such as TomTom has little operating history on which to judge stability of margins. Two aspects about the company suggest that the broad approach to projecting operating prot would not be a useful starting point for TomTom. First, the company operates in an area of rapid technological change; and, second, the company appears to be in a period of rapid growth. Solution to 2: JNJ: JNJs actual operating prot margin for 2005 was 26.5 percent ($13.4 billion divided by sales of $50.5 billion), which is very close to the companys three-year average operating prot margin of approximately 26.6 percent. If the average operating prot margin had been applied to perfectly forecasted 2005 sales to obtain forecasted operating prot, the forecasting error would have been minimal. BHP: BHPs actual operating prot margin for the year ended June 2006 was 30.3 percent ($9.7 billion divided by sales of $32 billion). If the companys average prot margin of 22.5 percent had been applied to perfectly forecasted sales, the forecasted operating prot would have been approximately $7.2 billion, 26 percent less than actual operating prot. TomTom: TomToms actual operating prot margin for 2005 was 27.1 percent (195 million divided by sales of 720 million). If the average prot margin of 23.5 percent had been applied to perfectly forecasted sales, the forecasted operating prot would have been approximately 169 million, or 13 percent below TomToms actual operating prot. Although prior years prot margins can provide a useful starting point in projections for companies with relatively stable business, the underlying data should, nonetheless, be examined to identify items that are not likely to reoccur. Such nonrecurring (i.e., transitory) items should be removed from computations of any prot amount or prot margin that will be used in projections. Example 9-4 illustrates this principle. EXAMPLE 9-4 Issues in Forecasting In reviewing Motorolas 2005 performance, an analyst notes the following items. What is the relevance of each item in forecasting the item given in italics? c09.indd 359 9/17/08 11:43:30 AM 360 International Financial Statement Analysis 1. Of Motorolas $4,696 million of operating earnings, $458 million was from other income, primarily payment received from a former customer that had defaulted several years ago on obligations to Motorola. Operating earnings. 2. Motorolas income included $1.9 billion from gains on sales of investments. Investments at the end of 2005 were $1.6 billion compared with $3.2 billion at the end of 2004. Net income. 3. Motorolas effective tax rate for 2005 was 29.5 percent compared with 32.6 percent for each of the previous two years. A main reason for the lower effective tax rate was a one-time tax incentive for U.S. multinational companies to repatriate accumulated earnings from their foreign subsidiaries. Net income. 4. Motorola had losses from discontinued operations of $21 million and $659 million for the years 2005 and 2004, respectively. Net income. Solution to 1. This item related to a specic former customer and is not an ongoing source of operating earnings. Therefore, it is not relevant in forecasting operating earnings. Solution to 2. Gains on sales of investments are not a core part of Motorolas business, and the sale in 2005 halved the amount of Motorolas investments. Thus, this item should not be viewed as an ongoing source of earnings, and it is, therefore, not relevant to forecasting net income. Solution to 3. The lower tax rate does not appear to reect an ongoing change and, therefore, a projection would probably consider the previous years higher rate as more representative and more useful in forecasting net income. Solution to 4. Results of discontinued items should not be included either when assessing past performance or when forecasting future net income. In general, when earnings projections are used as a basis for market-based valuations, an analyst will make appropriate allowance for transitory components of past earnings. 3.2. Projecting Multiple-Period Performance Projections of future nancial performance over multiple periods are needed in valuation models that estimate the value of a company or its equity by discounting future cash ows. The value of a company or its equity developed in this way can then be compared with the market price as a basis for investment decisions. Projections of future performance are also used for credit analysis, in which case conclusions include an assessment of a borrowers ability to repay interest and principal of debt obligations. Investment recommendations depend on the needs and objectives of the client and on an evaluation of the risk of the investment relative to its expected returnboth of which are a function of the terms of the debt obligation itself as well as nancial market conditions. Terms of the debt obligation include amount, interest rate, maturity, nancial covenants, and collateral. Example 9-5 presents an elementary illustration of net income and cash ow forecasting to illustrate a format for analysis and some basic principles. In Example 9-5, assumptions are shown rst and the period-by-period abbreviated nancial statement that results from the assumption is shown below. c09.indd c09.indd 360 9/17/08 11:43:40 AM Chapter 9 361 Financial Statement Analysis: Applications Depending on the use of the forecast, an analyst may choose to compute further, specic cash ow metrics. For example, free cash ow to equity, used in discounted cash ow approaches to equity valuation, can be found as net income adjusted for noncash items, minus investment in net working capital and in net xed assets, plus net borrowing.6 EXAMPLE 9-5 Basic Example of Financial Forecasting Assume a company is formed with $100 of equity capital, all of which is immediately invested in working capital. Assumptions are as follows: Dividends Nondividend Paying First-year sales $100 Sales growth 10% per annum Cost of goods sold/sales 20% Operating expense/sales 70% Interest income rate 5% Tax rate 30% Working capital as percent of sales 90% Based on the above information, forecast the companys net income and cash ow for ve years. Solution. Exhibit 9-3 below shows the net income forecasts in Line 7 and cash ow forecasts (change in cash) in Line 18. EXHIBIT 9-3 Basic Financial Forecasting Time 0 1 2 3 4 5 (1) Sales 100.0 110.0 121.0 133.1 146.4 (2) Cost of goods sold (20.0) (22.0) (24.2) (26.6) (29.3) (3) Operating expenses (70.0) (77.0) (84.7) (93.2) (102.5) (4) Interest income 0.0 0.9 0.8 0.8 0.7 (5) Income before tax 10.0 11.9 12.9 14.1 15.3 (6) Taxes (3.0) (3.6) (3.9) (4.2) (4.6) 7.0 8.3 9.0 9.9 10.7 (7) Net income (8) Cash/Borrowing 0.0 17.0 16.3 15.4 14.4 13.1 (9) Working capital (noncash) 100.0 90.0 99.0 108.9 119.8 131.8 (Continued ) 6 See Stowe et al. (2002) for