FINANCIAL ANALYSIS AND REPORTING

LECTURE O1

Accounting is the process of identifying, measuring, and communicating economic

information to permit informed judgements and decisions by users of the information.

Financial accounting --> for the benefit of external users

- Financial reporting captures the communication to external users through disclosure
Management accounting is accounting conducted for the benefit of internal users.
- Backward looking

Management accounting --> for the benefit of internal users.

- Bookkeeping is about recording the data – about keeping records of money and
financially related movements.
- Forward looking

Role: decrease information asymmetry

The users of financial statements

THE FLOW OF ACCOUNTING INFORMATION

1. Business activities: value is created when a firm earns a return on investment in
excess of the required return by capital providers
2. Accounting system: provide a mechanism through which business activities are
selected, measured and aggregated
3. Financial statements: summarize the economic consequences of the business
activities

BUSINESS ACTIVITIES
- Operating activities
A company’s typical daily processes that generate income. Operating activities pertain
to a company’s core business activities, such as manufacturing, distributing,
marketing and selling a product or service. The core and primary activities.

1
 “Primary” = the activities through which the owners hope to profit from their
investment Providing customers with goods and services, generating cash

- Investing activities
Purchases and sales of resources that provide productive capacity
Buying machinery or intangible assets; acquiring other businesses
Involve resource (cash) commitments expected to provide long-term benefits

- Financing activities
Acquiring the financial resources necessary to engage in operating and investing
activities
• Raising and settling equity capital or debt
• Making dividend and interest payments

Principles-based: Europe, higher flexibility, more leeway to allow for meaningful

representation
Rules-based: what matters is compliance to the rules, enforcement is easier

USERS OF FINANCIAL INFORMATION

The primary users of financial information are present and potential investors, lenders and
other creditors, who use that information to make economic decisions
- Common to all users is their interest in the ability of an entity to generate cash
- Investors as the primary user group
The Framework notes that FS cannot provide all the information users might need to make
economic decisions
- FS show the financial effects of past events and transactions, whereas decision users
have to relate them to the future
- The information in FS helps users to make their own forecasts

ELEMENTS OF FINANCIAL STATEMENTS

Elements related to financial positions (balance sheet):
- Assets: economic resources controlled by the entity which are expected to produce
future economic benefit to the entity
- Liabilities: present obligations of the entity which are expected to result in outflow of
economic benefit of the entity
- Equity: stock or other security representing an ownership interest, that is the amount
of the funds contributed by the owners plus the retained earnings.

2
Elements related to performance (income statement):
- Revenues
- Expenses
- Income

FINANCIAL STATEMENTS’ QUALITATIVE CHARACTERISTICS

Relevance: information needs to be relevant to the prediction of future events, or relevant In

helping confirm past events

Materiality: information is material if omitting it or misstating it could influence decisions

that users make on the basis of financial information

Reliability
- Complete: all the information that is necessary for faithful representation is provided
- Neutral: company cannot select information to favor one set of interested parties over
another
- Free from error

ACCRUAL ACCOUNTING
Distinguishes between the recording of costs/benefits associated with the economic activities
and the actual payment/receipt of cash.

- The effects of economic transactions are recorded on the basis of expected (not
necessarily actual) cash receipts/payments
- Expected cash receipts from delivery of products/services are recognized as revenues;
Expected cash outflows associated with these revenues (matching principle!) are
recognized as expenses

Timing differences between the recording of costs/benefits and the cash inflow/outflow result
in the recognition of assets and liabilities

THE FINANCIAL STATEMENTS

INCOME STATEMENT
Income statement reports revenue and expenses for the period, measuring the company’s
financial performance over an accounting period. Also known as P&L.

3
 - Made based on accrual revenue

BALANCE SHEET or STATEMENT OF FINANCIAL POSITION

The SoFP (balance sheet) summarizes a company’s assets, liabilities, and shareholders’ equity
at a specific point in time. These three balance sheet segments give investors an idea as to
what the company owns and owes, as well as the amount invested by the shareholders.

The balance sheet reports the financial position and claims of investors at a given time.

Asset = liabilities + equity

4
RETAINED EARNINGS

CASH FLOW STATEMENT

The cash flow statement (CFS) provides aggregate data regarding all cash inflows a
company receives from both its ongoing operations and external investment sources, as well
as all cash outflows that pay for business activities, investments and financing during a given
accounting period.

STATEMENT OF CHANGES IN EQUITY

the document details the change in owners’ equity over an accounting period by presenting
the movement in capital and reserves comprising the shareholder’s equity.

5
STATEMENT OF COMPREHENSIVE INCOME
The document summarizes both standard net income and other comprehensive income (OCI).
The net income is the result of the income statement. Whereas, the OCI consists of all
unrealized gains and losses on assets that are not reflected in the income statement (i.e.,
pension obligations, foreign currency translations, derivatives, AFS securities)

NOTES TO THE FS
- Activity of the company
- Basis for presentation of the annual accounts
Financial reporting legislation applicable
True and fair view
Non-mandatory accounting principles applied
Critical aspects for measuring and estimating uncertainty
- Business combination and other information
- Distribution of profit
- Recognition and measurement standards applied (general recognition criteria per area)
- Detailed notes (Intangible assets, Tangible assets, Financial assets, Provisions,
Equity...)
- Deferred tax
- Environmental information
- Subsequent events

6
 - Others

THE DOUBLE-ENTRY SYSTEM

Accounting is based on a double-entry system which records the dual effects on the entity,
each transaction will affect at least two accounts.
To increase or decrease each account, we debit or credit it.

Debits are recorded on the left side of a T account in a ledger → record of financial
transactions. Debits increase balances in asset accounts and expense accounts and decrease
balances in liability accounts, revenue accounts, and capital accounts.

Credits are recorded on the right side of a T account in a ledger. Credits increase balances in
liability accounts, revenue accounts, and capital accounts, and decrease balances in asset
accounts and expense accounts.

LECTURE 01.B.

IFRS (International Financial Reporting Standards) is a set of standards stating how

different types of transactions and other events should be reported in the financial statements.

• Expanding world trade

• Proliferation of multinational corporations (overly complex reporting!)
• Increasing role of global capital markets (stock exchanges need to be attractive for
worldwide companies)
• Increased foreign direct investments (need for global comparability)
• Growth of multinational political organizations
• A way to minimize costs

More than 100 countries have moved to IFRS

IFRS effects:
- Transparency effects
- Comparability effects
- Improve reporting quality
- Cost saving

Comparability
Financial statements are considered comparable if:
• Similar economic transactions → similar accounting items, and
• Different economic events → different reported items.

7
LECTURE 02 – TANGIBLE ASSETS
Tangible / intangible assets

Relevant in economic terms?

