1
Q
return on equity (ROE)
A
= net income / BV of shareholder equity (average)
- NI is period of time, VC is point in time so that’s why take average
2
Q
Dupont analysis
A
= profit margin * asset turnover * financial leverage
= net income/sales * sales/assets * assets/BV of equity
- tradeoff between profit margin and asset turnover
- profit margin & asset margin as operating while financial leverage is non-operating
- also equals ROA (net income/total assets) * financial leverage
3
Q
why is ROA imperfect of operating performance?
A
- ROA = net income / total assets
- material interest expense effect (impacted by capital structure)
- need to adjust for non-operating assets and & operating liabilities
4
Q
operating assets
A
A/R
PP&E
Inventory
Prepaid Expenses
5
Q
nonoperating assets
A
Cash
ST Investments
6
Q
operating liabilities
A
A/P
Deferred Revenue
Accrued Liabilities
7
Q
nonoperating liability
A
debt
8
Q
accounting analysis
A
- analysis of specific accounts (deriving info from the footnotes)
- analytic adjustments (finance vs operating leases)
9
Q
Porter’s Five Forces (Understanding the Business)
A
- industry competition: competition and rivalry raise the cost of doing business
- bargaining power of buyers: buyers with strong bargaining power can extract price concessions
- bargaining power of suppliers: suppliers with strong bargaining power can demand higher prices
- threat of substitution: as number of product substitutes increases, sellers have less power to raise prices and/or pass on costs to buyers
- threat of entry: new markets entrants increases competition and companies must develop new technologies and human capital to create barriers to entry (capex required, IP, size of companies, regulatory) and economies of scale
10
Q
flows
A
numbers from the IS, such as sales, measured over a period of time
11
Q
stocks
A
numbers from BS sheet are measured at a point of time
12
Q
flows & stocks metrics
A
when ration involves taking both (ex. ROA, asset turnover), take average of BS values
13
Q
ROE (for companies with non-controlling interst and companies with preferred stock)
A
- for companies with non-controlling interest: ROE = net income attributable to company shareholders / average equity attributable to company shareholders
- for companies with preferred stock: ROE = (net income attributable to company shareholders - preferred dividends)/(avg equity attributable to company shareholders - avg preferred equity)
14
Q
what does ROE mean?
A
$1 invested in equity, generates XX amount in Net Income
15
Q
inflation of ROE
A
- stock buybacks have increased dramatically in the past several years
- many balance sheets report large levels of treasury stock or very low retained earnings
- smaller equity balances in the denominator inflates ROE
16
Q
margin vs turnover tradeoff
A
- among firms in the same industry + within firms: asset turnover usually increasing in unit volume, so generally reflects a margin vs. volume story
- among firms in the industry, maps roughly into a product differentiator (higher margin/lower turnover) vs cost leader (lower margin/higher turnover story)
- product differentiators “earn” their high margins via lower asset turnover: ownership of upstream firms in supply chain to ensure product quality, carrying lots of inventory to ensure availability for customers, slower production process to ensure quality
- across industries: often attributed to responsiveness of asset investment to sales fluctuations
17
Q
gross profit margin
A
= gross profit / sales
- influenced by the selling price of a company’s products and the cost to make or buy these productions (important metric for variation in quality)
- low of decreasing GM signals more competition or less demand for company’s products: competitive intensity has increased, product line has lost appeal, product cost have increased, product mix has shifted to lower-margin products
18
Q
COGS
A
- cost of primary inputs into the production process
- often goes for COGS for physical goods
19
Q
What is Cost of Sales for:
Manufacturing
Retail
Consulting
SaaS
A
- D&A on plant, utility of plant, direct material/overhead
- freight costs, inventory
- salaries of consultants
- hosting (servers), AWS, software engineer salaries
20
Q
operating expense margin
A
= operating expenses / sales
- measures general operating costs for each sales dollar
- operating expenses is more expansive than just SG&A (like D&A and R&D)
- compare margins over time and against peers
21
Q
days inventory turnover (DIO)
A
= 365 * inventory / COGS
22
Q
days sales outstanding (DSO)
A
= 365 * A/R / Sales
23
Q
days payable outstanding (DPO)
A
= 365 * A/P / COGS
24
Q
cash conversion cycle
A
- cash conversion cycle is the average number of days to: buy inventory on credit, sell inventories on credit, collect receivables, pay the account payable
