Last Revised: 06/29/2023

2024 Level 1 - Financial Statement Analysis

Learning Modules Page

Introduction to Financial Statement Analysis 2

Analyzing Income Statements 10

Analyzing Balance Sheets 25

Analyzing Statements of Cash Flows I 31

Analyzing Statements of Cash Flows II 42

Analysis of Inventories 48

Analysis of Long-Term Assets 51

Topics in Long-Term Liabilities and Equity 59

Analysis of Income Taxes 71

Financial Reporting Quality 78

Financial Analysis Techniques 87

Introduction to Financial Statement Modeling 102

This document should be used in conjunction with the corresponding learning modules in the 2024 Level 1 CFA® Program
curriculum. Some of the graphs, charts, tables, examples, and figures are copyright 2023, CFA Institute. Reproduced and
republished with permission from CFA Institute. All rights reserved.

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Introduction to Financial Statement Analysis

a. describe the steps in the financial statement analysis framework

b. describe the roles of financial statement analysis

c. describe the importance of regulatory filings, financial statement notes and

supplementary information, management’s commentary, and audit reports

d. describe implications for financial analysis of alternative financial reporting

systems and the importance of monitoring developments in financial
reporting standards

e. describe information sources that analysts use in financial statement analysis

besides annual and interim financial reports

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Financial Statement Analysis

1. Determine the purpose and context of the analysis

2. Collect data - Financial Statements

- Discussions with management
- Company site visits

3. Process data - Ratios

- Growth Rates
- Common Size Statements
- Statistical tools

4. Analyze/interpret data - Conclusions/Recommendations

5. Develop/Communicate Conclusions - Analyst Report - Note: Fact v. opinion

6. Follow up

Roles of Financial Statement Analysis

Evaluate performance and position for purpose of making economic decisions

Potential Investment Other

Past
Current Credit

Equity Invt. for Loan decision Merger/

Portfolio Acqn.
Debt Rating
Valuation for a
Recommendation

VC/PE investment

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1. Regulatory Filings

- IOSCO: Objectives and Principles of Securities Regulation

Protecting investors
Objectives Ensuring that markets are fair, efficient and transparent
Reducing systemic risk

10 categories including Regulators, Auditing, Issuers

2 Principles for Issuers relate directly to Financial Reporting
Principles - Full, Accurate, Timely disclosure of Risk, Results, Other

- Accounting Standards used high and internationally

accepted quality

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1. Regulatory Filings

- US Securities and Exchange Commission (SEC)

Securities Act 1933 - information & registration
Significant
Securities Exchange Act 1934 - empowered SEC
Statutes
Sarbanes-Oxley Act 2002 - auditors, internal controls

Securities offerings registration statement 8-K

Forms 10-K, 20-F, 40-F (Annual) Forms 3, 4, 5, 144
Filings Annual report Form 11-K
Proxy Statement/Form DEF-14A
10-Q and 6-K

1. Regulatory Filings

- European Union

member states regulate their own capital markets

some regulation at EU level
- notably consolidated accounts of EU-listed companies
use IFRS

securities regulation:
- European Securities Committee (ESC)
- European Securities and Market Authority (ESMA)

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2. Financial Statement Notes and Supplementary Schedules

- additional information on every line of B/S, I/S plus:

major accounting policies
subsequent events
contractual obligations
off-balance sheet items ... etc.

- Business and Geographic Segment Reporting Revenue & (expenses)

disclose key line items by operating segment results reviewed

if ≥ 10% Revenue, Assets, Profit discrete data

all reported segments must add to 75% external revenue

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3. Management Commentary (MD&A)

- included in 10-K , 10-Q

- unaudited !! (except for Germany)

- IASB provides a framework for ‘decision-useful management commentary’

1. the nature of the business

2. management objectives and strategies Prices Inflation

3. significant resources, risks, relationships significant events/

uncertainties
4. results of operations favorable/unfavorable trends

5. critical performance measures accounting policies

off B/S obligations
- SEC specifies content

4. Audit Reports
- Financial Statements audited by independent Auditor in accordance
with specified auditing standards
independent auditor provides written opinion, the ‘audit report’
- International Auditing Standards (ISA) - Sarbanes-Oxley Act (US)
Reasonable assurance express opinion on internal
Free from material misstatement controls

Prepared in accordance with acceptable standards

- unmodified = unqualified = clean

- modified Qualified

Adverse

Disclaimer

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4. Audit Reports

IFRS versus the World

- global adoption of IFRS has advanced goal of convergence

- IFRS v. US GAAP differences still exist:

e.g.
Reconciliation between standards
not required

Analysts should monitor developments

new products/transactions may not

have specific guidance

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Other Sources of Information

- Issuer Sources: earnings calls, presentations, press releases, ...

- Public Third Party: industry whitepapers, analyst reports, social media, ...

- Proprietary Third Party: Bloomberg etc., Analyst reports, industry specific, ...

- Proprietary Primary Research: surveys, conservations, product comparisons, ...

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Analyzing Income Statements

a. describe general principles of revenue recognition, specific revenue

recognition applications, and implications of revenue recognition choices for
financial analysis

b. describe general principles of expense recognition, specific expense

recognition applications, implications of expense recognition choices for
financial analysis and contrast costs that are capitalized versus those that are
expensed in the period in which they are incurred

c. describe the financial reporting treatment and analysis of non-recurring items

(including discontinued operations, unusual or infrequent items) and changes
in accounting policies

d. describe how earnings per share is calculated and calculate and interpret a
company’s basic and diluted earnings per share for companies with simple
and complex capital structures including those with antidilutive securities

e. evaluate a company’s financial performance using common-size income

statements and financial ratios based on the income statement

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Analyzing Income Statements

Revenue
- Recognized when earned Risks and Rewards transferred

‘more likely
IFRS than not’
- Converged Standard
1. Identify contract with customer ➞ collectability ‘probable’ US ‘likely to
GAAP occur’
2. Identify separate/distinct performance obligations
3. Determine the transaction price ➞ allocate to distinct obligations

4. Allocate the price to performance obligations

5. Recognize revenue when entity satisfies a performance obligation

‘highly probable not reversed’

Revenue

5. Recognize revenue when entity satisfies a performance obligation

- transfer control of good/service to customer

- entity has present right to payment

- customer has legal title

- customer has physical possession

- customer has significant risks & rewards o’ship

- customer has accepted the good or service

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Revenue

Revenue

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Revenue

Expenses
- Recognize in period that:
- economic benefits associated with the expenditure are consumed

OR - Previously recognized economic benefit is lost

Three models Capitalization and
Matching Expensing as Incurred Subsequent Depreciation
or Amortization
Expenses and Revenues Period Costs
Tangible Intangible
e.g. COGS Sales e.g. Admin., Payroll Assets Assets

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Expenses
- Interest: companies must capitalize interest costs associated with
acquiring or constructing an asset that takes a long period
of time to get ready for its intended use

Asset Own Use Asset to Sell

Balance Sheet: Long-Lived Asset Balance Sheet: Inventory

Income Statement: Depreciation Income Statement: Cost of Sales

Cash Flow Statement: Investing Cash Flow Statement: Investing

(CFI) (CFI)

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Expenses
- companies must capitalize software development costs after a product’s
feasibility is established

Judgment!

