Financial Statements Analysis:

COGS = beg INV + purchases end INV;

COGS and End INV are inversely related

IFRS: Specific Identification, FIFO, and Weighted Avg Cost;

GAAP: same + LIFO

Inflationary Conditions:
FIFO -> More Accurate ending Inv. Cost; COGS Understated; Earnings Over stated
LIFO -> COGS ; Earnings ; Taxes CFO ; BS
Periodic vs Perpetual Accounting Systems
Periodic: Inv and COGS determined @ end of Accounting Period; Perpetual -> updated continuously
FIFO & Specific Identification -> end INV + COGS = same either way
WA & LIFO -> could be very different!
Inv Cost
Lifo Reserve = FIFO Inv LIFO Inv;

FIFO Inv = Lifo Inv + Lifo Reserve

Once Adjusting LIFO Inv to FIFO inv, A = L + E equation does not balance! We must adjust cash and OE
Inc OE by reserve x (1-tax rate)
FIFO COGS = LIFO COGS (End LIFO

cash (reserve x tax rate)

- Beg LIFO

Balance Sheet
Income Statement
- Adjust cash (taxes paid)
- COGS ( in reserve
)
- Adjust Inv (Reserve)
- Taxes
- Adjust Retained Earnings (Net Tax)
*multiple years diff tax rate -> be careful with tax, COGS, assets, equity, etc
Inv Value:
Carrying Value on BS
IFRS:
Lower of cost or Net Realizable Value; NRV = sales price selling & completion costs.
If BS cost > NRV , written down (loss on IS); Subsequent Recovery = written up (gain in IS) *cant be
written up more than original cost*

US GAAP:
Lower of cost or market value:

Market Value = replacement Cost;

* Market cannot exceed NRV and cant be less than NRV Normal Profit Margin.
(NRV Normal PM < Market
recognized in IS. No write up allowed!

< NRV); If cost > market, written down & loss

Long Lived Assets:

Capitalizing Vs Expensing
Capitalizing -> Higher Assets & Equity compared to expensing; Higher CFO, Lower CFI
Expensing -> Outflow of CFO (entire amount expensed)
All else the same -> Total CF is the same
Capitalized Interest -> if Asset is being constructed for firms own use, rate based on specific debt, or
unrelated borrowings; recognize through depreciation (own use) or COGS (if for sale); Capitalized
interest is CFI & Interest expense is CFO
Financial Ratios: Capitalizing -> higher NI Initially, lower subsequently; Higher Shareholders Equity
Interest Coverage Ratio: EBIT / Int expense
In the year of expenditure, capitalizing results in lower interest expense & higher NI compared to
expensing. Result -> higher interest coverage ratio! Subsequent periods -> opposite (EBIT ).
*many bond rating agencies calc int coverage w capitalized int included. [reverse effects]
To reverse the effects of Capitalizing Interest:
1- Interest Capitalized during the year should be added back to the interest expense (disclosed in
financial footnotes)

2- Capitalized Interest, net of depreciation to date, should be removed from Assets &
Shareholders Equity
3- The allocation of interest capitalized in previous years should be removed from depreciation
expense.
4- Interest Capitalized during the year was classified as outflow to CFI. It should be added back to
CFI & subtracted from CFO
5- Ratios Recalculated
Intangible Assets:
Internally developed costs are expensed as incurred; Exception -> R&D and Software Development
IFRS -> Research Expensed, development Capitalized;
GAAP -> both expensed (exception: software); Software Dev Costs -> expensed until technologically
feasibility has been established.
Depreciation
STR8 Line:(cost salvage) /# years; DDB: 2/# years X Book Value @ beg of year X ;Units of Production: %
Manipulation: Longer life = Depreciation and NI; Higher Salvage Value = Depreciation and NI
tax can be diff. than financial reporting (eg. DDB for tax, str8 line for financial) DTL!
in estimate reported prospectively (-> going forward)
Impairment IFRS: (tested annually)
Impaired when Carrying Value (Book value: orig cost - less depreciation) exceeds recoverable amount
(greater of Fair Value selling cost or value in use). Value in use = PV of Future CF stream from
continued use.
If impaired, asset is written down on BS and impairment loss is recognized in the IS. Can be reversed if
Asset recovers. Recovery revalue asset and recognize gain in IS. Gain beyond initial loss, gain reported
in Other Comprehensive Income.
GAAP -> tested for impairment only when events and circumstances indicate. 2 Steps: 1 tested for
impairment by recoverability test; 2 measure the loss
1- Impaired if Carrying Value > future UNDISCOUNTED cash flow stream.
2- Asset written down to fair value, loss recog. In IS.; FV = DISCOUNTED value of Future Cash
Flows***
No CF impact.
Hint-> compare annual capital expenditures to depreciation expense, see if firm
is replacing PP&E @ same rate

