1
Q
Pro forma reporting
A
Financial reporting the excludes extraordinary items
2
Q
Primary concerns of regulators and oversight committees regarding pro forma reporting:
A
- Antifraud provisions: Obviously, these provisions still apply for pro forma reporting. Pro forma cannot be misleading.
- Basis for presentation: Extraordinary items need to be indicated and the reason they’re being excluded should be addressed.
- Timing of the report: Firms can release the pro forma reporting (unaudited) before the audited financials.
- Aggressive accounting
3
Q
Aggressive accounting
A
A method of accounting that’s used to report lower expenses and higher income, or to overstate assets while understating liabilities.
4
Q
True or false: Capitalization is an example of aggressive accounting?
A
True. Capitalization allows expense recognition to be deferred.
5
Q
True or false: One of the fundamental concepts of GAAP is to match costs and revenues over time?
A
True
6
Q
Ways to measure Depreciation:
A
- Straight-line
- Accelerated depreciation
a. Double declining balance (DDB)
- With few exceptions, the IRS only allows DDB for accelerated depreciation methods.
7
Q
Straight-line depreciation
A
Produces a constant depreciation expense and a constant decline in carrying value of the asset.
Calculation: Original cost ÷ Estimated useful life
- Whenver possible, firms will use an accelerated method for tax reporting purposes and straight line depreciation under GAAP for reporting to shareholders. This will create deferred tax.
8
Q
Modified Accelerated Cost Recovery System (MACRS)
A
IRS regulations that require the entire cost of an asset to be written off over its depreciable life.
9
Q
Double declining balance
A
An accelerated method of depreciation.
Calculation: (2 * straight-line depreciation rate) * Carrying value
10
Q
Methods to use for accounting for investments:
A
- Cost method: When a firm owns <20% of another company. Carried at par.
- Equity method: When a firm owns >=20% but <=50% of another company. Under this method, the firm that owns the shares will report a proportionate share of the investee’s earnings.
- Purchase method: When a firm owns >50% of another company
- In the equity method, the investment is referred to as an affiliate.
11
Q
Principal characteristics of the purchase method
A
- Mandatory for use in a cash deal
- Viewed as an acquistion of new assets
- The BV used for PP&E and other fixed assets may be adjusted (increased) to MV.
- Goodwill is created if the acquisition price > MV of the assets acquired.
- If there is an impairment to goodwill, earnings must be written down.
- Minority interest must be created if < 100% is acquired.
- With the purchase method, balance sheets and income statements are combined.
12
Q
Goodwill calculation
A
MV of a company’s net tangible assets - price
13
Q
Net tangible assets calculation
A
Total assets - liabilities - existing goodwill - intangible assets
- Intangibles with an identifiable market value may be included in the tangible book value per share
14
Q
3 ways that firms account for investments in stocks and bonds
A
- Tradable
- AFS
- HTM: Typically, these are highly rated bonds or CDs.
- HTM securities are listed on the b/s at their original cost + any accrued expenses to date.
- HTM securities that will mature in less than a year are classified as CA, whereas if they mature in more than a year they’re considered fixed assets.
- Tradable securities are listed as a CA at MV. URG/URL are recognized in the IS.
- AFS securities are listed at MV.
15
Q
True or false: Consolidated financial statements MUST be prepared when a firm owns 25% or more of another firm?
A
False, 50%
16
Q
Noncontrolling interest/minority interest
A
An item that’s shown in the equity section of the parent’s b/s.
17
Q
Noncontrolling interest in net earnings of consolidated companies
A
An account in the IS that shows how much income in a given period belongs to noncontrolling or minority shareholders (rather than the parent).
Ex: Firm A owns 70% of Firm B and Firm B reports NI of $200M. Firm A and Firm B would consolidate their income statements, and a deduction of ($200M * 30% = $60M) is made under noncontrolling interest.
18
Q
True or false: FASB requires firms to capitalize the interest incurred during the period of construction of non-current assets?
