Professional Documents
Culture Documents
Ex/ Land and building purchased in a bundle for $25,000,000. 40% land, 60% building
- Effects: since depreciation expense is greater in the early life of the asset, net income
is lower; net income will be higher in later years, however; if an entity is growing and
continually purchasing and replacing capital assets, depreciation expense almost always
lower than declining balance; if entity not growing, declining balance eventually
produces lower depreciation expenses
- Usage-Based Depreciation: used if asset's consumption can be associated with its use, not to
the passage of time or obsolescence
- Units of Production: manager must be able to estimate the number of units that the
asset will produce over its life; depreciation expense is the portion of units produced in
the year to total estimated units to be produced over its useful life; assumption is made
that the asset's actual lifetime production will equal the production estimated by the
manager, rarely true in practice
Goodwill = Purchase Price - Fair Value of Identifiable Assets & Liabilities Purchased
- Identifiable Assets & Liabilities: tangible, intangible assets and liabilities that can be specifically
identified; include cash, inventory, land, buildings, patents, copyrights, research & development
- Assumed extra amount paid for something of value; often attributed to things such as
management ability, location , synergies, customer loyalty, reputation, benefits associated with
the elimination of a competitor; all things should lead to higher profits, very difficult to
specifically identify and measure
- Internally-Generated Goodwill: things like management ability, location, customer loyalty
exist before the company is sold, but are not recorded on the balance sheet; too difficult to
determine if there are future benefits associated with expenditures that give rise to goodwill, so
amounts expensed as incurred
- Amortization: goodwill is not amortized, according to IFRS; management must estimate fair
value of goodwill each year to determine if it is impaired; if fair value less than carrying amount,
goodwill must be written down, write-down amount expensed in yearly income statement;
despite IFRS guidelines for estimating fair value, management has considerable leeway in
deciding timing and amount of any write-down
Sale of Capital Assets
- When entity sells asset not usually sold in the ordinary course of its business for an amount that is
different from its carrying amount, gain or loss occurs; gain when sold for more than carrying amount,
loss when sold for less than the carrying amount
- When depreciable asset sold, cost of asset and its accumulated depreciation must both be removed
from the books; any changes affecting the carrying amount of an asset will change the amount of gain or
loss reported, assuming the selling price is constant
- Managerial Discretion: manager's decision to sell an asset may be affected by amount of any
gain or loss; if entity requires higher net income to meet requirements of loan, manager may be
unwilling to sell capital asset at a loss, may sell one to generate a gain
Ex/ Equipment for $1,200,000; Residual $200,000; Useful Life 10 Years; Carrying Amount
$500,000; sold 1/4 of the way though the year; Straight-Line Basis
- IFRS states write-downs of capital assets can be reversed if the recoverable amount increases in a later
period, excluding write-downs of goodwill
- Longer-Term Perspective: inventory uses the lower of "cost" or "net realizable value" rule, compared at
the end of each period, written down if NRV less than cost; but for capital assets, cash flows over entire
life are considered; short-term reduction in net cash flows or fair value not enough to trigger write-
down of capital asset
- Accumulated Depreciation: where the write-down is credited to; decrease the carrying amount of the
asset; cash is not affected by the journal entry, despite the potential for future cash flow losses
- Managerial Discretion: lot of judgement needed in deciding timing and amount of write-down; future
cash flows, present value of future cash flows, fair value are highly uncertain; manager's will time write-
downs of capital assets to accomplish reporting objectives
- Big Bath: assets written down, resulting in large expenses now, paving way for higher earnings
in future because less carrying amount of assets to depreciate; must be justifiable, but
management can usually make a reasonable justification if company not performing well
- ASPE: capital asset impaired if undiscounted net cash flow asset is expected to generate over
remaining life, including residual value, is less than carrying amount; carrying amount of asset is
compared with fair value; when fair value less than carrying amount, asset is written down to fair value;
does not allow write-downs to be reversed
Does the Way Capital Assets are Accounted for Affect the Cash Flow Statement?
- Accounting choices do not affect the actual amount of cash entering/leaving an entity, but can affect
how cash flows are classified
- When expenditure is capitalized, appears as an investing activity in the cash flow statement; if that
expenditure was expensed instead, it would have been included in cash from operations
- Capitalization: outlay classified as investing activity; amortization expense added back to net income in
the calculation of CFO using the indirect method
- Expense: in the calculation of CFO, amortization expense is added back to net income; does not appear
explicitly in the cash flow statements
- Managerial Discretion: even though statement of cash flows is designed to neutralize the effects of
accounting choices by managers; managers can influence it by deciding which outlays will be capitalized
and which will be expensed; impairs comparability between similar companies
- Why Accounting Choice?: allows managers to present information in ways that are useful to
stakeholders, but provides them the means to achieve their own reporting objectives; stakeholders
should recognize opportunity for abuse and use accounting information cautiously; accounting very
important role in communicating information about an entity; essential that managers and any external
accountants behave ethically; if stakeholders cannot use accounting information with confidence, costs
of doing business will increase and economic performance will decline
Financial Statement Analysis Issues
- Limits: when analyzing historical cost information, there are limits to the insights one can gain;
usefulness of historical cost information about capital assets is questionable; extensive choice about
how to account for capital assets, how it is done significantly affects numbers in the financial
statements; expenses, net income, assets, retained earnings, any ratios will be greatly affected by what
costs get capitalized, depreciation method used, estimates of useful life and residual value, existence of
unrecorded assets, and the impairment of capital assets
- Return on Assets: used to measure performance and operating efficiency of an entity; measure of how
efficiently an entity used its assets to generate profit; can improve ROA by lowering asset base or
increasing profits;
Return on Assets (ROA) = (Net Income + After-Tax Interest Expense) / Average Total Costs
- Problems: ratio will be affected by management's accounting choices, when assets purchased;
assets purchased at different times will have different costs, so comparing ROA of different
firms must be done with caution
- Fixed- Asset Turnover Ratio: used to examine efficiency of use of PPE; measures number of dollars of
sales generated by each dollar invested in PPE; higher ratio implies more efficient use of assets
- Ratio must be analyzed carefully, may be other characteristics of the industry or company that
influences the fixed-asset turnover ratio; care also must be exercised comparing ratios of
different industries; one can reasonably expect a lower ratio for companies in more capital
extensive industries
CHAPTER 9: LIABILITIES
Introduction: What are Liabilities?