further information. c09.indd 361 9/17/08 11:43:46 AM 362 International Financial Statement Analysis EXHIBIT 9-3 (Continued ) 0 1 2 3 4 5 100.0 107.0 115.3 124.3 134.2 144.9 0.0 0.0 0.0 0.0 0.0 0.0 (12) Equity 100.0 107.0 115.3 124.3 134.2 144.9 (13) Total liabilities Equity 100.0 (10) Total assets (11) Liabilities 107.0 115.3 124.3 134.2 144.9 (14) Net income 7.0 8.3 9.0 9.9 10.7 (15) Plus noncash items 0.0 0.0 0.0 0.0 0.0 (16) Less: investment in working capital 10.0 9.0 9.9 10.9 12.0 (17) Less: investment in xed capital 0.0 0.0 0.0 0.0 0.0 (18) Change in cash 17.0 0.7 0.9 1.0 1.3 (19) Beginning cash 0.0 17.0 16.3 15.4 14.4 17.0 16.3 15.4 14.4 13.1 (20) Ending cash To explain the exhibit, at time zero, the company is formed with $100 of equity capital (Line 12). All of the companys capital is assumed to be immediately invested in working capital (Line 9). In future periods, because it is assumed that no dividends are paid, equity increases each year by the amount of net income. Future periods working capital is assumed to be 90 percent of annual sales. Sales are assumed to be $100 in the rst period and to grow at a constant rate of 10 percent per annum (Line 1). The cost of goods sold is assumed constant at 20 percent of sales (Line 2), so the gross prot margin is 80 percent. Operating expenses are assumed to be 70 percent of sales each year (Line 3). Interest income (Line 4) is calculated as 5 percent of the beginning cash/borrowing balance (Line 8) and is an income item when there is a cash balance, as it is in this example. (If available cash is inadequate to cover required cash outows, the shortfall is presumed to be covered by borrowing. This borrowing would be shown as a negative balance on Line 8 and an associated interest expense on Line 4. Alternatively, a forecast can be presented with separate lines for cash and borrowing.) Taxes of 30 percent are deducted to obtain net income (Line 7). To calculate each periods cash ow, we begin with net income (Line 7 Line 14), add back any noncash items such as depreciation (Line 15), deduct investment in working capital (Line 16), and deduct investment in xed capital (Line 17).7 In this simple example, we are assuming that the company does not invest in any xed capital (longterm assets) but, rather, rents furnished ofce space. Therefore, there is no depreciation, and thus noncash items are zero. Each periods change in cash (Line 18) is added to the beginning cash balance (Line 19) to obtain the ending cash balance (Line 20 Line 8). 7 Working capital represents funds that must be invested in the daily operations of a business such as to carry inventory and accounts receivable. The term investment in this context means the addition to or increase. The investment in xed capital is also referred to as capital expenditure or capex. See Stowe et al. (2002), Chapter 3, for further information. c09.indd c09.indd 362 9/17/08 11:43:55 AM Chapter 9 Financial Statement Analysis: Applications 363 Example 9-5 is simplied to demonstrate some principles of forecasting. In practice, each aspect of a forecast presents substantial challenges. Sales forecasts may be very detailed, with separate forecasts for each year of each product line and/or each geographical or business segment. Sales forecasts may be based on past results (for relatively stable businesses), management forecasts, industry studies, and/or macroeconomic forecasts. Similarly, gross margins may be detailed and may be based on past results or forecast relationships. Expenses other than cost of goods sold may be broken down into more detailed line items, each of which may be forecasted based on its relationship with sales (if variable) or on its historical levels. Working capital requirements may be estimated as a proportion of the amount of sales (as in the example) or the change in sales, or as a compilation of specic forecasts for inventory, receivables, and payables. Most forecasts will involve some investment in xed assets, in which case depreciation amounts affect taxable income and net income but not cash ow. Example 9-5 makes the simplifying assumption that interest is paid on the beginning-of-year cash balance. Example 9-5 developed a series of point estimates for future net income and cash ow. In practice, forecasting generally includes an analysis of the risk in forecastsin this case, an assessment of the impact on income and cash ow if the realized values of variables differ signicantly from the assumptions used in the base case or if actual sales are much different from forecasts. Quantifying the risk in forecasts requires an analysis of the economics of the companys businesses and expense structures, and the potential impact of events affecting the company, the industry, and the economy in general. That investigation done, the analyst can assess risk using scenario analysis or Monte Carlo simulation. Scenario analysis involves specifying assumptions that differ from those included as the base case assumptions. In the above example, the projections of net income and cash ow could be recast using a more pessimistic scenario, with assumptions changed to reect slower sales growth and higher costs. A Monte Carlo simulation involves specifying probability distributions of values for variables and random sampling from those distributions. In the above analysis, the projections would be repeatedly recast using randomly selected values for the drivers of net income and cash ow, thus permitting the analyst to evaluate the range of results possible and the probability of simulating the possible actual outcomes. An understanding of nancial statements and ratios can enable an analyst to make more detailed projections of income statement, balance sheet, and cash ow statement items. For example, an analyst may collect information on normal inventory and receivables turnover ratios and use this information to forecast accounts receivable, inventory, and cash ows based on sales projections rather than use a composite working capital investment assumption, as in the above example. As the analyst makes detailed forecasts, he or she must ensure that they are mutually consistent. For instance, in Example 9-6, the analysts forecast concerning days of sales outstanding (which is an estimate of the average time to collect payment from sales made on credit) should ow from a model of the company that yields a forecast of the change in the average accounts receivable balance given as the solution to the problem. Otherwise, predicted days of sales outstanding and accounts receivable would not be mutually consistent. EXAMPLE 9-6 Consistency of Forecasts8 Brown Corporation had an average days-of-sales-outstanding (DSO) period of 19 days in 2005. An analyst thinks that Browns DSO will decline to match the industry 