ACCOUNTING 2
1 – Reporting and Interpreting Stockholders’ Equity
What are the benefits of issuing equity?
The corporate form of business has a critical advantage over sole proprietorships and
partnerships because they can raise large amounts of capital from both large and small
investors.
- Shares of stock may be purchased in small amounts.
- Ownership interests can be transferred easily through the sale of shares on established
markets such as the New York Stock Exchange or the NASDAQ Stock Exchange.
- Stock ownership provides investors with limited liability.
Corporations enjoy a continuous existence separate and apart from its owners. A
corporation can own assets, incur liabilities, sue others or be sued, expand and contract in size,
enter into contracts independently of its owners. Corporations are created by application to a
state government (not the federal government). Corporations are governed by a board of
directors elected by the stockholders.
Owners of common stock (known as stockholders or shareholders) receive several benefits:
- Financial Benefits
o dividends à proportional share of the distribution of profits.
o residual claim à proportional share of the distribution of remaining assets upon
the liquidation of the company.
- Control Benefits
o A voice in management à right to vote.
The stockholders’ equity section of the balance
sheet lists two primary sources of equity:
1. Contributed capital from the sale of
stock.
2. Earned capital generated by the
company’s profit-making activities
(Retained Earnings or Accumulated
Deficit, if negative).
We can distinguish between Common Stock (Add Paid in Capital) and Preferred Stock (Add
Paid in Capital), both form the Contributed Capital. Speaking of benefits, preferred
shareholders have more financial than control benefits, in fact they have the priority when
speaking of financial benefits.
Common stock is the basic voting stock issued by a corporation. Common stock ranks
behind preferred stock for dividends and assets distributed upon liquidation. Preferred
stock typically does not have voting rights. All companies issue common stock. Only some
firms issue preferred stock.
Retained Earnings is not part of contributed capital but Earned Capital.
Breaking up contributed capital, speaking of individual shares we can distinguish between
- authorized shares, maximum number of shares of stock a corporation can issue as
specified in its charter:
o Issued are the total number of shares sold to the public.
§ Outstanding, number of shares owned by stockholders at a specific point
in time.
1
Treasury Stock, shares bought back by the corporation although already
being sold.
o Unissued are the shares that have never been sold. N.B Shares that are retired
resume a status of being authorized but not issued.
A few states do not allow treasury stock. In these states companies must retire shares that
are repurchased. Microsoft is incorporated in one of those states (Washington State). In fiscal
2020, Microsoft repurchased and retired 126 million shares of common stock. Since those
shares are not listed as treasury stock, Microsoft’s number of outstanding shares is equal
to its number of issued shares.
§
Transactions relating Common Stock
Common stock is held by investors called shareholders or stockholders, who are the owners
of a corporation; as a stockholder, I receive shares of stock that I subsequently sell on
established stock exchanges. Stockholders have the ultimate authority in a corporation, BoD
and all employees are accountable to the stockholders. Stockholders have the right to:
• Vote.
• Share in profits of the business through dividends.
• Elect the board of directors who hire and monitor the executives who manage a
company’s activities on a day-to-day basis.
Though stockholders are owners and have the right to vote and share in the profitability of the
business through dividends, they do not actively participate in managing the business.
Instead, they elect a BoD and it is the board’s role to hire and monitor executives who manage
a company’s activities daily.
Timeline of events when recording a transaction involving Common Stock
1) Issuance. There are many types of Issuances of Equity
a. IPO à Initial Public OYering
b. SEO à Seasonal Equity OYering
2) Compensation, but we won’t see journal entries related to this.
3) Distribution, either through dividends or through share repurchases.
Depending on state law, a company’s common stock may be required to have a par value.
Par value is the nominal value per share, established in the corporate charter (depends on the
State), ≠ Market Value.
Par value no longer has any economic significance. It is mainly a legal obligation required by
certain states. An investor would typically not care whether the common stock purchased has
a par value or is no-par value stock unless the par value was set at a high dollar value which
could aYect any distribution to common stockholders in the event of bankruptcy.
The original purpose of assigning a par value to a share of common stock was to protect
creditors by specifying a permanent amount of capital that owners could not withdraw
before a bankruptcy, which would leave creditors with something in the event the company
failed à legal capital.
Legal capital is the amount of capital, required by the state, that must remain invested in the
business. There are some states that require the issuance of no-par value stock, in this case
legal capital is defined by state law.
2
An initial public oQering, or IPO, involves the very first sale of a company’s stock to the public
(i.e., when the company first “goes public”). Investors sometimes earn significant returns on
IPOs, but also take significant risks! Once the company’s stock has been traded on established
markets, additional sales of new stock to the public are called seasoned oQerings.
Assume Microsoft sold 1 million shares of its $0.00000625 par value common stock for $220
per share. The company would record the following journal entry:
Sale of Stock in Secondary Markets
When a company sells stock to the public, the transaction is between the issuing corporation
and the investor. After the initial sale, investors can sell shares to other investors without
directly aQecting the corporation. Stockholders expect to earn money on their investments
through possible dividends and increases in a company’s stock price à The corporation is not
a part of the transaction and therefore does not receive or pay anything.
Stock Issued for Employee Compensation
Managers may not act in the owners’ best interest. Compensation packages can be developed
to reward employees for meeting goals important to stockholders.
Another strategy is to oYer employees stock, either directly through stock awards or indirectly
through stock options:
- Stock awards grant shares of stock to employees that vest on future dates.