CCC = DIO + DSO - DPO - generally, companies prefer lower cash conversion cycle because then the operating cycle is generating profit and cash flow quickly
- CCC depends on business model which reflects credit terms offered to customers, types of inventory carried (perishable or non perishable goods), time period in which suppliers are paid for goods and services
25
CCC from lowest to highest (industry)
- energy
- communication services
- utilities (electricity hard to store)
- consumer discretionary
- industrials
- healthcare (production long, insurance so high DSO)
26
cash conversion cycle of apple
- carries little inventory, products are presold and shipped when manufactured
- has quick collection of sales and relatively longer time to pay suppliers
- negative number means that Apple can invest the cash its receives from product sales for CCC days before that cash is needed to pay suppliers
- Apple generates profit from the sale and from investing its cash
- negative CCC can be viewed positively
27
PPE turnover
- sales/average PP&E
- improving PP&E turnover is not easy, often entails: divesting of unproductive assets of entire business lines; joint ventures to jointly use PP&E assets such as distribution networks, information tech, production facilities, warehouses
28
operating leverage
operating income = GP - fixed operating cost
OR Sales * GM - fixed operating costs
operating leverage = operating income / sales
- sensitivity of operating income to sales fluctuations (results from higher fixed costs, offset by higher gross margins)
- reflected in higher GM and lower PP&E turnover + higher PP&E as a % of total assets (plant investments tend to generate fixed costs)
- COGS is the biggest variable cost; SG&A has some variable costs but more so fixed (rent, salaries, etc.)
- those that have lots of fixed costs have higher sensitivity for the operating margin graph
29
disaggregation ROE
- ROE disaggregation with an operating focus recognizes that companies create value mainly through core operations
- balance sheet and IS has both operating and non operating items
- analysis can be improved if we separately identify the operating and non operating components of the business and their separate returns
- thus ROE = operating return (RNOA)+ non operating return
- ROE includes return on the company's operating activities (sales, expenses, etc.) and return from non operating activities (financing and non operating investments)
30
return on net operating assets (RNOA)
- operating returns are measured by the return on net operating assets (RNOA), AKA return on invested capital (ROIC)
RNOA = net operating profit after taxes (NOPAT) / average net operating assets (NOA)
- must classify balance sheet and income statement into operating and non operating components (balance sheet: net operating assets, NOA) and income statement: net operating profit after taxes, NOPAT
31
operating assets
- A/R
- inventories
- prepaid expenses / supplies
- PP&E and right of use assets
- intangible assets and goodwill
- deferred tax assets
- equity method investments
(primary value generating assets; investors expect company to put cash/money to work)
32
operating liabilities
- A/P
- accrued expenses
- unearned (deferred) revenue
- income taxes payable
- deferred tax liabilities
- pension obligations
- other post employment benefits
- no explicit interest rate attached to these / self liquidating liabilities
33
net operating assets (NOA)
= operating assets - operating liabilities
34
borrowed money (liabilities)
- loans / bonds / mortgages
- usually explicitly interest earnings
35
equity method investments
own more than 20% (have significant influence)
36
dividends payable
financing liability, not arise from operations
37
NOPAT
- NOPAT = net operating profit before tax (NOPBT = sales - operating expenses) - tax on operating profit
38
operating expenses
- COGS
- SG&A: wages, advertising, occupancy, insurance, D&A, litigation, and restructuring expenses (include one time costs because technically still operating)
- R&D
- impairments of operating assets such as goodwill
- income from joint ventures, partnerships, and associated companoes
- gains and losses on asset disposal
- "other" operating expenses or income
39
tax shield
- taxes a company saves by having tax deductible on operating assets
= pretax net operating expenses * statutory tax rate
40
tax on operating profit
= tax expenses + tax shield
- taxes saved by the tax shield do not relate to operating profit, we add it back to the tax shield
41
nonoperating items on the income statement
interest expenses on debt and lease obligations
loss or income related to discontinued operations
debt issuance and retirement costs
interest and dividend income on marketable securities
"other" income or expense if reported separately from operating income
- for most companies, non operating activities create a pretax net operating "expense"
- if it creates income, then have to reduce it for tax on operating profit