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Expenses
- Recognition: Conservative or Aggressive

early recognition is conservative

- Estimates: Comparisons year v. year / between companies

should consider estimates:
uncollectable debts as a % sales
warranty expenses as a % sales
useful lives of assets

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Non-Recurring Items

- income statements tell us about the past. What about the future?
- Forecast accuracy improved by removing items less likely to repeat
Unusual or Infrequent Items
- IFRS: income/expenses ‘material or relevant’ to understanding performance
disclosed separately
- US GAAP: ‘material items that are unusual or infrequent or both are shown as
part of continuing operations but disclosed separately.

e.g. Restructuring charges

Sale of a business

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Non-Recurring Items

- Discontinued Operations: disposed of or established plan to dispose of

a component operation
IFRS and US GAAP require separate disclosure
- component must be separable both physically & operationally
- results presented on a net basis at the bottom of the income statement
- assets and liabilities shown on balance sheet as held for sale

- Changes in accounting policy v. Changes in accounting estimates

new standards may require prospective always prospective
or retrospective adoption
no restatement
management may change policies to
‘better reflect company performance’

- Changes in scope and exchange rates no required disclosures!

Earnings Per Share

- EPS based on net profit (or loss) and net profit or loss from continuing
operations must be disclosed on the face of the income statement

- ‘per share’ refers to: ordinary shares (IFRS) interchangeable

common stock/shares (US GAAP) terms

- Complex Capital Structure

any structure with financial instruments that are potentially
convertible into common stock e.g. Convertible Bonds
Convertible Preferred Shares
These instruments have the
Employee Stock Options
potential to dilute EPS
Warrants

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Earnings Per Share uses weighted average number

of shares outstanding
- Simple Capital Structure: report basic EPS

- Complex Capital Structure: report basic and diluted EPS

Assumes all dilutive
instruments are converted/
exercised

Basic EPS e.g. Net Income USD 1,950,000

𝐍𝐞𝐭 𝐈𝐧𝐜𝐨𝐦𝐞 − 𝐏𝐫𝐞𝐟𝐞𝐫𝐫𝐞𝐝 𝐃𝐢𝐯𝐢𝐝𝐞𝐧𝐝𝐬 shares outstanding 1,500,000
𝐖𝐞𝐢𝐠𝐡𝐭𝐞𝐝 𝐚𝐯𝐞𝐫𝐚𝐠𝐞 # 𝐬𝐡𝐚𝐫𝐞𝐬 𝐨𝐮𝐭𝐬𝐭𝐚𝐧𝐝𝐢𝐧𝐠 No preferred stock

Earnings Per Share

Basic EPS calculations

Stock split

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Earnings Per Share

Diluted EPS: Adjust Basic EPS for dilutive instruments

Basic EPS Adjustments

Net income - preferred divs. + savings from conversion

weighted avg. # shares outstanding + shares issued on conversion/exercise

Convertible preferred stock: + convertible preferred dividend

+ shares issued on conversion

Convertible debt securities: + interest (1 - tax rate)

+ shares issued on conversion

Convertible Preferred

Net income - preferred divs. + savings from conversion

weighted avg. # shares outstanding + shares issued on conversion/exercise

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Convertible Debt

Net income - preferred divs. + savings from conversion

weighted avg. # shares outstanding + shares issued on conversion/exercise

Treasury Stock Method (TSM)

Net income - preferred divs.

weighted avg. # shares outstanding + net shares issued using TSM

- for outstanding stock options & warrants calculate diluted EPS using
the treasury stock method (US GAAP):
1. Assume all dilutive options/warrants have been exercised
2. Assume company uses exercise proceeds to repurchase as many
shares as possible at the average market price for the period

3. Add net number of shares to the denominator of basic EPS

- IFRS uses similar method, unnamed but same result

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Treasury Stock Method (TSM)

Net income - preferred divs.

weighted avg. # shares outstanding + net shares issued using TSM

Antidilutive Securities

If adjusting for an instrument increases EPS above basic EPS then it

is antidilutive Antidilutive Securities are ignored in the calculation
of diluted EPS

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Ratios and Common Size Analysis

- Common size income statement - each line stated as a % of sales

- removes the effect of size
- useful for cross sectional/time series analysis

𝐧𝐞𝐭 𝐢𝐧𝐜𝐨𝐦𝐞 𝐠𝐫𝐨𝐬𝐬 𝐩𝐫𝐨𝐟𝐢𝐭

- Profitability Ratios net margin gross margin
𝐬𝐚𝐥𝐞𝐬 𝐬𝐚𝐥𝐞𝐬

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Analyzing Balance Sheets

a. explain the financial reporting and disclosures related to intangible assets

b. explain the financial reporting and disclosures related to goodwill

c. explain the financial reporting and disclosures related to financial instruments

d. explain the financial reporting and disclosures related to non-current liabilities

e. calculate and interpret common-size balance sheets and related financial ratios

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Analyzing Balance Sheets

ill?
Goodw
Intangible Assets
- Intangible Assets are - Identifiable can be acquired on a stand alone basis
- Non Monetary
- Without physical substance

- Recognition - IFRS - Cost or Revaluation Model

- US GAAP - Cost only

- useful life may be assessed as finite or indefinite

- Finite : Amortized over useful economic life, review annually

Impairment as for PPE

- Indefinite : No amortization
Annual Review of Assumption and test for impairment

Intangible Assets Probable Future Economic

Benefit
- Identifiable intangible asset recognized on balance sheet if:
Cost measured reliably
e.g. Patents, trademarks, licenses

- Internally created intangibles: IFRS - Research Costs (seeking knowledge) expensed

e.g. brands, customer lists, - Development Costs (design/testing) capitalized if
training costs, advertising criteria RE: feasibility, profitability, completion met

US GAAP - expense research and development

- Purchased Intangibles: capitalized if arise from contractual/legal right or can be sold

separately
Analyst Adjustments - Intangibles are viewed with ‘caution’ and some
may exclude them to get “tangible book value”
- B/S : Reduce Assets - I/S : add back amortization to
Reduce Equity pretax income

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Goodwill
- Goodwill arises on acquisition of one company by another (internally generated
goodwill not recognized)

- Calculation : excess purchase price above fair value of identifiable assets and
liabilities