- Stock options give employees the right to buy stock in the future at a fixed price.
Both stock awards and stock options provide incentives for employees to take actions that
increase a company’s stock price (thereby aligning their interest with the interest of
stockholders).
Repurchase of Stock
A corporation repurchases its stock from existing stockholders for several reasons. Reasons
are:
- One common reason is the existence of an employee bonus plan that provides workers
with shares of the company’s stock as part of their compensation. Due to SEC
regulations, it is less costly to give employees repurchased shares than to issue new
ones.
Moreover, if a company was to pay bonuses with newly issued shares each period à it
would increase the number of shares in the market à lowering the company’s stock
price (dilution)
- anti-dilution. Reissuing treasury stock avoids diluting existing shareholders’
investments, as each share of stock they own would be worth less.
- Another reason is capital structure adjustment.
- Undervaluation.
- Tax reasons.
3
Stock that has been repurchased and is held by the issuing corporation is called Treasury
Stock.
• Treasury stock is not an asset, rather it is a contra-equity account.
• Treasury stock is shown as a negative number on the balance sheet.
This makes sense because when stock is repurchased and held as treasury, it is not removed
from the Common Stock account, but it is shown in a separate account within SE, and since
repurchasing shares reduces assets, it also reduces equity.
Treasury shares have no voting, dividend, or other stockholder rights while they are held as
treasury stock, therefore, it does not have the benefits of equity. Transactions involving
Treasury Stock do not imply profits or losses.
Repurchase of Stock
IBM reacquired 100,000 shares of its common stock when it was selling for $140 per share.
The decrease in stockholders’ equity doesn’t come with a reduction in common stock, but
rather with an increase in Treasury Stock, which is indeed a contra-equity account.
Selling Treasury Stock à Reissuance
IBM reissued 10,000 shares of treasury stock at $150 per share (earned 1500000 cash).
Therefore, cash increases by 10.000*150, on the other hand Treasury Stock is reduced by
10.000*140, the diQerence is covered by Additional paid-in capital.
What if I reissue shares at a lower price than repurchased? The reasoning is symmetrical, we
debit Additional paid-in capital. IBM reissued 10,000 shares of treasury stock at $130 per share.
Dividends
The return from investing in a company’s common stock can come from two sources: stock
price appreciation and dividends.
Some investors prefer to buy stocks that pay little or no dividends, because companies that
reinvest most of their earnings back into their operations tend to increase their future
earnings potential and therefore their stock price.
Wealthy investors in high tax brackets prefer to receive their return in the form of higher stock
prices because capital gains may be taxed at a lower rate than dividend income.
4
Other investors, such as retired people who need a steady income, prefer to receive their
return in the form of dividends. Retirees seek stocks that will pay relatively high dividends,
such as utility stocks. Analysts compute the dividend yield ratio to evaluate a company’s
dividend policy.
The declaration and payment of a dividend
involve several key dates.
1. Declaration date. The date on which the
Board of Directors oYicially approves the
dividend. As soon as the board declares a
dividend, a liability is created and must
be recorded.
2. Date of record. The date on which the corporation prepares the list of current
stockholders who will receive the dividend payment. The dividend is payable only to
those names listed on the record date. No journal entry is made on this date.
3. Date of payment. The date on which cash is disbursed to pay the dividend liability.
Date of Declaration: Assume Microsoft declared a $3,886 million dividend on 9/18/2019, we
record a liability and we decrease Retained Earnings:
Date of Record: 11/21/2019, stockholders who own shares on this date will receive the
dividend. (No journal entry)
Date of Payment: 12/12/2019 the liability is paid.
The declaration and payment of a cash dividend reduces assets (cash) and stockholders’
equity by the same amount. This explains the 2 fundamental requirements for payment of a
cash dividend, the corporation must have:
- suYicient retained earnings
- and cash to cover the amount of the dividend.
Investors should be careful to research a company’s dividend policy (which is determined by
the BoD) before investing. Indeed, in the US, regardless of how profitable the company is, there
is no legal obligation for a company to declare dividends. However, once the BoD declares
a dividend, there is a legal obligation to pay that dividend.
Nature of Stock Dividends
Though cash dividends are the most common type of dividend, companies can also distribute
additional shares of stock as dividend. Stock dividends represent a distribution of additional
shares of stock to stockholder on a pro rata basis at no cost to the stockholder. Pro rata basis
means that each stockholders receives additional shares equal to the percentage of
shares held. A stockholder with 10% of outstanding shares will receive 10% of any additional
shares issued as stock dividend. Therefore, stockholders retain the same percentage
ownership after stock dividends are distributed. Both before and after the stock dividend, the
5
stockholder owns 10% of the company. Therefore, a stock dividend by itself has no economic
value!
N.B. The value of an investment is determined by the percentage of a company the stockholder
owns and not by the number of shares held.
Stock dividends do not change the stock’s par value or total stockholders’ equity.
The stock market reacts immediately when a stock dividend is issued:
- The stock price falls. The fall in price might not be exactly proportional to the number
of new shares issued. If the stock price before a stock dividend is 60$, and the company
doubles the number of shares outstanding by issuing the stock dividend, it’s not often
the case that the company’s stock falls to 30$.
- The lower market price may make the stock more attractive to new investors. Many
investors prefer to buy stocks in round lots (cifre tonde) usually multiples of 100. If I have
10.000$ I won’t buy stock selling for 150$, because I cannot aYord to buy 100 shares.