• Maybe look at their function?
• Tangible assets are more likely to be tradeable on a market
• Intangibles are more likely to be firm-specific and not-tradeable

Intangible assets are a broad and heterogeneous category of assets:

• Extremely important in determining firm profitability and market value (especially forward
looking);
• Difficult to book and retain as assets in the balance sheet – risky items

PROPERTY, PLANT & EQUIPMENT (IAS 16)

Tangible assets are divided in:
1. Property, plant and equipment IAS 16
Used in the production of goods/services or for administrative purpose, expected to be
used in more than one period
2. Investment property IAS 40
Property held to earn rentals or for capital appreciation or both, use in the
production/supply of goods/services or for administrative purpose

Feature of PPE:
A) Held by the company for the production or supply of goods and services, or for
administrative purposes.
B) Expected to be used for more than one period (more than one year)
C) Usually firm-specific hence their “value in use” is more relevant than market valuations
D) Physical life versus Economic Life

Accounting for tangible assets

1. Initial measurement and recognition
PPE should be measured at its cost.
Cost is:
- The purchase price when the asset is purchased in a market transaction (general)
- The construction cost when the asset is self- constructed
- Calculated in other ways when the asset is obtained in leasing, donation

8
 Should firms treat expenditures as:
- Expenses in the period incurrent P&L (profit&loss)
- Asset by capitalizing costs BS – Assets
An expenditure is an asset if the firm acquired rights to future use as the result of a
past transaction, and can measure or quantify the future benefits

The purchase price includes:

- all non-refundable duties and taxes
- any trade discount and rebates
- Any directly attributable cost to the item’s set up (plus)
Examples: professional fees; pre-operating tests; installation and assembly costs;
site preparation
- Borrowing costs as recorded per IAS 23
- The initial estimate of the cost of dismantling, removing the item and restore the
site on which it is located

Company A buys a land and needs to remove an old building before the newly
proposed one can be built.
• Is the cost of removal of the old building a cost of the land or a cost of the new
building?
Yes, site preparation cost
• Are the promotional costs, related to the building’s opening, costs of the new
building?
No! Cost of introducing a new product or service, including advertising/promotional
costs, cannot be capitalized

Borrowing costs IAS 23

Directly attributable to the acquisition/construction of the asset: those costs that would
have been avoided (i.e., by avoiding additional borrowings, or by using funds paid out
for the qualifying asset to repay existing borrowing) if the expenditure on the asset
had not been made
To the extent that an entity borrows funds specifically for the purpose of obtaining a
qualifying asset
To the extent that an entity borrows funds generally and uses them for the purpose of
obtaining a qualifying asset

Capitalization rate should be the weighted average of the borrowing costs applicable
to all borrowing of the entity that are outstanding during the period, other than
borrowings made specifically for the purpose of obtaining the qualifying asset until all
the activities to prepare the asset for its intended use are complete.

9
 An entity shall begin capitalising borrowing costs at commencement date, which is
when:
1) expenditures are incurred
2) borrowing costs are incurred
3) Activities to prepare the asset for its use are undertaken (including administrative
ones)

2. Subsequent costs (e.g., Maintenance, Changes in useful life)

3. Measurement subsequent to initial recognition
4. Determination of carrying amounts
IAS 16 allows two measurement models, policy chosen must be applied to a whole
class of assets:
- Cost model: acquisition / production cost, accumulate depreciation, impairment
- Revaluation model: assets fair value at the revaluation date, accumulated
depreciation, impairment

5. Depreciation
Depreciation is the accounting process of allocating the cost of tangible assets to
expense in a systematic and rational manner to those periods expected to benefit from
the use of the asset
- It arises when the asset starts working and it is used over time
- At the end of each reporting period tangible assets must be depreciated

Component / cost approach: different useful lives and depreciation rates can be used for
different components.
- Each item shall be depreciated
- Depreciation charge for each period shall be recognized in the P&L
- The depreciable amount of an asset shall be allocated on a systematic basis over
its useful life

10
Revaluation model
Measurement basis is fair value (FV)
- Fair value is the amount for which an asset could be exchanged or a liability
settled between knowledgeable, willing parties in an arm’s length transaction
Constraints:
- Revaluation performed regularily such that the carrying amount of
assets is not materially different from their FV
- If an item of PPE is revalued, the entire class of assets to which it belongs shall be
revalued.
No selective revaluation of assets

How to handle the revaluation:

Method 1- Restate accumulated depreciation proportionately with change in gross carrying
amount;

- Appreciation should go in OC

Method 2 -Eliminate accumulated depreciation against gross amount of asset and then restate
the net amount (this is as if the asset was bought new after the revaluation!)

11
Asset is revaluated upward, the increase is:
- Recognized in OCI and accumulated in equity under the heading of revaluation
surplus
- Recognized in P&L to the extent that it reverses a revaluation decrease of the same
asset previously recognized in P&L

Asset is revaluated downward, the decrease is:

- Recognized in P&L
- A decrease reversing a previous increase ins recognized in OCI and it eliminates the
surplus before recognizing the expense

INVESTMENT PROPERTY IAS 40

Limitations of historical cost:
- The depreciation understates the real economic costs of using depreciable assets
- Historical cost understates the current economic value of assets thus resulting in
understatement of assets and equity

The fair value will provide:

- Economic value during the period
- Current replacement cost of an asset

The fair value of land and buildings is usually determined from market-based evidence by
appraisal that is normally undertaken by professionally qualified valuers.
The fair value of items of plant and equipment is usually their market value determined by
appraisal.
If there is no market-based evidence of fair value because of the specialized nature of the
item of PPE and the item is rarely sold, except as part of a continuing business, an entity may
need to estimate fair value using an income or a depreciated replacement cost approach.

Investment property: property held to earn rentals or for capital appreciation, or both
- IP valued at fair value
- Ip shall not be depreciated
- The IP shall be measured at fair value yearly

LECTURE 03 – INTANGIBLE ASSETS IAS 38

Intangible assets are normally firm specific so the estimation of fair value is difficult.
It is not true that by using intangibles we reduce their value, and often are the greatest part of
a balance sheet.

12
Intangible asset an identifiable non-monetary asset without physical substance.
Three attributes:
1. Identifiability: if either separable, or arises from contractual or legal rights, regardless
of whether those rights are transferable
2. Control: if the entity has the power to obtain future economic benefits flowing from
the underlying resource and to restrict the access to those benefits
3. Lack of physical substance

Intangible asset can be recognize if and only if it meets the definition of an asset:
1. The asst is controlled by the entity
2. It is probable that the future economic benefits that are attributable to the asset will
flow to the entity
3. The cost of the asset can be measure reliably

If purchased separately, an intangible asset should be measured initially at cost (same as IAS
16). This comprises:
- its purchase price, including any non- refundable purchase taxes and import duties
- any directly attributable expenditure of preparing the asset for its intended use:
Employees benefits cost
Professional fees
Cost of testing...