A
True
- This is done because if something is in construction, it’s probably not allowing a firm to generate revenue yet. Capitalization is when the interest cost IS NOT included in the interest expense on the IS, but instead included in the cost of the building on the b/s, and is depreciated over the useful life. Once the construction is completed, the interest expense must be included in the IS.
19
Q
How firms account for leasing an asset
A
When firms lease an asset, they must create a liability for future lease payments. The liability equals the PV of the lease payments. In order to balance the b/s, leasees will create an asset called the rights of use (ROUs). Since leased equipment and facilities are often used for more than one year, ROUs are generally fixed assets.
Leases will impact the leasee’s IS, but it will depend on if it’s a financial lease or operating lease.
20
Q
Finance lease vs operating lease
A
Operting lease: A firm will recognize its lease payments as an operating expense. These expenses are constant over the lease term.
Finance lease: An asset that is likely to be acquired after a lease term is up. Payments for finance leases are split up into an interest component and an amortization component. The interest portion is expensed after operating costs on an IS. Because of this, financing leases give firms higher operating incomes. The amortization component decreases each year.
Finance lease payments decline over the lease term.
- Operating leases are considered more aggressive.
- Finance leases typically decline over the lease term since interest expense will fall and amortization will be constant.
- Finance leases will have higher D/E ratio and lower ROA.
21
Q
How to test for impairment w/ goodwill:
A
- Identify any any impairments by comparing MV to the b/s value. If the MV > b/s value, there’s NO impairment.
- If impairment is identified, a loss equal to the excess is recognized in the IS.
22
Q
True or false: Intangible assets ARE NOT amortized?
A
False. If the intangible asset has a useful life (ex: copyrights, patents, etc.), it can be amortized.
23
Q
What are the 2 methods of revenue recognition:
A
- Percentage-of-completion method
- Completed contract method
24
Q
Percentage-of-completion method
A
Revenue is reported each period as the company incurs costs to complete the project.
- Typically used for long-term contracts.
25
Completed contract method
Revenues nor expenses are recognized until the contract is complete.
26
True or false: Firms can switch between revenue recognition methods during contracts?
True
## Footnote
* It's important to understand how earnings are affected by these switches. For example, if a firm is using % of completion method and then switches to the completed contract method, revenues will be lower in the short-term and higher once the contract is completed.
27
Defined contribution plan
The employer makes a set annual contribution (usually a % of the employee's salary) to an account managed by a trustee. Employee bears the risk.
## Footnote
* Pension assets are separated from the assets of the firm.
28
Defined benefit plan
A plan that gaurantees an employee a certain pension benefit, tied to the length of employment at the firm and the employee's salary. Employer bears the risk.
## Footnote
* ERISA establishes minimum amounts that must be funded every year.
29
The Employee Retirement Income Security Act (ERISA)
Establishes minimum amounts that must be funded in a pension plan each year. The amount expensed and the amount contributed can differ dramatically. If pension assets > pension liabilities, the plan is overfunded and if vice versa, it's underfunded.
30
Normal service cost
The amount that current employees earn toward their pension.
## Footnote
* The amt expensed by firms is the PV of these benefits.
31
Interest of the projected benefit obligation
The liability associated w/ the accumulated normal service cost, incorporating various assumptions like years to retirement and assumed salary increases. Interest accrues on the projected benefit obligation, which is a PV figure and represents part of pension expense in the IS.
32
Prior service cost
Changes to the pension plan can cause an additional expense, such as an increase in benefit payable under a defined benefit plan. Accounting standards allow firms to amortize these changes over the life of its work force.
33
True or false: Interest rate increases will increase the value of pension fund assets?
False. If interest rates decrease, pension fund assets will increase. However, pension fund obligations will rise even faster since long-term obligations will cost more to fund in PV dollars- a lower discount rate = higher PV. If this trend continues, it coud lead to unfunded pension liabilities.
## Footnote
* Conservative accounting for pension funds assumes low discount rates, high-assumed rate of salary growth.
34
DTAs vs DTLs
DTAs/prepaid tax income: If taxable income > accounting income
DTLs: If accounting income > taxable income
35
How to determine if there is a DTA or DTL?