But if the stock price was lower than 100$ as the result of a stock dividend, I might buy.
The entry for a stock dividend is a transfer from the Retained Earnings account to the
Common Stock account (and Additional Paid-in Capital account for small stock dividends),
to reflect the additional shares issued. The amount transferred depends on whether the stock
dividend is classified as a large stock dividend or a small stock dividend.
- Large Stock Dividend. Involves the distribution of shares that amount to be more than
20/25% of currently outstanding shares. It significantly decreases the company’s
stock price, so the GAAP requires the amount to be transferred to the Common Stock
accounts to be based on the par value of the stock.
- Small Stock Dividend. Involves the distribution of shares that amount to be less than
20/25% of outstanding shares. The GAAP requires the amount to be recorded based on
the market value of the stock, with the par value being transferred to Common Stock
and the excess to Additional Paid-In Capital.
Large Stock Dividend: Assume Microsoft issued 40 million shares of its $0.00000625 par value
stock. On the date of declaration, the following journal entry is made:
Small Stock Dividend: Assume Microsoft issued 4 million shares of its $0.00000625 par value
stock when it was trading at $220 per share. On the date of declaration, the following journal
entry is made:
NOTE: Regardless of whether a stock dividend is classified as large or small, there is no change
in the total amount of stockholders’ equity!
Stock Splits
6
Stock splits are not dividends. While they are similar because they distribute additional
shares of stock to stockholders, they diYer on how they impact accounts. In a stock split, a
company gives stockholders a specified number of additional shares for each share that
they currently hold. Whether a company distributes additional shares of stock by declaring
stock dividend or initiating a stock split Is determined by state law.
When a company declares a two-for-one stock split, a stockholder who owned one share
before the split will own two shares after the split. The first share has been “split” in two
shares.
Companies do not make journal entries to record stock splits, but disclose them in notes.
When a company initiates a stock split, it reduces the par value of its stock so that the total
dollar amount in the Common Stock account remains unchanged.
In contrast to a stock dividend, a stock split does not change any account balances in the
SE section of the balance sheet (no accounts are aQected). In both a stock dividend and a
stock split, the stockholder receives more shares of stock without having to invest additional
resources to acquire the shares (no cost), and they both cause a decrease in the market
value per share. A stock dividend requires a journal entry; a stock split does not but is
disclosed in the notes to the financial statements.
This chart shows the comparative eYects of a large stock dividend versus a stock split.
Assume that a corporation had 300,000 shares of $1 par value common stock outstanding
before a 100% stock dividend versus a two-for-one stock split:
100% stock dividend and a 2-for-1
stock split both double the number
of shares outstanding. As we can
see though, only after the stock split
the par value has decreased,
common stock is unchanged. In the
end total stockholders’ equity is
UNCHANGED!
Preferred Stock Transactions
In addition to common stock, some corporations issue preferred stock. The journal entries
regarding the issuance and repurchase are the same as those related to common stock.
However, preferred stock is:
- Less risky because of priority payments of dividends and assets before common
stock.
- Typically, does not have voting rights. It doesn’t appeal to investors who want some
control over the operations of a corporation.
- Typically has a fixed dividend rate. Attractive to investors who want stable income from
their investments.
Preferred stock oYers a dividend preference over common stock.
- Current dividend preference: Requires a company to pay current dividends to
preferred stockholders before paying dividends to common stockholders. After this
is met then dividends can be paid to common stockholders. Preference is always a
feature of preferred stock.
- Cumulative dividend preference: Requires any unpaid dividends on preferred stock
to accumulate. This unpaid amount, called dividends in arrears, must be paid before
common dividends are paid. If preferred stock is noncumulative, any dividends not
7
declared in previous years are permanently lost and will never be paid. USUALLY
preferred stock is cumulative (NOT ALWAYS).
Note: Dividends in arrears are disclosed in the notes to the financial statements, they are
not reported on the BS. They are not a liability until the board of directors declares them.
Wally Company has the following stock outstanding:
Assume a current dividend preference only:
Dividends are 3000, of which
2400 are preferred stock and the
rest common stock.
Assume the preferred stock is cumulative and that dividends have been in arrears for two
years:
Dividends have been in
arrears for 2 years so I have
to consider these two years +
this years’ dividends.
N.B. the residual common stock is the amount paid to common shareholders.
8
2 – Reporting and Interpreting Investments in Other Corporations
A company may invest in the securities of another company to:
- Earn a return on idle cash (a passive investment)
- Influence the other company’s policies and activities.
- Control the other company’s future.
We can distinguish between:
- Active Investments.
o Investments made with the intent of exerting significant influence over another
corporation, i.e. the ability of the investing company to have an important
impact on the operating, investing and financial policies of another
company. It holds if the investing company owns from 20 to 50 percent of the
outstanding voting shares, such percentage does not guarantee significant
influence. However, other factors may indicate significant influence such as
membership on board of directors, etc. Purpose is to take an active role as an
investor. The equity method is used to measure and report this category of
investments.
o Investments made with the intent to exert control over another corporation, i.e.
the ability to determine the operating and financial policies of another company
through ownership of voting stock. Presumed if the investing company owns
more than 50% of the outstanding voting stock of the other company. The
acquisition method is used.
- Passive Investments. Passive investments are made to earn a return on funds that may
be needed for future purposes.
o Investments in debt securities (bonds and notes) are always considered
passive investments because there is no ownership at stake. There are 3 types:
§ Held-to-maturity investments. These securities are:
• Measured at amortized cost.
