CB 3041

Financial Statement Analysis

Asset Valuation and Income
Recognition
Review
 Importance of Asset Valuation
Measuring asset value is important because this will
determine whether the firm has any “income”, or
accounting profits. The net changes in assets and
liabilities will be reported as revenues, expenses,
gains, and losses.
 Mixed Asset Valuation Models
➢ IFRS and GAAP require firms to use mixed attribute
measurement model to
• Provide the most relevant and representationally
faithful information
• Assess the risk, timing, and future cash flows
➢ Depending on the nature of the asset, companies measure
the value of the asset by
• Historical cost method
• Revaluation method
 Relevance and Representational
Faithfulness
➢ Financial information is relevant if it can influence a
user’s decision.
➢ Information is representationally faithful if it represents
what it purports to represent.
➢ Accounting standards require that some assets and
liabilities be measured based on more relevant
information and others must be based on more
representationally faithful information.
➢ Under the mixed attribute measurement model,
valuations of assets and liabilities reflect various
combinations of historical costs, fair values, and present
values of future cash flows.
 Primary Valuation Alternatives
Valuation Methods

Historical Cost Revaluation

Liabilities Liabilities
Assets Assets

Initial Present Value Market (or Fair) Value

Acquisition Cost Current Replacement Cost

Adjusted Acquisition Cost Net Realizable Value

 Historical Cost vs. Revaluation Model
➢ Is historical cost measurement relevant and
representationally faithful?
• At the time a firm acquires an asset?
• As time passes?

➢ Is revaluation based on fair value measurement

relevant and representationally faithful?
• Fair value (Level 1/2/3)?
• Current replacement cost?
Accounting Standards for Asset Valuation
➢ HKAS 16 – Property, Plant & Equipment
• Cost method: Cost less depreciation
• Revaluation method: Fair value less
depreciation and recognize value changes in
OCI
➢ HKAS 40 – Investment Properties
• Cost method: Cost less depreciation
• Fair value method: Fair value and recognize fair
value changes in profit & loss account
Accounting Standards for Asset Valuation
➢ HKAS 38 – Intangible Assets
• Reports at cost less amortization (cost method)/
fair value less amortization and recognize value
changes in OCI (revaluation method)
➢ HKFRS 3 – Goodwill
• From business combination (M&A) -- The
acquirer recognizes goodwill as the excess of
the consideration transferred over the fair value
of the net assets acquired.
• Afterwards, goodwill is tested for impairment.
Accounting Standards for Asset Valuation
➢ HKAS 2 – Inventories
• Inventories should be measured at the lower of
cost and net realizable value
(i.e., Min {cost, net realizable value})
• If net realizable value < costs → Write-down
• When the circumstances that previously caused
inventories to be written down no longer exist,
the amount of the write-down is reversed, but
limited to the amount of the original write-
down.
 Take Away
• The need for reliable and verifiable numbers makes many
firms measure long-lived assets using historical cost.
• Depreciation differences can complicate comparisons
across firms.
• Footnote details can be used to improve these
comparisons.
• Asset impairment write-downs depend on subjective
forecasts and could be used to manage earnings.
• When comparing return on assets (ROA) ratios across
firms, remember that ROA drifts upward as assets age.
 Accrual Accounting
➢The ultimate goal of a firm is to create wealth for
stakeholders by generating more cash flows.
➢A simple way to report financial performance would be
simply to report cash inflows and outflows.
➢However, reporting cash flows suffers from timing issues
as a measure of firm performance and financial condition.
➢Accrual accounting recognizes revenues and expenses
based on the underlying economic accomplishments and
sacrifices in a particular period rather than simply when
cash inflows or outflows occur.
 Three approaches to income recognition
➢Three approaches to income recognition have evolved:
• Approach 1. Recognize income effects changes in economic
value income effects on the balance sheet and income statement
when they are realized in a market transaction.
• Approach 2. Recognize changes in economic value on the
balance sheet and income statement when they occur, even
though they are not yet realized in a market transaction.
• Approach 3. Recognize changes in economic value on the
balance sheet when the value changes occur over time, but
delay recognition in net income until the value changes are
realized in a market transaction.
 Revenue Recognition
➢Revenue recognition criteria:
• Earned – products have been delivered or services have been
rendered.
• Generally, delivery of the products is necessary. However,
there could be specific instances where revenue can be
recognized prior to delivery (e.g., if bill and hold requested by
the buyer or risks and rewards of ownership transferred to the
buyer).
• Realized – payment received or collectability is reasonably assured.
• Sales returns and uncollectibility of accounts receivables
(allowance for doubtful accounts or allowance for bad debts)
should be estimated.
 Expense Recognition
➢Matching principle:
• Expenses are recognized when the associated revenues are
recognized or during the period of benefit.
• Product costs (direct expenses):
• Directly associated with sales of goods and services. E.g., cost
of goods sold (COG&S), warranty expense, direct labor,
manufacturing overhead.
• Match expenses to associated revenues.
• Period costs (indirect expenses):
• Cannot be directly associated to specific sales of goods and
services. E.g., depreciation, insurance, interest, selling, general
& administrative (SG&A).
• Match to period of benefit or when the underlying asset
“expires”.
 Cash Flows vs. Income Flows