42
NNO
net operating obligations
non operating liabilities - net operating assets
43
FLEV
financial leverage
average nno / average stockholders equity
44
NNE
net operating expense
NOPAT - total net income or nonoperating expense * (1-statutory tax rate)
45
NNEP
net operating expense percent
NNE / average NNO
46
spread
RNOA - NNEP
return on net operating assets - net nonoperating expense percentage
47
advanced DuPont
ROE = RNOA + FLEV * (FNOA - NNEP) * (maybe NCIR)
which is operating return + nonoperating return
48
net operating assets
cash
cash equivalents
marketable securities
long term investments
discontinued assets
derivative assets
49
net operating liabilities
short term and long term debt
lease obligations
interest payable
dividends payable
discontinued liabilities
derivative liabilities
50
nonoperating return
= FLEV * Spread
= average non operating obligations (NNO) / average stockholders equity * (RNOA - NNEP)
51
NCIR
- (net income attributable to shareholders / net income) / (equity attributable to shareholders / average total equity)
52
right of return (revenue rec)
estimate the amount that will likely be returned and deduct that amount to arrive at NET sales
53
gift cards (revenue rec)
recognize when gift card is used by the customer
54
nonrefundable up front fees (revenue rec)
recognize when future goods or services are provided (odd, but even if non refundable)
55
bill and hold arrangements (revenue rec)
recognize when control of goods transfer to the customers
56
consignment sales (revenue rec)
if the seller acts as an agent, recognize commission (inventory and COGS don't show up on the books)
57
licenses (revenue rec)
revenue recognition depends on the contract
right to use - recognize revenue when the customers can first use licensed IP (software installed on premises, media content available to streaming service)
promise of access - recognize over a period of time (SaaS based software)
58
cost of consignment revenue
consists of credit card fees, packaging, customer service personnel related costs, website hosting services, and consignor inventory adjustments related to lost or damaged products
59
cost of direct revenue
consists of cost of goods sold, credit card fees, packaging, customer service personnel related costs, website hosting services, and inventory adjustments for lower of cost or net realizable value provisions and for lost or damaged products
60
cost of shipping services revenue
consists of outbound shipping and handling costs to deliver purchased items to our buyers, the shipping costs for consigned products returned by our buyers to use within policy and allocation of the credit card fees associated with the shipping fee charged
61
franchise (revenue req)
goods component is recognized when the goods are transferred to the buyer
services component (use of trade name or license) recognized as the serves are delivered
62
multiple element contracts (revenue req)
multiple products and services
- separate sale into distinct goods and services valued on a stand alone basis
- recognize revenue separately on each distinct component
63
cost to cost method for long term contracts
recognize revenue over the life of a long term contract in amounts that track the percentage of completion of the contract (involves judgement and observation)
basically backing into revenue by the percent complete
64
sale allowances
right of return, sales discounts for volume purchases, and retailer promotions (point of sale price markdowns and other promotions)
- reduce the amount of cash the company receives
- under GAAP companies must report amount of cash expected to be recieved
- companies must deduct from GROSS sales the expected sales return and other allowances
- sometimes provide a rollforward of their sales allowance
65
three ratios used to analyze sales allowance
1) additions charged to gross sale: measures income statement amount, reveals effect of pricing pressure on net sales, expect percentage of sales allowance to gross sales to increase (thus reducing net sales) as pricing pressure increases
2) allowance as percentage of gross sales (scaling the balance sheet amount by sales)
3) adequacy of the allowance amount: compares dollar amount of the estimates for future sales return to the amount actually realized
66
where to find "rollforwards"
valuation and qualifying accounts, at bottom of 10K
67
where to find info on revenue recognition policies?
MD&A: significant accounting policies and application of critical accounting estimates and assumptions
Notes to Financial Statements: Note 1 on significant accounting
68
where to find estimate changes and effects on revenue
usually in the MD&A, critical accounting policies and estimates
69
magnitude of accounts receivable
accounts receivable turnover = sales / avg A/R
days sales outstanding = 365/accounts receivable turnover
70
collecting A/R more quickly ...