8 Adapted from a past CFA Institute examination question. c09.indd 363 9/17/08 11:44:07 AM 364 International Financial Statement Analysis average of 15 days in 2006. Total sales (all on credit) in 2005 were $300 million, and Brown expects total sales (all on credit) to increase to $320 million in 2006. To achieve the lower DSO, the change in the average accounts receivable balance from 2005 to 2006 that must occur is closest to A. B. C. D. $3.51 million. $2.46 million. $2.46 million. $3.51 million. Solution. B is correct. The rst step is to calculate accounts receivable turnover from the DSO collection period. Receivable turnover equals 365/19 (DSO) 19.2 for 2005, and 365/15 24.3 in 2006. Next, we use the fact that the average accounts receivable balance equals sales/receivable turnover to conclude that for 2005, average accounts receivable was $300,000,000/19.2 $15,625,000, and for 2006, it must equal $320,000,000/24.3 $13,168,724. The difference is a reduction in receivables of $2,456,276. The next section illustrates the application of nancial statement analysis to credit risk analysis. 4 . APPLICATION: ASSESSING CREDIT RISK Credit risk is the risk of loss caused by a counterpartys or debtors failure to make a promised payment. For example, credit risk with respect to a bond is the risk that the obligor (the issuer of the bond) is not able to pay interest and principal according to the terms of the bond indenture (contract). Credit analysis is the evaluation of credit risk. Credit analysis may relate to the credit risk of an obligor in a particular transaction or to an obligors overall creditworthiness. In assessing an obligors overall creditworthiness, one general approach is credit scoring, a statistical analysis of the determinants of credit default. As noted above, credit analysis for specic types of debt (e.g., acquisition nancing and other highly leveraged nancing) typically involves projections of period-by-period cash ows. Whatever the techniques adopted, the analytical focus of credit analysis is on debt-paying ability. Unlike payments to equity investors, payments to debt investors are limited by the agreed contractual interest. If a company experiences nancial success, its debt becomes less risky, but its success does not increase the amount of payments to its debtholders. In contrast, if a company experiences nancial distress, it may be unable to pay interest and principal on its debt obligations. Thus, credit analysis has a special concern with the sensitivity of debt-paying ability to adverse events and economic conditionscases in which the creditors promised returns may be most at risk. Because those returns are generally paid in cash, credit analysis usually focuses on cash ow rather than accrual-income returns. Typically, credit analysts use return measures related to operating cash ow because it represents cash generated internally, which is available to pay creditors. c09.indd c09.indd 364 9/17/08 11:44:09 AM Chapter 9 365 Financial Statement Analysis: Applications These themes are reected in Example 9-7, which illustrates the application of four groups of quantitative factors in credit analysis to an industry group: scale and diversication, tolerance for leverage, operational stability, and margin stability. Scale and diversication relate to a companys sensitivity to adverse events and economic conditions as well as to other factorssuch as market leadership, purchasing power with suppliers, and access to capital marketsthat can affect debt-paying ability. Financial policies or tolerance for leverage relates to the obligors ability to service its indebtedness (i.e., make the promised payments on debt). In the example, various solvency ratios are used to measure tolerance for leverage. One set of tolerance-forleverage measures is based on retained cash ow (RCF). RCF is dened by Moodys as operating cash ow before working capital changes less dividends. A ratio of RCF/total debt of 0.5, for example, indicates that the company may be able to pay off debt in approximately 1/0.5 2 years from cash ow retained in the business (at current levels of RCF and debt), assuming no capital expenditures; a ratio adjusting for capital expenditures is also used. Other factors include interest coverage ratios based on EBITDA, which is also chosen by Moodys in specifying factors for operational efciency and margin stability. Operational efciency as dened by Moodys relates to cost structure: Companies with lower costs are better positioned to deal with nancial stress. Margin stability relates to the past volatility of prot margins: Higher stability should be associated with lower credit risk. EXAMPLE 9-7 Factors9 Moodys Evaluation of Quantiable Rating Moodys Investors Service indicates that when assigning credit ratings for the global paper and forest products industry, they look at a number of factors, including quantitative measures of four broad factors. These factors are weighted and aggregated in determining the overall credit rating assigned. The four broad factors, the subfactors, and weightings are as follows: Subfactor Weighting (%) Broad Factor Weighting (%) Average annual revenues 6.00 15 Segment diversication 4.50 Geographic diversication 4.50 Broad Factor Subfactors Scale and diversication Financial policies (tolerance for leverage) Retained cash ow (RCF)/Total debt 11.00 (RCF Capital expenditures)/ Total debt 11.00 Total debt/EBITDA 11.00 (EBITDA Capital expenditures)/Interest 11.00 EBITDA/Interest 11.00 55 9 Moodys Investors Service (2006, pp. 819). c09.indd 365 9/17/08 11:44:12 AM 366 International Financial Statement Analysis Broad Factor Subfactors Subfactor Weighting (%) Broad Factor Weighting (%) 15 Operational efciency Vertical integration 5.25 EBITDA margin 5.25 Margin stability Average percentage change in EBITDA margin EBITDA/Average assets Total 4.50 15.00 15 100.00 100 1. What are some reasons why Moodys may have selected these four broad factors as being important in assigning a credit rating? 