- Liabilities: obligations to provide cash, goods, or services to customers, suppliers, employees,
governments, lenders and anyone else an entity "owes something to"; some obligations are not even
recorded on the balance sheet; all companies will have some extent of liabilities because not all
purchases are for cash
- Current Liabilities: debt to be settled within a year
- Long-Term Liabilities: debt shall last longer than one year
- Liquidity: whether an entity has adequate resources to meet claims; assessed using information about
liabilities, are claims on entity's cash and other resources
- Solvency: whether an entity will be able to meet its obligations as they come due; assessed using
information about liabilities, are non-negotiable, must be paid; an entity unable to meet obliations likely
to face legal or economical consequences
-IFRS Criteria: obligations arising from past transactions or economic events; require sacrificing
economic resources to settle
- Valued at present-value; timing and amount of cash flows known or can be estimated; possible to
identify appropriate discount rates, but not all liabilities are discounted to present-value (discounting of
current liabilities is immaterial)
Current Liabilities
- Obligations that shall be satisfied in one year or one operating cycle; important for assessing short-
term liquidity of a firm; not usually discounted to their present-value
- Bank & Other Current Loans
- Demand Loans: reported as current liabilities if amount must be repaid within the next year or
operating cycle; lender can ask for repayment at any time; loans remain on books for long time
- Line of Credit: allows entity to borrow up to a specified maximum amount whenever it requires
the money; only classified as a liability if money is actually borrowed
- Accounts Payable
- Amounts owed to suppliers for goods and services, include anything entity uses in its
operations; measuring amount not difficult, payable triggered by invoice from supplier
- Collections on Behalf of Third Parties
- Usually not disclosed separately, would be included in accounts payable
- Most entities act as tax collectors for various government taxation authorities
- Firms adding Harmonized Sales Tax (HST) to the purchase price
- Employers withholding amounts from employees' pay for transfer payments
- Employers withholding amounts for items (shares of benefits, pension plan
contributions, charitable donations, etc.)
- Money withheld does not belong to entity; liability reflects obligation to send amounts to
appropriate institutions
- Money withheld from employees' pay also does not belong to the employer
- Disclosure
- IFRS: disclosure requirements for current liabilities general, wide variation in classification and
detail provided by public companies; must be segregated by main class; detailed disclosure on
provisions also required; most entities separate current and non-current liabilities, IFRS allows
entities to order by liquidity, without the current vs. non-current classification
Bonds & Other Forms of Long-Term Debt
- Debt: amounts borrowed and owed by an entity; non-current (long-term) or current; long-term debt is
often used to finance business operations
- Collateral: protection for lenders should the borrower not repay the loan; lenders get the collateral or
the proceeds from the sale; can be anything from inventory to land
- Variable Rate Loan: interest rate varies with market conditions
- Fixed-Rate Loan: interest rate does not change
- Debt Instruments:
- Bond: formal borrowing arrangement in which a borrower agrees to make periodic interest
payments to lenders as well as repay the principal at a specified time in the future
- Debenture: bond with no collateral provided to the lenders
- Mortgage: loan that provides the borrower's property as collateral
- Note Payable: formal obligation signed by the borrower, promising to repay a debt
- Financing by Debt: liabilities that have to be repaid; interest is tax-deductible, means actual cost of
borrowing is lower than the interest rate stated on the loan; debt holders do not have a say in the firm's
management; riskier for the issuing entity because interest and principal payments have to be made as
specified regardless of how the entity is doing; less risky for investors because debt investors must be
fully repaid before equity investors get anything if an entity goes bankrupt; less costly way to finance an
entity because less risky for investors; higher risk investors face, higher return they expect
- Characteristics of Bonds
- Face Value: amount the bondholder will receive when the bond matures
- Maturity Date: date on which borrower has agreed to pay back the principal (face value)
- Coupon Rate: percentage of face value the issuer pays to investors each period
- Proceeds; amount the issuer receives from sale of the bond; not necessarily the face value
- Effective Interest Rate: real or market rate of interest required by investors to invest in
the bond; if coupon rate different from effective interest rate, bond's selling price must
allow investors to earn the effective interest rate; if coupon rate lower than effective
interest rate, bond sold at discount and proceeds less than face value; if coupon rate
greater than effective interest rate, bond sold at premium, proceeds greater than face
value; if coupon rate and effective interest rate same, proceeds equal face value
- Additional Features of Bonds: cause a change in the interest rate; if feature beneficial to
investors, issuing entity should be able to offer a lower interest rate, vice-versa
- Callable Bond: bond issuer has option to repurchase bond from investors at a time
other than maturity date; attractive to issuer because if interest rates fall, issuer can call
bond and make another issue at a lower interest rate; not attractive to investors as
they lose an investment paying a higher-than -market rate of interest
- Convertible Bond: may be exchanged by investor for other securities of the issuing
entity, such as common stock
- Retractable Bond: investors have the option of cashing in the bond before the maturity
date, under certain conditions
- Bond Restrictions: on issuer's activities; intended to reduce investor's risk, reduce cost of
borrowing; many stated in relation to accounting ratios; violations can have significant economic
consequences, so managers take steps (both accounting and operating decisions) to avoid them
- Pricing of Bonds
- Bonds and other long-term debts are priced according to recent value tools; price of bond is
equal to present value of the cash flows that will be paid to the investor, discounted at the
effective interest rate; effective interest rate determined by market forces, depends on risk;
riskier the bond, higher the rate
First, use present value annuity formula to calculate present value for interest payments
Proceeds from bond are the sum of these two present value calculations
If effective interest rate lower than coupon rate, proceeds would be higher than face
value. If effective interest rate the same as the coupon rate, proceeds equal face value.