• Classified as “Noncurrent held-to-maturity Investments”,
unless they mature within 1 year, then they are reported as current
assets.
§ Trading Securities. Investments to be sold before maturity and are
actively traded.
• Measured using the fair value method.
• Current Assets
§ Available-for-sale securities. Not intended to be held to maturity or
actively traded.
• Measured using the fair value method.
• Current or Noncurrent Assets, depending on the management.
o Investments in equity securities (stocks) are presumed to be passive if the
investing company owns less than 20 percent of the outstanding voting shares,
with no significant influence over the investee.
§ Investment in Equity Securities are
• Measured using the fair value method.
• Current or Noncurrent Equity Investments, depending on the
management.
9
Passive Investment in Debt Securities - Purchasing Debt Securities
A debt security (typically, a bond or note) may be purchased at the maturity amount (at par),
for less than the maturity amount (at a discount), or for more than the maturity amount (at a
premium).
The total cost of the investment, including all incidental acquisition costs such as transfer
fees and broker commissions, is debited to the Investments account (A+).
EXAMPLE
Assume on October 1, 2023, The Walt Disney Company paid the par value of $150,000 for 6
percent bonds that mature on September 30, 2028. Interest at 6 percent per year is paid on
March 31 and September 30. The journal entry to record the purchase of the bonds is:
Passive Investment in Debt Securities - Earning Interest Revenue
Suppose that the fiscal year ends on September 30. Because no premium or discount needs to
be amortized (because the bonds were purchased at par), Interest Revenue (R+, SE+) of
$4,500 ($150,000 × 0.06 × 1⁄2 year) is earned and received in cash on March 31, 2024, and again
on September 30, 2024.
The following journal entry records the receipt of interest:
This entry will be made every March 31 and September 30 during the period that Disney holds
the bonds.
HOWEVER, at the end of each fiscal year, measuring and reporting investments in debt
securities depends on management’s purpose. Will the debt instruments be:
- Held to their maturity dates (classified as either current or noncurrent investments
depending on the maturity date),
- Traded actively over a short period of time (classified as current assets), or
- Neither held to maturity nor actively traded (classified as current or noncurrent
investments based on management’s intent)?
10
Passive Investment in Debt Securities: Held to Maturity
When management has the intent and ability to hold debt securities (bonds or notes) until
their maturity date, they are considered held-to-maturity investments. These investments are
reported at cost adjusted for the amortization of any discount or premium (amortized cost
method), not at their fair value. No fair value adjusting entry is necessary at the end of the
fiscal period.
When the bonds in the illustration mature on September 30, 2028, the journal entry to record
receipt of the principal payment would be:
Passive Investment in Debt Securities: Actively Traded
Investments in debt securities that are actively traded over short periods of time are accounted
for as trading securities. The objective is to generate profits on short-term changes in the
price of the securities. Trading securities with readily determinable market values are recorded
by applying the fair value method and are reported as current assets on the balance sheet.
To apply this method, at the end of each fiscal year, the trading securities portfolio is adjusted
up or down to the portfolio’s fair value (a security’s current market value).
The adjusting journal entry will cause total assets to increase or decrease.
The oQsetting eQect is reported on the income statement as an unrealized gain or loss (that
is, the amount associated with the price change from holding the investment—no actual
exchange transaction has been made). The unrealized gain or loss is subsequently closed to
Retained Earnings to keep the balance sheet in balance.
EXAMPLE
Let’s illustrate the year-end valuation of trading securities by assuming The Walt Disney
Company decides to actively trade its $150,000 investment in debt securities provided in the
prior example.
Assume that
(1) Disney has no prior trading securities,
(2) the investment in debt securities has a fair value at the end of the fiscal year on September
30, 2024, of $140,000, and
(3) the investment is sold on September 30, 2025 (end of the next fiscal year), for $165,000.
First, compute the adjustment that is needed as demonstrated in the following table:
At the end of fiscal year 2024 the unrealized loss of $10,000 is reported on the Income
Statement. The adjusting entry to record the trading securities at fair value is:
11
When the securities are traded (sold) on September 30, 2025, there are two journal entries:
(1) the trading securities first are adjusted to new fair value of $165,000
(2) then the sale is recorded
N.B. The total net unrealized gain of $15.000 (25.000-10.000) is equal to the diYerence
between the sales price of $165.000 and the original cost of $150.000.
Passive Investment in Debt Securities: Not Held to Maturity or Actively Traded
In this case, investments in debt securities are considered, by default, available-for-sale
securities. These are common investments for companies interested in earning a return on
funds needed for future purposes.
Available-for-sale securities with readily determinable market values are reported at fair
value and may be classified as current or noncurrent assets.
The available-for-sale securities portfolio is adjusted up or down to the portfolio’s fair value.
The adjusting journal entry for the unrealized holding gain or loss is not reported on the
income statement, unlike the treatment for trading securities. Any unrealized gain or loss is
recorded as a component of Other Comprehensive Income (OCI) on the Statement of
Comprehensive Income.
When a sale takes place, the investment portfolio is adjusted to fair value on the sale date.
Then, the accumulated net unrealized gain or loss for those investments that are sold is
reclassified out of Other Comprehensive Income and reported on the current period’s
income statement as a realized gain or loss.