2. Why might nancial policies be weighted so heavily? Solution to 1. Scale and Diversication: Large scale can result in purchasing power over suppliers, leading to cost savings. Product and geographic diversication should lower risk. Financial Policies: Strong nancial policies should be associated with the ability of cash ow to service debt. Operational Efciency: Companies with high operational efciency should have lower costs and higher margins than less efcient companies and so be able to withstand a downturn easier. Margin Stability: Lower volatility in margins would imply lower risk relative to economic conditions. Solution to 2. The level of debt relative to earnings and cash ow is a critical factor in assessing creditworthiness. The higher the current level of debt, the higher the risk of default. A point to note regarding Example 9-7 is that the rating factors and the metrics used to represent each can vary by industry group. For example, for heavy manufacturing (manufacturing of the capital assets used in manufacturing and production processes), Moodys distinguishes order trends and quality as distinctive credit factors affecting future revenues, factory load, and protability patterns. Analyses of a companys historical and projected nancial statements are an integral part of the credit evaluation process. As noted by Moodys, the rating process makes: . . . extensive use of historic nancial statements. Historic results help with understanding the pattern of a companys results and how the company compares to others. They also provide perspective, helping to ensure that estimated future results are grounded in reality.10 10 Ibid., p. 6. c09.indd 366 9/17/08 11:44:17 AM Chapter 9 367 Financial Statement Analysis: Applications As noted in the above example, Moody computes a variety of ratios in assessing creditworthiness. A comparison of a companys ratios to its peers is informative in evaluating relative creditworthiness, as demonstrated in Example 9-8. EXAMPLE 9-8 Peer Comparison of Ratios A credit analyst is assessing the tolerance for leverage for two paper companies based on the following subfactors identied by Moodys:11 International Paper Louisiana-Pacic RCF/Debt 8.2 % 59.1% (RCFCapital expenditures)/Debt 0.2% 39.8% Debt/EBITDA 5.6x 1.0x (EBITDACapital expenditures)/Interest 1.7x 8.1x EBITDA/Interest 3.1x 10.0x Based solely on the data given, which company is more likely to be assigned a higher credit rating? Solution. The ratio comparisons are all in favor of Louisiana-Pacic. Louisiana-Pacic has a much higher level of retained cash ow relative to debt whether capital expenditures are netted from RCF or not. Louisiana-Pacic has a lower level of debt relative to EBITDA and a higher level of EBITDA relative to interest expense. Louisiana-Pacic is likely to be assigned a higher credit rating. Before calculating ratios such as those presented in Example 9-8, rating agencies make certain adjustments to reported nancial statements, such as adjusting debt to include offbalance-sheet debt in a companys total debt.12 A later section will describe some common adjustments. Financial statement analysis, especially nancial ratio analysis, can also be an important tool used in selecting equity investments, as discussed in the next section. 5 . APPLICATION: SCREENING FOR POTENTIAL EQUITY INVESTMENTS Ratios using nancial statement data and market data are used to screen for potential equity investments. Screening is the application of a set of criteria to reduce a set of potential investments to a smaller set having certain desired characteristics. Criteria involving nancial ratios generally involve comparing one or more ratios with some prespecied cutoff values. 11 Ibid., p. 12; the values reported are based on average historical data. Ibid., p. 6. 12 c09.indd c09.indd 367 9/17/08 11:44:25 AM 368 International Financial Statement Analysis A security selection approach incorporating nancial ratios may be used whether the investor uses top-down analysis or bottom-up analysis. Top-down analysis involves identifying attractive geographic segments and/or industry segments and then the most attractive investments within those segments. Bottom-up analysis involves selection from all companies within a specied investment universe. Regardless of the direction, screening for potential equity investments aims to identify companies that meet specic criteria. An analysis of this type may be used as the basis for directly forming a portfolio, or it may be undertaken as a preliminary part of a more thorough analysis of potential investment targets. Fundamental to this type of analysis are decisions about which metrics to use as screens, how many metrics to include, what values of those metrics to use as cutoff points, and what weighting to give each metric. Metrics can include not only nancial ratios but also characteristics such as market capitalization or membership as a component security in a specied index. Exhibit 9-4 is an example of a hypothetical simple stock screen based on the following criteria: a valuation ratio (price-to-sales) less than a specied value; a solvency ratio measuring nancial leverage (total assets/equity) not exceeding a specied value; dividend payments; and positive one-year-ahead forecast EPS. The exhibit shows the results of applying the screen to a set of 4,203 U.S. securities that comprise a hypothetical equity managers investment universe. Several points about the screen in Exhibit 9-4 are observed in many screens seen in practice: Some criteria serve as checks on the interpretation of other criteria. In this hypothetical example, the rst criterion selects stocks that are relatively cheaply valued. However, the stocks might be cheap for a good reason, such as poor protability or excessive nancial leverage. So, the criteria requiring forecast EPS and dividends to be positive serve as checks on protability, and the criterion limiting nancial leverage serves as a check on nancial risk. Of course, nancial ratios or other statistics cannot generally control for exposure to certain types of risk (e.g., related to regulatory developments or technological innovation). If all the criteria were completely independent of each other, the set of stocks meeting all four criteria would be 329, equal to 4,203 times 7.8 percentthe product of the fraction of stocks satisfying the four criteria individually (i.e., 0.371 0.505 0.594 0.703 0.078, or 7.8 percent). As the screen illustrates, criteria are often not independent, and the result is more securities passing the screen. In this example, 473 (or 11.3 percent) of the securities passed all four screens. As an example of the lack of independence, dividendpaying status is probably positively correlated with the ability to generate positive earnings EXHIBIT 9-4 Example of a Stock Screen Stocks Meeting Criterion Criterion Number Total assets/Equity Dividends 2.0 0 Consensus forecast EPS 0 Meeting all four criteria simultaneously 37.1% 50.5% 2,497 1.5 1,560 2,123 Price per share/Sales per share Percent of Total 59.4% 2,956 70.3% 473 11.3% Source for data: http://nance.yahoo.com. c09.indd 368 9/17/08 11:44:30 AM Chapter 9 Financial Statement Analysis: Applications 369 and the value of the fourth criterion. If stocks that pass one test tend to also pass the other, fewer would be eliminated after the application of the second test. The results of screens can sometimes be relatively concentrated in a subset of the sectors represented in the benchmark. The nancial leverage criterion in Exhibit 9-4 would exclude all banking