- Accounting for Bonds
- When Effective Interest Rate = Coupon Rate, Bonds Sold at Face Value
- When Effective Interest Rate > Coupon Rate, Bonds Sold at Discount
- Carrying Value: face value of the bonds less bond discount; net present value of bonds
discounted using the effective interest rate
- Discount Amortization: can be thought of as interest investors must receive to earn the
effective interest rate; compensation for the low coupon rate; is amortized over the life
of the bonds, included as part of the interest expense each year
- Straight-Line Method: same as straight-line amortization for capital assets; can
be chosen by companies following ASPE; allocates an equal amount of premium
or discount to each period; divide initial amount of premium or discount by
number of periods until maturity; interest expense for each period is the same
- Effective Interest Rate Method (IFRS REQUIRED): annual interest expense
calculated as amount of liability outstanding at the beginning of the period
(carrying amount) multiplied by the effective interest rate; amount of discount
amortized in a period is difference between interest expense (calculated using
effective interest rate) and amount of interest paid (based on coupon rate)
- Some Perspective on Technical Complexity: details of how premiums and discounts are
amortized is less important than understanding how price of bonds is determined, why
premiums and discounts arise, and what impact premiums and discounts have on the interest
expense; you are learning this so that you can understand what the numbers in financial
statements mean so you can use them intelligently and effectively
- Accruing Interest on Long-Term Debt
- Must record an accrued expense/accrued liability adjusting entry
Leases
- Lease: one entity (lessee) agrees to pay another entity (lessor) a fee for use of an asset
- Lessee: entity that leases an asset from its owner; has certain rights and obligations, as defined
in the lease agreement
- Lessor: entity that leases assets it owns to other entities; owns the asset
- Benefits to Leasing
- Entity does not have to obtain separate financing for the purchase; important when already
much debt existent, lenders reluctant
- Allows for financing 100% cost of asset; lenders often only lend a portion of a purchase amount
- Provides flexibility to lessees; perhaps some protection from technological obsolescence,
depending on contract terms
- Attractive for entities that do not need certain assets continuously; allows entity to use an
asset without the cost of owning assets that are idle for significant amounts of time
- Off-Balance-Sheet Financing: entity incurs an obligation without reporting a liability on its balance
sheet; allowed before accounting standards for leasing introduced, rules only required a lessee to
record a lease or rent expense when payment to lessor was paid or payable; allows entity to incur
liability without balance sheet consequences, making it seem like the firm has less debt and is less risky
- As practice became more common, rules established requiring leased assets and associated
liabilities to be reported on lessee's balance sheet if the lease resulted in the transfer of risks
and rewards of ownership to lessee; lease accounted for similarly to a purchase, if criteria met
- Types of Leases:
- Capital/Financing Leases: transfers risks and rewards of ownership to the lessee; leased asset
and liability recorded on lessee's balance sheet at present value of the lease payments; lease is
depreciated over its useful life (or term of lease if shorter); lessor treats lease as a sale,
removing the asset from its books, reporting receivable equal to the present value
- Must be likely the lessee will get ownership of the asset by the end of the lease
- Bargain Purchase Option: lessor will sell item to the lessee at the end of the
lease term for a significantly lower price
- Lease term must be long enough that the lessee receives most of the economic
benefits of the asset
- Present value of the lease payments must be equal to most of the fair value of the
leased asset
- Operating Leases: risks and rewards of ownership are not transferred to the lessee, retained by
lessor; lessee does not record leased assets or an associated liability; lessee recognizes an
expense when payment to lessor paid or payable; lessor recognizes revenue from lease when
payments received or receivable; lessee has off-balance-sheet financing
- Depreciation: if the term of the capital lease is shorter than the useful life of the asset,
lessee is not likely to take title of asset at the end of the lease, asset should be
depreciated over the term of the lease
- Straight-Line: over estimated five-year life; annual depreciation expense
$50,718, assuming no residual value
- Defined-Benefit Pension Plan: employer promises to provide employees with specified benefits in each
year they are retired; employers bear the risk because they promise specified benefits to employees,
regardless of how investments perform, must pay regardless of how much money is in the plan
- Determining How Much to Fund: calculation straightforward, assumptions difficult;
assumptions will be based on events that occur over many years; must assume the following for
each employee...