EXAMPLE
To illustrate the year-end valuation and then subsequent sale of available-for- sale debt
securities, assume that The Walt Disney Company purchased its $150,000 in bonds at par and
intends to hold the securities for a couple of years. Assume that:
(1) Disney has no additional investment in available-for-sale securities.
(2) the investment in debt securities has a fair value at the end of the fiscal year on September
30, 2024, of $140,000, and
(3) the investment is sold on September 30, 2025 (end of the next fiscal year), for $165,000.
First, compute the adjustment that is needed as demonstrated in the following table:
12
At the end of fiscal year 2024 the unrealized loss of $10,000 is reported on the Statement of
Comprehensive Income. The adjusting entry to record the available-for-sale securities at fair
value is:
For available-for-sale securities sold in 2025, there are
three journal entries to make:
- Adjust to fair value. The investment account needs to
be adjusted to its fair value of the date of sale
September 2025, 165.000. The adjustment is an
increase in the investment account of $25,000 with the
unrealized gain increasing Other Comprehensive
Income (OCI).
-
Reclassify the Other Comprehensive Income balance. The total net unrealized gain
or loss accumulated in Other Comprehensive Income for the securities that are sold is
reclassified as a realized gain or loss to be reported on the income statement. It is
recorded as Gain or Loss on Sale of Investments. It is equal to the net adjustments
over the holding period in Other Comprehensive Income (($10,000) + $25,000). It is
equal to the diYerence between the current fair value and the original cost.
-
Record the sale of the available-for-sale securities. Finally, the sale is recorded with
the investments account decreased by its book value (equal to fair value after the
adjustment in the first entry) and cash received of $165,000.
Passive Investment in Equity Securities
When a company purchases and owns less than 20 percent of the outstanding voting stock of
another company, the investment in these equity securities is usually considered passive.
Passive investments in equity securities, whether current or noncurrent, are reported at fair
value with any year-end adjustments for unrealized gains or losses reported in net income (like
accounting for debt securities actively traded).
Purchasing Equity Securities & Earning Dividend Revenue
13
To illustrate accounting for investment in equity securities, assume that on October 1, 2023,
The Walt Disney Company purchased 10 percent of the voting common stock of Green Light
Pictures4 for $15 per share. To record the purchase of the stock:
Green Light, an independent film studio, has 100,000 shares of stock outstanding. In addition,
the studio pays a dividend of $0.50 per share each year at the end of September, its fiscal year
end. Remember that the pov is the one of the investor.
In debt securities we have the interest revenue, here the dividend revenue.
Passive Investment in Equity Securities: Applying the Fair Value Method
Because Disney owns less than 20 percent of the outstanding
voting common stock of Green Light Pictures, Disney accounts
for its investment in equity securities by applying the fair value
method.
The equity investments portfolio is increased or decreased
each period with the oYsetting eYect reported on the income
statement as an unrealized gain or loss (from holding the
investment).
Example
Assume that
(1) Disney has no other investments in equity securities;
(2) the fair value of Green Light’s common stock was $12 per share at September 30, 2024
($120,000), and $16.50 per share at September 30, 2025 ($165,000); and
(3) Disney sold the stock portfolio on March 31, 2026, for $19 per share ($190,000) (before
Green Light declared any dividends).
Compute the adjustment needed as demonstrated in this table:
The adjusting entry to record the investments in equity securities at fair value at the end of
Fiscal Year 2024 is:
14
The adjustment at the end of Fiscal Year 2025 is the amount needed to bring the investments
from the account’s $120,000 book value to the $165,000 current year-end fair value—an
increase of $45,000.
There are two entries that need to be recorded for the sale of investments in equity securities,
in 2026:
(1) Adjust to fair value: The investment account is again adjusted to its fair value on the sale
date of March 31, 2026. The current fair value is $190,000 and the book value is $165,000. The
adjustment is an increase to the investment account of $25,000.
(2) Record the sale of the equity securities: The sale is recorded with the investments account
decreased by its book value (equal to fair value after the adjustment in (1) above) and cash
received of $190,000.
The following summarizes the eQects on financial statements across years for equity
securities investments:
Investments for Significant Influence: Equity Method
An investor may want to exert influence (presumed by owning 20 to 50 percent of the
outstanding voting stock) without becoming the controlling shareholder (owning more than
50 percent of the voting stock).
Examples follow:
- A retailer may want to influence a manufacturer to be sure that it can obtain certain
products designed to its specifications.
- A manufacturer may want to influence a computer consulting firm to ensure that it
can incorporate the consulting firm’s cutting-edge technology in its manufacturing
processes.
- A manufacturer may recognize that a parts supplier lacks experienced management and
could prosper with additional managerial support.
15
The equity method must be used when an investor can exert significant influence over an
aYiliate.
The investor’s 20 to 50 percent ownership of a company presumes significant influence over
the aQiliate’s process of earning income.
(LEFT) The investor reports its
portion of the aQiliate’s net
income as its income and
increases the investment account
by the same amount.
(RIGHT) A net loss decreases the
investment account. The receipt
of dividends by the investor is
treated as a reduction of the
investment
account,
not
revenue.
The Investments account is reported on the balance sheet as a long-term asset.
Example
- In September 2020 (end), Disney had no long-term investment in companies over
which it exerted significant influence.
- In September 2021, Disney purchased 40% interest in Green Light for 400.000 cash
(40.000 shares of Green Light’s 100.000 outstanding voting common stock).
- GL earns diQering amounts of net income each year and declares dividends
annually. Its fiscal year ends similarly on September 30.