stocks, for example. What constitutes a high or low value of a measure of a nancial characteristic can be sensitive to the industry in which a company operates. Screens can be used by both growth investors (focused on investing in high-earningsgrowth companies), value investors (focused on paying a relatively low share price in relation to earnings or assets per share), and market-oriented investors (an intermediate grouping for investors whose investment disciplines cannot be clearly categorized as value or growth). The criteria of growth screens would typically feature criteria related to earnings growth and/or momentum. Value screens, as a rule, feature criteria setting upper limits for the value of one or more valuation ratios. Market-oriented screens would not strongly emphasize valuation or growth criteria. The use of screens involving nancial ratios may be most common among value investors. There have been many studies researching the most effective items of accounting information for screening equity investments. Some research suggests that certain items of accounting information can help explain (and potentially predict) market returns (e.g., Chan et al., 1991; Lev and Thiagarajan, 1993; Lakonishok et al., 1994; Davis, 1994; Arbanell and Bushee, 1998). Representative of such investigations is Piotroski (2000), whose screen uses nine accounting-based fundamentals that aim to identify nancially strong and protable companies among those with high book value/market value ratios. For example, the protability measures relate to whether the company reported positive net income, positive cash ow, and an increase in return on assets (ROA). An analyst may want to evaluate how a portfolio based on a particular screen would have performed historically, using a process known as backtesting. Backtesting applies the portfolio selection rules to historical data and calculates what returns would have been earned if a particular strategy had been used. The relevance of backtesting to investment success in practice can, however, be limited. Haugen and Baker (1996) describe some of these limitations: Survivorship bias. If the database used in backtesting eliminates companies that cease to exist because of a merger or bankruptcy, then the remaining companies collectively will appear to have performed better. Look-ahead bias. If a database includes nancial data updated for restatements (where companies have restated previously issued nancial statements to correct errors or reect changes in accounting principles),13 then there is a mismatch between what investors would have actually known at the time of the investment decision and the information used in backtesting. Data-snooping bias. If researchers build models based on previous researchers ndings, then using the same data base to test the model is not actually a test. Under this scenario, the same rules may or may not produce similar results in the future. One academic study argues that the apparent ability of value strategies to generate excess returns is largely explainable as the result of collective data snooping (Conrad, Cooper, and Kaul, 2003). 13 In the United States, restatements of previously issued nancial statements have increased in recent years. The U.S. Government Accounting Ofce (2002) reports 919 restatements by 834 public companies in the period from January 1997 to June 2002. The number of restatements increased from 613 in 2004 to 1,195 in 2005 (Wall Street Journal, 2006.) c09.indd 369 9/17/08 11:44:30 AM 370 International Financial Statement Analysis EXAMPLE 9-9 Investments Ratio-Based Screening for Potential Equity Below are two alternative strategies under consideration by an investment rm: Strategy A invests in stocks that are components of a global equity index, have a ROE above the median ROE of all stocks in the index, and a P/E ratio less than the median P/E. Strategy B invests in stocks that are components of a broad-based U.S. equity index, have price to operating cash ow in the lowest quartile of companies in the index, and have shown increases in sales for at least the past three years. Both strategies were developed with the use of backtesting. 1. How would you characterize the two strategies? 2. What concerns might you have about using such strategies? Solution to 1. Strategy A appears to aim for global diversication and combines a requirement for protability with a traditional measure of value (low P/E). Strategy B focuses on both large and small companies in a single market and apparently aims to identify companies that are growing and yet managing to generate positive cash ow from operations. Solution to 2. The use of any approach to investment decisions depends on the objectives and risk prole of the investor. With that crucial consideration in mind, ratiobased benchmarks can offer an efcient way to screen for potential equity investments. However, in doing so, many types of questions arise. First, unintentional selections can be made if criteria are not specied carefully. For example, Strategy A might unintentionally select a loss-making company with negative shareholders equity because negative net income divided by negative shareholders equity would arithmetically result in a positive ROE. Strategy B might unintentionally select a company with negative operating cash ow because price to operating cash ow would be negative and thus very low in the ranking. In both cases, the analyst can add additional screening criteria to avoid unintentional selection (e.g., criteria requiring positive shareholders equity and operating cash ow). Second, the inputs to ratio analysis are derived from nancial statements, and companies may differ in the nancial standards applied (e.g., IFRS versus U.S. GAAP); the specic accounting method chosen within those allowed under any body of reporting standards; and/or the estimates made in applying an accounting method. Third, backtesting may not provide a reliable indication of future performance because of survivorship bias, look-ahead bias, or data snooping; furthermore, as suggested by nance theory and by common sense, the past is not necessarily indicative of the future. Fourth, implementation decisions can crucially affect returns. For example, decisions about frequency and timing of portfolio selection and reevaluation affect transaction costs and taxes paid out of the portfolio. c09.indd 370 9/17/08 11:44:31 AM Chapter 9 Financial Statement Analysis: Applications 371 6 . ANALYST ADJUSTMENTS TO REPORTED FINANCIALS When comparing companies that use different accounting methods or estimate key accounting inputs in different ways, analysts frequently adjust a companys nancials. In this section, we rst provide a framework for considering potential analyst adjustments to facilitate such comparisons and then provide examples of such adjustments. In practice, required adjustments vary widely. The examples presented here are not intended to be comprehensive, but rather to illustrate the use of adjustments to facilitate comparison. 