However, over sufficiently long time periods, net

income equals cash inflows minus cash outflows,
other than cash flows with owners.
 Income Measurement
➢ Revenues and Gains
• Revenues are earned or prospective inflows, or
inflows of cash from operations; revenues are
expected to recur
• Gains are recognized inflows or prospective inflows
of cash from non-operations; non-recurring
➢ Expenses and Losses
• Expenses are incurred outflows, prospective
outflows, or allocations of past outflows of cash
from operations
• Losses are decreases in a company’s net assets
arising from non-operations
 Income Measurement
Operating versus Non-Operating Income
➢ Operating income--measure of company income as
generated from operating activities
• Two important aspects of operating income
✓ Pertains only to income generated from
operations
✓ Pertains only to ongoing business activities (i.e.,
results from discontinued operations is excluded)
➢ Non-operating income--includes all components of
net income excluded from operating income
 Framework for Analyzing the Effects of
Transactions on the Financial Statements
Assets = Liabilities + Stockholders’ Equity

Cash + Non-cash Assets

Contributed Capital + AOCI + Retained Earnings

Cash + Non-Cash = Liabilities + Contributed + AOCI + Retained

Assets Capital Earnings
 CB 3041
Financial Statement Analysis
Lecture 4_Part 1
Understanding the Statement of
Cash Flows
 Learning Objectives
➢ Identify the purpose and importance of the statement of
cash flows
➢ Describe the structure and interpretation of operating,
investing, and financing cash flow activities
➢ Use the statement of cash flows to determine where the
firm is in its life cycle
 Learning Objectives
➢ Understand the relations among the statement of cash
flows, the income statement, and the balance sheet
➢ Prepare a statement of cash flows from balance sheet and
income statement data
➢ Examine how the statement of cash flows provides
information for accounting and risk analysis
Purpose of the Statement of Cash Flows
➢ The statement of cash flows assists financial statement
users in understanding the cash inflows and outflows that
arise from a firm’s primary activities.
• Just as the income statement gives users an
understanding of how a firm performed during the
period, the statement of cash flows gives users an
understanding of how the firm generated and used cash
 Purpose of the Statement of Cash Flows
➢ The vast majority of firms use the indirect method of preparing
the statement of cash flows.
➢ The statement of cash flows links net income to the change in
cash on the balance sheet.
• Net income captures changes in all assets and liabilities
from transactions with non-owners
• The change in cash is also affected by transactions with
owners.
• Hence, the reconciling items include changes in non-cash
assets and liabilities and net cash flows from transactions
with owners (e.g., dividends and share issues).
 Purpose of the Statement of Cash Flows
➢ Accrual accounting help investors better predict the nature,
amount, and timing of future cash flows.
➢ In contrast, the statement of cash flows “unravels” the
accrual accounting procedures to reveal the (volatile timing
of) underlying cash flows.
Beg. Cash + Cash inflows – Cash outflows = End. Cash