Impairment Loss indicates firm has not recognized enough depreciation or amortization, thereby
overstating earnings.
Overstate impairment loss in current period -> increase future earnings.
Understate impairment loss in current period -> Overstate current period earnings.
GAAP -> Mostly LLAs are reported at depreciated costs. Re-valuing upwards is prohibited EXCEPT -> LLAs
held for sale (Can be reversed)
IFRS -> Also mostly reported at depreciated costs. Otherwise, @ Fair Value; If revaluation = loss, loss
reported in IS. Subsequent Gain to the extent of the loss in IS. Revaluation beyond initial loss = other
comprehensive income.
Revalue Upwards = Higher TA and Shareholder Equity; Lower leverage Ratios (D/A; D/E) ; Higher
Depreciation and lower profit (Periods After Revalue); Lower ROA/ROE in periods after.
Age = Accumulated Depreciation / Annual Depreciation Expense;
Avg Life (orig cost) = Ending Gross Investment / Annual Dep. Expense
Remaining Life = Ending Net Investment / Annual Dep. Expense.
Leasing Vs buying:

Lessor -> Owner of Asset;

Lessee -> Allowed to use Asset

Finance Lease (Capital Lease) -> Purchase financed with debt; @ inception, lessee adds equal amounts
to both Assets and Liabilities on BS. Over time, recognize depreciation on the Asset and interest expense
on liability.
Operating Lease: Rental Agreement, No Asset or Liability is reported. Periodic Lease payments
recognized as rental expense on IS.
Benefits: Less costly financing (no down payment); Reduced obsolescence; Off BS financing; tax
advantages (synthetic leas -> capital for tax and rental for financing)
IFRS -> rights and risks are transferred = finance lease
GAAP -> Financial (capital) lease if title is transferred at the end, bargain purchase option exists, lease
period is 75% of assets life, NPV of lease payments is over 90% of FV of Asset.
Reporting by Lessee:
(Operating) -> @ inception, no BS entry made. During term, IS = rent expense. CF = outflow from
operating activities (CFO)
Financing Lease : -> @ inception, lower of PV of future lease payments or Fair Value is recognized as
asset & Liability on B.S. Over term of lease, asset is depreciated (depreciation expense & interest

expense) in IS. Int. Expense = lease liability @ beg period X interest rate. In CFS: Payment is separated
into interest and principal (Amortizing). CFO -> Interest Outflow; CFF -> principal Outflow
Finance: CFO higher; CFF lower; EBIT higher
* Derive Lease interest rate as IRR of future lease payments
Lessor:
GAAP -> Capital Lease = sales type or direct financing
If PV exceeds > carrying value : sales type;

if PV = Carrying Value : direct financing

IFRS does not distinguish!