6.1. A Framework for Analyst Adjustments In this discussion of potential analyst adjustments to a companys nancial statements, we employ a balance sheetfocused framework. Of course, because the nancial statements are interrelated, adjustments to items reported on one statement must also be reected in adjustments to items on another statement. For example, an analyst adjustment to the balance sheet item inventory affects the income statement item cost of goods sold; and the owners equity amount is affected by analyst adjustments relating to expense or revenue recognition. Regardless of the particular order in which an analyst considers the items that may require adjustment for comparability, the following considerations are appropriate: Importance. Is an adjustment to this item likely to affect my conclusions? In other words, does it matter? For example, in an industry where companies require minimal inventory, does it matter that two companies use different inventory accounting methods? Body of standards. Is there a difference in the body of standards being used (U.S. GAAP versus IFRS)? If so, in which areas is the difference likely to affect a comparison? Methods. Is there a difference in methods? Estimates. Is there a difference in important estimates? The following sections illustrate analyst adjustmentsrst those relating to the asset side of the balance sheet and then those relating to the liability side. 6.2. Analyst Adjustments Related to Investments Accounting for investments in the debt and equity securities of other companies (other than investments accounted for under the equity method and investments in consolidated subsidiaries) depends on managements intention (i.e., to actively trade the securities, make them available for sale, or, in the case of debt securities, to hold them to maturity). When securities are classied as trading securities, unrealized gains and losses are reported in the income statement. When securities are classied as available-for-sale securities, unrealized gains and losses are not reported in the income statement and instead are recognized in equity. If two otherwise comparable companies have signicant differences in the classication of investments, analyst adjustments may be useful to facilitate comparison. Also, IFRS requires that those unrealized gains and losses on available-for-sale debt securities that arise due to exchange rate movements be recognized in the income statement, whereas U.S. GAAP does not. To facilitate comparison across companies, increases (decreases) in the value of available-for-sale debt securities arising from exchange rate movements can be deducted from (added to) the amount of income reported by the IFRS-reporting company. c09.indd 371 9/17/08 11:44:44 AM 372 International Financial Statement Analysis EXAMPLE 9-10 Adjustment for a Company Using LIFO Method of Accounting for Inventories An analyst is comparing the nancial performance of SL Industries (AMEX: SLI), a U.S. company operating in the electric lighting and wiring industry, with a company that reports using IFRS. The IFRS company uses the FIFO method of inventory accounting, and you therefore must convert SLIs results to a comparable basis. EXHIBIT 9-5 Data for SL Industries 31 December 2005 Total current assets 2004 $44,194,000 18,387,000 Total current liabilities $37,990,000 18,494,000 NOTE 6. INVENTORIES Inventories consist of the following ($ in thousands): Raw materials $ 9,774 $ 9,669 Work in process 4,699 5,000 Finished goods 1,926 3,633 16,399 18,302 (1,829) (2,463) Less: Allowances $14,570 $15,839 Source: 10-K for SL Industries, Inc. for the year ended 31 December 2005; led with the SEC 24 March 2006. The above includes certain inventories that are valued using the LIFO method, which aggregated $4,746,000 and $3,832,000 as of December 31, 2005, and December 31, 2004, respectively. The excess of FIFO cost over LIFO cost as of December 31, 2005, and December 31, 2004, was approximately $502,000 and $565,000, respectively. 1. Based on the information in Exhibit 9-5, calculate SLIs current ratio under FIFO and LIFO for 2004 and 2005. 2. Interpret the results of adjusting the current ratio to be consistent with inventory on a FIFO basis. Solution to 1. The calculations of SLIs current ratio (current assets divided by current liabilities) are given below. 2005 2004 $44,194,000 $37,990,000 18,387,000 18,494,000 2.40 2.05 I. Current Ratio (Unadjusted) Total current assets Total current liabilities Current ratio (unadjusted) c09.indd 372 9/17/08 11:44:44 AM Chapter 9 373 Financial Statement Analysis: Applications 2005 2004 II. Current Ratio (adjusted) Adjust the inventory to FIFO, add Total current assets (adjusted) Total current liabilities Current ratio (adjusted) 502,000 565,000 $44,696,000 $38,555,000 18,387,000 18,494,000 2.43 2.08 To adjust the LIFO inventory to FIFO, the excess amounts of FIFO cost over LIFO cost are added to LIFO inventory, increasing current assets by an equal amount. The effect of adjusting inventory on the current ratio is to increase it from 2.05 to 2.08 in 2004 and from 2.40 to 2.43 in 2005. Solution to 2. SLI appears to be somewhat more liquid based on the adjusted current ratio. However, the year-over-year improvement in the current ratio on an adjusted basis at 16.8 percent (2.43/2.08 1) was slightly less favorable than the improvement of 17.1 percent (2.40/2.05 1) on an unadjusted basis. 6.3. Analyst Adjustments Related to Inventory With inventory, adjustments may be required for different accounting methods. As described in previous chapters, a companys decision about the inventory method will affect the value of inventory shown on the balance sheet as well as the value of inventory that is sold (cost of goods sold). If one company, not reporting under IFRS,14 uses LIFO (last in, rst out) and another uses FIFO (rst in, rst out), comparison of the two companies may be difcult. However, companies that use the LIFO method must also disclose the value of their inventory under the FIFO method. To place inventory values for a company using LIFO reporting on a FIFO basis, the analyst would add the ending balance of the LIFO reserve to the ending value of inventory under LIFO accounting; to adjust cost of goods sold to a FIFO basis, the analyst would subtract the change in the LIFO reserve from the reported cost of goods sold under LIFO accounting. Example 9-10 illustrates the use of a disclosure of the value of inventory under the FIFO method to make a valid current ratio comparison between companies reporting on a LIFO and FIFO basis. In summary, the information disclosed by companies using LIFO allows an analyst to calculate the value of the companys inventory as if it were using the FIFO method. In the example above, the portion of inventory valued using the LIFO method was a relatively small portion of total inventory, and the LIFO reserve (excess of FIFO cost over LIFO) was also relatively small. However, if the LIFO method is used for a substantial part of a companys inventory and the LIFO reserve is large relative to reported inventory, the adjustment to a FIFO basis can be important for comparison of the LIFO-reporting company with another company that uses the FIFO method of inventory valuation. Example 9-11 illustrates a case in which such an adjustment would have a major impact on an analysts conclusions. 