Purchase of Stock
In early 2024, Disney purchased a 40% interest in Green Light Pictures for $400,000 in cash
(40,000 shares of the 100,000 outstanding voting common stock).
-
Disney was presumed to have significant influence over the aYiliate.
Therefore, Disney must use the equity method to account for this investment.
The purchase of the asset would be recorded at cost.
Earnings of AEiliates
During the fiscal year ending in 2024, Green Light Pictures reported a net income of $500,000
for
the year. The Walt Disney Company’s percentage share of Green Light’s income is $200,000
(40% × $500,000)
and is recorded as
follows.
16
-
The investor company bases its investment income on the aQiliates’ earnings rather
than the dividends aYiliates declare.
If the aYiliates report a net loss for the period, the investor records a loss of the amount
equal to the percentage share of the loss by decreasing the investment account and
recording Equity in Investee Losses.
The Equity in Investee Earnings (or Losses) is reported in the Other Items section of
the income statement.
Dividends Declared
During the fiscal year ending in 2024, Green Light declared a cash dividend of $0.50 per share
to stockholders. Disney will receive $20,000 ($0.50 × 40,000 shares) from Green Light in the
future.
-
Any dividends declared by the aYiliate should not be recorded as investment income.
Instead, dividends declared by the aYiliate reduce the investment account.
Remember that dividends declared reduce retained earnings, the earnings of the
company.
The Investments account is reported on the balance sheet as a long-term asset, originally at
cost. However, after the investment purchase, the investment account does not reflect either
cost or fair value. Instead:
- Account is increased by
o the cost of shares that were purchased and
o the proportional share of the aQiliates’ net income.
- Account is reduced by
o the proportional number of dividends declared from aYiliate companies,
o the proportional share of aYiliates’ net losses,
o and the cost of any shares that were sold.
At the end of the accounting period there is NO AJE of the investment account to reflect
changes in fair value.
N.B If sold, any gain or loss on the sale of the investment (diYerence between the cash
received and the book value of the investment) is reported in the income statement in the
Other Items section.
Exercise on the slides
Disposal: If sold, any gain or loss is reported in the income statement
Let’s assume that the investment in Green Light is sold after the previous events:
• Initial Purchase: Inv. +400,000$
• Equity in Investee Rev.: Inv. +200,000$
• Dividend Declaration: -20,000$
➔ Inv. = 580,000$ is the book value of the investment (400.000 + 200.000 – 20.000)
The stock market price of Green Light at the time of the disinvestment is 15$ (➔Cash (+A): 15$
x 40,000# = 600,000$)
So, we record a Gain on Sale of Investment of 600.000-580.000=20.000
17
Cash (A+)
600.000
Gain on Sale of Investment (R+, SE-)
20.000
Investments (A-)
580.000
18
3 – Statement of Cash Flows
This statement explains how the amount of cash on the balance sheet at the beginning of
the period has become the amount reported at the end of the period.
Positive cash flows permit a company to:
- Pay dividends to owners.
- Take advantage of investment opportunities.
- Expand its operations.
- Replace worn assets.
Example
The financials of BConsulting Company report the following information for Fiscal Year X:
• Service revenues earned: 80,000$. Of which in accounts receivable at FY end: 30,000$
• Salaries expense for services sold during the year: 40,000$. Of which in salaries payable
at FY end: 10,000$
• Payment for insurance premium: 12,000$. Insurance covers the company for 2 FYs
• Payment for oYice supplies (ink cartridges and paper): 2,000. OYice supplies worth
1,000 have been used to generate the services sold in the FY
The financials of BConsulting Company report the following information for FY X+1:
• Service revenues earned: 80,000$. Of which in accounts receivable at FY end: 0$
• Salaries expense for services sold during the year: 40,000$. Of which in salaries payable
at FY end: 0$
• OYice supplies worth 1,000 have been used to generate the services sold in the FY.
From an income statement perspective, the two years are exactly the same.
Revenue and Expense Matching: Accrual accounting allows businesses to match revenues
with the expenses incurred to generate those revenues, providing a more accurate picture of a
company's profitability during a specific time. This is because revenue is recorded when
earned, and expenses are recorded when incurred, regardless of when cash is exchanged.
We need a diYerent a “cash-based” income statement, telling us the ability of the
corporation to generate cash in year X and year X+1, which is totally diYerent!
This Statement is characterized by:
- Less Subjectivity: The calculation of cash flow involves less subjectivity than other
financial metrics, such as earnings, which can be significantly aYected by
assumptions and judgments in areas like depreciation, amortization, and provisions for
doubtful debts.
- Clear View of Cash Position: This method provides a clear, real-time picture of how
much cash is actually available at any given time. This can be particularly important
for businesses that need to closely monitor their cash on hand to meet operational
expenses and avoid cash shortages.
19
The definition of cash includes cash and cash
equivalents. Cash equivalents are shortterm, highly liquid investments that are both:
- Readily convertible into known amounts
of cash and
- So near to maturity there is little risk that
their value will change if interest rates
change.
For instance, investments in:
• Short-term treasury security with
maturity in 2 months
• Short-term debt issued by a large
investment grade company with maturity
1 month (commercial paper)
• Funds investing in the securities above
(money market fund)
o Bond issued by a small firm with maturity
5 years and traded twice a week ARE
NOT.
Generally, only investments with original
maturities (AND NOT RESIDUAL) of three months or less qualify as cash equivalents.
