The role of financial reporting is to provide a variety of users with useful information about a company’s performance and financial position.

The role of financial statement analysis is to use the data from financial statements to support economic decisions.

The statement of financial position (balance sheet) shows assets, liabilities, and owners’ equity at a point in time.

The statement of comprehensive income shows the results of a firm’s business activities over the period. Revenues, the cost of generating those revenues, and the resulting profit or loss are presented on the income statement.

The statement of changes in equity reports the amount and sources of changes in the equity owners’ investment in the firm.

The statement of cash flows shows the sources and uses of cash over the period.

Important information about accounting methods, estimates, and assumptions is disclosed in the footnotes to the financial statements and supplementary schedules. These disclosures also contain information about segment results, commitments and contingencies, legal proceedings, acquisitions or divestitures, issuance of stock options, and details of employee benefit plans.

Management’s commentary (management’s discussion and analysis) contains an overview of the company and important information about business trends, future capital needs, liquidity, significant events, and significant choices of accounting methods requiring management judgment.

The objective of audits of financial statements is to provide an opinion on the statements’ fairness and reliability.

The auditor’s opinion gives evidence of an independent review of the financial statements that verifies that appropriate accounting principles were used, that standard auditing procedures were used to establish reasonable assurance that the statements contain no material errors, and that management’s report on the company’s internal controls has been reviewed.

An auditor can issue an unqualified (clean) opinion if the statements are free from material omissions and errors, a qualified opinion that notes any exceptions to accounting principles, an adverse opinion if the statements are not presented fairly in the auditor’s opinion, or a disclaimer of opinion if the auditor is unable to express an opinion.

A company’s management is responsible for maintaining an effective internal control system to ensure the accuracy of its financial statements.

The framework for financial analysis has six steps:

1. State the objective of the analysis.
2. Gather data.
3. Process the data.
4. Analyze and interpret the data.
5. Report the conclusions or recommendations.
6. Update the analysis.

Transactions are recorded in accounts that form the financial statement elements:

• Assets—the firm's economic resources.
• Liabilities—creditors' claims on the firm's resources.
• Owners' equity—paid-in capital (common and preferred stock), retained earnings, and cumulative other comprehensive income.
• Revenues—sales, investment income, and gains.
• Expenses—cost of goods sold, selling and administrative expenses, depreciation, interest, taxes, and losses.

The basic accounting equation:

assets = liabilities + owners’ equity

The expanded accounting equation:

assets = liabilities + contributed capital + ending retained earnings

The expanded accounting equation can also be stated as:

assets =	liabilities + contributed capital + beginning retained earnings + revenue −
	expenses − dividends

The balance sheet shows a company’s financial position at a point in time.

Changes in balance sheet accounts during an accounting period are reflected in the income statement, the cash flow statement, and the statement of owners’ equity.

The objective of financial statements is to provide economic decision makers with useful information about a firm’s financial performance and changes in financial position.

Reporting standards are designed to ensure that different firms’ statements are comparable to one another and to narrow the range of reasonable estimates on which financial statements are based. This aids users of the financial statements who rely on them for information about the company’s activities, profitability, and creditworthiness.

Standard-setting bodies are private sector organizations that establish financial reporting standards. The two primary standard-setting bodies are the International Accounting Standards Board (IASB) and, in the United States, the Financial Accounting Standards Board (FASB).

Regulatory authorities are government agencies that enforce compliance with financial reporting standards. Regulatory authorities include the Securities and Exchange Commission (SEC) in the United States and the Financial Services Authority (FSA) in the United Kingdom. Many national regulatory authorities belong to the International Organization of Securities Commissions (IOSCO).

Efforts to achieve convergence of local accounting standards with IFRS are underway in most major countries that have not adopted IFRS.

Barriers to developing one universally accepted set of financial reporting standards include differences of opinion among standard-setting bodies and regulatory authorities from different countries and political pressure within countries from groups affected by changes in reporting standards.

The IFRS "Conceptual Framework for Financial Reporting" defines the fundamental and enhancing qualitative characteristics of financial statements, specifies the required reporting elements, and notes the constraints and assumptions involved in preparing financial statements.

The fundamental characteristics of financial statements are relevance and faithful representation. The enhancing characteristics include comparability, verifiability, timeliness, and understandability.

Elements of financial statements are assets, liabilities, and owners’ equity (for measuring financial position) and income and expenses (for measuring performance).

Constraints on financial statement preparation include cost versus benefit and the difficulty of capturing non-quantifiable information in financial statements.

The two primary assumptions that underlie the preparation of financial statements are the accrual basis and the going concern assumption.

Required financial statements are the balance sheet, comprehensive income statement, cash flow statement, statement of changes in owners’ equity, and explanatory notes.

The general features of financial statements according to IAS No. 1 are:

• Fair presentation.
• Going concern.
• Accrual accounting.
• Consistency.
• Materiality.
• Aggregation.
• No offsetting.
• Reporting frequency.
• Comparative information.