Sales Type (typically manufacturer or dealer) -> treated as if it is a sale with financing. @ Inception,
Lessor recognizes sale = PV of Lease Payments; COGS = Carrying value of Asset. Difference is Gross
Profit. Asset is removed from BS and lease receivable is created. As payments are received, Principal
portion reduces lease receivable Interest Portion is revenue. In CFS -> Interest Revenue = CFO inflow;
Principal = CFI inflow.
Direct Financing -> No Gross Profit Recognized @ Inception. Financing only. Treated this way if PV of
lease payments = carrying value of Asset (usually not a manufacturer or dealer). @ inception, BS = same
as ST lease. In IS, interest income; In CFS, interest = CFO inflow; principal = CFI inflow;
Operating Lease -> Lessor simply recognizes lease payment as rental income. Keeps leased asset on BS
and recognize depreciation expense over assets useful life. All CF is CFO.
Inter-corporate Investments:
Financial Assets: No Significant control (usually <20% considered passive) (HTM, AFS, FV, HFT (Gaap)
Associates: Significant influence over operations (20 50%) (Equity method) Board representation,
policy making, material intercompany transactions, dependence on tech., interchange personelle.
Business Combinations: Control over operations (50%+) (Acquisition Method)
Joint Ventures:

use equity method; In rare cases -> proportionate consolidation.

Reporting:
Financial Assets: Recorded @ cost (FV @ acquisition); Div/Int income recorded in IS
1 - Held to Maturity -> reported on B.S. @ amortized cost. (PV discount @ rate AT ISSUANCE); Interest
income in IS; s to FV ignored
2 Held for Trading -> purpose is to profit in the near term (less than 3 months); Reported on BS @ fair
value; s (realized and unrealized) recognized in IS w dividends or interest income
2 Fair Value -> Just like HFT, Unrealized & realized s in IS; BS @ Fair Value
3 - Available for Sale -> Neither 1 or 2; Reported on BS @ Fair Value. However, only realized gains/losses
and div/interest income recognized in IS. Unrealized are reported in Shareholders Equity.
GAAP -> Other Comprehensive Income; when sold, removed from OCI and sent to IS.
IFRS -> same thing, except unrealized gains/losses from foreign exchange movements. (IFRS = IS; GAAP =
equity)

Reclassification of FA:
IFRS does not allow into/out of FV through profit or loss; Or out of HFT category; debt classified as AVS
can to -> to HTM. BS value re-measured to reflect FV @ time of Reclassification.
HTM -> AVS (IFRS only): carrying value re-measured to Fair Value; difference goes to OCI;
GAAP -> does permit in/out of HFT or FV; all aspects fairly intuitive pg 73

Impairment of FAS:
If recovery value < Carrying value : FA is impaired; HTM and AVS -> Tested for impairment @ each
reporting period; HFT not needed (already recog. in IS as occurred); HTM impaired: carrying value
decreased to present value of estimated future CFs (using rate when security was purchased). Loss
on IS. IFRS: May be reversed for debt, not equity;
GAAP: Cannot be reversed ever!
Available for Sale impaired -> Unrealized loss from Comprehensive Income reclassified to IS.
IFRS 9 (New standards) 3 new groups (Amortized Cost; FV through P/L; FV through OCI)
Associates: Equity Method
Initial Investment recorded @ cost on BS (non-current asset). -> proportionate % share of investee
earnings inc investment account on BS and in IS. ***Dividends treated as return of capital & reduce
investment account*** not shown in IS.
Investee reports a loss: % share of loss reduces investment account & lowers earnings in IS. If loss
reduces Investment Account to zero, discontinue use of equity method.
Excess of Purchase Price over Book Value: Excess of Purchase price of BV of % investees tangible A&L is
allocated to Investees tangible A&L based on their FVs. remainder is Goodwill *Investors balance
sheet. Portion is depreciated each year like other assets (additional depreciation)
Impairments of Investments in Associates: If FV < Carrying Value (investment account on BS), investment
is written down & loss recognized on IS.
Equity Method -> Tested for impairment. If decline considered permanent, written down to FV & loss
recognized on IS. No write up is allowed!
Transactions with Investee:

Investor Profit must be deferred until 3rd party involvement.

Upstream -> investee to investor;

Down-stream, investor to investee;

***Investor must always reduce portion of profit in the equity Income

Acquisition Method:
All Assets, Liabilities, Revenues, Expenses of Subsidiary are combined with Parent. Intercompany
transactions excluded. Where parent owns less than 100%, Non-controlling (minority) interest account
(in L/E section). Purchase price allocated to Identifiable As & Ls of Target on basis of Fair Value.
Remainder is Goodwill.
In IS, combine all but (remove minority interest) at bottom just above NI
GAAP-> Goodwill = amount by which FV of subsidiary > FV of its identifiable assets (full Goodwill).
ENTIRE AMOUNT; Diff between full and partial reflected in minority interest.