The ending cash balance should agree with the balance sheet.
The statement of Cash Flows reports cash inflows and outflows in 3 broad categories:
- Operating Activities. Cash inflows and outflows directly related to earnings from
normal operations.
- Investing Activities. Cash inflows and outflows related to the acquisition or sale of
productive facilities and investments in the securities of other companies. Everything
not tightly related to the operating cycle.
- Financing Activities. Cash inflows and outflows related to external sources of financing
(owners and creditors) for the enterprise.
Cash Flows from Operating Activities
Two Formats for Reporting Cash Flow from Operating Activities:
- Direct Method. Reports the cash eYects of each operating activity. It reports the
components of cash flow from operating activities as gross receipts and gross
payments.
Increases à Cash Inflows (+). Cash received from
• Customers
• Dividends and interest on Investments
Decreases à Cash Outflows (-). Cash paid for
• Purchase of services (electricity, etc.) and goods for resale (e.g. cash payment
for other expenses)
• Salaries and wages
• Income taxes
• Interest on liabilities
The diYerence between inflows and out flows is the net cash provided by (or used for)
operating activities. The direct method is rarely used in the US although FASB
recommends it. It is considered to be more expensive than the indirect method. Both
FASB and IASB are considering a proposal to require this method.
20
-
Indirect Method. Starts with accrual net income and converts it to cash flow from
operating activities, it actually eliminates noncash items to arrive at net cash inflow
(outflow) from operating activities. Used by 99% of large companies.
The cash flows from operating activities are always the same, regardless of whether the
direct or indirect method is used. The two are just alternative ways to arrive at the same
number.
Cash Flows from Investing Activities.
Cash inflows and outflows related to the acquisition or sale of productive facilities and
investments in the securities of other companies.
- Cash Inflows. Cash received from
o Sale or disposal of property, plant, and equipment
o Sale or maturity of investments in securities
- Cash outflows. Cash paid for
o Purchase of property, plant, and equipment
o Purchase of investments in securities
Again, the diYerence is the net cash provided by investing activities.
Cash Flows from Financing Activities.
Financing Activities. Cash inflows and outflows related to external sources of financing
(owners and creditors) for the enterprise.
- Cash Inflows. Cash received from:
o Borrowings on notes, mortgages, bonds, etc., from creditors
o Issuing stock to owners
- Cash outflows. Cash paid for:
o Repayment of principal to creditors (excluding interest, which is an operating
activity)
o Repurchasing stock from owners
o Dividends to owners
Again, the diYerence is the net cash provided by financing activities. The combination of the
net cash flows from operating, investing, and financing activities must equal the net
increase or decrease in cash. Remember the exceptions :
21
Relationships to the Balance Sheet and
Income Statement
Preparing and interpreting the cash flow statement requires an analysis of the balance sheet
and income statement accounts that relate to the three sections of the cash flow statement.
But companies cannot prepare the statement of cash flows using the amounts recorded in the
T-accounts because those amounts are based on accrual accounting. They must analyze the
numbers recorded under the accrual method and adjust them to a cash basis.
To prepare the statement of cash flows, they need the following data:
• Comparative balance sheets used in calculating cash flows from all activities.
• A complete income statement used primarily in calculating cash flows from operating
activities.
• Additional details concerning selected accounts where the total change in account
balance during the year doesn’t reveal the underlying nature of the cash flows.
Preparation and understanding of the cash flow statement focuses on the changes in the
balance sheet accounts.
From the fundamental accounting equation A = L+SE, we manipulate it.
First, we split assets into cash and noncash assets
∆𝐶𝑎𝑠ℎ + ∆𝑁𝑜𝑛𝑐𝑎𝑠ℎ 𝐴𝑠𝑠𝑒𝑡𝑠 = ∆𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 + ∆𝑆𝑡𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟𝑠 ! 𝐸𝑞𝑢𝑖𝑡𝑦 à
∆𝐶𝑎𝑠ℎ = ∆𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 + ∆𝑆𝑡𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟𝑠 ! 𝐸𝑞𝑢𝑖𝑡𝑦 − ∆𝑁𝑜𝑛𝑐𝑎𝑠ℎ 𝐴𝑠𝑠𝑒𝑡𝑠
Thus, any transaction that changes cash must be accompanied by a change in liabilities,
stockholders equity or noncash assets.
IN DETAIL
ΔCash =
NI + Depreciation – Gains on Inv. Sales + Losses on Inv. Sales – Δ Current Op. Assets
+ ΔCurrent Operating Liabilities
-Purchases + NetBVSold + Gains on Inv. Sales – Losses on Inv. Sales
+ Δ Financial Liabilities + ΔCommon Stock + ΔAdditional Paid In Capital - Dividends
22
How do we derive it?
1. A=L+E
2. Cash + Current Op. Assets + Investments = (Current
Operating Liabilities + Financial Liabilities)
+(Retained Earnings + Common Stock + Additional
Paid In Capital)
3. ΔCash + ΔCurrent Op. Assets + ΔInvestments =
(ΔCurrent Operating Liabilities + ΔFinancial
Liabilities) + (ΔRetained Earnings + ΔCommon Stock
+ ΔAdditional Paid In Capital)
4. ΔCash = ΔRetained Earnings – Δ Current Op.