14 IAS No. 2 does not permit the use of LIFO. c09.indd 373 9/17/08 11:44:56 AM 374 International Financial Statement Analysis EXAMPLE 9-11 Analyst Adjustment to Inventory Value for Comparability in a Current Ratio Comparison Company A reports under IFRS and uses the FIFO method of inventory accounting for its entire inventory. Company B reports under U.S. GAAP and uses the LIFO method. Exhibit 9-6 gives data pertaining to current assets, LIFO reserves, and current liabilities of these companies. EXHIBIT 9-6 Data for Companies Accounting for Inventory on Different Bases Company A (FIFO) Company B (LIFO) $300,000 $80,000 NA $20,000 $150,000 $45,000 Current assets (includes inventory) LIFO reserve Current liabilities Based on the data given in Exhibit 9-6, compare the liquidity of the two companies as measured by the current ratio. Solution. Company As current ratio is 2.0. Based on unadjusted balance sheet data, Company Bs current ratio is 1.78. Company As higher current ratio indicates that Company A appears to be more liquid than Company B; however, the use of unadjusted data for Company B is not appropriate for making comparisons with Company A. After adjusting Company Bs inventory to a comparable basis (i.e., to a FIFO basis), the conclusion changes. The table below summarizes the results when Company Bs inventory is left on a LIFO basis and when it is placed on a FIFO basis for comparability with Company A. Company B Company A (FIFO) Unadjusted (LIFO Basis) Adjusted (FIFO Basis) Current assets (includes inventory) $ 300,000 $ 80,000 $ 100,000 Current liabilities $ 150,000 $ 45,000 $ 45,000 2.00 1.78 2.22 Current ratio When both companies inventories are stated on a FIFO basis, Company B appears to be more liquid, as indicated by its current ratio of 2.22 versus Company As ratio of 2.00. The adjustment to place Company Bs inventory on a FIFO basis was signicant because Company B was assumed to use LIFO for its entire inventory and its inventory reserve was $20,000/$80,000 0.25, or 25 percent of its reported inventory. c09.indd 374 9/17/08 11:44:59 AM Chapter 9 Financial Statement Analysis: Applications 375 As mentioned earlier, an analyst can also adjust the cost of goods sold for a company using LIFO to a FIFO basis by subtracting the change in the amount of the LIFO reserve from cost of goods sold. Such an adjustment would be appropriate for making protability comparisons with a company reporting on a FIFO basis and would be important to make when the impact of the adjustment would be material. 6.4. Analyst Adjustments Related to Property, Plant, and Equipment Management generally has considerable discretion in the determination of depreciation expense. Depreciation expense affects reported net income and reported net xed asset values. Analysts often consider managements choices related to depreciation as one qualitative factor in evaluating the quality of a companys nancial reporting and, in some cases, they may adjust reported depreciation expense for a specic analytic purpose. The amount of depreciation expense depends on both the accounting method and the estimates used in the calculations. Companies can depreciate xed assets (other than land) using the straight-line method, an accelerated method, or a usage method. The straightline method reports an equal amount of depreciation expense each period, computed as the depreciable cost divided by the estimated useful life of the asset (when acquired, an assets depreciable cost is calculated as its total cost minus its estimated salvage value). Accelerated methods depreciate the asset more quickly, apportioning a greater amount of the depreciable cost to depreciation expense in the earlier periods. Usage-based methods depreciate an asset in proportion to its usage. Apart from selecting a depreciation method, companies must estimate an assets salvage value and useful life to compute depreciation. Disclosures required for depreciation often do not facilitate specic adjustments, so comparisons across companies concerning their decisions in depreciating assets are often qualitative and general. The accounts that are associated with depreciation include the balance sheet accounts for gross property, plant, and equipment (gross PP&E); accumulated depreciation; the income statement account for depreciation expense; and the statement of cash ows disclosure of capital expenditure (capex) and asset disposals. The relationships between these items can reveal various pieces of information: Accumulated depreciation divided by gross PP&E, from the balance sheet, suggests how much of its useful life the companys overall asset base has passed. Accumulated depreciation divided by depreciation expense suggests how many years worth of depreciation expense has already been recognized (i.e., the average age of the asset base). Net PP&E (net of accumulated depreciation) divided by depreciation expense is an approximate indicator of how many years of useful life remain for the companys overall asset base. Gross PP&E divided by depreciation expense can suggest the average life of the assets at installation. Capex divided by the sum of gross PP&E plus capex can suggest what percentage of the asset base is being renewed through new capital investment. Capex in relation to asset disposal provides information on growth of the asset base. These relationships can be evaluated across companies in an industry to suggest differences in strategies for asset utilization or areas for further investigation. c09.indd 375 9/17/08 11:45:11 AM 376 International Financial Statement Analysis EXAMPLE 9-12 Differences in Depreciation An analyst is evaluating the nancial statements for two companies in the same industry. The companies have similar strategies with respect to the use of equipment in manufacturing their products. The following information is provided (amounts in millions): Company A Net PP&E Depreciation expense Company B $1,200 $750 $120 $50 1. Based on the information