2 steps: 1: If CV> FV, impairment exists ; 2 loss measured as difference in CV of goodwill & implied FV of
goodwill. Impairment loss recognized in income statement in Continuing operations.
IFRS -> Goodwiil = Excess of Purchase Price of Acquiring companys % of Targets identifiable Assets
(partial goodwill) : lower than full goodwill method;
1 step: determine NAV calcs first
then multiply by % owned and subtract from payment.
Single Step: if CV > Recoverable Amount: Impairment Loss Recognized
Non-controlling Interest: Full Goodwill : based on Aquired FV; Partial -> based on FV of identifiable Net
assets.
As if 100% ownership
Full goodwill higher TA and TE than partial; ROA and ROE lower.
Joint Venture: Entity where control is shared by 2 or more investors.
IFRS -> Proportionate Consolidation preferred (Equity Method permitted): GAAP -> Equity Method!
Proportionate Consolidation: Just like acquisition method, but only report proportion of each account
(asset, liability, revenues, expenses); no Minority Interest.

Business Combinations:
IFRS -> no differentiation based on structure of surviving entity.
GAAP -> Merger: Acquiring firm absorbs A + L of acquired (ceases to exist);
Acquisition -> Both entities continue to exist in parent-subsidiary relationship
Consolidation -> New entity formed that absorbs both combining companies.
Special Purpose Entities -> created for Single Purpose
Acquisition Method (Purchase Method) (Pooling of Interest Method (no longer exists))

Goodwill Impairment -> IFRS = Carrying Value - FV; GAAP = Fair Value Net Assets

SPE: Special Purpose and Variable Interest Entities ->

1 - At risk equity insufficient to finance activities w/o help; 2 Equity investors lack decision making
rights/obligation to absorb losses/rights to residual returns.
If SPE is considered VIE -> must be consolidated to primary beneficiary!!!
Employee Compensation:
Defined Contribution VS Defined Benefit Plans
Contribution: Firm contributes a certain sum each period to employees retirement account. Pension
expense = employers contribution; Thats it thats that!
Defined Benefit: Promise to make periodic payments after retirement; usually based on years of service,
compensation, etc.
Plan Assets > Funded Obligation -> Overfunded;

Plan Assets< Fund Obligation: Underfunded

Unfunded Plan -> (Health Plans): Expenses recognized when benefits earned, but ive CF not affected
until paid out.
Projected Benefit Obligation (PBO) (PVDBO in IFRS): PV of all future pension benefits earned to date,
based on FUTURE expected salary increases.
Obligation @ Beginning
+ Current Service Cost (PV of benefits earned by employees during current period)
+ Interest Cost (increase in obligation due to passage of time)(Obg @ beg x discount rate)
+ Unrecog. prior service costs (retroactive benefits awarded to employees when plan amended)
*IFRS expensed immediately; GAAP amortized over avg service life.
+/- Actuarial (gains) and losses (s in variables (mortality, empl turnover, retirement age, discount rate)
- Benefits Paid (reduce obligation to employees)
= Obligation @ End Period
[PBO @ end]
Current Service Cost = PV of benefits earned by employees in current period (includes estimate of
compensation growth).
Interest Cost = Increase in PBO due to passage of time (It is calculated by PBO beg X discount rate)
Actuarial Gains/Losses: s in actuarial assumptions associated with mortality rates, employee turnover,
retirement age, discount rate; Gain -> decrease benefit obligation; Loss -> increase B.O.
Expected Return on Plan Assets: return on plan assets has no effect on PBO. Expected return reduces
pension expense.
Difference between expected return and actual return is combined w other items related to changes in
actuarial assumptions into actuarial gains and losses account
Plan Assets
FV @ beg
+ Contributions
+ actual return
- benefits paid
= FV @ end