Other presentation requirements include a classified balance sheet and specific minimum information that must be reported in the notes and on the face of the financial statements.

The IASB and FASB frameworks are similar but are moving towards convergence. Some of the remaining differences are:

• The IASB lists income and expenses as performance elements, while the FASB lists revenues, expenses, gains, losses, and comprehensive income.
• There are minor differences in the definition of assets. Also, the FASB uses the word probable when defining assets and liabilities.
• The FASB does not allow the upward revaluation of most assets.

Firms that list their shares in the United States but do not use U.S. GAAP or IFRS are required to reconcile their financial statements with U.S. GAAP. For IFRS firms listing their shares in the United States, reconciliation is no longer required.

A coherent financial reporting framework should exhibit transparency, comprehensiveness, and consistency.

Barriers to creating a coherent framework include issues of valuation, standard setting, and measurement.

The income statement shows an entity’s revenues, expenses, gains and losses during a reporting period.

A multi-step income statement provides a subtotal for gross profit and a single step income statement does not. Expenses on the income statement can be grouped by the nature of the expense items or by their function, such as with expenses grouped into cost of goods sold.

Revenue is recognized when earned and expenses are recognized when incurred.

Methods for accounting for long-term contracts include:

• Percentage-of-completion—recognizes revenue in proportion to costs incurred
• Completed-contract—recognizes revenue only when the contract is complete

Revenue recognition methods for installment sales are:

• Normal revenue recognition at time of sale if collectability is reasonably assured.
• Installment sales method if collectability cannot be reasonably estimated.
• Cost recovery method if collectability is highly uncertain.

Revenue from barter transactions can only be recognized if its fair value can be estimated from historical data on similar non-barter transactions.

Gross revenue reporting shows sales and cost of goods sold, while net revenue reporting shows only the difference between sales and cost of goods sold and should be used when the firm is acting essentially as a selling agent and does not stock inventory, take credit risk, or have control over supplier and price.

The matching principle requires that firms match revenues recognized in a period with the expenses required to generate them. One application of the matching principle is seen in accounting for inventory, with cost of goods sold as the cost of units sold from inventory that are included in current-period revenue. Other costs, such as straight-line depreciation of fixed assets or administrative overhead, are period costs and are taken without regard to revenues generated during the period.

Depreciation methods:

• Straight-line: Equal amount of depreciation expense in each year of the asset’s useful life.
• Declining balance: Apply a constant rate of depreciation to the declining book value until book value equals residual value.

Inventory valuation methods:

• FIFO: Inventory reflects cost of most recent purchases, COGS reflects cost of oldest purchases.
• LIFO: COGS reflects cost of most recent purchases, inventory reflects cost of oldest purchases.
• Average cost: Unit cost equals cost of goods available for sale divided by total units available and is used for both COGS and inventory.
• Specific identification: Each item in inventory is identified and its historical cost is used for calculating COGS when the item is sold.

Intangible assets with limited lives should be amortized using a method that reflects the flow over time of their economic benefits. Intangible assets with indefinite lives (e.g., goodwill) are not amortized.

Users of financial data should analyze the reasons for any changes in estimates of expenses and compare these estimates with those of peer companies.

Results of discontinued operations are reported below income from continuing operations, net of tax, from the date the decision to dispose of the operations is made. These results are segregated because they likely are non-recurring and do not affect future net income.

Unusual or infrequent items are reported before tax and above income from continuing operations. An analyst should determine how “unusual” or “infrequent” these items really are for the company when estimating future earnings or firm value.

Extraordinary items (both unusual and infrequent) are reported below income from continuing operations, net of tax under U.S. GAAP, but this treatment is not allowed under IFRS. Extraordinary items are not expected to continue in future periods.

Changes in accounting standards, changes in accounting methods applied, and corrections of accounting errors require retrospective restatement of all prior-period financial statements included in the current statement. A change in an accounting estimate, however, is applied prospectively (to subsequent periods) with no restatement of prior-period results.

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When a company has potentially dilutive securities, it must report diluted EPS.

For any convertible preferred stock, convertible debt, warrants, or stock options that are dilutive, the calculation of diluted EPS is:

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Common-size income statements are useful in examining a firm’s business strategies.

Two popular profitability ratios are gross profit margin (gross profit / revenue) and net profit margin (net income / revenue). A firm can often achieve higher profit margins by differentiating its products from the competition.

Transactions with shareholders, such as dividends paid and shares issued or repurchased, are not reported on the income statement.

Other comprehensive income includes other transactions that affect equity but do not affect net income, including:

• Gains and losses from foreign currency translation.
• Pension obligation adjustments.
• Unrealized gains and losses from cash flow hedging derivatives.
• Unrealized gains and losses on available-for-sale securities.