Net cash flows = Change in cash

Note that we use the term cash to mean cash and cash equivalents. Cash
equivalents include highly liquid short-term investments that are readily
convertible into cash, including commercial paper, and money market funds.
Purpose of the Statement of Cash Flows
➢ The statement of cash flows is logically organized into
three sections (operating activities, investing activities, and
financing activities).
➢ On the statement of cash flows, net cash flows equal the
(net) sum of cash flows provided by or used for operating,
investing, and financing activities.
➢ The sum of these cash flows reconciles with the increase or
decrease in cash shown on the balance sheet.
 Cash Flows Versus Net Income
A firm’s cash flows will differ from net income each period
because:
➢Cash receipts from customers do not necessarily occur in the
same period the firm recognizes revenues.
➢Cash expenditures do not necessarily occur in the same
period firms recognize expenses.
➢Cash inflows and outflows from investing and financing
activities do not immediately flow through the income
statement.
➢Some cash inflows and outflows from financing activities
never flow through the income statement.
 Cash Flows Versus Net Income
Cash is clearly necessary for operating, investing, and
financing activities.
➢Investors are keenly interested in the inflows and outflows
of cash across reporting periods.
➢It is essential that firms report the flows of cash in and out of
the firm each period.
➢In addition to providing information on cash inflows and
outflows, the statement of cash flows is useful for
interpreting information on the balance sheet and income
statement.
Relations among the Cash Flow Activities
➢The three sections of the statement of cash flows follow
this logical progression:
• Operating activities: directly involving the production
and delivery of goods or services.
• Investing activities: expenditures for and proceeds from
dispositions of assets, such as plant and equipment and
investments in securities.
• Financing activities: cash received from and paid to
capital providers such as banks, other lending
institutions, and shareholders.
Relations among the Cash Flow Activities
➢One intuitive way to think about a firm is that it generates
cash inflows and outflows every day from its operating
activities, and continually reinvests cash by investing it in
long-term productive assets; needs for additional cash
trigger new financing, whereas excess cash flows allow a
firm to pay off debt or distribute dividends to shareholders.
The three sections of the statement of cash flows follow this
logical progression.
Relations among the Cash Flow Activities
➢The activities to start up a firm, however, occur in reverse
order: the firm first obtains cash through financing
activities, like issuing equity and debt, then the firm invests
the cash in productive assets, followed by generating cash
flows from operating activities.
Relations among the Cash Flow Activities
➢For established companies

➢For start-up companies

 Statement of Cash Flows
Sino Biopharmaceutical_2019

Net cash flows = 5,324,634 – 3,824,344 + 2,800,837 = 4,301,127

Δ Cash (net of effect of exchange rate) = 10,631,210 – 6,235,029 – 95,054
= 4,301,127
 Statement of Cash Flows
Sino Biopharmaceutical_2019
 Cash Flows and Financial Analysis
➢A firm’s cash flows will play an important role when using
the steps in financial statement analysis:
• Step 1: Identify the characteristics of a business.
• Step 2: Identify the strategy of the firm.
• Step 3: Identify nonrecurring, unusual items.
• Step 4: Provide insight into the use of accounting
discretion by managers.
• Step 5: Analyze profitability and risk.
• Step 6: Prepare forecasted financial statements.
• Step 7: Value the firm.
 Cash Flows and Financial Analysis
➢A firm’s cash flows will play an important role when
performing the financial statement analysis :
• Economic Characteristics of a Business: differences in the
pattern of cash flows from operating, investing, and financing
activities among various types of businesses as well as throughout
various stages of a firm’s life cycle. For example, high-growth,
capital-intensive firms typically generate insufficient cash flow
from operations to finance capital expenditures (investing
activities); thus, they require external sources of capital (financing
activities). In contrast, mature companies usually generate
sufficient cash flows from operations to pay for capital
expenditures and to repay debt, pay dividends, or repurchase
common stock (financing activities).
 Cash Flows and Financial Analysis
➢A firm’s cash flows will play an important role when
performing the financial statement analysis :
• Strategy of the Firm: reveal the overall strategy of a
firm, especially how the firm generates and uses cash to
execute its operating, investing, and financing
strategies, as well as its growth strategies. (e.g., organic
growth vs. growing by M&A)
 Cash Flows and Financial Analysis
➢A firm’s cash flows will play an important role when
performing the financial statement analysis :
• Identify Nonrecurring, Unusual Items: The cash
flow statement provides you with information about the
cash versus noncash components of unusual items, such
as one-time gains or losses and discontinued
operations. In addition, if you choose to eliminate
nonrecurring or unusual items from net income to more
clearly assess operating profitability, then you also
should adjust the relevant parts of the cash flow
statement.
 Cash Flows and Financial Analysis
➢A firm’s cash flows will play an important role when
performing the financial statement analysis :
• Provide Insight into the Use of Accounting
Discretion by Managers: You also will find that the
reconciling adjustments in the operating section, which
report the noncash components of revenues and
expenses, can sometimes reveal the extent to which
managers use accounting discretion to affect reported
earnings.
 Cash Flows and Financial Analysis
➢A firm’s cash flows will play an important role when
performing the financial statement analysis :
• Analyze Profitability and Risk: the ability of a firm to
generate sufficient cash flow from operations to finance
capital expenditures and service debt obligations is a
key signal of the financial health of the firm.
• Help Forecasting Financial Statements: forecast
growth rate in net income depend on whether the firms
makes continued investments in productive assets.
• Value the Firm: firm valuation based on “free cash
flows” to equity shareholders
 Quick Check Question 1
➢ The vast majority of firms prepare their statement of cash
flows using the:

a. Historical method
b. Direct method
c. Indirect method
d. Cash method
 Quick Check Question 2
➢ Which of the following would be least likely to cause a
change in investing cash flows?