Trademarks/brands are recorded an intangible assets only if they are purchased.

Price – book value of equity --> higher fair value of assets --> specific intangible -->
goodwill
Purchased as part of business combination

13
800 = 1000 (price) – 200 (equity)

Internally generated goodwill is not recognized as an asset because it is not an identifiable

resource controlled by the entity that can be measured reliably.

Internally generated
It is difficult to assess whether an internally generated intangible asset qualifies for
recognition because of problems in:
- Identifing whether it will generate future economic benefits;
- Determining its cost reliably.

So, an entity should classify the generation of the asset into:

- a research phase and
- a development phase.

Research is original and planned investigation undertaken with the prospect of gaining new
scientific or technical knowledge ad understanding

Examples of research activities are:

• activities aimed at obtaining new knowledge
• the search for, evaluation and final selection of, applications of research findings or
other knowledge
• the search for alternatives for materials, devices, products, processes, systems or
services
• the formulation, design, evaluation and final selection of possible alternatives for new
or improved materials, devices, products, processes, systems or services.

Development is the application of research findings or other knowledge to plan or design to

produce new or improved materials, devices, productions, etc.

Examples of development activities are:

• the design, construction and testing of pre-production or pre-use
• the design of tools, jigs, moulds and dies involving new Technology;
• the design, construction and operation of a pilot plant that is not of a scale
economically feasible for commercial production;
• the design, construction and testing of a chosen alternative for new or improved
materials, devices, products, processes, systems or services.

No intangible assets arising from research shall be recognized. Expenditure on research

shall be recognised as an expense in P/L when incurred.

Account costs
Costs can be accounted in three ways:
- capitalize development costs but not research (IFRS)
- do not allow the capitalization of R&D (US GAAP)
- allow to capitalization of R&D (Italy e.x.)

An intangible asset arising from development should be recognised if and only if an

enterprise can demonstrate all of the following:
1. how the intangible will generate Probable future economic benefits

14
 2. its Intention to complete the intangible asset and use or sell it;
3. the availability of adequate technical, financial and other Resources to complete and
to use or sell the intangible asset;
4. its Ability to use or sell the intangible asset;
5. the Technical feasibility of completing the intangible asset so that it will be available
for use or sale;
6. its ability to measure reliably the Expenditure attributable to the intangible asset
during its development.

Example 1
Firm “Four T” is able to vacuum-pack onions. In order to set up the productive process the
firm carried out many experiments during 2016 and it used:
- 10.000 kg of onions; cost: 10,000€
- 200h of work; cost: 20,000€
- Other raw materials; cost: 5,000 €

Example 2
Company B operates in the prepared food industry and implements a market survey with the
aim of studying consumers’ preferences in the Chinese market.
During the fiscal year the company sustains 30,000 as expenses for staff costs and 8,000 as
general administrative expenses.

Example 3
In 2017, Ghostbusters Corp. Spent 420,000 for “goodwill” visits by sales personnel to key
customers. The purpose of these visits was to build a solid, friendly relationship for the future
and to gain insights into the needs of the companies served.
How should this expenditure be reported?
- Company cannot recognize self-created goodwill. These expenditure will most
likely be recorded as selling expenses (P&L)

INTANGIBLE ASSETS – MEASUREMENT SUBSEQUENT TO INITIAL

RECOGNITION

15
Cost model, after initial recognition, an intangible asset shall be carried at its cost less any
accumulated amortization (same as in tangible assets IAS 16)
Revaluation model, after initial recognition, an intangible asset shall be carried at a revalued
amount less any accumulated amortization.

There must be an active market to apply the revaluation model:

- the items traded in the market are homogeneous
- willing buyers and sellers can be found at any time,
- prices are available to the public

An active market cannot exist for: brands, newspaper mastheads, music and film publishing
rights, patents or trademarks, because each of such asset is UNIQUE!

The revaluation model can be applied to:

- transferable taxi licenses
- fishing licences
- production quotas

If, as a result of a revaluation, the carrying amount:

Increases: the increase shall be recognize in OCI and accumulated in
(However, if the asset was impaired before and the loss recognized in P/L, then the increase
shall be recognized in P/L to the extent that it reverses the previous impairment)
Decreases: the decrease shall be recognize as expense in P/L.
(However, if the asset was previosly revalued upward and credited in the revaluation surplus,
then the decrease shall be recognized in OCI to the extent that it reverses the previous
revaluation surplus)

Finally, when the asset is realized or used: you may transfer any revaluation surplus to
retained earnings.

The accounting for intangible assets is based on assets’ useful life.

• An intangible asset with a finite useful life is amortised;
• An intangible asset with an indefinite useful life is not. A firm has to test for
impairment these intangible assets annually.

Factors considered in determining the useful life of an intangible asset include:

- Expected usage by the entity
- Typical product life cycles
- Industry stability
- Level of maintenance expenditure required
- Expected action by competitors
- Rates of technological change
- Legal restrictions

Intangible asset with finite useful life:

• The cost less the residual value should be amortized on a systematic basis over the
useful life
• The amortization method should reflect the pattern of benefits
• If the pattern cannot be determined reliably, amortise by the straight line method
• The amortization charge should be recognized in P&L

16
 • The amortisation period should be reviewed at least annually

- The asset should ALSO be assessed for impairment, if needed

Intangible assets with indefinite useful life:

• Should not be amortized!
• Tested for the impairment annually
• Indefinite useful life should be reviewed periodically and justified

Example case 1
The head accountant of the Zurina Company provides you with the following information on
3 transactions (events) during the life of the firm.
1. Zurina acquired a franchise on 1st January X3 by paying an initial franchise fee of
160,000. The franchise term is 8 years;
2. Zurina incurred advertising expenses amounting to 300,000 related to various
products. According to the marketing department, these expenses could generate
revenues for approximately 4 years;
3. During X3, Zurina incurred legal fees of 40,000 in connection with the unsuccessful
defense of a patent. The patent had been acquired at the beginning of X2 for 150,000
and was being amortized over a 5-years period. As a result of the unsuccessful
litigation, the patent was considered to be worthless at the end of year X3
Analyze each piece of information and show how you would record each event.

Q1

1. Recording of the acquisition of the franchise as an intangible asset

2. Franchise Amort. Expense: (160/8). We recognize one year of consumption (amortization)
of the productive capacity of the asset.