- Represents: value not recognized on balance sheet e.g. Reputation, Staff skills

intangible assets that have not been recorded e.g. Research

strategic value e.g. Future operating cost savings

- Goodwill capitalized and tested annually for impairment

- Analyst Adjustments - B/S : exclude goodwill

I/S : exclude impairment charges

Financial Instruments

Definition : ‘contract that gives rise to a financial asset of one entity

and a financial liability or equity instrument of another’

(focus on this reading is financial assets)

Realized gains/losses ➞ I/S

Measurement of Financial Assets: Fair Value (Profit and Loss)
Unrealized gains/losses ➞ I/S

Fair Value (other comprehensive income) Realized gains/losses ➞ I/S

Unrealized gains/losses ➞ OCI

Realized gains/losses ➞ I/S

Amortized Cost
Unrealized gains/losses not recognized

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Financial Instruments

IFRS : Amortized Cost Method - Cash flows are on specified dates and consist
of principal and interest only (debt)
(US GAAP ‘held to maturity’) - Business model is to hold the asset to maturity

IFRS Fair Value through OCI - Debt

- Business model is to collect cash flows and
(US GAAP ‘available-for-sale’)
sell the asset
- Equity only if irrevocable election at purchase
IFRS only

IFRS Fair Value through P&L - If not in either of the other categories

US GAAP ‘trading’ (debt) - Or if made irrevocable election at purchase

and all equity

Financial Instruments
Example : Purchase 5% semi-annual coupon bond for EUR 100,000,000
in six months fair value is EUR 102,000,000.

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Non-Current Liabilities

Long Term Financial Liabilities : Amortized Cost except

- Held for trading

- Derivatives

- Non-derivatives that are hedged by derivatives

Deferred Tax Liabilities : Result from temporary timing differences

e.g. Accelerated depreciation for tax purposes

v. Straight line in accounts

Ratios and Common Size Analysis

Vertical Common Size Analysis : every line stated as a % of total assets

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Ratios and Common Size Analysis

Liquidity Ratios Solvency Ratios

(Ability to meet short-term obligations) (Ability to meet long-term obligations)

Long-Term 𝐓𝐨𝐭𝐚𝐥 𝐋𝐨𝐧𝐠 𝐓𝐞𝐫𝐦 𝐃𝐞𝐛𝐭

𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐀𝐬𝐬𝐞𝐭𝐬 =
Current = Debt-to-Equity 𝐓𝐨𝐭𝐚𝐥 𝐄𝐪𝐮𝐢𝐭𝐲
𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐋𝐢𝐚𝐛𝐢𝐥𝐢𝐭𝐢𝐞𝐬
Debt-to-Equity = 𝐓𝐨𝐭𝐚𝐥 𝐃𝐞𝐛𝐭
𝐓𝐨𝐭𝐚𝐥 𝐄𝐪𝐮𝐢𝐭𝐲
𝐂𝐚𝐬𝐡 + 𝐌𝐚𝐫𝐤𝐞𝐭𝐚𝐛𝐥𝐞 𝐒𝐞𝐜. + 𝐑𝐞𝐜𝐞𝐢𝐯𝐚𝐛𝐥𝐞𝐬
Quick =
𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐋𝐢𝐚𝐛𝐢𝐥𝐢𝐭𝐢𝐞𝐬 𝐓𝐨𝐭𝐚𝐥 𝐃𝐞𝐛𝐭
(Acid Test) Total Debt =
𝐓𝐨𝐭𝐚𝐥 𝐀𝐬𝐬𝐞𝐭𝐬

𝐂𝐚𝐬𝐡 + 𝐌𝐚𝐫𝐤𝐞𝐭𝐚𝐛𝐥𝐞 𝐒𝐞𝐜𝐮𝐫𝐢𝐭𝐢𝐞𝐬

Cash = Financial Leverage = 𝐓𝐨𝐭𝐚𝐥 𝐀𝐬𝐬𝐞𝐭𝐬
𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐋𝐢𝐚𝐛𝐢𝐥𝐢𝐭𝐢𝐞𝐬
𝐓𝐨𝐭𝐚𝐥 𝐄𝐪𝐮𝐢𝐭𝐲

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Analyzing Statements of Cash Flows I

a. describe how the cash flow statement is linked to the income statement and the
balance sheet

b. describe the steps in the preparation of direct and indirect cash flow statements,
including how cash flows can be computed using income statement and balance
sheet data

c. demonstrate the conversion of cash flows from the indirect to direct method

d. contrast cash flow statements prepared under International Financial Reporting

Standards (IFRS) and US generally accepted accounting principles (US GAAP)

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Analyzing Statements of Cash Flows I

Linkages Between Statements

Linkages Between Statements

Example: Purchases, Sales on Credit Balance Sheet Income Statement Statement Cash Flows
Inventory +100 Revenue - CFO -
1 Jan. Purchase EUR 100 Accounts +100 Cost of Sales -
Inventory on credit Payable

Accounts -100 Revenue -

31 Jan. Pay for Inventory Payable Cost of Sales -
Cash -100 CFO -100

1 Feb. Sell Inventory for Inventory -100 Revenue +150

CFO -
EUR 150 on credit Accounts Cost of Sales +100
Receivable +150

15 Feb. Customer pays Accounts -150 Revenue -

Receivable CFO +150
EUR 150 Cost of Sales -
Cash +150

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Linkages Between Statements

Example: Depreciation Balance Sheet Income Statement Statement Cash Flows

1 Jan. Own equipment, PPE 100 Depreciation CFI -

Expense
-
Cost USD 100
Depreciation for year USD 10

1 July Buy equipment for cash

PPE +200 Depreciation
- CFI -200
Cost USD 200 Expense
Cash -200
Depreciation for year USD 50

Accumulated Depreciation
+35 CFI -
31 Dec. Charge depreciation Depreciation Expense +35

expense for year

Linkages Between Statements

Example: Borrowing Balance Sheet Income Statement Statement Cash Flows

Cash +500 Interest CFF +500

31 March Borrow USD 500 -
Expense
Loan +500

Cash -525 Interest CFO/CFF -25

30 Sept. Repay USD 500 +25
Expense
Loan -500 CFF -500
and USD 25 interest

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Linkages Between Statements

Example: Deferred Revenue Balance Sheet Income Statement Statement Cash Flows

Company agrees to manufacture Cash - Revenue - CFO -

a custom piece of equipment Deferred
Revenue -
for a customer for USD 1000

1 Oct. Customer makes a down Cash +300 CFO +300

Revenue -
payment of USD 300 Deferred +300
Revenue

30 Nov. Equipment delivered Cash +700 CFO +700

Revenue +1,000
and balance paid Deferred
-300
Revenue

The Direct Method

Direct presentation lists out cash flows by type to calculate CFO

Most common presentation is indirect, but direct can be constructed using

the income statement and opening and closing balance sheets:

Cash Received from Customers : B/S : Accounts Receivable I/S : Revenue

2018 2017
e.g. B/S: Accounts Receivable 1,012 957 increase 55
I/S: Revenue 23,598

Revenue 23,598

[deduct] Increase in AR (55)

23,543

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The Direct Method

Cash paid to suppliers B/S : Accounts Payable I/S : Cost of Goods Sold
Inventory
2018 2017
e.g. B/S: Inventory 3,984 3,277 increase 707
Accounts Payable 3,588 3,325 increase 263

I/S: Cost of Goods Sold 11,456

Cost of Goods Sold (11,456)

[deduct] Increase in Inventory (707)
Purchases from Suppliers (12,163)
add
back Increase in Accounts Payable 263
Cash Paid to Suppliers (11,900)

The Direct Method

Cash paid to employees B/S: Salary and Wages Payable I/S: Salary and Wages Expense

2018 2017
e.g. B/S: Salary and Wages Payable 85 75 increase 10

I/S: Salary and Wages Expense 4,123

Salary and Wages Expense (4,123)

add Increase in Salary and Wages Payable 10

back
Cash Paid to Employees (4,113)

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The Direct Method

Cash paid for other operating expenses B/S: Prepaid Expenses I/S: Other Operating
Accrued Liabilities Expenses
2018 2017
e.g. B/S : Prepaid Expenses 155 178 decrease 23
Accrued Liabilities 1,126 1,104 increase 22

I/S : Other Operating 3,577

Expenses

Other Operating Expenses (3,577)

add
back Decrease in Prepaid Expenses 23
add Increase in Accrued Liabilities 22
back
Cash Paid for Other Operating Expenses (3,532)

The Direct Method

Cash paid for Interest B/S: Interest Payable I/S: Interest Expense

2018 2017

e.g. B/S : Interest Payable 62 74 decrease 12

I/S : Interest Expense 246

Interest Expense (246)

Decrease in Interest Payable (12)

Cash Paid for Interest (258)

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The Direct Method

Cash paid for Income Taxes B/S: Income Tax Payable I/S: Income Tax Expense

2018 2017
e.g. B/S : Income Tax Payable 55 50 increase 5
I/S : Income Tax Expense 1,139

Income Tax Expense (1,139)

add
back Increase in Income Tax Payable 5
(1,134)

The Indirect Method

Instead of disclosing cashflows by type, CFO is calculated by adjusting net income

for : (1) non cash items (2) changes in operating working capital items

Additions
Depreciation & Amortization expense
Depletion expense of natural resources Subtractions
Amortization of bond discount Amortization of bond premium
Loss on sale/write-down of assets Gain on sale of assets
Loss on retirement of debt Gain on retirement of debt
Loss on investments under equity method Income on investments under equity method
Increase in deferred income tax liability Decrease in deferred income tax liability
Decrease in current operating assets Increase in current operating assets
(AR, Inventory, Prep.) Decrease in current operating liabilities
Increase in current operating liabilities
(AP, Accruals)

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Indirect Example (CFO)

Net Income 2,210

Depreciation Expense 1,052
Gain on Sale Equipment (205)
Increase in Accounts Receivable (55)
Increase in Inventory (707)
Increase in Accounts Payable 263
B/S 2018 2017 Change Increase in Salary and Wage Payable 10
Decrease in Prepaid Expenses 23
Increase in Other Accrued Liabilities 22
Decrease in Interest Payable (12)
Increase in Income Tax Payable 5
Net Cash Provided by Operating Activities 2,606

Direct Example (CFO)

Cash Received from Customers [23,598-55] 23 543

Cash Paid to Suppliers [(11,456)-707+263] (11,900)
Cash Paid to Employees [(4,123)+10] (4,113)
Cash Paid for Other Operating Expenses
[(3,577)+23+22] (3,532)
Cash Paid for Interest [(246)-12] (258)
Cash Paid for Income Taxes [(1,139)+5] (1,134)
B/S 2018 2017 Change Net Cash Provided by Operating Activities 2,606

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Converting Indirect ➞ Direct (CFO)

Three Step Process:
(1) Disaggregate net income into revenues and expenses
(2) Remove non-operating and non-cash items
(3) Convert accruals based revenue/expenses into cash flow by adjusting for changes
in working capital amounts

(1) Revenue [23,598 + 205] 23 803

Expenses [(11,456)+(4,123)+(1,052)+(3,577)+(246)+(1,139)]
(21,593)
2,210
(2) Total Revenue less non-cash items [23,803-205] 23,598
Total Expenses less non-cash items [(21,593)+1,052] (20,541)

(3) Exactly as per direct method!

Cash Flows From Investing Activities

Most common components are cash flows from purchase/sale of PPE:
Purchase: cash spent on additions is an outflow from investing activities
Sale : cash received from disposals is an inflow from investing activities
Net PPE on balance sheet also changes due to depreciation which is not a cash flow
if historic cost and depreciation are given separately:
Beginning Historic Cost PPE x Beginning Accumulated Depreciation x
Additions x Accumulated Depreciation of Disposals (x)
Historic Cost of Disposals (x) Depreciation Expense x
Ending Historic Cost PPE x Ending Accumulated Depreciation x
If only given net PPE : Beginning Net PPE x
Additions x
NBV of Disposals (x)
Depreciation Expense (x)
Ending Net PPE x

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Cash Flows From Investing Activities

2018 2017 Beginning Historic Cost PPE 12,745
Additions 1,300
Historic Cost of Disposals (1,057)
Ending Historic Cost PPE 12 988

Beginning Accumulated Depreciation 2,891

Accumulated Depreciation of Disposals (500)
Depreciation Expense 1,052
Ending Accumulated Depreciation 3,443

Beginning Net PPE 9,854

Additions 1,300
NBV of Disposals (557)
Depreciation Expense (1,052)
Ending Net PPE 9,545

Cash Flows From Investing Activities

Beginning Historic Cost PPE 12,745
Additions 1,300 Cash Paid for Purchase of Equipment (1,300)
Historic Cost of Disposals (1,057) Cash Received from Sale of Equipment 762
Ending Historic Cost PPE 12 988 Net Cash Used for Investing Activities 538

Beginning Accumulated Depreciation 2,891

Accumulated Depreciation of Disposals (500)
Depreciation Expense 1,052
Ending Accumulated Depreciation 3,443 Proceeds 762
NBV of Disposal 557
Beginning Net PPE 9,854 Gain on Sale 205
Additions 1,300
NBV of Disposals (557)
Depreciation Expense (1,052)
Ending Net PPE 9,545

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Cash Flows From Financing Activities