Funded Status = Fair Value of Plan Assets - PBO

GAAP -> If funded status is +ive = Asset; -ive = Liability
IFRS -> Companies have the option to defer recognition of Prior Service Costs & Actuarial G&Ls. BS
Asset (Liablity) = funded status + unrecognized prior service cost + unrecognized actuarial (gains) and
losses.
Total Periodic Pension Cost = employer contributions (end fund status beg fund status)
OR

CSC
+ Int cost
ACTUAL return on Plan Assets
+/- Actuarial Losses Gains due to s in
assumptions affecting PBO
+ Prior Service Cost

Not all components are immediately recognized in IS. Some components are deferred & amortized to
smooth volatility of Pension Expense & Income.
Current Service Cost: Expensed Immediately.
Interest Cost:

Expensed Immediately

Expected return on Plan Assets: no effect on PBO; However, reduces Pension expense. Difference
between expected return and actual return is combined w other items related to changes in actuarial
assumptions into actuarial gains and losses account
Amortization of actuarial gains / losses: Increase/decrease in the PBO that is the result of changing
actuarial assumptions is accumulated w the defined gains and losses that result from the differences in
the expected and actual returns.
Actuarial Gains and Losses recognized in OCI
IFRS -> Not amortized! GAAP -> amortized (corridor approach) pg 109

Amortization of Past (Prior) Service Calls: When firm Adopts/Amends pension plan, PBO is immediately
increased. GAAP: not expensed immediately -> part of Other Comp Income, amortized over service life
of employees. IFRS: vested portion expensed immediately; Unvested -> kept of BS & amortized over
vesting period.

Pension Expense:
Current Service Cost
+ Interest Cost
Expected ROA
+/- Amort. Actuarial (G)& L
+ Amortization of past service costs
= Net Pension Expense

Economic period cost

OR

End status
- beg status
- contributions

CSC
+ Int Cost
+ Unreckognized Prior SC
- ACTUAL ROA
=Economic Period Cost

= Economic Cost

3 Assumptions Disclosed: Discount Rate; Rate of Compensation Growth; Expected Return

Discount (Settlement) Rate: Rate used to compute PV of benefit obligation & the current service cost
component of pension expense. (not risk free rate). Usually interest rate of high quality fixed income
investments w maturity similar to future obligation. * Affects PBO & Pension Expense
Rate of Compensation Growth: Avg annual rate by which employee compensation is expected to
increase over time. * Affects PBO & Pension Expense
Expected Return on Assets: - Assumed long term rate of return on plan investments. (expected return
reduces pension expense, differences in ER & Actual Return are deferred.) IFRS -> Discount Rate Used
Improve Reported Results:
Increase discount rate ->( reduce PVs and PBO lowerimproves funded status) *1
*1 usually result in lower Pension Expense (lower current service cost); usually reduce interest
cost (PBO x discount rate) unless plan is very mature; If very mature, higher interest cost could
result if PBO decreases very slightly.*rare
Reduce compensation growth -> (reduce Future Pension payments, PBO lower ; improve funded
status; reduce current service cost and lower interest cost -> Pension Expense lower
Increase expected return on Assets -> (reduce pension expense; Not effect BO or Funded Status)GAAP
only

Notes -> adjustments may be needed:

1) Gross Vs Net Pension Assets /Liablilities
- Two reasons to net (employer controls assets & bears risks; assets can only be used for paying
benefits)
2) Differences in Assumptions Used (between firms in same industries)
3) Differences between IFRS and GAAP (total periodic expense -> IS vs OCI)
4) Differences due to Classification in IS
IFRS -> Report funded status Also; Option of differing recognition of Past Service Costs in IS or Other
Comp Income. *Must disclose reconciliation of funded status in Financial Footnotes

Not all s in PBO & Plan Assets are immediately recognized as pension expense in IS. s in actuarial
assumptions, past service costs & difference between (expected & Actual) returns are recognized in the
IS over time, smoothing pension expense.
Corridor Approach (GAAP) If beginning balance of actuarial G/L exceeds 10% of greater of beg PBO or
Plan Assets, amortization is required. Amount over the corridor is amortized over remaining service
lives.
Amortization of Prior Service Costs
When plan amended, PBO immediately increased;
GAAP -> replaced as OCI & amortized over remaining service life;