17
Q2

3. Advertising expense is not considered as an intangible asset (application of the prudence –

conservatism- principle)

Q3

4. legal fees are recorded as incurred

5. the patent and accumulated amortization accounts are cancelled and a loss of 90 is
recorded

LECTURE 03.B.
IMPAIRMENT TEST IAS 36
The objective of the impairment test is to ensure that the carrying value of an asset is not
greater than its recoverable amount (i.e., that assets are not overvalued)
Recoverable amount is the higher of an asset’s net selling price and its value in use:
- Net selling price is the amount obtainable from the sale of an asset in an arm’s
length transaction between knowledgeable, willing parties (FV) less the costs of
disposal;
- Value in use is the present value of estimated future cash flows expected to arise
from the continuing use of an asset and its disposal at the end of its useful life.

• If the recoverable amount of an asset is less than its carrying amount, then the
carrying amount of the asset should be reduced to its recoverable amount.
• That reduction is an impairment loss
• An impairment loss should be recognized as an expense in the income statement
immediately.

18
Impairment loss to be done if the book value > recoverable amount

Test is always to be performed if there is a triggering event

Indefinite lived intangible

- Tested in year of acquisition
- Thereafter annual

Intangibles not yet available for use

- Tested annually

Goodwill
- Tested in year of acquisition
- Thereafter annually at the same time every period

TRIGGERING EVENTS
External indicators
• Faster decline of market value than expected from normal use
• Negative changes of technological, economic, legal and market environment
• Increase in market interest rates or other market rates of return on investment
• Net assets (BV) exceed an entity’s market capitalization

Internal indicators
• Indication of the asset’s obsolescence or physical damage
• Significant strategic or operational changes with an adverse effect on the enterprise
(e.g. technology loss of customer, discontinued operations)
• Economic performance worse than expected
• Higher maintenance costs than expected

When it is not possible to assess a single asset for impairment because the single asset
generates cash flows only in combination with other assets → Companies must identify the
smallest group of assets (CGU) that generate cash flows independently of the cash flows
from other assets

Annual evaluation of goodwill

Because of its nature goodwill has to be tested at least yearly

19
 - It must not be amortized
- And the test has to figure out whether the excess of consideration measured at the
acquisition date still hold

Also, goodwill does not produce Cash Flows autonomously

So, for the purpose of the impairments test it must be allocated to one cash generating unit
(CGU) or more.

CGU, Cash Generating Unit

The definition of CGU is really broad: “the smallest identifiable group of assets” and this
group of assets must create independent cash flows from continuous use
Additional specification:
The identification of a CGU should consider:
- How management monitors the entity’s operations
- How managers make decisions about continuing or disposing entity’s assets and
operations
- If an active market exists for the output of a group of assets
Even if some of the output is used internally

CGUs should be identified consistently from period to period

IMPAIRMENT TEST STEPS

Steps to be followed:
1. Identify cash generating units (CGU)
2. Allocate goodwill & assets to these units
3. Forecast future cash flows for each unit
4. Identify discount rate and discount the cash flows
5. Compare resulting value in use with carrying value
6. Write down as necessary to reflect any impairment loss thus identified

Impairment loss
An impairment loss should be recognized for a cash generating unit if (and only if) the
recoverable amount for the cash generating unit is less than the carrying amount in the
statement of financial position for all the assets in the unit.
The asset’s carrying amount should be reduced to its recoverable amount in the statement of
financial position.

The impairment loss should be allocated between the assets in the unit in the following order:
1. To any assets that are obviously damaged or destroyed
2. To the goodwill allocated to the cash generating unit
3. To all other assets in the cash-generating unit, on a pro-rata basis
These reductions shall be treated as impairment losses on individual assets and recognized in
the IS

Example 1
A company has acquired another business and it has generated a goodwill for € 300,000. The
goodwill is allocated to a CGU in which there are tangible assets for a carrying amount of
€500,000 and a brand for a carrying amount of €100,000. The net selling price of the CGU is
€700,000 while the value in use is € 800,000.
 Perform the impairment test

20
The carrying amount of the CGU cannot be higher than the recoverable amount

The recoverable amount is the highest of:

- Value in use (PV of future cash flows)
- Fair Value (net selling price)

Based on the actual management of operations, the Group has defined each of the
commercial premises in which it carries out its activities (stores) as basic cash generating
units, although these basic units can be aggregated at retail concept-country level, or even at
the level of all the companies located in a given
country or all the companies corresponding to a given concept (concept level). Group assets
which are not clearly assignable under this structure (for example industrial or logistics
assets) are treated separately in a manner consistent with this general policy but considering
their specific nature.

ESTIMATING THE RECOVERABLE AMOUNT

Value in use
- An asset is worth what it is capable of generating.
How is it calculated?
Discounted cash flow method

Fair value
- An asset is worth what the market is willing to pay for it
How it is determined?
Multiple valuation, bid offers, market capitalization…

Discounted cash flow elements

- Financial projections
- Free cash flow (FCF)
- Projected period
- Growth in perpetuity (G)
- Terminal value (TV)
- Discount rate (WACC)

Financing projections
• Must be based on reasonable and supportable assumptions that represent
management’s best estimate of the set of economic conditions that will exist over the
remaining useful life of the asset
• Must be based on the most recent financial budgets/forecasts approved by
management — without including cash inflows or outflows from future restructurings
to which the entity is not yet committed
• Should exclude borrowing costs, income tax receipts or payments and capital
expenditures that improve or enhance the asset’s performance

21
FCF = EBIT + depr. (+/-) other adjustments (+/-) change in wc – capex =
FCF = cash from operations – cash investments

These projections can cover a maximum period of 5 years

Cash flows for the period beyond forecasts or budgets assume a steady, declining or even
negative growth rate (only in exceptional circumstances should an increasing growth rate be
used)

In the case of NCA, a large component of value attributable to an asset or CGU arises from
its terminal value, which is the net present value of all of the forecasted free cash flows that
are expected to be generated by the asset or CGU after the explicit forecast period

Terminal value = FCFt+1/(p-1)

Discount rate: A rate that reflects current market assessments of the time value of money
and the risks specific to the asset is the return that investors would require if they were to
choose an investment that would generate cash flows of amounts, timing and risk profile
equivalent to those that the entity expects to derive from the asset

In practice, many entities use the WACC (weighted average cost of capital) to estimate the
appropriate discount rate. The appropriate way to calculate the WACC is an extremely
technical subject, about which there is much academic debate and no general agreement. The
selection of the rate is obviously a crucial part of the impairment testing process

The objective, therefore, must be to obtain a rate which is sensible and justifiable.