Cash Flows from sources of finance (debt and equity) and dividends paid
(although there is a choice under IFRS for dividends paid)
Movements in debt and equity are straightforward to calculate from the balance sheet
Dividends paid can be calculated using net income and retained earnings:
Beginning Retained Earnings 2,876
Net Income 2,210
Dividends (1,120)
Ending Retained Earnings 3,966

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 Investing Activities (2,220)

US GAAP v. IFRS
US GAAP : Interest Received CFO IFRS : Interest Received CFO or CFI
Interest Paid CFO Interest Paid CFO or CFF
Dividends Received CFO Dividends Received CFO or CFI
Dividends Paid CFF Dividends Paid CFO or CFF

Bank Overdrafts Part of Cash Bank Overdrafts CFF

Taxes Paid CFO Taxes Paid CFO or CFI or
CFF

Format of Statement : US GAAP : Direct or Indirect (Direct encouraged)

Reconciliation of Net Income to CFO must be provided

IFRS : Direct or Indirect (Direct encourage)

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Analyzing Statements of Cash Flows II

a. analyze and interpret both reported and common-size cash flow statements

b. calculate and interpret free cash flow to the firm, free cash flow to equity, and
performance and coverage cash flow ratios

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Analyzing Statements of Cash Flows II

Analyze Cash Flow Statements

Evaluation of the cash flow statement involves: 1. Assessment of sources and uses of
cash in CFO, CFI, CFF
2. Assessment of the main drivers of cash
flow in CFO, CFI, CFF
1. Major Sources and Uses
Major sources of cash for a company vary with its stage of growth
Mature Companies: Operating activities should be primary source ➞ CFO can be used in
investing or financing activities
if profitable opportunities exist if no profitable opportunities exist
New/Growth Stage Companies: CFO likely to be negative for a period, must eventually
turn positive
Long Run : Desirable for CFO to cover capital expenditure

Main Drivers of Cash Flows

2. Analyze Main Drivers of Cash Flows
CFO : Is the company generating cash from its operation? How?
- movements in Receivables, Inventories, Payables
- compare CFO to Net Income (earnings quality)
- CFO > Net Income due to non-cash charges
- Net Income > CFO may indicate poor earnings quality
CFI : Identify each line as a source or use of cash
- is the company using cash to invest in PPE, make acquisitions, invest in liquid assets
- what sources of cash are being used to cover investments, excess CFO,
CFF or sales of assets (CFI)?
CFF : Is the company raising capital or repaying capital
- if consistently raising capital, when is repayment required
- CFF will also include dividend payments

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E.G. Group Danone

2016 2017
CFO 2,652 2,958
CFI (848) (11,437)
CFF (1,616) 8,289
Ex Rates (151) 272
Inc/dec Cash 38 81

1. Major sources and uses?

2. Does CFO cover CAPEX?
3. What is the relationship between net income and CFO?

Common Size Statements and Ratios

There are two approaches to common size cash flow statements:
(1) Every inflow is shown as a % of total inflows
(outflow) (outflows)
- Direct Method - Indirect Method

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Common Size Statements and Ratios

(2) Each line item is expressed as a % of net revenue useful in forecasting

1. Trend in depreciation?
2. Trend in CAPEX?

3. CFO v. Net Income

Free Cash Flow Measures

Operating cash flows should be sufficient to cover capital expenditures:
CFO - Capital Expenditures = Free Cash Flow (FCF)
Analysts calculate two FCF measures for valuation purposes:
(1) Free Cash Flow to the Firm (FCFF) : FCF available to both debt and equity investors
after operating expenses and taxes are paid
(2) Free Cash Flow to Equity (FCFE) : FCF available to equity investors after borrowing
costs have been paid
(1) Free Cash Flow to the Firm (FCFF)
FCFF = Net Income + Non Cash Charges - Working Capital Investment - Fixed Capital Investment
+ Interest(1-𝐭)
FCFF = NI + NCC + Int(1-𝐭) - FCInv - WCInv

(2) Free Cash Flow to Equity (FCFE)

FCFE = Net Income + Non Cash Charges - Working Capital Investment - Fixed Capital Investment
+ Net Borrowings - Net Repayment
FCFE = NI + NCC - FCInv - WCInv + NB

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Free Cash Flow Measures

FCFF Calculation
Assume a marginal tax rate of 34%

FCFF = NI + NCC + Int(1-𝐭) - FCInv - WCInv

Free Cash Flow Measures

(2) Free Cash Flow to Equity
FCFE = CFO - FCInv + Net Borrowing
(- Net Debt Repayment)

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Cash Flow Ratios

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Analysis of Inventories

a. describe the measurement of inventory at the lower of cost and net realisable
value and its implications for financial statements and ratios

b. calculate and explain how inflation and deflation of inventory costs affect the
financial statements and ratios of companies that use different inventory
valuation methods

c. describe the presentation and disclosures relating to inventories and explain

issues that analysts should consider when examining a company’s inventory
disclosures and other sources of information

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Analysis of Inventories

Measurement of Inventory
IFRS: Value inventory at lower of cost and net realizable value
if NRV < cost write-down charged to income statement
subsequent increases in NRV recognized and reduce
Cost of Sales in the income statement (reversal)

US GAAP: Any method other than LIFO, Retail Inventory method:

same as IFRS except: no reversals permitted
LIFO, Retail Inventory method:
lower of cost or market value
market value is defined as current replacement cost

Exception: Agricultural products, forest products, minerals, commodity broker-traders

(both)

Measurement of Inventory
Impact of write-down on ratios
Write-down: Reduces inventory (current, total assets ↓) less likely using LIFO
Increases expenses (net income, equity ↓)
Solvency Ratios Liquidity Ratios Profitability Ratios Activity Ratios
[negative effect] [negative effect] [negative effect] [positive effect]
Decrease in Equity Decrease in Current Assets Decrease in Net Income Decrease in Assets
Increase in COGS

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Effect of Inflation and Deflation

How the cost of inventory is allocated between inventory (B/S) and cost of sales (I/S)
depends on the accounting method used
Key Point: FIFO method: oldest units in I/S LIFO method: newest units in I/S
newest units in B/S oldest units in B/S

Inflation: FIFO method: Higher Profit (I/S) LIFO method: Lower Profit (I/S)
(Rising Input Prices) Higher Inventory (B/S) Lower Inventory (B/S)
Higher Taxes Lower Taxes

Presentation and Disclosure

Choice of accounting method for inventory affects - Cost Sales, Gross Profit, Net Income
- Inventory, Current Assets, Total Assets, Equity
IFRS Disclosures
Accounting Policy adopted
Total carrying amount broken down by: merchandise, raw materials, prodn supplies, work
in progress, finished goods
Carrying amount of inventories held at fair value less costs to sell
Amount of inventories recognized as an expense during period (cost of sales)
Amount of write-downs recognized as an expense in the period
Amount of any reversal of any write-down recognized as a reduction in cost of sales in
the period
Circumstances/events that led to reversal
Carrying amount of inventories pledged as security for liabilities
US GAAP Disclosures
As above: Less: Disclosures on reversals
Add: Significant estimates applicable to inventories
Any material income resulting from a LIFO liquidation