Assets are resources controlled as result of past transactions that are expected to provide future economic benefits. Liabilities are obligations as a result of past events that are expected to require an outflow of economic resources. Equity is the owners’ residual interest in the assets after deducting the liabilities.

A financial statement item should be recognized if a future economic benefit to or from the firm is probable and the item’s value or cost can be measured reliably.

The balance sheet can be used to assess a firm’s liquidity, solvency, and ability to pay dividends to shareholders.

Balance sheet assets, liabilities, and equity should not be interpreted as market value or intrinsic value. For most firms, the balance sheet consists of a mixture of values including historical cost, amortized cost, and fair value.

Some assets and liabilities are difficult to quantify and are not reported on the balance sheet.

Current (noncurrent) assets are those expected to be used up or converted to cash in less than (more than) one year or the firm’s operating cycle, whichever is greater.

Current (noncurrent) liabilities are those the firm expects to satisfy in less than (more than) one year or the firm’s operating cycle, whichever is greater.

Cash equivalents are short-term, highly liquid financial assets that are readily convertible to cash. Their balance sheet values are generally close to identical using either amortized cost or fair value.

Accounts receivable are reported at net realizable value by estimating bad debt expense.

Inventories are reported at the lower of cost or net realizable value (IFRS) or the lower of cost or market (U.S. GAAP). Cost can be measured using standard costing or the retail method. Different cost flow assumptions can affect inventory values.

Property, plant, and equipment (PP&E) can be reported using the cost model or the revaluation model under IFRS. Under U.S. GAAP, only the cost model is allowed. PP&E is impaired if its carrying value exceeds the recoverable amount. Recoveries of impairment losses are allowed under IFRS but not U.S. GAAP.

Intangible assets created internally are expensed as incurred. Purchased intangibles are reported similar to PP&E. Under IFRS, research costs are expensed as incurred and development costs are capitalized. Both research and development costs are expensed under U.S. GAAP.

Goodwill is the excess of purchase price over the fair value of the identifiable net assets (assets minus liabilities) acquired in a business acquisition. Goodwill is not amortized but must be tested for impairment at least annually.

Held-to-maturity securities are reported at amortized cost. Trading securities, available-for-sale securities, and derivatives are reported at fair value. For trading securities and derivatives, unrealized gains and losses are recognized in the income statement. Unrealized gains and losses for available-for-sale securities are reported in equity (other comprehensive income).

Accounts payable are amounts owed to suppliers for goods or services purchased on credit. Accrued liabilities are expenses that have been recognized in the income statement but are not yet contractually due. Unearned revenue is cash collected in advance of providing goods and services.

Financial liabilities not issued at face value, like bonds payable, are reported at amortized cost. Held-for-trading liabilities and derivative liabilities are reported at fair value.

Owners’ equity includes:

• Contributed capital—the amount paid in by common shareholders.
• Preferred stock—capital stock that has certain rights and privileges not possessed by the common shareholders. Classified as debt if mandatorily redeemable.
• Treasury stock—issued common stock that has been repurchased by the firm.
• Retained earnings—the cumulative undistributed earnings of the firm since inception.
• Noncontrolling (minority) interest—the portion of a subsidiary that is not owned by the parent.
• Accumulated other comprehensive income—includes all changes to equity from sources other than net income and transactions with shareholders.

Balance sheet ratios, along with common-size analysis, can be used to evaluate a firm’s liquidity and solvency. Liquidity ratios measure the firm’s ability to satisfy its short-term obligations as they come due. Liquidity ratios include the current ratio, the quick ratio, and the cash ratio.

Solvency ratios measure the firm’s ability to satisfy its long-term obligations. Solvency ratios include the long-term debt-to-equity ratio, the total debt-to-equity ratio, the debt ratio, and the financial leverage ratio.

Cash flow from operating activities (CFO) consists of the inflows and outflows of cash resulting from transactions that affect a firm’s net income.

Cash flow from investing activities (CFI) consists of the inflows and outflows of cash resulting from the acquisition or disposal of long-term assets and certain investments.

Cash flow from financing activities (CFF) consists of the inflows and outflows of cash resulting from transactions affecting a firm’s capital structure, such as issuing or repaying debt and issuing or repurchasing stock.

Under U.S. GAAP, dividends paid are financing cash flows. Interest paid, interest received, and dividends received are operating cash flows. All taxes paid are operating cash flows.

Under IFRS, dividends paid and interest paid can be reported as either operating or financing cash flows. Interest received and dividends received can be reported as either operating or investing cash flows. Taxes paid are operating cash flows unless they arise from an investing or financing transaction.

Under the direct method of presenting CFO, each line item of the accrual-based income statement is adjusted to get cash receipts or cash payments. The main advantage of the direct method is that it presents clearly the firm’s operating cash receipts and payments.