IFRS -> expensed Immediately

IFRS -> smoothing also affects Net Pension Asset/Liability reported on BS.
Funded Status (FV of Assets PBO)

+/- Unrecognized actuarial (gains) and losses

+ Unrecognized past service costs
= Net Pension Asset (Liability) reported on BS.
IFRS -> Net Pension A/L on BS = funded status adjusted for unrecognized items
GAAP -> Net Pension A/L = funded status without adjustment for unrecog. Items
SFAS 158 -> After 2005, Must show Funded Status as NPL/NPA
Economic Pension Expense: Eliminate smoothing amounts and use Actual return on assets. Results in
more volatile measure of pension expense; Include all Unrecognized items instead of smoothing.
Double check -> reconciliation of PBO and Plan Assets
Economic pension expense = end fund status beginning fund status contributions
Share Based Compensation: Stock Options / Grants:
Non-public: Grants -> Estimate of Value;

Options -> either way

Stock Options -> intrinsic value method: Compensation expense based on fair value of the option on
grant date based on # of options expected to vest. Use Option Pricing model
Compensation Expense -> allocated in IS over Service Period (between grant and vest dates);
recognition of expense -> decrease NI & RE; increase Paid in Capital by same amount
Option Pricing Models: exercise price, stock price @ grant date, expected term, expected volatility,
expected dividends, RFR,
Multinational Operations:
Local Currency -> currency of country being referred to;
Functional Currency -> determined by mgmt. (Currency of Primary Economic Environment) Generates
and spends cash.
Presentation Currency -> Reporting Currency (Parent Company financial statements)
Direct Quotation -> home currency in numerator *
Gains and Losses occur when payment date & transaction date differ
Re-measurement -> converting local currency into functional currency using temporal method
Translation -> converting functional currency into parent companys reporting currency using current
rate method.
If functional currency Parent Reporting Currency, Current Rate Method used to translate foreign
currency financial statements

If functional = Parent presentation currency, the Temporal Method is used to re-measure foreign
currency financial statements.
If local, functional, and presentation currency all differ, both temporal and current rate methods are
used.

If subsidiary in Hyperinflationary environment:

GAAP -> functional considered presentation (Temporal)
IFRS -> subsidiary FSs restated for inflation then
translated @ current rate method. (currency not restated)
Current rate = on balance sheet date
Avg rate = over reporting period
Historical rate = rate when original transaction occurred.
Current Rate Method:
Income Statement accounts translated @ avg rate
BS accounts translated @ current rate (except @ historic common stock)
Dividends @ rate that applied when paid
Translation gain/loss reported in shareholders equity (CTA -> Cumm Translation Adjustment)
Temporal Method:
Monetary Assets & Liabilities re-measured using current exchange rate (incl AP/AR/ LTD / STD)
All other A&L considered non-monetary & are re-measured @ historical rate. Most commonly
include (inventory, fixed assets, intangible assets, unearned revenue)
*Exception -> A&L on BS @ FV are re-measured @ current rate, not historic rate.
Common Stock & Dividends paid re-measured @ historic (actual) rate
Expenses related to non-monetary assets (COGS, depreciation, amortization) @ historic rate
Revenues & Other expenses @ avg rate
Gain/Loss recognized in IS. Results in more volatile NI compared to CR Method where reported in
Shareholders Equity.