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Analysis of Long-Term Assets

a. compare the financial reporting of the following types of intangible assets:

purchased, internally developed, and acquired in a business combination

b. explain and evaluate how impairment and derecognition of property, plant, and
equipment and intangible assets affect the financial statements and ratios

c. analyze and interpret financial statement disclosures regarding property, plant, and
equipment and intangible assets

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Analysis of Long-Term Assets

Intangible Assets
Definition : Non-Monetary
Lack Physical Substance
IFRS Definition Criteria: (1) Identifiable Goodwill!
(2) Under the control of the company
(3) Expected to generate future economic benefits
IFRS Recognition Criteria: (1) Probable that the expected future economic benefits will flow to
(2) Cost of the asset can be reliably measured the company

Purchased (other than Bus. Combn) Developed Internally Acquired in a Business Combination
Record on B/S at fair value (cost) Expensed as incurred Purchase price allocated to identifiable
(cost allocated to each asset if part Exceptions: Development assets & liabilities at fair value
of a group)
Capitalizing versus Expensing IFRS: Must meet the definitional
Higher Assets Lower Assets and recognition criteria
Higher CFO Lower CFO US GAAP: (1) arises from contractual
Lower CFI Higher CFI or legal right
or (2) can be separated from co.

Goodwill
In a business combination the excess of the
purchase price over and above the fair value
of identifiable assets and liabilities acquired
is goodwill
Purchase Price x
FV ID NA Acquired (x)
Goodwill X

Goodwill is not separable

has indefinite life
is not amortized
is checked annually for impairment

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Intangible Assets
Internally Developed: Specific rules for research and development and software
development costs
Research and Development
IFRS Research (gaining knowledge and understanding) expensed
Development (application to design new/improved products) capitalized technically
feasible
intent to use/sell
US GAAP Research and development expensed
Exception: software development costs - capitalize when technologically feasible
probable completion (for
internal use project)

Impairment
Property, Plant, and Equipment
At the end of each period the company ‘assesses whether there are indications of impairment’
(obsolescence, decline demand for product etc.)
If there are indications Impairment Test

IFRS (one step) US GAAP (two step)

Impaired if carrying value > recoverable amount 1. If undiscounted cash flows
from use < carrying value
Higher of Value in use asset is impaired
Fair value less 2. If impaired, calculate the
costs to sell amount of impairment as:
carrying value - fair value
Impact on Accounts : PPE, Total Assets, Equity ↓
Not a cashflow!
Net Income ↓

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Impairment
PPE Example

1. Under IFRS, what would the company report for the machine? 2. Under US GAAP, what would the company report for the machine?

Impairment
PPE Example (2)

1. Under IFRS, what would the company report for the machine? 2. Under US GAAP, what would the company report for the machine?

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Impairment
Intangible Assets : Finite Lives
As with PPE, assessed for indications of impairment e.g. Adverse change in legal or
economic factors
Accounting is as for PPE

Intangible Assets : Indefinite Lives

Intangible assets with indefinite lives are not amortized but : Reviewed annually for impairment

Long-Lived Assets Held-For-Sale

Long-lived assets held-for-sale if Management’s intent is to sell
Sale is highly probable
Tested for impairment when classified as held-for-sale
If carrying value > fair value less costs to sell, recognize impairment loss
(Held-for-sale assets are not depreciated or amortized)

Reversal of Impairments

What if after recording an impairment, recoverable amount recovers?

IFRS US GAAP
Reverse : Record a credit in income statement (I/S) Only for held-for-sale
Increase asset carrying value (B/S)
Can only reverse up to previous carrying amount
Held-for-use, or held-for-sale losses can be reversed

Impact on Accounts : Long-lived assets, total assets, equity ↑ Not a cash flow!
Expenses decrease so net income ↑

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Derecognition
Derecognize an asset when it no longer provides economic benefit
If sale is highly probable move to held for sale
Gain/Loss on Sale
Proceeds From Sale* x CFI (cash flow statement), + cash B/S
Net Book Value (x) Remove from PPE in B/S
Gain/(Loss) x/(x) Income Statement - other gains and losses
- separate if material
*[zero if abandoned]

= FV asset given up
or FV asset acquired if
Asset Exchange ‘more evident’
or CV asset if no reliable FV
Carrying value removed, replaced with fair value asset acquired
[G/L = zero]

Disclosures
IFRS US GAAP
Measurement Basis (Historic Cost, Fair Value)
Depreciation Method (straight line, declining balance etc.)
Gross Carrying Amount start and end of period
Accumulated Depreciation + estimated amortization
Depreciation Expense for Period expense for next 5 yrs.
Reconciliation of Carrying Amount from Beginning to End Period
Major Classes of Assets
Justification of Indefinite Lives for Intangibles
Restrictions on title, pledges as security
Contractual Agreements to Acquire PPE
Revaluation Model : Date of revaluation
Details of fair value calculation not allowed
Carrying amount under cost model
Revaluation surplus

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Disclosures
IFRS US GAAP
Amount of impairment losses
Circumstances leading to impairment + method of determining fair value
Amount of impairment losses reversed not allowed for held-for-use
Circumstances leading to reversal
Where impairment losses are recognized

Note: If company uses ‘function of expense’ method for income statement depreciation
expense is shown separately

Using Disclosures
The extensive amount of PPE disclosure can be used to calculate:
1. Fixed Asset Turnover : Total Revenue
Higher Ratio = More efficient use of assets
Average Net Fixed Assets

2. Asset Age Ratios : Historic Cost = Estimated Total Useful Life

Annual Depreciation Expense

Accumulated Depreciation = Estimated Age of Assets

Annual Depreciation Expense

Assumptions : Straight Line Depreciation

No Salvage Value

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Using Disclosures
Orange BCE Verizon
Total Life: 97,092 69,230 246,498 - 806
4,708 3,037 14,741
20.6 22.8 16.7

Age : 70,427 45,197 157,930

4,708 3,037 14,741
15.0 14.9 10.7

Remaining : 5.6 7.9 6.0

Life

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Topics in Long-Term Liabilities and Equity

a. explain the financial reporting of leases from the perspectives of lessors and lessees

b. explain the financial reporting of defined contribution, defined benefit, and stock-
based compensation plans

c. describe the financial statement presentation of and disclosures relating to long-

term liabilities and share-based compensation

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Topics in Long-Term Liabilities and Equity