Under the indirect method of presenting CFO, net income is adjusted for transactions that affect net income but do not affect operating cash flow, such as depreciation and gains or losses on asset sales, and for changes in balance sheet items. The main advantage of the indirect method is that it focuses on the differences between net income and operating cash flow. This provides a useful link to the income statement when forecasting future operating cash flow.

Operating activities typically relate to the firm’s current assets and current liabilities. Investing activities typically relate to noncurrent assets. Financing activities typically relate to noncurrent liabilities and equity.

Timing of revenue or expense recognition that differs from the receipt or payment of cash is reflected in changes in balance sheet accounts.

The direct method of calculating CFO is to sum cash inflows and cash outflows for operating activities.

• Cash collections from customers—sales adjusted for changes in receivables and unearned revenue.
• Cash paid for inputs—COGS adjusted for changes in inventory and accounts payable.
• Cash operating expenses—SG&A adjusted for changes in related accrued liabilities or prepaid expenses.
• Cash interest paid—interest expense adjusted for the change in interest payable.
• Cash taxes paid—income tax expense adjusted for changes in taxes payable and changes in deferred tax assets and liabilities.

The indirect method of calculating CFO begins with net income and adjusts it for gains or losses related to investing or financing cash flows, noncash charges to income, and changes in balance sheet operating items.

CFI is calculated by determining the changes in asset accounts that result from investing activities. The cash flow from selling an asset is its book value plus any gain on the sale (or minus any loss on the sale).

CFF is the sum of net cash flows from creditors (new borrowings minus principal repaid) and net cash flows from shareholders (new equity issued minus share repurchases minus cash dividends paid).

An analyst should determine whether a company is generating positive operating cash flow over time that is greater than its capital spending needs and whether the company’s accounting policies are causing reported earnings to diverge from operating cash flow.

A common-size cash flow statement shows each item as a percentage of revenue or shows each cash inflow as a percentage of total inflows and each outflow as a percentage of total outflows.

Free cash flow to the firm (FCFF) is the cash available to all investors, both equity owners and debt holders.

• FCFF = net income + noncash charges + [interest expense × (1 − tax rate)] − fixed capital investment − working capital investment.
• FCFF = CFO + [interest expense × (1 − tax rate)] − fixed capital investment.

Free cash flow to equity (FCFE) is the cash flow that is available for distribution to the common shareholders after all obligations have been paid.

FCFE = CFO − fixed capital investment + net borrowing

Cash flow performance ratios, such as cash return on equity or on assets, and cash coverage ratios, such as debt coverage or cash interest coverage, provide information about the firm’s operating performance and financial strength.

Ratios can be used to project earnings and future cash flow, evaluate a firm’s flexibility, assess management’s performance, evaluate changes in the firm and industry over time, and compare the firm with industry competitors.

Vertical common-size data are stated as a percentage of sales for income statements or as a percentage of total assets for balance sheets. Horizontal common-size data present each item as a percentage of its value in a base year.

Ratio analysis has limitations. Ratios are not useful when viewed in isolation and require adjustments when different companies use different accounting treatments.

Comparable ratios may be hard to find for companies that operate in multiple industries. Ratios must be analyzed relative to one another, and determining the range of acceptable values for a ratio can be difficult.

Activity ratios indicate how well a firm uses its assets. They include receivables turnover, days of sales outstanding, inventory turnover, days of inventory on hand, payables turnover, payables payment period, and turnover ratios for total assets, fixed assets, and working capital.

Liquidity ratios indicate a firm’s ability to meet its short-term obligations. They include the current, quick, and cash ratios, the defensive interval, and the cash conversion cycle.

Solvency ratios indicate a firm’s ability to meet its long-term obligations. They include the debt-to-equity, debt-to-capital, debt-to-assets, financial leverage, interest coverage, and fixed charge coverage ratios.

Profitability ratios indicate how well a firm generates operating income and net income. They include net, gross, and operating profit margins, pretax margin, return on assets, operating return on assets, return on total capital, return on total equity, and return on common equity.

Valuation ratios are used to compare the relative values of stocks. They include earnings per share and price-to-earnings, price-to-sales, price-to-book value, and price-to-cash-flow ratios.

Basic DuPont equation:

ROE = [image]

Extended DuPont equation:

ROE =[image]

Ratios used in equity analysis include price-to-earnings, price-to-cash flow, price-to-sales, and price-to-book value ratios, and basic and diluted earnings per share. Other ratios are relevant to specific industries such as retail and financial services.

Credit analysis emphasizes interest coverage ratios, return on capital, debt-to-assets ratios, and cash flow to total debt.

Firms are required to report some items for significant business and geographic segments. Profitability, leverage, and turnover ratios by segment can give the analyst a better understanding of the performance of the overall business.

Costs included in inventory on the balance sheet include purchase cost, conversion costs, and other costs necessary to bring the inventory to its present location and condition. All of these costs for inventory acquired or produced in the current period are added to beginning inventory value and then allocated either to cost of goods sold for the period or to ending inventory.