Deferred tax = Income tax expense (accounting income * tax rate) - current tax (taxable income * tax rate)
| If positive, it's a DTL. If negative, it's a DTA.
36
How to account for cash dividends.
When a dividend is declared:
There's a difference in accounting for cash dividends based on dividend declaration and payment of the dividend. When a cash dividend is declared, dividends payable increase (a CL), and RE are reduced.
When a dividend is paid:
When the dividend is paid, cash (a CA) is reduced and dividends payable are also reduced. Therefore, the reduction of assets (cash) is shown in the reduction of equity (RE).
## Footnote
* When a dividend is declared, the current ratio and WC will be reduced.
* When a dividend is paid, WC remains the same.
37
Stock dividend example:
Firm A declares a 5% stock dividend when its shares trade at $25 per share and there are 2mm shares outstanding. Each share has a par value of $2. How many shares outstanding are there after the split and what will the stock trade at?
2mm * 1.05 = $2.1mm
Common stock increase = 100,000 * $2 = $200,000
RE will be reduced by the MV of the stock: $25 * 100,000 = $2.5mm.
In order to balance shareholders' equity, paid-in capital will have to increase by $2.3mm.
38
How is paid-in capital, RE, par value of CS, and par value per share affect by a stock split.
Paid-in capital: No change
RE: No change
Par value of CS: No change
Par value per share: No change
39
How is paid-in capital, RE, par value of CS, and par value per share affected by a stock dividend?
Paid-in capital: Increase
RE: Decrease
Par value of CS: Increase
Par value per share: No change
40
Foreign currency translation gain/loss example:
Firm A holds 10,000 Swiss franks (SF) at 1.6SF per $1. If the exchange rate changes to 1.3 SF per dollar, what is the foreign currency translation gain/loss?
At first, the exchange rate represents $6,250 (10,000 ÷ 1.6).
Then, it become $7,692 (10,000 ÷ 1.3).
Thus, there is a foreign currency translation gain of $1,442 on the IS.
41
How to account for foreign subsidiaries that the parent controls?
When a U.S. based company owns a controlling interest in a foreign subsidiary, the parent must engage in a process called ***translation*** which converts combines the two financial statements and converts the subsidiary's into dollars.
42
Temporal method vs current method
GAAP allows the current method and the temporal method. If the functional currency is the local currency, the current rate method is used. If the functional currency is the U.S. dollar, the temporal method is used and the term remeasurment is used in place of translation. The functional currency is the currency of the firm where transactions are denominated.
## Footnote
* The temporal method passes the gain/loss onto the IS
* The current method passes the gain/loss to a separate account in equity called Foreign Currency Translation Adjustments.
43
How can a firm change the way it accounts for certain items?
If a firm changes an accounting method, GAAP requires the firm to retroactively make adjustments. The cumulative difference must be reported on the IS.
44
Inventory
Finished goods that are available for sale or goods that are in process that are ***a significant CA for manufacturers and retailers***. GAAP requires these be listed at historical cost.
## Footnote
* With inventory, lower of cost or market appears in many financial statements where 'market' means the replacement cost to reacquire the product.
45
Cost of goods available for sale
The sum of the inventory at the start of the period, plus the purchases made during the period.
46
Cost of goods sold
An expense item in the IS (usually the most significant item on a manufacturer's or retailer's IS) listed below the revenue line.
47
Periodic inventory system
No specific record is maintained to reflect the reduction in inventory when goods are sold. At some interval, the firm stops business and counts units that are left.
48
Specific identification method
A system used when the inventory is unique and the matching of products sold can be easily accomplished.
49
True or false: The effective rate is typically higher than the marginal tax rate?
False, the effective tax rate is typically lower. The marginal tax rate combines federal and local taxes.
50
Internal rate of return (IRR)
A method of evaluating the return on an investment which is the rate of discount that equates the PV of the expected cash outflows with the PV of the expected cash inflows.