Leases
Lease : A contract that conveys the right to use an asset for a period of
time in exchange for consideration
Lessee : Pays consideration and uses an asset (e.g. a manufacturer leases a warehouse to
use)

Lessor : Receives consideration for granting the use of an asset (e.g. an investment
property company)
Requirements For Lease Accounting
The Contract Must: identify a specific underlying asset
give the customer the right to obtain largely all of the economic
benefits from the asset over the contract term
give the customer, not the supplier, the ability to direct how and for
what objective the underlying asset is used

Leases
Advantages to Leasing (v. Purchasing):
less cash required up front
lower ‘finance’ cost than an unsecured loan - asset acts as security
convenience and lower risks of ownership e.g. obsolescence
lessor widens market for customers
lessor receives income stream over the lease term

Accounting Standards classify leases as operating : Resembles a rental agreement

or finance : Resembles the purchase of an asset
Classified as finance if it meets any of the following criteria:
1. The lease transfers ownership of the underlying asset to the lessee
2. The lessee has an option to purchase the underlying asset and is reasonably certain it
3. The lease term is for a major part of the asset’s life will do so
4. The PV of the sum of lease payments equals or exceeds substantially all the FV of the
asset
5. The underlying asset has no alternative use to the lessor

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Leases
Is it a lease? specific asset
largely all benefits over term
customer directs use

Finance lease? transfers ownership

option to purchase (reasonably
certain)
term = major part of asset’s life
PV pmts. substantially all of FV
asset no other use to lessor

Leases
Exemption from lease accounting : Term ≤ 12 months (IFRS and US GAAP)
Asset ≤ USD 5,000 (IFRS only)
Lessee Accounting (IFRS)
Operating and Finance Leases treated identically:
Lease Liability B/S at inception Right-of-Use Asset
Present value* of future lease payments Present value* of future lease payments
(amortize using effective interest method) (amortized, usually straight line)

Interest expense I/S during life Amortization expense

Principal Repayment : (CFF) C/F during life

Interest Payment : (CFO)/(CFF)

* [discount rate = implicit rate or estimated secured borrowing rate]

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Leases (IFRS)

Leases
Lessee Accounting (US GAAP)
Finance Leases treated identically to IFRS
Operating Leases treated differently

US GAAP Operating Leases

Lease Liability B/S at inception Right-of-Use Asset
Present value* of future lease payments Present value* of future lease payments
(amortize using effective interest method) (amortization = lease payment - interest)
I/S during life
Lease Expense
(one line, equal to lease payment)

Lease Payment : (CF0) C/F during life

* [discount rate = implicit rate or estimated secured borrowing rate]

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Leases (US GAAP)

Leases (US GAAP)

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Leases
Lessor Accounting
IFRS and US GAAP pleasingly similar

Finance Lease
Derecognize Leased Asset B/S at inception Lease Receivable Asset
Remove from Balance Sheet Present value* of future lease payments
Reduced by pmts. using effective interest
method
I/S at inception
Difference = Gain/Loss
I/S during life
Interest income (Revenue if primary activity)
C/F during life
CFO

[ * discount rate = implicit rate]

Leases
Lessor Accounting
IFRS and US GAAP pleasingly similar

Operating Lease
Retain Leased Asset B/S at inception
Do Not Remove from Balance Sheet
I/S during life
Lease Revenue Recognized Straight Line

Cash Flow during life

CFO

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Leases

Employee Compensation
Salary Defined Contribution Pension Plan
Bonus Defined Benefit Pension Plan
Health & Life Insurance Premiums Share Based Compensation

Usually vest immediately or shortly after Deferred - employees may earn compensation
the grant date in the current period but receive in future
Reported as an expense in the period periods
in which they vest Amount may be based on future variables
e.g. Final Salary, Stock Price

Defined Contribution Plan

Company pays into plan, no further
obligation
Payment recorded as an expense in
the period

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Employee Compensation
Defined Benefit Plan
Company promises a value of future benefits to be paid in retirement:
e.g. Annual payment during retirement until death equal to # Yrs. service × Final Salary
60
Company has an obligation which it will fund with assets

PV of future obligation Held in separate legal entity (Pension Trust Fund)

Discount Rate = yield on high quality corp. bond Company makes payments into fund which
Assumptions used significantly affect obligation are invested until needed
Fund makes pension payments when required
PV of future obligation > Fair value plan assets [deficit]
Company reports a net pension liability (B/S)

PV of future obligation < Fair value plan assets [surplus]

Company reports a net pension asset (B/S)

Employee Compensation
Accounting For Defined Benefit Plan
The change in the net pension asset/liability over the year is recognized in either
the income statement or other comprehensive income (OCI). The split differs between
IFRS and US GAAP
IFRS
Income Statement Other Comprehensive Income
Service Cost - PV increase in benefit earned Remeasurements - (1) Actuarial Gains/Losses from
by employee in the year changes in assumptions
- Past service costs resulting from (e.g. Avg. service life, salary increases etc.)
changes in plan rules - (2) Difference between the actual
Net Interest return on assets and return
Expense/Income - Change in the PV of the net included in interest (P&L)
pension asset/liability due to the
passage
= (Net Pension Asset/Liability × Disc. Rate)

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Employee Compensation
US GAAP
Income Statement Other Comprehensive Income
Service Cost - PV increase in benefit earned Actuarial
by employee in the year Gains/Losses - on obligation (as for IFRS)
- actual return on assets less
Interest Expense - interest accrued on beginning expected return on assets (I/S)
plan obligation using discount [Typically amortized into income statement over
rate time. May be recognized immediately in I/S]

Expected Return
on Assets - return plan assets would have - past service costs resulting from
generated using expected rate changes in plan rules
of return [Amortized into income statement over
future service period of employees]

Employee Compensation
Share-Based Compensation
Aim is to align employee’s interests with those of shareholders - does it though?
Potentially involves no cash outlay but:
is a form of compensation expense
has the potential to dilute EPS
may be cash settled
may cause management to be risk averse/take excessive risks
Stock Grants
Compensation expense based on fair value of stock on the grant date
Expense recognized over the plan’s vesting schedule
Outright - Allocated over service period (current period unless specified)
Restricted - Allocated over service period related to performance

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Employee Compensation
Stock Options
Compensation based on fair value of option on grant date

Valuation Mode Required (Black Scholes, Binomial?)

Standards do not specify a particular model but require that it:
(1) Be consistent with fair value measurement
(2) Be based on established principles of financial economic theory
(3) Reflect all substantive characteristics of the award ➞ if dependent on events after
Key Valuation Inputs the grant date wait until
Exercise Price those facts are known
Stock Price Volatility
Estimated life of award
Estimated # options that will be forfeited
Dividend yield
Risk-Free interest rate

Employee Compensation
Accounting For Stock Options
Grant Date Vesting Date Exercise Date

Service Period Price at exercise date irrelevant

to compensation expense
Compensation expense recognized Record cash and APIC
over Service Period
Add to additional paid in
capital
No impact on equity!