Period costs, such as abnormal waste, most storage costs, administrative costs, and selling costs, are expensed as incurred.

Inventory cost flow methods:

• FIFO: The cost of the first item purchased is the cost of the first item sold. Ending inventory is based on the cost of the most recent purchases, thereby approximating current cost.
• LIFO: The cost of the last item purchased is the cost of the first item sold. Ending inventory is based on the cost of the earliest items purchased. LIFO is prohibited under IFRS.
• Weighted average cost: COGS and inventory values are between their FIFO and LIFO values.
• Specific identification: Each unit sold is matched with the unit’s actual cost.

Under LIFO, cost of sales reflects the most recent purchase or production costs, and balance sheet inventory values reflect older outdated costs.

Under FIFO, cost of sales reflects the oldest purchase or production costs for inventory, and balance sheet inventory values reflect the most recent costs.

Under the weighted average cost method, cost of sales and balance sheet inventory values are between those of LIFO and FIFO.

When purchase or production costs are rising, LIFO cost of sales is higher than FIFO cost of sales, and LIFO gross profit is lower than FIFO gross profit as a result. LIFO inventory is lower than FIFO inventory.

When purchase or production costs are falling, LIFO cost of sales is lower than FIFO cost of sales, and LIFO gross profit is higher than FIFO gross profit as a result. LIFO inventory is higher than FIFO inventory.

In either case, LIFO cost of sales and FIFO inventory values better represent economic reality (replacement costs).

In a periodic system, inventory values and COGS are determined at the end of the accounting period. In a perpetual system, inventory values and COGS are updated continuously.

In the case of FIFO and specific identification, ending inventory values and COGS are the same whether a periodic or perpetual system is used. LIFO and weighted average cost, however, can produce different inventory values and COGS depending on whether a periodic or perpetual system is used.

When prices are rising and inventory quantities are stable or increasing:

LIFO results in:	FIFO results in:
higher COGS	lower COGS
lower gross profit	higher gross profit
lower inventory balances	higher inventory balances
higher inventory turnover	lower inventory turnover

The weighted average cost method results in values between those of LIFO and FIFO.

Under IFRS, inventories are valued at the lower of cost or net realizable value. Inventory write-ups are allowed, but only to the extent that a previous writedown to net realizable value was recorded.

Under U.S. GAAP, inventories are valued at the lower of cost or market. Market is usually equal to replacement cost but cannot exceed net realizable value or be less than net realizable value minus a normal profit margin. No subsequent write-up is allowed.

Required inventory disclosures:

• The cost flow method (LIFO, FIFO, etc.) used.
• Total carrying value of inventory and carrying value by classification (raw materials, work-in-process, and finished goods) if appropriate.
• Carrying value of inventories reported at fair value less selling costs.
• The cost of inventory recognized as an expense (COGS) during the period.
• Amount of inventory writedowns during the period.
• Reversals of inventory writedowns during the period (IFRS only because U.S. GAAP does not allow reversals).
• Carrying value of inventories pledged as collateral.

Inventory turnover, days of inventory on hand, and gross profit margin can be used to evaluate the quality of a firm’s inventory management.

Inventory turnover that is too low (high days of inventory on hand) may be an indication of slow-moving or obsolete inventory.

High inventory turnover together with low sales growth relative to the industry may indicate inadequate inventory levels and lost sales because customer orders could not be fulfilled.

High inventory turnover together with high sales growth relative to the industry average suggests that high inventory turnover reflects greater efficiency rather than inadequate inventory.

When a firm makes an expenditure, it can either capitalize the cost as an asset on the balance sheet or expense the cost in the income statement for the current period. Capitalizing results in higher assets, higher equity, and higher operating cash flow compared to expensing. Capitalizing also results in higher earnings in the first year and lower earnings in subsequent years as the asset is depreciated.

Interest incurred during construction of an asset is generally capitalized. The capitalized interest is added to the asset’s value and depreciated over the life of the asset. Because the capitalized interest results in a higher interest coverage ratio (lower denominator), some analysts reverse the transaction and add the capitalized interest to interest expense for the period.

The cost of a purchased finite-lived intangible asset is amortized over its useful life. Indefinite-lived intangible assets are not amortized, but are tested for impairment at least annually. The cost of internally developed intangible assets is expensed.

Under IFRS, research costs are expensed and development costs are capitalized. Under U.S. GAAP, both research and development costs are expensed as incurred.

Depreciation methods:

• Straight-line: Equal amount of expense each period.
• Accelerated (declining balance): Greater depreciation expense in the early years and less depreciation expense in the later years of an asset’s life.
• Units-of-production: Expense based on usage rather than time.

In the early years of an asset’s life, accelerated depreciation results in higher depreciation expense, lower net income, and lower ROA and ROE compared to straight-line depreciation. Cash flow is the same assuming tax depreciation is unaffected by the choice of method for financial reporting.