- Number of years employee would live after retirement
- Appropriate discount rate to be used in Present Value of an Annuity Formula
- Number of years employees will work for the employer
- Number of employees who will qualify for benefits
- Number of employees who will die before they retire
- Age at which employees will retire
- Salary employees will earn in the year(s) on which the pension is based
- Number of years employees will live after retirement
- Return the money in the pension fund will yearn (higher the expected return, less
needed in the pension fund
- Post-Retirement Benefits: accounting done similarly, is similarly complex; companies not required to
fund non-pension post-retirement benefits, most pay as they occur; obligations significant, will likely
grow as number of retired employees grows
- Importance: benefits represent very significant obligations to an entity; may affect solvency;
stakeholders want to assess impact benefits have on entity's ability to survive, compete, and be
profitable; employees and retired employees have interest in information since it affects the quality of
their lives after retirement; provides information about cash flow requirements
- Judgement: since many assumptions are made, managers exercise considerable judgement
Contingencies
- Contingent Liabilities: a possible obligation whose existence has to be confirmed by a future event
beyond the control of the entity; an obligation with uncertainties about the probability that payment
will be made or about the amount of payment (does not meet definition of a provision, however); not
recognized in financial statements, disclosed in the notes, unless probability of having to pay is remote;
if recognized, it is recorded as a provision
- Contingent Assets: an asset whose existence is uncertain; are not recognized in financial statements,
disclosed in the notes if realization is probable ("more likely than not" according to IFRS); if realization of
asset virtually certain, asset recognized in financial statements, no longer referred to as a contingent
asset
- Judgement: considerable judgement required, necessary to estimate probability of a contingency being
realized and its amount
Commitments
- Commitment: contractual agreement to enter in a future transaction; not reported as liability (IFRS)
- Executory Contracts: when neither party to a contract has performed its part of the bargain; liability to
pay, asset representing good or service to be received are both not recorded
- Alternative Methods to IFRS
- Record asset, liability associated with contract (maybe only when not possible for either side to
cancel contract); no effects of this method, increases assets and liabilities
- IFRS Judgement: though recognition of executory contracts not allowed, information about
significant commitments can be important to stakeholders, should be disclosed; managers must
exercise their judgement when deciding if an executory contract is significant enough to
disclose; disclosure is helpful for predicting future cash requirements and financing needs
Events After the Reporting Period/Subsequent Events
- Subsequent Event: event after the reporting period; economic event that occurs after an entity's year-
end but before financial statements are released to stakeholders
- Events that Provide Information About Circumstances that Existed at Year-End
- Financial statements adjusted to reflect the new information, allows managers to make better
estimates; no information about these adjustments disclosed in notes, instead used to revise
statement numbers
- Events that Happened After the End of the Period
- Only disclosed in the notes, financial statements unaffected;
- Judgement: IFRS says the events that should be disclosed are those that will have a material
effect on the entity; managers have flexibility in deciding what is material
- Public Companies: most relevant situations would be disclosed via media
- Private Companies: disclosure would be a lot more likely to be news to stakeholders
- Subsequent events useful for forecasting future earnings or cash flows
- Debt & Taxes: entities allowed to deduct interest when calculating taxable income; actual cost of
borrowing money less than amount paid to lender; taxpayers pay for a portion of the cost of borrowing
- Taxable Income: measure of income, defined by Income Tax Act, used to calculate amount of
tax an entity must pay
- After-Tax Cost of Borrowing: interest rate an entity pays after taking into consideration the
savings that come from being able to deduct interest in the calculation of taxable income
- Analysis: ratio represents how many dollars of liabilities a firm has for every dollar of equity;
cannot be analyzed without a context; entities with highly reliable cash flows can carry more
debt, can be confident that cash flows will be able to make interest and principal payments
- Interest Coverage Ratio: measures an entity's ability to meet fixed financing charges; indicates how
easily an entity can meet its interest payments from its current income; earnings and cash flows can be
volatile, coverage ratios can change dramatically from period to period
Interest Coverage Ratio = (Net Income + Interest Expense + Income Tax Expense) /
Interest Expense
- Analysis: larger the ratio, better able entity is to meet interest payments; must remember that
this ratio does not include other financing charges
The Impact of Off-Balance-Sheet Liabilities
- Significant effect on measures of capital structure and risk; misleading conclusions drawn if they are
not considered
- Extensive use of operating leases will cause liabilities and the debt-to-equity ratio to be understated
- Can impair comparability if companies use different approaches to acquiring assets (purchase vs. lease)
- Risk not affected by including off-balance-sheet items in debt-to-equity ratio, but risk management is
- Excess Cash: repurchasing shares is a way of distributing cash to investors without creating a
precedent of paying regular or higher dividends
- Earnings Per Share: net income / average number of common shares outstanding during the
period; increases when share repurchases occur; should increase share price by extension,
assuming that operating activity of entity not affected by the repurchase (ownership divided
among fewer shares)
- Communication: way to tell market that company thinks it is understating its share value
- Exchanges Between Investors: accounting records only updated when firm issues shares or
repurchases shares; daily trades on the stock exchange have no affect on the company's
financial statements; stock price is still important because share price can affect managers'
wealth, job prospects, and because it indicates how the company is seen to be performing
Retained Earnings, Dividends, & Stock Splits
- Retained earnings: accumulated earnings of an entity less all dividends paid to shareholders over the
entire life of the firm; profits that have been reinvested in the entity by shareholders; indirect
investment by shareholders because investors do not decide to make the investment
- Net income/Loss: measure of how owner's wealth has changed over a period