Formula: A0 = (A1 ÷ (1 + r)) + (A1 ÷ (1 + r)^2)... + (An ÷ (1 + r)^n)
51
Relationship between increase/decrease in assets and CF position?
If an asset increases, that's a use of cash. If an asset decreases, it's a source of cash.
If a liabiliity increases, that's a source of cash. If a a liability decreases, that's a use of cash.
52
Restructuring charges
A one-time expense that a company pays when reorganizing its operations. Reflected in the operating section of the IS, as well as in the footnotes of a firm's financials.
53
Channel stuffing
A deceptive business practice used by a company to inflate its sales and earnings figures by deliberately sending retailers in its distribution channel more products than they're able to sell. This allows these distributors to reduce inventory and increase AR. ***Channel stuffing is illegal.***
## Footnote
* Research analysts can detect if there is channel stuffing by reviewing the Days of Sales Outstanding, which measures how quickly a company turns its sales into cash.
54
True or false: Net operating losses can be carried forward indefinitely to reduce taxable income?
True
## Footnote
* They CANNOT be carried back
55
Turnover ratios
* Asset turnover
* Receivables turnover
* Payables turnover
* Inventory turnover
56
Asset turnover
An indication of how well the firm uses its asset base in generating sales.
Formula: Sales ÷ Avg. assets
## Footnote
* A low ratio may indicate the firm is tying up its capital relative to the other needs of the firm.
* A high ratio may indicate that fully depreciated assets are being used to generate sales.
57
Receivables turnover
An important liquidity measure that shows how quickly a firm can collect its receivables.
Formula: Sales ÷ Avg. receivables
## Footnote
* A high ratio shows the firm is collecting on its accounts and has a greater ability to pay its current liabilities.
58
Payables turnover
An indication of how quickly a firm pays its suppliers in relation to COGS.
Formula: COGS ÷ Avg. payables
## Footnote
* If a firm increases its receivables turnover while maintaining payables turnover, it's improving its cash conversion cycle.
59
Inventory turnover
Indicates how often the company sells the goods it produces.
Formula: COGS ÷ Avg. inventory
| In some cases, sales is used in the numerator.
60
Liquidity analysis ratios
* Current ratio
* Working capital per dollar of sales
* Quick ratio/Acid ratio
61
Current ratio
Indicates how many dollars of current assets are available to pay each dollar of current liabilities.
Formula: CA ÷ CL
## Footnote
* If asked to calculate the current ratio after a merger, you need to know if the company used a line of credit. If yes, the amount must be added to CL.
62
Working capital per dollar of sales
Net working capital ÷ Sales
63
Quick ratio
(Cash + Cash equivalents + AR) ÷ CL
## Footnote
* Deducts inventory since it's often less liquid than other CA.
64
Profitability analysis ratios
* EPS
* Fully diluted EPS
* EBIT margin
* EBITDA margin
* Equity turnover
* Profit margins
* ROA
* ROE
* Days of sales outstanding
65
Basic EPS
The amount of profit generated by the company that's allocated to each share of CS outstanding.
Formula: (NI - preferred dividends) ÷ Weighted Avg. # of Shares of CS Outstanding
66
Dilutive EPS
(NI + adjustments for common stock equivalents and other potentially dilutive securities) ÷ (Weighted avg. # of shares of common stock + weighted avg. common stock equivalents and other potentially dilutive securities)
## Footnote
* DO NOT use treasury stock method. Use the "if converted" method, which assumes that all convertible securities are converted.
67
Securities/actions that are dilutive:
- Conversion of bonds of preferred shares into common stock
- Issuing in-the-money warrants, preemptive rights, or ESOP
- M&A purchases using stock
- Issuing new shares of CS
68
Securities/actions that are non-dilutive:
* Stock splits and dividends
* Reverse stock splits
* M&A purchases using cash
* Stock buybacks
69
Anti-dilution provision
The right of current shareholders to maintain their fractional ownership of a company by buying a proportional number of shares of any future issue of common stock. A provision is an option or a convertible security, it protects an investor from dilution resulting from later issues of stock at a lower price than the investor originally paid.