Firms can reduce depreciation expense and increase net income by using longer useful lives and higher salvage values.

Straight-line method:

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Double-declining balance (DDB), an accelerated depreciation method:

DDB depreciation in year x =

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Units of production method:

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IFRS requires component depreciation, in which significant parts of an asset are identified and depreciated separately.

Under IFRS, firms have the option to revalue assets based on fair value under the revaluation model. U.S. GAAP does not permit revaluation.

The impact of revaluation on the income statement depends on whether the initial revaluation resulted in a gain or loss. If the initial revaluation resulted in a loss (decrease in carrying value), the initial loss would be recognized in the income statement and any subsequent gain would be recognized in the income statement only to the extent of the previously reported loss. Revaluation gains beyond the initial loss bypass the income statement and are recognized in shareholders’ equity as a revaluation surplus.

If the initial revaluation resulted in a gain (increase in carrying value), the initial gain would bypass the income statement and be reported as a revaluation surplus. Later revaluation losses would first reduce the revaluation surplus.

Under IFRS, an asset is impaired when its carrying value exceeds the recoverable amount. The recoverable amount is the greater of fair value less selling costs and the value in use (present value of expected cash flows). If impaired, the asset is written down to the recoverable amount. Loss recoveries are permitted, but not above historical cost.

Under U.S. GAAP, an asset is impaired if its carrying value is greater than the asset’s undiscounted future cash flows. If impaired, the asset is written down to fair value. Subsequent recoveries are not allowed for assets held for use.

Asset impairments result in losses in the income statement. Impairments have no impact on cash flow as they have no tax or other cash flow effects until disposal of the asset.

When a long-lived asset is sold, the difference between the sale proceeds and the carrying (book) value of the asset is reported as a gain or loss in the income statement.

When a long-lived asset is abandoned, the carrying value is removed from the balance sheet and a loss is recognized in that amount.

If a long-lived asset is exchanged for another asset, a gain or loss is computed by comparing the carrying value of the old asset with fair value of the old asset (or fair value of the new asset if more clearly evident).

There are many differences in the disclosure requirements for tangible and intangible assets under IFRS and U.S. GAAP. However, firms are generally required to disclose:

• Carrying values for each class of asset.
• Accumulated depreciation and amortization.
• Title restrictions and assets pledged as collateral.
• For impaired assets, the loss amount and the circumstances that caused the loss.
• For revalued assets (IFRS only), the revaluation date, how fair value was determined, and the carrying value using the historical cost model.

Deferred tax terminology:

• Taxable income. Income subject to tax based on the tax return.
• Accounting profit. Pretax income from the income statement based on financial accounting standards.
• Deferred tax assets. Balance sheet asset value that results when taxes payable (tax return) are greater than income tax expense (income statement) and the difference is expected to reverse in future periods.
• Deferred tax liabilities. Balance sheet liability value that results when income tax expense (income statement) is greater than taxes payable (tax return) and the difference is expected to reverse in future periods.
• Valuation allowance. Reduction of deferred tax assets (contra account) based on the likelihood that the future tax benefit will not be realized.
• Taxes payable. The tax liability from the tax return. Note that this term also refers to a liability that appears on the balance sheet for taxes due but not yet paid.
• Income tax expense. Expense recognized in the income statement that includes taxes payable and changes in deferred tax assets and liabilities.

A deferred tax liability is created when income tax expense (income statement) is higher than taxes payable (tax return). Deferred tax liabilities occur when revenues (or gains) are recognized in the income statement before they are taxable on the tax return, or expenses (or losses) are tax deductible before they are recognized in the income statement.

A deferred tax asset is created when taxes payable (tax return) are higher than income tax expense (income statement). Deferred tax assets are recorded when revenues (or gains) are taxable before they are recognized in the income statement, when expenses (or losses) are recognized in the income statement before they are tax deductible, or when tax loss carryforwards are available to reduce future taxable income.

Deferred tax liabilities that are not expected to reverse, typically because of expected continued growth in capital expenditures, should be treated for analytical purposes as equity. If deferred tax liabilities are expected to reverse, they should be treated for analytical purposes as liabilities.

An asset’s tax base is its value for tax purposes. The tax base for a depreciable fixed asset is its cost minus any depreciation or amortization previously taken on the tax return. When an asset is sold, the taxable gain or loss on the sale is equal to the sale price minus the asset’s tax base.

A liability’s tax base is its value for tax purposes. When there is a difference between the book value of a liability on a firm’s financial statements and its tax base that will result in future taxable gains or losses when the liability is settled, the firm will recognize a deferred tax asset or liability to reflect this future tax or tax benefit.

If taxable income is less than pretax income and the cause of the difference is expected to reverse in future years, a DTL is created. If taxable income is greater than pretax income and the difference is expected to reverse in future years, a DTA is created.