Impairment loss: accounting treatment

If (and only if) the recoverable amount of an asset or a CGU is less than the carrying amount
in the statement of financial position for the asset or all the assets in the unit:
• The carrying amount should be reduced to its recoverable amount in the statement of
financial position
• An impairment loss should be recognized as an expense in P/L
• If the affected asset is a revalued asset (under IAS 16 or 38) any impairment loss
should be recorded first against the previously recognized revaluation gains in OCI

Reversals of impairment loss

In some cases, the recoverable amount of an asset that has previously been impaired might
turn out to be higher than the asset’s current carrying value.
- The reversal of the impairment loss should be recognized immediately as income in
profit or loss.
- The carrying amount of the asset should be increased to its new recoverable amount
(but not above the value it would have had without the prior impairment)
Reversals of impairment losses for goodwill are not permitted under IAS 36!!

22
LECTURE 04: CONSOLIDATION OF FINANCIAL STATEMENTS (IFRS 10)
Companies often grow by means of acquisitions of stakes (a given number of shares) in other
entities creating what is called groups of companies (corporations).

Those corporations, elaborate, additionally to separate financial statements, consolidated

financial statements (CFS) which reflect the financial and economic position of the group as a
whole.

Consolidation is the technique used to obtain the financial statements needed by investors,
creditors, and other users corresponding to a group of companies (financial statements
corresponding to a single company are denominated “Separate Financial Statements”

Purposes of Consolidated Financial Statements:

1. Provide complete information about the group to shareholders of the
2. Consolidated FS Prevents parent company from distorting their financial results and
position
3. Show only the results derived from transactions with parties external to the group of
entities

A typical issue
Alfa wishes to expand into a new business and has the following options:
1. Investing into new assets (i.e., purchasing PPEs, Intangibles) and fund them with new
equity or raise debt (organic growth).

2. Setting up a new separate entity, and keep assets/liabilities and future profit/losses in
the separate entity
Two possible funding structures:
A subsidiary could be owned at 100%, or
Seek for additional investors to finance the venture

3. Purchasing an existing firm whose investments and financing profile resembles the
one Alfa is looking for. Three options:
- Purchase majority
- Purchase a minority stake
- Make a joint venture

What is a GROUP?
Definition of a Group: IFRS define a “group” as “a parent and all its subsidiaries” (IFRS
10)

IFRS require the preparation of consolidated financial statements (CFS) when a group
exists. A group is deemed to exist where a parent company owns one or more subsidiaries

A parent is exempted from presenting the CFS if it meets all of the following conditions:
(i) it is itself a wholly-owned subsidiary
(ii) its debt or equity instruments are not traded in a public market (domestic or foreign stock
exchange);
(iii) it did not file, nor is it in the process of filing, its financial statements with a securities
commission (or other regulators) for the purpose of issuing any class of instruments in a

23
public market; and
(iv) its ultimate or any intermediate parent produces financial statements that are available for
public use and comply with IFRS, in which subsidiaries are consolidated

The economic need to prepare CFS (beyond legal requirements) lies in the fact that financial
statements of a parent alone would not give a complete account of the parent’s economic
activities or economic position.
• Additionally, it avoids accounting manipulation
CFS provide such information because they contain information about the results and
financial position of a group as if it were a single entity

Accounting for investments

When an investing company decides to purchase a stake in another entity using the
acquisition of shares method, the percentage of share capital acquired is likely to determine:
 The level of influence that the investor can exercise over the policies of the investee and,
 The accounting treatment which applies to the investment under IAS/IFRS in the financial
statements of the investor to prepare CFS
Investments in other entities can give rise to influence over the operating and financial
policies of the investee, ranging from limited influence to control

The proportion of voting shares purchased in another entity is likely to be the principle
determining factor in the level of influence the investor may have.

The operating and financial policies of an entity usually include the following:
- Dividend policy (crucial for the investor to control)
- Raising of finance
- Strategic direction
- Approval of business plans and budgets

Three levels of voting shares recognized by IFRS that an investing company could acquire in
another entity and the associated degree of influence acquired in each case:
- Subsidiary: the acquirer gains control of the acquiree
- Associate: the acquirer gains significant influence over the acquiree
- Joint Venture: two acquirers get the joint control of a third entity

SUBSIDIARY: an entity that is controlled by another entity (known as a parent) under

IFRS10

CONTROL
Control: when the investor is exposed, or has rights, to variable returns from its involvement
with the investee and has the ability to affect those returns through its power.

Thus, the principle of control sets out the following three elements:
(a) power over the investee
(b) exposure, or rights, to variable returns from involvement with the investee;
(c) the ability to use power over the investee to affect the amount of the investor’s returns

Control is presumed to exist when the parent owns more than 50% of the voting power of an
entity.

24
Exception to the >50% rule

Control (de facto) may also exist where the investing company does not acquire more
than 50% of the voting rights of the subsidiary but there is:
- Power over >50% of the voting rights by virtue of an agreement with other
investors (e.g., a shareholder owning 45% of the voting rights might have an
agreement with another investor owning 8%);
- Power to govern the financial and operating policies under statute or an agreement;
- Power to appoint or remove the majority of the members of the board of directors
and control of the entity is by that board

POWER
To have power over an investee: an investor must have existing rights that give the ability to
direct the relevant activities.
- Only substantive rights and rights that are not protective
- For a right to be substantive: the holder must have the practical ability to exercise
it.
-
Examples of rights that, either individually or in combination, can give an investor power
include rights:
1. in the form of voting rights
2. to appoint, reassign or remove an investee’s key management personnel who have the
ability to direct the relevant activities;
3. to appoint or remove any entity that directs the relevant activities;
4. rights to direct the investee to enter into transactions for the benefit of the investor;
5. other (decision-making rights specified in a management contract) that give the ability to
direct the relevant activities.

Keep in mind that it could also happen that companies where the parent owns more than 50%
of the shares are not considered as subsidiaries as control can not be exercised for several
reasons.

Subsidiaries will be accounted for using FULL CONSOLIDATION

Full Consolidation is a method of accounting that produces a SoFP similar to the one that
would be produced if the parent had acquired the net assets of the subsidiary rather than a
majority of its voting shares
- In Full Consolidation, the total SoFP, Income Statement and Cash Flow Statement
of each subsidiary are added to those of the parent at the end of the period.
- After the FS are added up, some eliminations will have to be accounted for in order
to obtain the correct consolidated financial statements.

ASSOCIATE
Associate: an entity over which the investor has significant influence and that is neither a
subsidiary nor an interest in a joint venture (IAS 28)

Significant influence: is the power to participate in the financial and operating policy
decisions of the investee but is NOT control or joint control over those policies.

25
The acquisition of between 20% and 50% of an entity usually gives rise to an investment in
an associate unless this can be rebutted (i.e., it can be shown that significant influence does
not exist)
Significant influence is best evidenced by representation on the board of directors of the
investee.
Associates will be accounted for using the EQUITY METHOD

Under this method the investment in an entity is initially recorded at cost and adjusted
thereafter by the post-acquisition change in the investor’s share of the net assets of the
investee.
- The investor’s P/L includes its share of the associate’s P/L.
- In simple terms, the value of the investment in the associate in the consolidated
SoFP is adjusted each year by the group’s share of the profit of the associate.