... increasing operating cash flow
71
quantify cash increases using DSO
- change in DSO, times the sales per day (sales/365) to find cash generated
72
allowance for credit losses
balance at beginning of period + charged cost and expenses - amounts written off as uncollectible = balance at end of period
73
three possible interpretations for the decrease in allownace
1) credit quality has improved
2) company is underestimating allowance account (to some degree rely on management judgement)
3) Gross A?R is just decreasing
- can overstate one year when doesn't care about the threshold and then underestimate bad debt expense the following year
74
R&D costs
broadly consist of: salaries and benefits for researchers and developers, supplies needed to conduct the research, licensing fees for intellectual property or software used in R&D, third party payments to collaborators at other firms and universities, laboratory and other equipment, property and buildings to be used as research facilities
- internally generated R&D are expenses as incurred, except for general purpose PPE assets which are capitalized and depreciated as usually (thought these flow through R&D expense on the income statement!)
75
R&D as percent of revenue for industries (high to low)
chemicals
machinery
pharma, life sciences, biotech
tech hardware and equipment
software and services
semiconductors and semiconductor equipment
76
analysis of acquired R&D expenses
companies report R&D on the income statement and acquire R&D when acquiring other companies that have patents or promising R&D projects
- when a company acquires in process R&D (IP R&D) it records it as an asset
- IP R&D assets are not amortized until the associated R&D activities are either completed or written off (abandoned)
- when get it would debit IP R&D and credit cash and then when reduce it would record as impairment charge and credit IP R&D
77
finite life intangible assets
amortized over estimated useful life (ex. patents, copyrights, franchise rights, IP R&D once "available for use")
78
indefinite life intangible assets
not amortized but tested periodically for impairment (ex. goodwill, trademarks, and IP R&D until "available for use")
79
discontinued operations
companies often divest business segments
when this occurs, company reports the event at the bottom of the income statement by segregating income from continuing versus discontinued operations
- companies are also required to segregate the discontinued operation's assets and liabilities on the current and prior year balance sheet
80
discontinued operations line item
- net income (or loss) from the segment business activities prior to the divestiture and any gain (or loss) on. the sale of the business
81
why segregate discontinued operations?
- discontinued operations are segregated in the income statement because they represent a transitory item
- transitory items won't recur and are largely irrelevant to predicting future performance
- investors tend to focus on income from continuing operations because that is the level of profitability that is likely to persist into the future
disposal of the business unit must represent a strategic shift for the company and have a major effect on the company's financial results
82
proforma income reporting
pro forma income statements are non GAAP numbers that company management believes provides a better understanding measure of their financial performance
SEC requires that companies reconcile non-GAAP info to GAAP numbers (regulation G)
83
2 categories of pro forma earnings adjustment
unusual and/or recurring: litigation settlements, M&A expense, asset impairment
recurring "bad" GAAP: ignoring intangible amortization, stock based compensation expensing
84
adjusted diluted EPS ...
is not a GAAP metric
the company makes these deductions and additions to its GAAP numbers because management believes doing so provides a better measure of financial performance
- adjusted income statements are sometimes referred to as pro-forma or non-GAAP numbers
85
regulation G reconciliation
SEC requires companies reconcile non-GAAP information to GAAP numbers so financial statement readers can have a basis for comparison and can evaluate the excluded items
86
pro-forma earnings (research summary)
large (>1% of assets), non recurring items are very common
over 1/2 of firms provide some kind of pro forma number
management defined earnings better than GAAP for predicting future performance but beware allegedly "non-recurring losses" (especially for smaller or growthier firms)
87
write off of uncollectible account
- if the company determines the receivable is not uncollectible, company records "write off" and adjusts the allowance
88
inventory is purchased or produced ...