The balance of the DTA or DTL is equal to the difference between the tax base and the carrying value of the asset or liability, multiplied by the tax rate.

Income tax expense and taxes payable are related through the change in the DTA and the change in the DTL: income tax expense = taxes payable + ΔDTL − ΔDTA.

When a firm’s income tax rate increases (decreases), deferred tax assets and deferred tax liabilities are both increased (decreased) to reflect the new rate. Changes in these values will also affect income tax expense.

An increase in the tax rate will increase both a firm’s DTL and its income tax expense. A decrease in the tax rate will decrease both a firm’s DTL and its income tax expense.

An increase in the tax rate will increase a firm’s DTA and decrease its income tax expense. A decrease in the tax rate will decrease a firm’s DTA and increase its income tax expense.

A temporary difference is a difference between the tax base and the carrying value of an asset or liability that will result in taxable amounts or deductible amounts in the future.

A permanent difference is a difference between taxable income and pretax income that will not reverse in the future. Permanent differences do not create DTAs or DTLs.

When a bond is issued, assets and liabilities both initially increase by the bond proceeds. At any point in time, the book value of the bond liability is equal to the present value of the remaining future cash flows (coupon payments and maturity value) discounted at the market rate of interest at issuance. The proceeds are reported in the cash flow statement as an inflow from financing activities.

A premium bond (coupon rate > market yield at issuance) is reported on the balance sheet at a value greater than its face value. As the premium is amortized (reduced), the book value of the bond liability will decrease until it reaches its face value at maturity.

A discount bond (market yield at issuance > coupon rate) is reported on the balance sheet at less than its face value. As the discount is amortized, the book value of the bond liability will increase until it reaches its face value at maturity.

Interest expense includes amortization of any discount or premium at issuance. Using the effective interest rate method, interest expense is equal to the book value of the bond liability at the beginning of the period multiplied by the bond’s yield at issuance.

For a premium bond, interest expense is less than the coupon payment (yield < coupon rate). The difference between interest expense and the coupon payment is subtracted from the bond liability on the balance sheet.

For a discount bond, interest expense is greater than the coupon payment (yield > coupon rate). The difference between interest expense and the coupon payment is added to the bond liability on the balance sheet.

Under IFRS, if substantially all the rights and risks of ownership are transferred to the lessee, the lease is treated as a finance lease by both the lessee and lessor. Otherwise, the lease is an operating lease.

Under U.S. GAAP, the lessee must treat a lease as a capital (finance) lease if any one of the following criteria is met:

• Title to the leased asset is transferred to the lessee at the end of the lease period.
• A bargain purchase option exists.
• The lease period is 75% or more of the asset’s economic life.
• The present value of the lease payments is 90% or more of the fair value of the leased asset.

Under U.S. GAAP, the lessor capitalizes the lease if any one of the finance lease criteria for lessees is met, collectability of lease payments is reasonably certain, and the lessor has substantially completed performance.

A finance lease is, in substance, a purchase of an asset that is financed with debt. At any point in time, the lease liability is equal to the present value of the remaining lease payments.

From the lessee’s perspective, finance lease expense consists of depreciation of the asset and interest on the loan. The finance lease payment consists of an operating outflow of cash (interest expense) and a financing outflow of cash (principal reduction).

An operating lease is simply a rental arrangement; no asset or liability is reported by the lessee. The rental payment is reported as an expense and as an operating outflow of cash.

From the lessor’s perspective, a finance lease is either a sales-type lease or a direct financing lease. In either case, a lease receivable is created at the inception of the lease, equal to the present value of the lease payments. The lease payments are treated as part interest income (CFO) and part principal reduction (CFI).

With a sales-type lease, the lessor recognizes gross profit at the inception of the lease and interest income over the life of the lease. With a direct financing lease, the lessor recognizes interest income only.

Both lessees and lessors are required to disclose useful information about finance leases and operating leases in the financial statements or in the footnotes, including:

• General description of the leasing arrangement.
• The nature, timing, and amount of payments to be paid or received in each of the next five years. Lease payments after five years can be aggregated.
• Amount of lease revenue and expense reported in the income statement for each period presented.
• Amounts receivable and unearned revenues from lease arrangements.
• Restrictions imposed by lease agreements.

In a defined contribution plan, the employer contributes a certain sum each period to the employee's retirement account. The employer makes no promise regarding the future value of the plan assets; thus, the employee assumes all of the investment risk.


In a defined benefit plan, the employer promises to make periodic payments to the employee after retirement. Because the employee’s future benefit is defined, the employer assumes the investment risk. Accounting is complicated because many assumptions are involved.

A firm reports a net pension liability on its balance sheet if the fair value of a defined benefit plan’s assets is less than the estimated pension obligation, or a net pension asset if the fair value of the plan’s assets is greater than the estimated pension obligation. The change in the net pension asset or liability is reflected in a firm’s comprehensive income each year.