given, estimate the average remaining useful lives of the asset bases of Company A and Company B. 2. Suppose that, based on a physical inspection of the companies plants and other industry information, the analyst believes that the actual remaining useful lives of Company As and Company Bs assets is roughly equal at 10 years. Based only on the facts given, what might the analyst conclude concerning Company Bs reported net income? Solution to 1. The estimated average remaining useful life of Company As asset base, calculated as net PP&E divided by depreciation expense, is $1,200/$120 10 years. For Company B, the average remaining useful life of the asset base appears to be far longer at 15 years ($750/$50). Solution to 2. If Company Bs depreciation expense were calculated using 10 years, it would be $75 million (i.e., $25 million higher than reported) and higher depreciation expense would decrease net income. The analyst might conclude that Company Bs reported net income reects relatively aggressive accounting estimates compared with Company As reported net income. 6.5. Analyst Adjustments Related to Goodwill Goodwill is an example of an intangible asset (i.e., one without physical substance). Goodwill arises when one company purchases another for a price that exceeds the fair value of the assets acquired. Goodwill is recorded as an asset. For example, assume ParentCo purchases TargetCo for a purchase price of $400 million, the fair value of TargetCos identiable assets is $300 million, and the excess of the purchase price is attributed to TargetCos valuable brands and well-trained workforce. ParentCo will record total assets of $400 million, consisting of $300 million in identiable assets and $100 million of goodwill. The goodwill is tested annually for impairment, and if its value has declined, ParentCo will reduce the amount of the asset and report a write-off due to impairment. One of the conceptual difculties with goodwill arises in comparative nancial statement analysis. Consider, for example, two hypothetical U.S. companies, one of which has grown by making an acquisition and the other one of which has grown internally. Assume that the economic value of the two companies is identical: Each has an identically valuable c09.indd c09.indd 376 9/17/08 11:45:11 AM Chapter 9 377 Financial Statement Analysis: Applications branded product, well-trained workforce, and proprietary technology. The company that has grown by acquisition will incur a related expenditure and will report assets on its balance sheet equal to the amount of the expenditure (assuming no write-offs). The company that has grown internally will have done so by incurring expenditures for advertising, staff training, and research, all of which are expensed as incurred under U.S. GAAP and are thus not directly reected on the companys balance sheet. Ratios based on asset values and/or income, including protability ratios such as return on assets and MV/BV, will generally differ for the two companies because of differences in the accounting values of assets and income related to goodwill, although by assumption the economic value of the companies is identical. EXAMPLE 9-13 Ratio Comparisons for Goodwill Miano Marseglia is an analyst who is evaluating the relative valuation of two footwear manufacturing companies: Phoenix Footwear Group (AMEX: PXG) and Rocky Brands (NASDAQ: RCKY). As one part of an overall analysis, Marseglia would like to see how the two companies compare with each other and with the industry based on price/book (P/B) ratios.15 Because both companies are nondiversied, are small, and have high risk relative to larger, more diversied companies in the industry, Marseglia expects them to sell at a lower P/B ratio than the industry average of 3.68. Marseglia collects the following data on the two companies. PXG RCKY Market capitalization at 11 October 2006 $37.22 million (market price per share times the number of shares outstanding) $67.57 million Total shareholders equity as of the most recent quarter (MRQ) $54.99 million $100.35 million Goodwill $33.67 million $24.87 million Other intangible assets $33.22 million $38.09 million Marseglia computes the P/B ratios as follows: PXG $37.22/$54.99 RCKY $67.57/$100.35 0.68 0.67 The companies have similar P/B ratios (i.e., they are approximately equally valued relative to MRQ shareholders equity). As expected, each company also appears to be selling at a signicant discount to the industry average P/B multiple of 3.68. Marseglia is concerned, however, because he notes that both companies have signicant intangible assets, particularly goodwill. He wonders what the relative value would be if the 15 Price/book, or P/B, is the price per share divided by stockholders equity per share. It is also referred to as a market/book, or MV/BV, ratio because it can also be calculated as total market value of the stock (market capitalization) divided by total stockholders equity. c09.indd 377 9/17/08 11:45:19 AM 378 International Financial Statement Analysis P/B ratio were computed after adjusting book value rst to remove goodwill and then to remove all intangible assets. Book value reduced by all intangible assets is known as tangible book value. The average price/tangible book value for the industry is 4.19. 1. Compute the P/B ratio adjusted for goodwill and the price/tangible book value ratio for each company. 2. Which company appears to be a better value based solely on this data? (Note that the P/B ratio is only one part of a broader analysis. Much more evidence on the valuation and the comparability of the companies would be required to reach a conclusion about whether one company is a better value.) Solution to 1. PXG Total stockholders equity $54.99 million RCKY $100.35 million Less: Goodwill $33.67 million $24.87 million Book value, adjusted $21.32 million $75.48 million Adjusted P/B ratio $37.22/$21.32 1.75 $67.57/$75.48 PXG Total stockholders equity $54.99 million 0.90 RCKY $100.35 million Less: Goodwill $33.67 million $24.87 million Less: Other intangible assets $33.22 million $38.09 million Tangible book value $(11.90) million $37.39 million Price/tangible book value ratio NM (not meaningful) $67.57/$37.39 1.81 Solution to 2. Based on an adjustment for goodwill accumulated in acquisitions, RCKY appears to be selling for a lower price relative to book value than PXG (0.90 versus 1.75). Both companies are selling at a signicant discount to the industry, even after adjusting for goodwill. Based on price/tangible book value, RCKY is also selling for a lower multiple than the industry (1.81 versus 4.19). PXG has a negative tangible book value, and its price/ tangible book value ratio is not meaningful with a negative denominator. Based on this interpretation and based solely on this i