Cash Settled Share Compensation

Stock Appreciation Rights (SARs) Reward for increase in share value without issuing shares
Limited potential to induce risk aversion
Fair Value allocated as expense over the service period

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Presentation and Disclosure

Leases
B/S : Assets : Right of Use Asset
(may be grouped in ‘other’ if not significant)
Liabilities: Lease Liability
Lessee Disclosures
Carrying Amount of ROU Asset at end of period (by class)
Total cash outflow for leases
Interest Expense on lease liabilities
Depreciation charges for ROU assets (by class)
Additions to ROU Assets
Maturity and qualitative analysis of lease liabilities and activities:
- Nature of the lessee’s leasing activities
- Future cash outflows to which lessee is potentially exposed (that are not in liabilities)
- Restrictions or Covenants imposed by leases
- Sale and leaseback transactions

Presentation and Disclosure

Lessor Disclosure
Finance Leases - Amount of selling Profit or Loss
- Finance income on the net investment in the lease
- Income relating to variable lease payments not included in measurement
of the lease
- Qualitative and Quantitative explanation of significant changes in the
carrying amount of the net investment
- Maturity Analysis of lease payments receivable - undiscounted CF Yrs. 1-5
thereafter

Operating Leases - lease income

- income relating to variable lease payments not based on an index or rate
- disaggregated information about each class of PPE subject to operating
leases
- maturity analysis of lease payments receivable - undiscounted CF Yrs. 1-5
thereafter

Plus : Qualitative and Quantitative information about leasing activities

How lessor manages risks associated with rights it retains in underlying leased assets

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Presentation and Disclosure

Postemployment Plans
Defined Contribution Pension Plan - Amount recognized in income statement for period
Defined Benefit Pension Plan
Characteristics and Risks
Identify and explain amounts in financial statements
Describe how plan may affect the amount, timing and uncertainty of the entity’s future
In addition, specific disclosures required include: cash flows

Nature of benefits provided, regulatory framework, governance, risks

Reconciliation opening net position to closing net position
Composition of plan assets by category (asset class)
Indications of the effect of the plan on the entity’s future cash flows
Sensitivity analysis showing how changes in assumptions would impact the financial statements
Discount Rate
Future Salary increases etc.

Presentation and Disclosure

Share-Based Compensation
Description of each type of share-based payment arrangement - Vesting Requirements
- Maximum Term of Options
- Method of Settlement
Options : Number outstanding at start of period
Granted during period
Forfeited during period
Exercised during period
Expired during period
Outstanding at the end of the period
Exercisable at the end of the period
Other equity instruments granted during the period - number and weighted average fair value
- How fair value was measured

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Analysis of Income Taxes

a. contrast accounting profit, taxable income, taxes payable, and income tax expense
and temporary versus permanent differences between accounting profit and taxable
income

b. explain how deferred tax liabilities and assets are created and the factors that
determine how a company’s deferred tax liabilities and assets should be treated for
the purposes of financial analysis

c. calculate, interpret, and contrast an issuer’s effective tax rate, statutory tax rate, and
cash tax rate

d. analyze disclosures relating to deferred tax items and the effective tax rate
reconciliation and explain how information included in these disclosures affects a
company’s financial statements and financial ratios

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Analysis of Income Taxes

Review of Terminology
Accounting Profit = Pretax Income: Reported in income statement, based on accounting standards
Taxable Income : Income subject to income taxes under relevant tax laws
Account Profit and Taxable Income are likely to be different
due to temporary differences and permanent differences
Income Tax Payable : Based on taxable income, appears on the balance sheet
Income Tax Paid : Cash amount paid, reduces income tax payable

Carrying Amount : The amount at which an asset/liability is recorded in the financial statements
Tax Base : The amount at which an asset/liability is valued for tax purposes
Carrying value and tax base are likely to be different
due to temporary differences and permanent differences

Taxable Temporary Difference Deductible Temporary Difference do not reverse

Carrying Value Asset > Tax Base Carrying Value Asset < Tax Base do not give rise to deferred tax
Carrying Value Liab. < Tax Base Carrying Value Liab. > Tax Base
[deferred tax liability] [deferred tax asset] [company tax rate ≠ statutory tax
rate]

Review of Terminology
Tax Expense = provision for income taxes : appears in income statement :

Tax Expense : Income tax payable X

Changes in deferred tax assets/liabilities X/(X)
X

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Deferred Tax Assets/Liabilities

DTA’s and DTL’s result from temporary differences and are shown on B/S
Assets
Carrying value > tax base ➞ deferred tax liability on B/S DTL
Carrying value < tax base ➞ deferred tax asset on B/S DTA
Liabilities
Carrying value > tax base ➞ deferred tax asset on B/S DTA
Carrying value < tax base ➞ deferred tax liability on B/S DTL
Calculation
Balance Sheet DTA/DTL : (temporary difference × tax rate)
Income Statement DT charge/credit : change in DTA/DTL during year
Valuation Allowance
Deferred tax assets should only be recognized if the company expects to be able to
realize the economic benefit of the deferred tax asset
If this is in doubt for existing DTA : IFRS : write down the DTA
US GAAP: create a valuation allowance to offset DTA

Deferred Tax Assets/Liabilities

Depreciation relates to PPE that cost 20,000 at start of year one. Assume statutory tax rate is 30%
End of: YR 3 YR 2 YR 1
Carrying Value 14,000 16,000 18,000
Tax Base 11,429 14,286 17,413
Temporary Difference 2,571 1,714 857
Balance Sheet : DT Liability 771 514 257

Income Statement : DT Charge 257 257 257

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Deferred Tax Assets/Liabilities

Income Tax Expense: Tax Payable (30%) 7,753 4,327 1,153

Tax Payable 7,753 4,327 1,153
Deferred Tax Charge 257 257 257
8,010 4,584 1,410

Practice Questions

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Calculating Tax Rates

Statutory Tax Rate
The corporate income tax rate in the country in which the company is domiciled
Effective Tax Rate
An accounting ratio: Reported Income Tax Expense
useful for forecasting NI
Pre-Tax Income

Cash Tax Rate

An accounting ratio: Tax Paid in Cash in Period
useful for forecasting CF
Pre-Tax Income
Statutory ≠ Effective due to:
Tax credits
Expenses not deductible for tax purposes
Adjustments to previous years
Withholding taxes on dividends
Activity outside country of domicile

Calculating Tax Rates

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Calculating Tax Rates

effective tax rate consistently lower than statutory /competitors not unusual
analysts should adjust for one-off items
normalized operating income may be used to calculate a normalized tax rate:
- Remove special items
- Remove associates

Analyzing Disclosures

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