The difference between Full Consolidation and the Equity Method is that, with the first, the
SoFP, Income statement and CFS of the subsidiary are added fully to the parent while, with
the second, this addition does not take place.

JOINT VENTURE
Joint venture: a contractual arrangement whereby two or more parties undertake an
economic activity that is subject to “joint control” (IAS 28).
Joint control: is the “contractually agreed sharing of control over an economic activity and
exists only when the strategic financial and operating decisions related to the activity require
the unanimous consent of the parties sharing control (the ventures)”

The method used for the accounting of Joint Ventures is the EQUITY METHOD

THE ACQUISITION METHOD

The Acquisition Method is a way to account for business combinations. It entails the
following steps:
1. Identifying the acquirer (IFRS 10)
2. Determining the acquisition date
3. Recognizing and measuring all identifiable assets acquired, the liabilities assumed and
any non-controlling interests in the acquiree, and
4. Recognizing and measuring goodwill or a gain from a bargain purchase

Cornerstone of full consolidation

The first approach to the consolidation is done by means of the SoFP:
When a parent entity has an investment in the share capital of a subsidiary, the non current
asset section of the financial statements of the parent will include an asset: Investment in S
Ltd.

However, this will not give the users of those financial statements information about the
assets and liabilities of that subsidiary and how they contribute to the net asset of the group as
a whole.

In the CSoFP the investment in S Ltd has to be replaced by all its assets and liabilities
(cornerstone of full consolidation)
To do that, we will aggregate the SoFP of the subsidiaries (assets, liabilities and equity) to the
SoFP of the parent,

26
Once done so, we will eliminate the Investment Asset of the parent against the Equity of the
subsidiary (100% of it, no matter the % owned)

CALCULATING GOODWILL
To account for the elimination, we need to calculate first of all the goodwill resulting from
the purchase
Goodwill: is the excess of what a parent pays for its investment in a subsidiary over what it
gets for that investment, and it is attributable to the parent
That is, the acquirer’s share of the fair value of the net assets (share capital and reserves)
acquired at the acquisition date.
• Goodwill is recorded as an intangible NCA in the consolidated SoFP and only written
down when its value becomes impaired.
• Where the amount paid for the investment is less than the acquirer’s share of the value
of the share capital and reserves purchased at the acquisition date, this is classified as
a “gain from a bargain purchase” which must be recognized in P&L in the
Consolidated Income Statement

Example

How to calculate goodwill (attributable to a parent)

The cost of control account comprises:
1. The debit entry for the cost of the investment in S Ltd (what the parent paid)
2. The credit entries for the group share of the share capital and reserves of S Ltd at the
date of acquisition (what the parent got for its investment)

Note: S Ltd may have a number of different reserves at acquisition date, e.g. share premium,
revaluation reserve, retained earnings.... As stated, cost of control is credited with the group’s
share of each reserve at the date of acquisition

27
Non-controlling interests
When a parent does not acquire 100% of the equity shares of a subsidiary, Non Controlling
interests (NCI) arise. These are the balance of the shares in the subsidiary (S Ltd) owned by
shareholders outside the group.
As defined by IFRS, NCI is “the equity in a subsidiary not attributable, directly or
indirectly, to a parent” (IFRS 10)
• The CSoFP should show separately the aggregate of share capital and reserves of S
Ltd attributable to NCI at the reporting period end. This represents the aggregate share
of the net assets of S Ltd at that date. NCI can be measured at Fair Value of Assets.
• This amount should be presented within “equity”, separately from the parent
shareholders’ equity, in the SoFP

Example 3: Calculating goodwill and NCI

Consolidation after the purchase takes place

The Consolidation procedures change a bit depending if we are consolidating:
At the same moment the acquisition of the subsidiary by the parent takes place; or in
years/periods later.
When consolidating at the same moment of the purchase, the steps to follow are:
1. Compute goodwill,
2. Compute Non Controlling Interests (if any)
3. Proceed with adjustments in the CSoFP, and replace the cost of the investment with the
assets and liabilities of the subsidiary (cornerstone of Full consolidation).

When we consolidate years/periods after, the procedure is very similar but we must not forget
that the Equity of the subsidiary might have changed.
So, increase/decrease of the equity value of the subsidiary that has taken place since the
moment we bought it, must be also reflected in our adjustment.
We will have to reflect and distribute the post-acquisition retained earnings of the
subsidiary between the parent and the NCI.

28
Example 6

INTERNAL TRANSACTIONS AND EQUITY METHOD (IAS 28)

It is likely that companies in the same group share significant interdependencies, that may
lead to intragroup transactions and balances, among which:
• Selling inventory or buying inventory
• Providing financing (e.g., debt) for working capital or long-term financing needs •
Transferring fixed assets
• Selling services...
Before dealing with the accounting treatment for the internal transactions, it is important to
understand that:
- Any adjustment that affects the post-acquisition retained earnings of the subsidiary
will also affect the calculation of NCI. NCI need to be updated as well as group
reserves.
- Remember that NCI at the reporting date comprises their share of the net assets of
the subsidiary at acquisition date plus their share of the post-acquisition retained
earnings of the subsidiary.

Unrealized invetory profits

We will be dealing with internal transactions regarding inventories when one of the
companies of the group sells/buys inventories to/from another company belonging to the
same group.
If that is the case, we will consider this transaction as “internal” and, therefore, some
consolidation adjustments are needed.
IAS 2 on Inventories states that:
inventories should be measured at the lower of cost and net realizable value.

When one group entity sells goods to another at a profit and some/all of those goods remain
in the inventory of the buying entity (at cost to them) at the reporting date, an element of
unrealized profit is included in the closing inventory of the group.

29
Why unrealized profit? Because those inventories have not been sold (yet) to third parties,
and the profit has been realized thanks to a group company!

Example 1

Intra group balances

Lending or obtaining financing from a group entity generates additional assets/liabilities (i.e.,
due to the principal) as well as additional revenues/expenses (i.e., due to interests)
When looking at a group as a single entity, it follows that all intragroup balances should be
eliminated, otherwise both the assets and liabilities of a group would be overstated.
Intragroup balances can be eliminated if they are in agreement. If they are not, the
adjustments must be included in the financial statements of a parent.
These adjustments do not generate Profit/Loss corrections but the elimination of the
corresponding assets and liabilities in each of the involved companies of the group and,
possibly also, the associated revenues and expenses

Consolidation adjustments will take the general form of:

Example

IAS 28 Investment in Associates and Joint Ventures, prescribes the same method of
accounting in the financial statements of the investor for:
• Investment in associates,
• Investments in joint ventures

An associate is defined as an entity over which the investor has significant influence, which
is the power to participate in the financial and operating policy decisions of the investee but is
not control or joint control of those policies.