it is capitalized on the balance sheet; when it is sold, it is transferred to Income Statement as COGS
89
capitalization
means the cost is recorded on the balance sheet and is not immediately expense in the income statement
90
capitalization of inventory
- for purchased inventory, amount is capitalized is the purchase price
- for manufacturing inventory, capitalize all manufacturing costs which consists of: cost of direct (raw) materials, cost of direct labor to manufacture product, manufacturing overhead
91
FIFO
first in, first out; transfers costs from inventory in the order that they were initially recorded
92
LIFO
las in, first out; transfers the most recent inventory costs from the balance sheet to COGS
93
average cost
computes the average cost to purchase or manufacture inventory available for sale during the period and applies the average to determine COGS and ending inventory
94
balance sheets effects of LIFO vs FIFO
- in periods of rising cost, LIFO inventory can be markedly lower than FIFO
- LIFO balance sheets do not accurately represent the cost that a company would incur to replace its current inventory
- LIFO and FIFO balance sheets are not comparable
- GAAP requires firms choose LIFO and also report (in footnotes) ,the equivalent inventory amounts
95
LIFP reserve
difference between LIFO and FIFO
96
LIFO helps what
helps with taxes
means that COGS are higher, so pretax income is lower which means taxes are lower
this helps with cash is higher (savings)
97
LIFO reserve equation
FIFO inventory = LIFO inventory + LIFO reserve
98
LIFO reserve adjustments
three adjustments to convert LIFO to FIFO on the balance sheet
1) increase inventory by the LIFO reserve
2) increase tax liabilities by the tax rate applied to the LIFO reserve (higher taxes)
3) increased retained earnings by the difference (higher net income)
99
FIFO COGS
FIFO COGS = LIFO COGS - change in LIFO reserve
100
LIFO liquidations
when companies reduce inventory levels, older inventory costs flow to the income statement. these older LIFO costs are often markedly different from current replacement costs
assuming an inflationary environment, sales of older pools often boost gross profit as lower, cost are matched against current selling prices on the income statement
101
rating agency treatment
rating agencies (Moody's & S&P) only adjust balance sheets in computing ratios for determining credit ratings
102
which is more popular: LIFO or FIFO
LIFO is less popular over time, making more of a comeback recently
103
R&D facilities and equipment charges
R&D facilities and equipment are not immediately expensed
if they are general use of nature, costs are capitalized on the balance sheet and depreciated over the useful life like other depreciable assets (flow through R&D expense, rather than depreciation expense)
R&D facilities and equipment that are purchased specifically for a single R&D project and have no alternative use, are expensed immediately
R&D costs do create future benefits and might seem to be assets but R&D costs (other than general use facilities and acquired R&D) are not capitalized under US GAAP
104
asset sales
gain or loss on the sale (disposition) of a tangible asset is computed as = proceeds from the sale - net book value of the asset sold
- net book value is acquisition cost less then accumulated depreciation
- when an asset is sold, both the acquisition cost and related accumulated depreciation are removed from the balance sheet
- any gain/loss is reported in income from continuing operations
105
argument for gain or loss on asset sale
one could argue that a gain or loss on the asset sale indicates the company misestimated asset's useful life or the depreciation pattern
gain suggests that too much depreciation was recorded over the asset's life and the income reported in prior financial statements was too low
a loss suggests the opposite
106
asset impairment
sometimes market value of PP&E assets decrease
if the asset value to be permanently impaired, then the company must write off the impaired cost and recognize losses
107
accounting for goodwill
goodwill is not amortized because it is considered to have an indefinite or life
goodwill must be evaluated for impairment at least annually and at the same time each year to prevent companies from gaming the impairment evaluation
108
goodwill impairment test
estimate the fair value of each subsidiary that has goodwill on its balance sheet
compares the estimated fair value of the subsidiary to its carrying value on the parent company's balance sheet
if the subsidiary's Fair Value < Carrying value the subsidiary's goodwill is impaired
109
periodic expenses
tangible assets or definite-life assets: depreciated/amortized based on economic or legal life
indefinite-life intangible: not amorized
110
impairment test for tangible assets or definite-life intangibles
recoverability test:
1) compare undiscounted cash flows to carrying value (purchase price - accumulated depr/amort - prior impairment)
2) if undiscounted CF's < carrying value, write down to the fair value
111
restructuring costs
corporate restructurings are designed to turn a company around and are frequently in response to: poor performance, mounting debt, shareholders pressure
restructuring can involve eliminating business segments, selling major assets, downsizing the workforce, reconfiguring debt
goal of restructuring is to positively impact a company's long term financial performance
112
disclosure of restructuring costs