70
Earnings momentum
The acceleration of a firm's EPS from period to period. As the economy peaks, cyclical companies will have the largest earnings momentum.
71
EBIT margin
EBIT ÷ sales
72
EBITDA margin
EBITDA ÷ sales
73
Equity turnover
Sales ÷ Avg. equity
74
Gross profit calculation
Revenue - COGS
75
Pre-tax margin
EBT ÷ Sales
76
Operating profit margin
Income from operations ÷ Sales
77
Return on equity (ROE)
(NI - preferred dividends) ÷ Avg. Equity
78
DuPont ROE
This calculation of ROE is generally used in industries with high margins (e.g., high-end fashion), high turnover (e.g., retail), or high leverage (e.g., financials).
Formula: (NI ÷ Sales) * (Sales ÷ Assets) * (Assets ÷ Equity)
79
Days of sales outstanding (DSO)
Measures how quickly a company turns its sales into cash.
Formula: (AR ÷ Total credit sales) * # of days in the accounting period
| If total credit sales is not provided, total sales can be used.
## Footnote
* A larger DSO could mean that a firm has liquidity issues.
* A decrease in DSO is considered an improvement, whereas an increase is considered bad.
* ***Know that this formula can be rearranged to calculate AR***
80
Capital structure and capital market analysis ratios
* Debt-to-capital
* Debt-to-equity
* Debt-to-EBITDA
* Dividend payout
* Interest coverage
81
Debt-to-capital (D/C)
An indication of the % of the total capitalization of the company comprised of debt. The ratio reflects the level that the company is trading on its equity.
Formula: Debt ÷ (Debt + Equity)
82
Debt-to-EBITDA
An indication of the company’s leverage; that is, the higher the ratio, the greater the leverage. ***A high ratio indicates a greater likelihood that a company may default on its debt. A lower ratio is an indication that a company may have the ability to incur additional debt, without a significant increase in the risk of default. The debt-to-equity and debt-to-total capitalization ratios measure debt capital, but not a company’s ability to meet its debt service obligations***
Formula: (short-term and long-term debt) ÷ EBITDA
83
Dividend payout ratio
Shows the level of earnings paid out in dividends.
Formula: Dividends ÷ NI
84
Earnings retention rate
The opposite of the dividend payout ratio. This shows the amount of earnings NOT paid out in dividends.
Formula: (EPS - dividends per share) ÷ EPS
85
Interest coverage ratio
An indication of how many dollars of earnings are available to meet interest expenses. It shows how many times during the year the company can meet its interest payments.
Formula: EBIT ÷ Interest expense
## Footnote
* A low ratio would indicate a high debt burden
86
True or false: Preferred dividends go into NI?
False, preferred dividends, same as common dividends, are taken out of NI. NI - preferred dividends = income available to common shareholders.
87
True or false: Operating leases are not presented on the b/s?
False
88
Firm A has issued debt to finance the construction of a factory. As construction begins, the price of the stock has remained unchanged. Which of the following statements best describes the impact on the IS and the P/E ratio?
A. Operating income will increase and P/E ratio will rise
B. Operating income will decline and P/E ratio will rise
C. NI will remain unchanged and EBITDA will rise?
D. No impact on operating income or P/E ratio
D. Since the interest will be capitalized, it won't be included in the IS- thus no impact on operating income. And since there's no impact on the stock price, there's no impact on the P/E ratio.
89
Firm A capitalizes its software costs. Firm A would be expected to have:
A. Higher EBITDA and higher capitalized costs
B. Higher EBITDA and lower capitalized costs
C. Lower EBITDA and lower capitalized costs
D. Higher EBIT and lower capitalized costs
A. Since the firm capitalizes the costs, D&A will be added back while interest expense will have never been taken out. If the company didn't expenses the cost, interest would have been added back to a NI that originally had interest expense deducted.
90
True or false: When combining the firms' income statements using the purchase method, DO NOT combine any other income?
True
Series 86
flashcards
Decks in class (7)
# Cards