- Dividends: distributes of earnings to shareholders
- Correction of Errors: accounting errors made in a previous period should be corrected
retroactively by adjusting retained earnings; previous years' financial statements restated so
they appear corrected
*Crediting retained earnings makes up for the previous understatement of assets, which
caused an overstatement of equity
Date of Declaration
Dr. Retained Earnings (equity -)* $$$
Cr. Dividend Payable on Common Shares (liability +)** $$$
To record declaration of dividend on common shares
Date of Payment
Dr. Dividend Payable (liability -) $$$
Cr. Cash (asset -)*** $$$
To record payment of common share dividend
- Property Dividend: paid with property instead of cash; can be any property an entity has, but is
often impractical because entity must have a property type that can be distributed equally;
possible to issue shares of another company owned by the issuing entity; recorded at property's
fair value on date the dividend is declared; gain/loss reported on income statement if fair value
not equal to the market value of the property
Date of Declaration
Dr. Investment in Other Firm (assets +) $$$
Cr. Gain on Disposal of Investment
(income statement +, equity +) $$$
To record gain on shares being distributed to shareholders as a property
dividend
Dr. Retained Earnings (equity -) $$$
Cr. Property Dividend Payable (liability +) $$$
To record declaration of property dividend
Date of Payment
Dr. Property Dividend Payable (liability -) $$$
Cr. Investment in Other Firm (asset -) $$$
To record payment of property dividend
- Stock Dividend: shareholders receive company shares as the dividend; number received
depends on how many shares shareholder owned on the date of declaration; each shareholder
owns exactly the same proportion of outstanding shares before and after the stock dividend;
market price would fall because nothing has changed besides the number of shares outstanding;
shares can be valued at either market price before issuance, or BOD can assign a value to the
shares on some other criteria
- No effect on assets, liabilities, or income statement; only the equity section of the
balance sheet is affected by a stock dividend
- Stock Splits: divides entity's shares into a larger number of units; each dividend worth a lesser amount;
similar to a big stock dividend; no accounting effect of a stock split, retained earnings and common
shares accounts are unchanged; no journal entry required; any measurement that uses the number of
shares outstanding will change relative to that value
- Reverse Stock Split: reduces number of shares
- Allows shareholders to receive something when entity unable or unwilling to pay a cash
dividend
- Lowers the price of stock into a range that makes it accessible to more investors
- Insight: neither stock splits nor stock dividends has real economic significance; no effect on
assets, liabilities, net income; no change in underlying value of a shareholder's interest in an
entity; no evidence to suggest shareholders are better off
Accumulated Other Comprehensive Income
- Comprehensive Income: created as an all-inclusive measure of performance capturing all transactions
and economic events; includes events excluded from the calculation of net income, that do not involve
owners
Return on Equity = (Net Income - Preferred Dividends) / Average Common Shareholder's Equity
- Makes good news better because using someone else's money to increase equity investors' returns
- Makes bad news worse because equity investors lose some of their initial investment to pay interest
- Return on equity can be increasing while net income is decreasing; the amount of income being earned
as a proportion of the equity investment is increase, regardless of the changes in the actual dollar
amount of net income
- Usefulness of Leverage:
- Allows for more investment or a larger venture
- Allows investors to diversify; can spread money around instead of investing all their money in
one project, reducing risk
- Allows project to continue even if investors do not have enough of their own money
- Interest: increases as more of a project is financed by debt; must be paid to creditor regardless of the
venture's performance; affects net income
- Operating Income: unchanged; important to separate an entity's business performance from
its cost of financing
- Borrowing Limits: borrowing too great a value compared to owner investment can cause bank to
charge a higher interest rate, or not lend, due to increased risk to them
- Tax Implications: must be taken into consideration in such situations
- Debt-to-Equity Ratio: provides insight into the amount of leverage an entity has; is basis for evaluating
the risk the entity is assuming
Employee Stock Options
- Employee Stock option: right to purchase a specified number of shares of the employer's stock at a
specified price lower a specified period of time; represent right to purchase shares, but not shares
themselves
- Exercise Price: price at which employee may purchase the shares; usually the same or greater than the
market price of the shares on the day it is granted, for tax purposes
- Expiry Date: final date an option can be exercised; option will only be exercised if the exercise price is
less than the market price, otherwise they would be buying shares for more than they are worth in the
open market
- Do not cost entity any cash; crucial for a company that is short of cash or is trying to conserve cash for
future growth
- Significant Economic Cost: exercised when exercise price is below the market value, dilutes
value of the shares of other shareholders; wealth of existing shareholders transferred to the
employees exercising the stock option
- Give employees opportunity to make a lot of money if the company is successful; limits on the number
of shares that can be reserved for any person or to employees in total; number of shares issuable in a
year cannot be greater than 10% of the issued and outstanding voting shares
- Vesting Period: time an employee must remain with a company to be entitled to exercise the options
- IFRS requires that value of stock options granted to employees be expensed as part of the
compensation expense; would lower net income significantly
- Stock options have an economic value as long as there is time before the stock option expires;
if did not, employees would not negotiate for them and accept them as compensation; entity
giving the opportunity to purchase stock at below-market prices, which is valuable
Economic Consequences
- Accounting matters because it has economic consequences for an entity and its stakeholders; wealth
of an entity's stakeholders is affected by how much the entity accounts for various transactions and
economic events; decisions and outcomes (bonuses, debt term compliance, entity selling price, taxation,
etc.) can be affected by entity's choices in how it represents its economic circumstances in the financial
statements
- Underlying economic activity is NOT affected by how an entity accounts, but the representation of
economic activity in the financial statements is affected
Financial Statement Analysis Issues