Inventory & COGS -> Temporal Method (historical Rate)

FIFO: INV @ recent rates; COGS @ older rates
LIFO: INV @ older rates; COGS @ recent rates
Temporal Method
1 start with BS -> Translate items
2 adjust RE to make things work (balance)
3 Get NI from beg RE + NI Div = calc from S2
4 Use NI -> remeasured for G/L in IS

Current Rate Method

1 translate IS to get NI
2 Use NI -> get new Retained Earnings
3 Tranlate A & L
4 Use CTA account on BS to make things balance

Parent Exposure:
CR Method -> exposure is Net Asset position of subsidiary. *likely +ive Net Asset
Foreign currency appreciating = gain; depreciating = loss
Temporal Method:
Net Monetary A&L Exposure to exchange rates (Net Monetary Asset Positions)
Few firms have monetary assets (only cash and receivables). most firms face net monetary Liability
exposures. If Parent has Net Monetary Liability exposure when foreign currency appreciating = loss;
Net Liability when foreign currency is depreciating = gain!
Calculating Gain/Loss: CTA is a plug figure to balance A = L + E (Current Rate Only)
Temporal -> Gain/Loss in IS (no CTA);

Retained Earnings in the plug: A L Common S = RE

Get NI from (Beg RE + NI div = End RE); Get Re-measurement G/L (IS): NI Income before Remeasure
G/L
Notes:
Current Rate: NI before and After Translation are the same! G & L in BS;

Temporal: G/L on IS;

Gains and Losses can have opposite signs between the two methods! (A > L) and (NMA < NML)

Translation / Re-measurement Gain/Loss reported in Shareholders Equity as part of CTA. CTA is a

plug figure that forces basic accounting equation (A = L + E) to balance. [CTA inc = Gain?]
Current rate net Assets (Assets > Liabilities) exposed to depreciating local currency (results in loss).
Temporal Method, Net Monetary liabilities (monetary liabilities > monetary assets) are exposed. Net ML
in depreciating environment results in gain!
CR method analysis
Pure balance Sheet & Income Statement ratios are unaffected by current rate method
Mixed BS and IS ratios result in differences. Usually numerator IS/ Denominator BS
Foreign currency depreciating = ratios increase (numerator is IS / denominator is BS)
Foreign currency appreciating = mixed ratios decrease (again -> numerator is IS / denominator is BS)

Procedure ->
1 determine foreign currency appreciating or depreciating
2 Determine which rate (historical/average/current) used to convert numerator under both methods
(larger/smaller/same temporal Vs Current)
3 Determine which rate (historical/average/current) used to convert denominator under both
methods (larger/smaller/same temporal Vs Current)
4 Determine Ratio Increase ; Decrease ; or Same
Hyperinflation: local currency can disappear on parents BS in presentation currency.
Inflation exceeds 100% over 3 year period (Annual of 26% compounded for three years)
Reality: non-monetary A & L not affected by HI because values increase to offset impact of HI.
US GAAP -> cannot re-adjust values -> use temporal (functional assumed as parent presentation)
Consider Functional Currency as Parents Presentation Currency. Temporal Method used to remeasure
Financial Statements
IFRS -> YES!
Temporal Not used; Instead, foreign currency FSs restated for inflation and then translated using
current rate [No CTA].
Restating for Inflation; then translated using current rate method.
- non-monetary A/L restated for inflation using Price Index
- Shareholder Equity restated by applying in Price Index from beginning
(RE is plug to make balance)
- IS items restated by multiplying in Price Index from date transactions occur.
(NI is from RE plug -> then G/L is final plug)
- Net Purchasing Power Gain/Loss recognized in IS based on Net Monetary A/L exposure:
Holding MA during inflation = PP loss; Holing ML during inflation = PP Gain
Analysis:

consider adding CTA to NI. Add s in SE to NI (clean surplus).

Effective Tax rate -> tax expense / pretax profit;

statutory tax rate: tax code of home country

Cash Basis -> Revenues Recognized when cash collected; expenses recognized when paid
Accrual Basis -> Revenues recognized when earned & expenses when incurred (must be weighted lower)
* provides for relevant and timely information to users; more manipulative; less sustainable
Earnings have a Cash Flow component and Accrual Component; CF - earnings = accrual component
Unearned Revenue; Accrued Revenue; Deferred Expense; Accrued Expense;
Forecast Error & Difference between sell-side forecast and reported earnings
Deter Manipulation -> Indep Audit, Board of Directors, Cert. of Senior Mgmt, Class Action litigation,
Regulators
Earnings Quality ->Measure by Persistence & Sustainability; NOT conservatism
Measurement: Earnings have CF component and Accrual Component; Diff between CF & earnings =
Accrual component
Balance Sheet Approach:
Accruals = in Net operating assets over a period ; NOA = Difference in Operating Assets and Liabilities
Operating Assets = TA Cash (and equivalents) & marketable securities.
Operating Liabilities = TL total debt (Short term & Long Term)
Accuals (BS) = NOAend NOA Beg ;