a. The sale of a division of the company

b. The purchase of a new machinery
c. An increase in depreciation expense
 Quick Check Question 3
➢ Sales of inventory would be classified as:

a. Operating cash flow

b. Investing cash flow
c. Financing cash flow
 Usefulness of Statement of Cash Flows
➢ In addition to the analysis of accounting quality, the
statement of cash flows is useful for identifying a firm’s
strategy and where a firm is in its life cycle as well as
liquidity and credit risk analysis.
➢ It can help gauge whether reported net income reflects the
underlying economics of the business.
➢ It highlights accounting accruals, which can provide
insight into the overall sustainability and quality of a
firm’s reported earnings.
Cash Flow Activities and a Firm’s Life Cycle
➢Cash flows will vary over a firm’s four life cycle phases of
introduction, growth, maturity, and decline:
➢Introduction Stage:
• Revenues are low, net income may be negative
• Negative cash flow from operating activities
• Negative cash flow from investing activities
• External financing (positive cash flow from financing)
Cash Flow Activities and a Firm’s Life Cycle
➢Cash flows will vary over a firm’s four life cycle phases of
introduction, growth, maturity, and decline:
➢Growth Stage:
• Increasing revenues, net income becomes positive
• Increasing cash flows from operations
• Continuing negative cash flows from investing activities
• Decreasing positive cash flows from financing activities
Cash Flow Activities and a Firm’s Life Cycle
➢Cash flows will vary over a firm’s four life cycle phases of
introduction, growth, maturity, and decline:
➢Maturity Stage:
• Peak net income, positive cash flows from operations
• Cash flows from investing activities may begin to
increase
• Cash flows from financing activities may become
negative (repayment of debt, stock repurchases, etc.)
Cash Flow Activities and a Firm’s Life Cycle
➢Cash flows will vary over a firm’s four life cycle phases of
introduction, growth, maturity, and decline:
➢Decline Stage:
• Revenues decrease, net income decreases (may become
negative)
• Cash flows from operations decreases
• Cash flows from investing activities positive (as firm
divests)
• Cash flows from financing activities negative
 Cash Flow Activities and a Firm’s Life Cycle
➢ Stylized Patterns of Revenues, Net Income, and Cash Flows from Operations,
Investing, and Financing at Various Stages of a Product or Business Life Cycle
Cash Flow Activities and a Firm’s Life Cycle
➢However, firms in introduction, growth, or mature stages
may find themselves facing severe competitive or
technological conditions, and may end up in decline, during
which they tend to lose customers and market share, and
their productive capacity and operating capabilities
diminish.
➢In the extreme, firms that are in decline may fail, if they
cannot successfully overcome competitive disadvantages
and re-enter an introduction, growth, or mature stage.
Cash Flow Activities and a Firm’s Life Cycle
➢Of course, firms need not progress linearly through life
cycle stages. Moreover, whether a firm successfully
progresses to the next stage or not, and the length of time a
firm spends in each stage, depends on many different
factors within the firm’s strategy, productive capabilities,
competitive conditions, technological constraints, and
financing.
 Quick Check Question 4
➢ Combined data for three years for two firms follow (in millions).
One of these firms is Amazon.com, a rapidly growing Internet
retailer, and the other is Kroger, a retail grocery store chain
growing at approximately the same rate as the population.
Identify each firm and explain your reasoning.
 Quick Check Question 4
➢ Which firm is Amazon.com? Explain.

a. Firm A
b. Firm B
 Quick Check Question 5
➢ Combined data for three years for two firms follow (in millions). The
two firms experienced similar growth rates in revenues during the three-
year period. One of these firms is Accenture Ltd., a management
consulting firm, and the other is Southwest Airlines, a provider of
airline transportation services. Identify each firm.
 Quick Check Question 5
➢ Which firm is Southwest Airlines? Explain.

a. Firm A
b. Firm B
 Quick Check Question 6 & 7
➢ Which company is more likely to be in the phases of
introduction, growth, maturity, and decline?
Company A 2020 2019 2018

Company B 2020 2019 2018

 Quick Check Question 6 & 7
➢ Which company is more likely to be in the phases of
introduction, growth, maturity, and decline?
Company C 2020 2019 2018

Company D 2020 2019 2018

 Quick Check Question 6
➢ Which company is more likely to be in the phases of
introduction? Explain.

a. Company A
b. Company B
c. Company C
d. Company D
 Quick Check Question 7
➢ Which company is more likely to be in the phases of
maturity? Explain.

a. Company A
b. Company B
c. Company C
d. Company D