- Price-to-Book (PB) Ratio
- Used to examine a stock's desirability; measure of the stock market's valuation of a company's
equity relative to its book value; indicates if shares are reasonably valued; low PB ratio indicates
stock undervalued, could either mean entity is an attractive investment, or is facing significant
problems; varies with industry, frequency of unrecorded assets
- Book Value: amount recorded in the accounting records for the assets, liabilities, and equities;
accounting value of accounting elements; carry amount
- Book Value of Equity: balance sheet value of an entity's equity; equal to assets less
liabilities as reported on financial statements; net assets or net worth of the entity; not
a measure of market value due to reasons like historical costing
- Sometimes considered what would be left over for shareholders if a company
shut down its operations, paid all creditors, collected from all debtors, and
liquidated itself; not a realistic interpretation for knowledge-based companies
that have many unrecorded assets
- Market Value of Equity: market price of an entity's shares multiplied by the number of
common shares outstanding; no readily available market price for private companies
- Earnings Per Share (EPS)
- Amount of net income attributable to each individual common share; analysts estimate future
EPS, whether an entity has had a successful period often measured by whether it has met
analyst forecasts; generally reported at the bottom of the income statement
- Basic Earnings Per Share (Basic EPS)
Dividend Payout Ratio = Common Annual Cash Dividends Declared / Net Income
- High Percentage: large proportion of earnings paid out, small amount reinvested; if too
high, can be concerning, company may not be able to maintain the dividend if it does
not perform as well
- Low Percentage: suggests existing dividend is safe, company can maintain it even if
earnings drop; room to increase dividend in future
- Per Share Basis:
Per Share Dividend Payout Ratio = Earnings Per Share / Cash Dividends Declared
Per Share
- Dividend Yield: similar information to dividend payout ratio; based on company's share price,
not earnings; changes daily, as share price changes, so is a more current indicator of the
dividend performance of a company
Dividend Yield: Common Annual Cash Dividends Per Share / Current Share Price
- High Yield: higher return to investors; should be cautious when it is too high, because
share price may be falling; company with falling share price may be unable to sustain
dividend, company may have to cut it to conserve cash
- Low Yield: may indicate company is growing, so investors will earn return on the
appreciation of the share value
- Insight: members in public have a lot of interest in performance of public companies, either
directly or indirectly through pension plans and mutual funds; no market price on which to base
reasonable estimate of private firms' market values
- Return on Shareholder's Equity (ROE)
- Measure of return earned by resources invested ONLY BY COMMON SHAREHOLDERS; affected
by how company is financed; more leverage/debt used by company, the more volatile ROE is
Return on Equity (ROE) = (Net Income - Preferred Dividends) / Average Common Shareholder's
Equity
- Cash From Operations: real cash; entity collects, spends specific amount during period;
accounting cannot change this number
- Accruals: non-cash part of earnings; require judgement, managers must estimate amounts,
actual amounts not known; depreciation, bad debt expense, accrued liabilities, provisions, write-
downs of assets, allowances for returns, etc.
- Compensation: if accrual overstated this period, will eventually be understated in a
following period to even things out; if managers make accruals that lower earnings in
one period, earnings will be higher in another period; accrual amounts are only certain
at the end of an entity's life, estimated during an entity's life; managers use uncertainty
of estimates and accruals to shift earnings among periods, lowering earnings quality
- Operating Decisions: timing of actual transactions; defer discretionary expenditures to later
period if entity wants to increase income in a period; deference can be counterproductive, cuts
create short-term increase in net income, but reduce future earnings; relationship between
current and future earnings is weakened from these operating decisions, so earnings quality
reduced
- Discretionary Spending: can evaluate by looking at expenditure in relation to sales;
significant decrease in the ratio could indicate attempt to boost earnings by cutting
discretionary expenses; must remember that ratios can also be legitimate
- Disclosure: most effective way to understand effects of entity's accounting choices on financial
statements; informed stakeholders are better able to assess quality of entity's earnings, create
better forecasts and assessments of quality of information provided by managers; not practical
to disclose every detail, so limitations to comprehensive analyses will always exist
- Future Implications: accounting choices almost always have implications beyond the period in
which the choice is made; transitory items create events in subsequent years that can be viewed
as permanent (i.e. big bath)
Using Ratios to Analyze Accounting Information
- Four analytical themes exist: evaluating performance, liquidity, solvency & leverage, other common
ratios
- No Standards: ratio or financial statement analysis can be done irrespective of any accounting
standards; person can modify or create any ratios appropriate for analysis; important to make sure the
right tool is used
- Dependence: ratios are presented separately, but must be considered in an integrated way; integrated
insights will allow you to be best informed
- Multiple Sources: financial information has to also be integrated with information from other sources;
provides a more complete picture of the entity and its circumstances
- Materiality: small percentage changes in some accountings may be very significant; large percentage
changes in some accounts may be insignificant
- Comparisons: financial statement information should be compared to earlier years' information for the
same entity; financial statement information must be to information for other companies, industry
standards, forecasts, and other benchmarks
- Vertical & Horizontal Analysis
- Eliminate impact of size from financial statement numbers; restate numbers as proportions
- Vertical Analysis (Common Size Financial Statements)
- Express amounts on balance sheet and income statement as percentages of other
elements in same year's statements; balance sheet amounts are stated as a percentage
of total assets; income statement values reported as a percentage of revenue
- Common Size Balance Sheet: each account is a percentage of total assets;
shows asset and liability composition of entity over time
- Make year-to-year comparisons very convenient; can see how each amount has
changed over time in a much simpler way than with normal financial statements;
financial statement analysis may help identify problems, will not usually explain them