30
Why would an investor acquire an interest in an associate?
Many entities acquire interests in associates for reasons such as:
- Attempting to ensure the supply of a vital raw material.
- Securing a return on investment by way of a stream of dividends.
- Gaining management expertise...

How is significant influence “evidenced”?

• Representation on the board of directors or equivalent governing body of the investee;
• Participation in policy-making processes, including participation in decisions about
dividends or other distributions;
• Material transactions between the investor and the investee;
• Interchange of managerial personnel; or
• Provision of essential technical information.
Representation on the board of directors of the investee is the strongest evidence. The
investing company should be influential in the direction taken by the associate through
participation in policy decisions such as strategy, dividends or capital expenditure.

An investor can only exercise significant influence over the financial and operating policies
of an associate as it owns only between 20% and 50% of its voting shares whereas it can
exercise control over a subsidiary. It is logical, therefore, that a different accounting treatment
be given to an investment in an associate (A Ltd)

When consolidating a subsidiary (S Ltd), the investment in S Ltd is replaced in the CSoFP by
its net assets.

Our focus now must change from consolidating all the assets and liabilities of a subsidiary
(Full consolidation) to consolidating none of the assets and liabilities of an associate (Equity
method)

In the case of an associate, the investment in A Ltd is carried to the CSoFP since the net
assets of A Ltd are not consolidated. Thus, the treatments for subsidiaries and associates are
effectively opposite in nature.

The Equity method is a method of accounting whereby the investment is initially recognized
at cost and adjusted thereafter for the post-acquisition change in the investor’s share of the
investee’s net assets.

The investor’s profit or loss includes its share of the investee’s profit or loss, and the
investor’s other comprehensive income includes its share of the investee’s other
comprehensive income.

In simple terms, in the SoFP of the investor, the investment in an associate is updated (tipped
up or write down) each year by the investor’s share of the post-acquisition retained earnings
(and any other reserves) of the associate and reduced by any impairment loss to the carrying
amount of the investment.

Unrealized Inventory Profit

Unrealized inventory profit can arise from transactions between an investor and an associate.
An associate is not a group company but the investors’ share of unrealized profit must be
eliminated in the consolidated SoFP.

31
Intercompany balances
Intercompany balances between parent and associate should not be eliminated.

LECTURE 05: DELOITTE

LECTURE 06: OPERATING SEGMENTS (IFRS 8)

IFRS 8 applies to both the individual financial statements of an entity, and the consolidated
financial statements of a group with a parent:
- whose debt or equity instruments are traded in a public market (domestic or
foreign stock exchange or o an over-the-counter market);
- that files, or is in process of filing, its financial statements with a securities
commission or other regulatory organization
Does not permit the omission of segment information when management believes that its
disclosure is commercially sensitive or potentially detrimental to the entity’s competitive
position.

The process of determining operating segments is important not only to entities applying
IFRS 8 for external reporting purposes, but also to entities implementing the requirements of
IAS 36 for testing goodwill for impairment.
Standard on impairment, applicable to all the entities, states that goodwill cannot be allocated
to a group of CGUs that are larger than an operating segment before the aggregation.

Operating segments: definition

An operating segment is defined as “a component of an entity:
- That engages in business activities from which it may earn revenues and incur
expenses;
- Whose operating results are regularly reviewed by the entity’s chief operating
decisions maker (CODM) to make decisions about
i) the resources to be allocated to the segment and
ii) assess its performance;
- For which discrete financial information is available.”

32
Operating segments aggregation
Regardless of the size, 2 or more operating segments can be aggregated if they have similar
economic characteristics (e.g., long-term average gross margins) and are similar in each of
the following aspects:
- Nature of the products and services
- The nature of the production process
- The type or class of customers for the products and services
- The methods used to distribute the products or provide the services
- If applicable, the nature of the regulatory environment

Quantitative thresholds
An operating segment is reportable if it meets any of the following thresholds:
1. It earns 10% or more of the combined revenues of all operating segments,
OR
2. It earns (loses) 10% or more of the greater between the combined reported profits of all
operating segments or the combined reported losses of all operating segments,
OR
3. Its assets are 10% or more of the combined assets of all operating segments.

Operating segments which individually fall below the size criteria may be combined with
other small operating segments into a single larger reporting segment, so that:
- The operating segments being combined have similar economic characteristics; and
- They share a majority of the criteria listed before.

Information about all other business activities and operating segments that are not reportable
should be combined and disclosed in a separate category under “all other segments”.

Case discussion 1: reportable segments: identify reportable segments

Disclosure requirements
NO requirements for segment information to be prepared in accordance ! with the accounting
policies used to prepare the financial statements of
the consolidated entity.

IFRS 8 requires amounts reported to be the same as those measures/used by the CODM for
determining resource allocation and for assessing performancepretty much internal
decision!!
The following information must be disclosed in the financial statements :
- General information on segment identified for reporting;
- Reported segment’s profit (loss), segment assets and liabilities;

33
 - Reconciliation of the totals of segment revenues, profit or loss,segment assets,
segment liabilities and other material segment items to the corresponding entity’s
financial statement amounts (under IFRS).

The disclosures should also include a description of the sources of the revenue classified in
the “all other segments”.
IFRS 8 proposes that entities disclose the title and description of the role of the individual (or
group) who is identified as the CODM.
Entities typically use a combination of different financial and other non-financial key
information indicators to assess performance of their operating segments and allocate the
resources to them.

IFRS requires certain entity-wide disclosures about products and services, geographical areas
and major customers:
1. Information about products and services;
2. Information about geographical location:
Revenues from external customers analyzed in terms of amounts attributed to the
entity’s country of domicile and the total of those attributed to foreign countries;
Assets located in entity’s country of domicile and the total of those located in foreign
countries;
3. Information about major customers:
If revenues from a single external customer account for 10% or more of the entity’s
total revenue, the entity should disclose:
- The fact,
- The total amount of revenues from each of such customer;
- The entity of the reportable segment, or segments reporting the revenues;

Nor disclosure of the name of each major customer, nor the amounts of revenue reported in
each segment for that customer is required.

However, disclosure must be provided if it relates only to one single segment!

Case discussion 2: segment reporting inditex

Have a look at “Inditex” Annual Report 2019 and identify:
https://static.inditex.com/annual_report_2019/pdfs/en/memoria/2019-Inditex-Annual-
Report.pdf
 Segments reported
 Products and services
 Geographical information
 Major customers
 Information provided for “all other segments”
 KPI’s used in the decision-making process
 Information provided in regard the reconciliation between the financial segment
information and the financial statements

LECTURE 6.1: ACCOUTING FOR LEASES (IFRS 16)

Lease definition
IFRS 16 defines a lease as a contract, or part of a contract, that conveys the right to use an
asset (the underlying asset) for a period of time in exchange for a consideration.