Accruals Ratio (BS) = NOAend NOA Beg

( NOAend NOA Beg) / 2

Cash Flow Statement Approach:

Subtract CFO and CFI from NI;
Accruals (CF) = NI CFO CFI;

Accruals Ratio (CF) = NI CFO CFI

( NOAend NOA Beg) / 2

*Accruals Ratio -> Lower is better!

Lower Ration indicates higher earnings quality

*Wide fluctuations are indication of earnings manipulation; big increases also a red flag.
* BS and CF approach can yield widely different results;
* compare 2 methods, eliminate $ paid for interest and taxes from operating CF by adding them
back ; IFRS -> may not be necessary for int WATCH OUT.
Operating CF / Operating Income
Must be over 1!!!
Mean Reversion (extreme earnings revert to normal). Occurs quicker when earnings are largely
composed of accruals.
Discretion in Revenue Recognition: Misstating revenue, accelerating revenue, misclassifying revenue, or
non-operating revenue
Expense Recognition: Understating expenses, delaying expenses, misclassifying operating expenses as
non-operating/non-recurring
BS: Off BS financing, Goodwill
CFS: Misclassifying CF; Ignoring CF, Managing CF, Revenue Policy
Core Operating Margin = (Sales COGS SG&A) / Sales
Off Balance Sheet Financing: Operating Leases -> treat as Capital
+ add PV of Lease Payments to A & L
Rent Expense removed from IS, Replaced with Int expense and Depreciation
Cash collected = Revenue - in AR + in unearned revenue
Evaluating Quality of Financial Reports
Earning Quality: high level of earnings (meat reqd ROI) and sustainability of earnings
Reporting Quality:

information described in reports

* HQ earnings without HQ reporting not possible!!! HQ reporting w/o HQ earning Yes possible
Measuring / Timing Issues: Rev recog; expense timing, etc;

Classification issues: operating vs non-operating; selling AR, etc

Biased Accounting: Misstate profitability -> channel stuffing, bill & hold, gains showing in NI w losses in
OCI; depreciation tricks, goodwill tricks, SPE tricks
*Signs -> Rev growth faster than peers; high customer returns, weird seasonality in 4QTR,
inconsistencies.
Business combinations -> M&A provides opportunities to manage results; Overstate acquired goodwill
by understating FV of assets
Beneish Model: Regression estimates probability of earning manipulation;
M-score = higher value = higher probability of manipulation;
DSRI; GMI; AQI; SGI; DEPI; SGAI; Accruals; LEVI
Altman Model: z-score to assess probability of bankruptcy filing. Compare items to total assets [WC; RE;
operating profit; sales]; Compare mkt value equity to BV equity
* One period analysis only -> does not capture s in variables over time
Earnings Quality:

Sustainable -> persistent in future;

Adequate: cover cost of capital

Earnings(t+1) = + 1 earnings (t) + E

Accruals: less quality than cash based; accruals is highly subjective; Non-discretionary accruals -> can be
normal business; Discretionary accruals -> can be manipulative
Major Flag -> Positive NI w ive CFO

Narrowly beat or meet estimates consistently

Mean reversion -> extreme earnings with revert to normal levels eventually.
Large Accruals -> revert quicker!
Flag -> sales % inc vs AR % inc ;

AR turnover & days out vs Industry Avg.

Expenses Capitalization:

under report operating expenses

CF: Operating Vs Investing ->

Interest Income/expense IFRS; AVS vs trading

DUPONT ROE refresher

ROE = NI / Equity
= NI/EBT

Tax burden (1-tax)

EBT/EBIT
int burden

EBIT/Revenue x
EBIT margin

Rev/Avg As x Assets / Equity

Asset turnover

Leverage