- Can easily compare entities of different sizes from different industries; eliminate
effects of size, present financial statement components on common basis; differences
interpreted carefully, can be from different accounting choices, different economic
performance, different natures of entities
- Horizontal Analysis (Trend Statements)
- Restate financial statements with each account amount as a percentage of a base year
amount; shows change in each account over time; first need to specify a base year
Trend Statement Account = (Current Year Amount / Base Year Amount) * 100%
- Amounts for future years stated as percentage of base year; to see percentage change
from time other than selected base year, calculation must be redone with a different
denominator
- Interpretational Issues:
- When balance in account changes from positive-to-negative or negative-to-
positive, change cannot be interpreted using only the percentage change
relevant to the base year
- If balance in a base year account is zero, cannot calculate a trend number for
following years; very small balances in the base year can lead to huge
percentage changes, which may not be meaningful
- Trend information gives no perspective on materiality; stakeholders can waste
time worrying about things that are not material because they do not have a
reference to the actual number
- Evaluating Performance
- Performance: multi-faceted concept; measured in different ways; different performance
indicators can tell conflicting stories about how an entity is doing
- Accounting Measurements: representations of entity's economic activity are subject to
accounting policies and estimates made by managers; not possible to know the economic reality
of an account; problems do not take away stakeholder need to use accounts to make decisions
- Income Statement: shows entity's economic benefits (revenues) and economic sacrifices
(expenses)
- Net Income/Loss; net economic benefit/sacrifice of owners of the entity over a period
- Ratios: most commonly used tools for analyzing financial statements, examining relationships
between numbers; eliminate effect of size from data
- Gross Margin
- Difference between sales and cost of sales; relevant to companies that sell goods
- Gross Margin Percentage: gross margin stated as a percentage of sales; percentage of
each dollar of sales available to cover other costs and return a profit to entity's owners
- Service Providers: do not have cost of sales or cost of goods sold
-Quick Ratio: stricter ratio test than current ratio; excludes less liquid current assets
- Inventory: excluded from calculations; takes quite long time to convert to cash; must
be sold, amount owed by customer collected before cash is realized
- Prepaids: will never be realized in cash
- Accounts Receivable Turnover: indicates how quickly an entity collects its receivables;
larger, the more quickly receivables are being collected; decrease relative to previous
fiscal years or to industry averages may suggest liquidity issues, entity with less cash to
meet obligations
- Inventory Turnover Ratio: number of times in period entity able to purchase and sell its
inventory stock; high rate shows inventory is liquid, sold more quickly, less cash invested
in inventory; when decreasing relative to previous years or industry benchmarks, may
indicate liquidity problem, inventory may even be obsolete
- Accounts Payable Turnover Ratio: depicts how quickly entity pays accounts payable;
focuses on amounts owed to inventory suppliers, but the accounts payable account
usually includes amounts owed to other types of suppliers, problematic; decreasing
amount may indicate cash flow problems, due to need to extend the time taken to pay
- Purchases: determined using cost of sales, which must be disclosed under IFRS
- Average Payment Period for Accounts Payable: number of days the entity
takes to pay its accounts payable
- Notes to Financial Statements: provide useful liquidity information that is not reflected in
financial statements themselves
- Executory Contracts: commitments to make cash payments in the future; contract
arrangements for which neither party has performed its side of the arrangement, so no financial
statement effects; affect liquidity, company is committed to spend cash in the future
- Solvency & Leverage
- Solvency: ability to meet long-term obligations; represents financial viability of the company
- Capital Structure: sources of financing; relative proportions of debt and equity; used to assess
solvency; more debt an entity has, more risk there is to long-term solvency
- Debt-to-Equity Ratio: measure of relative amount of debt to equity an entity is using; indicates
riskiness of entity, ability to carry more debt more debt increases risk, entity faces significant
economic and legal consequences if interest and principal payments are not made on time
- Misleading Results: can be mislead when you simply use the numbers on the balance
sheet to calculate debt-to-equity; leases, pensions, future income taxes can impair
interpretation; entity with significant operating leases will have an understated debt-to-
equity ratio because liabilities would be understated (operating leases occur off the
balance sheet)
- Debt: interest must be aid regardless of entity's performance; makes entity riskier;
beneficial because less costly than equity, debt holders specified, entitled to payment
before equity investors; interest on debt is tax-deductible; too much debt can lead to an
inability to pay obligations; debt becomes more expensive as relative amount increases,
lenders charge higher interest rates as risk increases; optimal amount of debt depends
on entity and accounting environment
- Cash Flow Reliability: firms with predictable cash flows can take out more
debt; affected by factors like competition, threat of technological change,
sensitivity to economic cycles, predictability of capital expenditures; firm that
can best generate cash from operations is best at meeting obligations; earnings
can be indicative of long-term cash flow, even though they are different in the
short-term
- Interest Coverage Ratio (Accrual Basis): measures ability of entity to meet fixed financing
charges (interest payments); larger, better able entity is to meet interest payments; ignores that
entities have fixed charges other than interest (debt repayment, lease payments on operating
leases, etc.); higher value is assurance to creditors that they will be repaid; acceptability of
coverage ratio depends on entity; shows what has happened, not what is going to happen,
historic trends can indicate future trends, but must be mindful of potential changes
- Interest Coverage Ratio (Cash Basis): shows number of dollars of cash from operations for each
dollar of interest that had to be paid
Interest Coverage Ratio = Cash From Operations Excluding Interest Paid/Interest Paid
Interest Coverage Ratio = Cash From Operations + Interest Paid / Interest Paid
- Numerator: interest paid is added back to cash from operations in order to exclude it,
because it is deducted in the calculation of cash from operations