34
A contract contains a lease if:
- there is an identified asset; and
- the contract conveys the right to control the use of the identified asset for aa period
of time ine xchnage for considation

If the customer has the right to control the use of an identified asset only for a portion of the
term of the contract, the contract contains a lease for that portion of the term.

Lease
• Leases are different from service contracts: a lease provides a customer with the right
to control the use of an asset; whereas, in a service contract, the supplier retains
control.
• The transaction is strictly related to passing on all the risks and benefits related to the
use of asset
• Usually, granting the ownership of the asset is considered an essential element for the
transfer of risks and economic benefits, and consequently for the recording of an asset
in the balance sheet

Contract elements
Identified asset
An asset is typically identified by being explicitly specified in a contract. However, an asset
can also be identified by being implicitly specified at the time that the asset is made available
for use by the customer. In any case, there is no identified asset if the supplier has a
substantive right to substitute the asset.

Right to obtain economic benefits

from use of asset throughout the period of use. These include its primary output and by-
products (including potential cash flows derived from these items), and other economic
benefits from using the asset that could be realized from a commercial transaction with a
third party.

The customer has the right to direct how and for what purpose the identified asset is used
throughout the period of use:
(i) the customer has the right to operate the asset (or to direct others to operate the asset
in a manner that it determines) throughout the period of use, without the supplier
having the right to change the operating instructions;
(ii) the customer designed the asset (or specific aspects of the asset) in a way that
predetermines how and for what purpose the asset will be used throughout the
period of use.

35
Examples

Determining a lease

Financial leases
• Under IFRS 16, in accounting for a lease, the lessees will no longer distinguish
between finance lease contracts (on balance sheet) and operating lease contracts
(P&L). They are required to recognize a right-of-use asset and a corresponding lease
liability for almost all(*) lease contracts.
• This is based on the principle that, in economic terms, a lease contract is the
acquisition of a right to use an underlying asset with the purchase price paid in
instalments.

36
 • The effect of this approach is a substantial increase in the amount of recognized
financial liabilities and LT assets!

The lease liability is:

- initially recognized at the commencement day;
- measured at an amount equal to the present value of the lease payments during the
lease term that are not yet paid.

The right-of-use asset is:

- initially recognized at the commencement day;
- measured at cost, consisting of the amount of the initial measurement of the lease
liability, plus any lease payments made to the lessor at or before the
commencement date less any lease incentives received, the initial estimate of
restoration costs and any initial direct costs incurred by the lessee.

Will there be any P&L item?

The right-of-use asset is depreciated in accordance with the requirements in IAS 16 (i.e.,
straight line basis)
Interest expenses (i.e., effective interest rate)

Example 1
On January 1st, a 3-year leasing contract is signed for a plant. The company must pay 3
annual fees in advance of €6,000 each. At the end of the contract, at the beginning of the year
X4, the lessee has the option to buy back the plant for €2,000.
- The useful life of the plant is 4 years.
- The discount rate is 6%

We should determine:
1. The Net present value of the plant;

2. The depreciation amount;

3. The interest amount due for each period.

The total amount of interest is determined as the difference between the value of the
asset at the beginning of the period and the lease fee (i.e., 6,000).
The interest is determined on the portion of the debt still to be repaid at the beginning
of the period.

37
Accounting for leases

38
The combination of a straight-line depreciation of the right-of-use asset and the interest rate
applied to the lease liability results in a decreasing “total lease expense” charged to P&L
throughout the lease term.
This effect is referred to as: frontloading

The carrying amount of the right-of-use asset and the lease liability will no longer be equal in
subsequent periods

Case 1 leases

LESSON 07: QUALITY OF EARNINGS AND ANALYSIS

• CFOs state that earnings, not cash flows are the key metric (superior information)
• The most important benchmarks are quarterly earnings for the same quarter last year
and analyst consensus estimate
• Meeting or beating benchmarks is key
• Trade-off between short-term need to ‘‘deliver earnings’’ and long-term objective of
maximizing value investments. 78% of surveyed executives would give up economic
value in exchange for smooth earnings to avoid severe market reactions
• Negative market reactions to small EPS misses is interpreted as firms not being able
to find 1-2 cents to hit the target which may signal hidden problems at the firm level

Why fixating on earnings?

•  Investors need a simple metric that summarizes corporate performance, easy to
understand, and relatively comparable across companies. EPS satisfies these criteria.
•  EPS metric gets the broadest distribution and coverage by media.

39
 •  By focusing on one number, the analyst’s task of predicting future value is made
easier. The analyst assimilates all the available information and summarizes it in one
number: EPS.
•  Analysts evaluate a firm’s progress based on whether a company hits consensus
EPS. Investment banks also assess analysts’ performance by evaluating how closely
the analyst predicts the firm’s reported EPS.

Why meeting earnings benchmark?

1. Stock price motivation
2. Enhanced reputation with stakeholders
3. Maximize present value of executives’ bonus compensation
4. Career concerns
5. Debt covenants/reduced cost of debt

Implications of earnings fixattion

Managers take real economic actions to maintain accounting appearances.
 80% of survey participants report that they would decrease discretionary spending on R&D,
advertising, and maintenance to meet earnings target.
 55% would delay starting a new project to meet earnings, even if such a delay entailed a
small sacrifice in value
Managers appear to be willing to burn ‘‘real’’ cash flows for the sake of reporting desired
accounting numbers
...Alternatively, they can manipulate accounting numbers (harder for them to admit!)

WHAT IS ACCOUNTING QUALITY?

Accounting quality analysis establishes the integrity of the accounting used for forecasting
How income shifting works:
Accounting methods can be applied to
 borrow income from the future
 push income from the present to the future
But, this income shifting leaves a trail that can be followed by the quality analyst.
Earnings are of good quality if they do not reverse!

Earnings management

40
 Permanent versus temporary accounting treatments
 Aggressive Accounting = indicates manipulation that temporarily
 Big-bath Accounting = indicates manipulation that temporarily reduces income
 The focus should be on Core Operating Income

5 questions about accounting quality

1. GAAP quality: is GAAP accounting deficient?
2. Audit quality: is the firm violating GAAP or committing outright fraud?
3. GAAP application quality: is the firm using GAAAP accounting to manipulate
reports?
4. Transaction quality: is the firm manipulating business to accommodate the
accounting?
a. Transaction timing
b. Transaction structuring
5. Disclosure quality: are discosures adequate to analyse the business?
a. Disclosures that distinguish operating items from a financial items in
the statements
b. Disclosures that distinguish core operating profitability from unusual
items
c. Disclosures about the accounting used

41