because of their magnitude, restructurings required enhanced disclosure either as a separate line item in the income statement or as a footnote
113
three components of restructuring costs
employee severance or relocation costs, asset write-downs, other restructuring costs
114
employee severance or relocation costs
to accrue employee severance or relocation expenses, company must: estimate total cost of terminating or relocating selected employees, report total estimated costs as an expense (and a liability) in the period restructuring program is announced
subsequent payment to employees reduce the restructuring accrual (the liabilitY
if a company overestimated the liability, it gets to record a restructuring reversal as a gain item so debit severance liability and CR restructuring reversal (IS gain item)
115
asset write down
restructuring activities usually involve closure or relocation of manufacturing or admin features
- can require a write down of assets
- restructuring write downs can involve long term assets like PP&E, intangible assets (goodwill), inventories
- writedowns have no cash flow effects unless the write down has tax consequences
116
PPET
- PP&E turnover = sales / avg PP&E, net
- critical issue in analyzing PP&E is determining productivity
- PP&E turnover is generally lower for capital-intensive firms and higher for companies in service or IT
- though rapid asset obsolescence and replacement can drive PPE turnover higher
117
PPET from lowest to highest for industries
utilities
oil, gas, consumable fuels
chemicals
consumer discretionary, retail
consumer staples
biotech
pharma
semiconductors
capital goods
118
average useful life
if we assume straight line depreciation and zero salvage value, can estimate the average useful life as
= avg. depreciable asset cost / depreciation expense
depreciable asset cost excludes land and construction in progress (gross P&E minus that)
119
PP&E percent used up
measures the proportion of a company's depreciable assets that have already been used up, that is, transferred to the income statement
ratio reflects percent of depreciable assets that are no longer productive and is computed as follow
percent used up = accumulated depreciation / depreciable asset cost
120
PP&E percent used up analyss
- knowing the degree to which a company's assets are used up is of interest in forecasting future cash flows
- ex. if 80% are used up, then might expect higher levels of capex to replace aging assets in the near future
121
operating vs financing leases
pre-2019: only finance leases (called capital leases) showed up on the balance sheet pre-2019
post 2019: operating and financing leases all on the balance lease
122
operating vs financing leases (balance sheet)
similar for both of them: all eases are recognized on the balance sheet (except leases with term of less than 12 months), lease asset is reported as either PP&E or right of use asset that is amortized over the lease life life, lease liability is reduced by principal payments each period, like a mortgage
123
operating vs financing leases (income statement)
- operating lease: rent expense is recognized for the straight line amortization of the total lease payments plus up front costs
- finance lease: straight line amortization expense at the right of use asset, plus; interest expense is recognized on the lease liability
124
operating vs financing leases (cash flow statement)
- operating lease: lease payments are classified as operating cash flow
- finance lease: interest portion of lease payments is classified as operating cash flow, principal portion of lease payments is classified as financing cash flow
125
summary on leases' effect on ratio construction
- make sure to include operating leases ROU assets in PPE turnover calc
- for RNOA calc: include ROU lease assets in operating assets and include operating lease liabilities in non-operating obligations
- for any ratios involving interest bearing debt, we will customarily include operating lease liabilities in debt so like for debt/assets or debt/equity
- add imputed lease interest expense to interest expense (and corresponsibly lower operating expenses by this amount)
126
acquiring intangible assets
when one company acquires another, we must allocate the purchase price to the assets acquired and the liabilities assumed
- after the purchase price is allocated, any excess is allocated to the acquired intangible assets
- each intangible asset must be identified, valued, and assigned a useful life, just like PP&E
- intangibles can compromise large portion of company's balance sheet
- although unlikely to yield future benefits, difficult to reliably measure those benefits
- they have tremendous economic value; can explain part of wide disparity between company's market value and book value of stockholder's equity
127
deferred tax asset
if cash taxes paid / GAAP pretax income > statutory rate
if book (GAAP) net assets are < tax net assets then deferred tax assets
128
deferred tax liability
if cash taxes paid / GAAP pretax income < statutory rate
if book (GAAP) net assets are more than tax net assets
129
effects of loss carryforward
A loss carryforward lets a company apply a current year’s net operating loss (NOL) to future taxable income.
Effect: reduces taxable income in future years → lowers future cash tax payments.
Accounting: creates a Deferred Tax Asset (DTA), since the company has already “paid” the loss today and gets to use it as a tax shield later.