- Covenants: accounting ratios set as boundaries of a credit agreement; if account ratio specified
by creditor not maintained, the creditor immediately recollects its investment
- Other Common Ratios
- Price-to-Earnings (P/E) Ratio: indicates how market values an entity's earnings, what market
sees as growth prospects; higher P/E, more market expects earnings to grow, more sensitive its
share price is to changes in earnings; indicates risk associated with future earnings, higher risk,
lower P/E for a given level of earnings, since future cash flows are discounted at a higher rate to
reflect the risk
Price-to-Earnings (P/E) Ratio = Market Price per Share / Earnings per Share
- Permanent & Transitory Earnings: different effects on market price of shares, which
has implications on the P/E ratio; P/E must be interpreted carefully
- Market Price of Share vs. Earnings: share price represents present value of cash flows
that will be received by shareholders, future-oriented perspective; earnings are
historically-focused measure; link between earnings and share price is not perfect;
current information immediately reflected in share price, but earnings not affected until
next financial statements prepared
- Loss of Meaning: P/E loses meaningfulness when earnings are very low but positive,
leads to a very large ratio; cannot determine P/E ratio if entity incurs a loss; not possible
to determine P/E ratio of private companies, market prices for shares are unavailable;
ratio varies with different accounting choices for same underlying economic activity,
because earnings are affected by accounting choices of managers
- Dividend Payout Ratio & Dividend Yield: information about dividends received to investors
- Dividend Payout Ratio: shows proportion of earnings paid to common shareholders as
dividends; the remainder is retained by the corporation; dividend payout greater than
1.0 is possible, if cash being dedicated to dividends is greater than net income
- Net Loss: company with net loss can still pay a dividend; if losses are
continuous, firm will eventually run out of the resources necessary to sustain
the dividend; firm must have cash; dividend payout ratio is no longer
meaningful, cannot calculate with a negative denominator value
- Dividend Yield: indicates return dividends investors are receiving from investment;
investors wanting cash flow from investments want to invest in companies that have
reliable annual dividends
Dividend Yield = Common Annual Cash Dividends Per Share/Current Share Price
Some Limitations and Caveats about Financial Statements & Financial Statement Analysis
- Analysis of IFRS-based information constrained by limitations of the information itself; financial
statement and ratio analysis is still a useful tool, but it is important to understand the strengths and
limitations present
- Historical Nature: financial statements used as starting point of an analysis; user must incorporate own
future-oriented information to make meaningful predictions
- Limitations from Change: accounting environment changes; future may be different from past, limiting
usefulness of historical financial statements; industries with rapid and unpredictable change are
especially limited in the uses of their financial statements (technology-intensive industries)
- Managerial Discretion: managers make financial statements; good because managers the one who
know and understand entity best; bad because self-interests can influence accounting choices made;
managers must choose among competing information needs of different stakeholders when creating
statements, because only one set of general purpose financial statements is prepared
- Incomprehensive: financial statements do not reflect all assets, liabilities, economic activity; value
resources and important obligations are often unreported; IFRS allows fair value usage, but cost usually
chosen as the basis of measurement
- Effect of Policy Choices & Estimates: firms can choose from alternative accounting policies; different
policies for similar economic activity can lead to different financial statements, and thus, different
ratios; must carefully read notes on significant accounting policies to recognize whether differences are
caused by real economic activity or accounting policy choices; estimates require managers to use their
professional judgement, affected by assumptions, information, biases, self-interests
- Difficulty of Comparison: common size financial statements and financial ratios allow financial
statement comparisons; sometimes comparisons may not be valid (different estimates and accounting
policies); must be cautious as a user of the financial statements
- Other Information Sources: not possible to analyze entity on financial statements alone; need to
integrate information from many sources to get an overall view of the corporation
- Diagnostic Tool: financial analysis does not necessarily provide explanations for identified issues;
accounting information reflects economic activity; problem areas identified through the economic
activity, but the root of a problem requires one to have a prior understanding of strategies, operations,
and management
Earnings Management
- Managers have choice in deciding how to account for, disclose, present financial statement
information; choices create significant economic consequences for stakeholders
- Choices also can affect lines other than net income, as well as balance sheet accounts; also applies to
how information is disclosed in the notes to the financial statements
- Motivated by economic consequences of accounting information; earnings of public companies
carefully studied by investors and analysts; managers of public companies under pressure to meet
investors' expectations, to maintain stock rice; managers use accounting choices to increase r smooth
earnings
- Compensation, opportunities in job market, job security affected by financial statement results
- Managers can also be motivated by trying to sell company shares for as high a price as possible, to
obtain the best terms for a loan, to avoid debt covenant violations, to get financial help from
government, to lower taxes, or to generally influence outcome of decisions that rely on accounting
information
- Most cases of earnings management occur within the rules; when they do not, considered a fraud;
managerial discretion must still be reasonable, even if it is not right
- Earnings Management Opportunities
- Revenue Recognition: when to recognize revenue; bad debts; returns; discounts
- Inventory: inventory valuation method (FIFO, average cost, specific identification); costs
included in inventory; write-downs of obsolete and damaged inventory
- Capital Assets: which assets are capitalized; depreciation method; useful lives; timing, amount
of write-downs and write-offs
- Liabilities: leases; warranty provisions; pensions; accrued liabilities
- Assets vs. Expenses: capitalization policies
- Other: big baths; income statement classifications as ordinary versus unusual; off-balance-
sheet financing; non-recurring items; disclosure of commitments and contingencies
A Final Thought
- Accounting is about high-level thinking skills, human nature, judgement