Under IFRS, service costs (including past service costs) and interest income or expense on the beginning plan balance are included in pension expense on the income statement. Remeasurements are recorded in other comprehensive income. These include actuarial gains or losses and the difference between the actual return and the expected return on plan assets.

Under U.S. GAAP, service costs, interest income or expense, and the expected return on plan assets are included in pension expense. Past service costs and actuarial gains or losses are recorded in other comprehensive income and amortized over time to the income statement.

Pension expense for a defined contribution pension plan is equal to the employer’s contributions.

Analysts use solvency ratios to measure a firm’s ability to satisfy its long-term obligations. In evaluating solvency, analysts look at leverage ratios and coverage ratios.

Leverage ratios, such as debt-to-assets, debt-to-capital, debt-to-equity, and the financial leverage ratio, focus on the balance sheet.

Debt-to-assets ratio = total debt / total assets

Debt-to-capital ratio = total debt / (total debt + total equity)

Debt-to-equity ratio = total debt / total equity

Financial leverage ratio = average total assets / average total equity

Coverage ratios, such as interest coverage and fixed charge coverage, focus on the income statement.

Interest coverage = EBIT / interest payments

Fixed charge coverage = (EBIT + lease payments) / (interest payments + lease payments)

Costs included in inventory on the balance sheet include purchase cost, conversion costs, and other costs necessary to bring the inventory to its present location and condition. All of these costs for inventory acquired or produced in the current period are added to beginning inventory value and then allocated either to cost of goods sold for the period or to ending inventory.

Period costs, such as abnormal waste, most storage costs, administrative costs, and selling costs, are expensed as incurred.

The "fraud triangle" consists of:

• Incentives and pressures—the motive to commit fraud.
• Opportunities—the firm has a weak internal control system.
• Attitudes and rationalizations—the mindset that fraud is justified.

Risk factors related to incentives and pressures for fraud include:

• Threats to the firm's financial stability or profitability.
• Excessive third-party pressures on management.
• Threats to the personal net worth of management or board members.
• Excessive pressure on management and employees to meet internal targets.

Risk factors related to opportunities for fraud include:

• The nature of the industry or operations.
• Ineffective monitoring of management.
• Complex or unstable organizational structure.
• Deficient internal controls.

Risk factors related to attitudes and rationalizations for fraud include:

• Inappropriate or inadequately supported ethical standards.
• Excessive participation by nonfinancial management in selecting accounting methods.
• A history of legal and regulatory violations by management or board members.
• Obsessive attention to the stock price or earnings trend.
• Aggressive commitments to third parties.
• Failure to correct known compliance problems.
• Minimizing earnings inappropriately for tax reporting.
• Continued use of materiality to justify inappropriate accounting.
• A strained relationship with the current or previous auditor.

Common warning signs of earnings manipulation include:

• Aggressive revenue recognition.
• Different growth rates of operating cash flow and earnings.
• Abnormal comparative sales growth.
• Abnormal inventory growth as compared to sales.
• Moving nonoperating income and nonrecurring gains up the income statement to boost revenue.
• Delaying expense recognition.
• Excessive use of off-balance-sheet financing arrangements including leases.
• Classifying expenses as extraordinary or nonrecurring and moving them down the income statement to boost income from continuing operations.
• LIFO liquidations.
• Abnormal comparative margin ratios.
• Aggressive assumptions and estimates.
• Year-end surprises.
• Equity method investments with little or no cash flow.

Stretching accounts payable by delaying payment is not a sustainable source of operating cash flow. Suppliers may refuse to extend additional credit because of the slower payments. Stretching accounts payable can be identified by increases in the number of days in payables.

Arranging for a third party to finance (pay) a firm’s payables in one period, so that the firm can account for repayment as a financing (rather than operating) cash flow in a later period, is a method to decrease operating cash flows in a period of seasonally high CFO and increase them in a subsequent period.

Securitizing accounts receivable accelerates operating cash flow into the current period, but this source of cash is not sustainable and artificially increases receivables turnover. Securitizing receivables may also allow the firm to immediately recognize gains in the income statement.

Some firms repurchase stock to offset the dilutive effect of the exercise of employee stock options. The analyst must determine whether the increase in operating cash flow resulting from the income tax benefits of the exercise of employee stock options is sustainable. For analysis, the net cash outflow to repurchase stock should be considered an operating activity instead of a financing activity, since it is essentially a compensation expense.

When companies use different accounting methods or estimates relating to areas such as inventory accounting, depreciation, capitalization, and off-balance-sheet financing, analysts must adjust the financial statements for comparability.

LIFO ending inventory can be adjusted to a FIFO basis by adding the LIFO reserve. LIFO cost of goods sold can be adjusted to a FIFO basis by subtracting the change in the LIFO reserve.

When calculating solvency ratios, analysts should estimate the present value of operating lease obligations and add it to the firm’s liabilities.