130
disclosure for income taxes
companies required to reconcile the difference between the US corporate tax rate and the company's effective rate (tax expense / pretax income)
reconciliation table provides valuable information about transitory items that affect taxes and net income (tax reductions like restructuring and law changes are not likely to recur in the foreseeable future)
131
for what exceptions below, temporary book-tax differences don't affect reconciliation
idea behind deferred taxes is that they help the effective tax rate get closer to statutory rates, by aiding in matching
- exception 1: changes in the DTA valuation allowance help make the effective rate higher (when allowance increases) or lower (when allowance decreases/reverses due to DTA's being more likely than not to be realized)
- exception 2: if there are changes in the tax rates, DTAs and DTLs can be revalued up or down
132
valuation allowance for DTA
- companies must establish a valuation allowance for DTA in the future realization of the tax benefits is uncertain
- the allowance reduce reported assets and increases tax expense, which reduce equity
- valuation allowance can be reduced or reversed by one of two events: company writes off the deferred tax asset (asset is reduced to zero and amount is written off is subtracted from the deferred tax valuation allowance; there is no effect on income from write off; occurs when NOLs expire before they can be used to offset other profits)
- companies determines that DTA will be realized: if company determines that realization of DTA is more likely than not, it can reverse the DTA valuation allowance; DTA allowance is reduced and tax expense is reduced by the same amount, thus increasing net income
133
tax credits vs tax deductions
deductions reduce tax burden by deduction * statutory tax rate
credits reduce tax burden by CREDIT amount
134
What are examples of book-tax timing differences that create deferred tax assets or liabilities?
Depreciation: Accelerated depreciation for tax vs straight-line for books (creates a deferred tax liability).
Bad debt expense: Allowance method (book) vs direct write-off (tax) → creates deferred tax asset.
Warranty expense: Estimated warranty liability (book) vs deductible only when paid (tax).
Pension obligations: Accrued pension cost (book) vs deductible when contributions are made (tax).
Stock-based compensation: Recognized at grant for book, deductible at exercise for tax
135
What is the key estimation risk in the cost-to-cost method of revenue recognition?
Analysts must estimate total project costs.
If early estimates are pessimistic (overstated costs), initial revenue recognized is lower → later periods record higher revenue as estimates are revised down.
If early estimates are too optimistic, later periods record lower revenue (downward revision).
Timing of revenue recognition shifts but total revenue over life of project is the same.
136
Why is being a “serial restructurer” a red flag for investors?
A firm that repeatedly takes restructuring charges (every few years) may be using restructuring as an earnings management tool.
One-time charges can be used to “big bath” current earnings, boosting future periods.
Frequent restructuring undermines credibility of “one-time” costs and suggests systematic poor performance.
137
How do analysts adjust the income statement to treat operating lease liabilities as debt? What information do you need?
Treat lease expense as if it were split into depreciation + interest expense (similar to a finance lease).
Adjustment steps:
Add back reported lease expense (in operating expenses).
Subtract imputed depreciation of ROU asset.
Subtract imputed interest expense on lease liability.
Information needed: present value of lease commitments (to estimate liability), lease term, and discount rate to impute interest.
138
Which industries typically have high receivables, inventory, PPE, and deferred revenue?
Receivables-heavy: Consulting, SaaS, professional services (work billed later).
Inventory-heavy: Retail, manufacturing, wholesale.
PPE-heavy: Airlines, telecom, utilities (large fixed assets).
Deferred revenue-heavy: SaaS, subscription media, insurance (cash received before service delivered).
139
If you wanted to adjust a LIFO follower’s balance sheet to reflect FIFO inventory, what information would you need, and what entries would you make as an analyst?
Information needed: LIFO Reserve (disclosed in footnotes).
Adjustment entry:
DEBIT: Increase Inventory by LIFO Reserve.
CREDIT: Increase Equity (Retained Earnings) by LIFO Reserve × (1 – tax rate) [after-tax effect].
CREDIT: Increase Deferred Tax Liability by LIFO Reserve × (tax rate).
140
If you wanted to adjust a LIFO follower’s income statement to reflect FIFO COGS, what information would you need, and how would you calculate it?
Information needed: Change in LIFO Reserve during the period.
Formula:
FIFO COGS = LIFO COGS – (Increase in LIFO Reserve)
If the reserve decreases → FIFO COGS = LIFO COGS + (Decrease in LIFO Reserve).
Adjustment entry (analyst view):
Decrease COGS if LIFO Reserve increased. (DEBIT LIFO Reserve and Credit COGS)
Increase COGS if LIFO Reserve decreased.
(Debit COGS and Credit LIFO Reserve
FSA
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