Assets + ΔCurrent Operating Liabilities –
Δinvestments + Δ Financial Liabilities + ΔCommon
Stock + ΔAdditional Paid In Capital
Recall that
Retained Earningsending = Retained Earningsstarting + NI – Dividends à
ΔRetained Earnings = Retained Earningsending – Retained Earningsstarting = NI – Dividends
And
Investmentsending = Investmentsstarting + Purchases – NetBookValueSold – Depreciation à
Δinvestments = Investmentsending – Investmentsstarting = Purchases – NetBVSold – Depreciation
5. ΔCash = (NI – Dividends) – Δ Current Op. Assets + ΔCurrent Operating Liabilities –
(Purchases – NetBVSold – Depreciation) + ΔFinancial Liabilities + ΔCommon Stock +
ΔAdditional Paid In Capital
6. ΔCash = NI + Depreciation – Δ Current Op. Assets + ΔCurrent Operating Liabilities –
Purchases + NetBVSold + Δ Financial Liabilities + ΔCommon Stock + ΔAdditional Paid In
Capital – Dividends
7. ΔCash = NI + Depreciation – Gains on Inv. Sales + Losses on Inv. Sales – Δ Current Op.
Assets + ΔCurrent Operating Liabilities
– Purchases + NetBVSold + Gains on Inv. Sales – Losses on Inv. Sales
+ Δ Financial Liabilities + ΔCommon Stock + ΔAdditional Paid In Capital - Dividends
Preliminary Steps to Prepare the Cash Flow Statement
1. Determine the change in each balance sheet account
2. Classify each change as Operating, Investing or Financing
The balance sheet accounts related to earning income (operating items) should be
marked with O (these are often operating assets an liabilities).
Accounts Marked with an O
- Most Current Asset (except short-term investments, I and cash)
- Most Current Liabilities (other than amounts owed to investors/financial institutions
that are F)
- Retained earnings (F and O because it increases by the amount of net income, the start
of the operating section; but decreases with dividends declared and paid, financing
outflow, F)
EX:
- Account R
- Inventories
23
- Prepaid Expenses
- Accounts P
- Accrued Expenses
- Retained Earnings
All the remaining assets on the BS are to be marked with an I
- Sh-term Investments
- PP&E, Net
All the remaining liabilities and stockholders’ equity are F
- Long-Term Debt
- Common Stock
- Add Paid in Capital
- Retained Earnings
Reporting and Interpreting Cash Flows from Operating Activities
The indirect method adjusts net income by eliminating noncash items.
Net Income
+ Depreciation and Amortization Expense
- Gain on sale of investing assets
+ Loss on sale of investing assets
+ Decreases in operating assets
+ Increase in operating liabilities
- Increase in operating assets
- Decreases in Operating Liabilities
= Net Cash Flow from Operating Activities
Example
Recall that
ΔCash =
= NI + Depreciation – Gains on Inv. Sales + Losses on Inv. Sales – Δ Current Op. Assets +
ΔCurrent Operating Liabilities
± Cash Flow Investing Activities
± Cash Flow Financing Activities
Assume a company had only one transaction for the year.
• Equipment with a net book value of $90,000 is sold for $100,000.
• What is the journal entry?
Cash (A+)
100.000
Equipment (A-)
90.000
Gain on Disposal (R+,SE-)
10.000
What is the eYect on NI? + 10,000
What is Cash Flow from Investing Activities? +100,000 (Equipment is an Investing Asset!!)
24
Indirect Cash Flow from Operations Adjustment: - 10,000 i.e. - Gains on Inv. Sales (as the
formula suggests).
Adjustment for Gains and Losses
Cash received from the sale or disposal of long-term assets is classified as investing cash
inflow. Gains/losses on the income statement, if any, are subtracted from/added to net income
in order to compute cash flow from operating activities.
- Gains must be subtracted from net income to avoid double counting the gain.
- Losses must be added to net income to avoid double counting the loss.
Change in Accounts Receivable
Sales on account increase the balance in accounts receivable, and collections from
customers decrease the balance. The balance sheet indicates an increase in accounts
receivable of $481 for the period, which means that cash collected from customers is lower
than revenue.
To convert to cash flows from operating activities, the amount of the increase (the amount of
sales over and above collections) must be subtracted from net income. (A decrease is added.)
Example 1
ΔCash From Operations =
= NI + Depreciation – Gains on Inv. Sales + Losses on Inv. Sales – Δ Current Op. Assets +
ΔCurrent Operating Liabilities
Assume a company had only one transaction for the year.
• Outstanding accounts receivable of $10,000 was collected
• What is the journal entry?
Cash (A+)
10.000
Accounts Receivable (A-)
10.000
What is the eYect on NI? 0 (no accounts aQect the Income Statement)
What was Cash Flow From Operating Activities? +10,000 (cash collected)
Indirect Cash Flow From Operations Adjustment: 10,000,
i.e. - Δ Current Op. Assets = -(-10000) = +10,000
Example 2
Assume a company had two transactions for the year.
• Accounts receivable of $10,000 was collected.
• On 31/12, $1,000 of new sales was made on credit.
• What are the journal entries?
1)
Cash (A+)
10.000
Accounts Receivable (A-)
10.000
2)
Account Receivable (A+)
1000
Sales Revenues (R+,SE+)
1000
25
What is the eQect on NI? 1,000
What was Cash Flow From Operating Activities? 10,000
Indirect Cash Flow From Operations Adjustment: 9,000, i.e. - Δ Current Op. Assets (= Cash
Flow from Operations – NI = 10.000-1000 = 9000)
Change in Inventory
The balance sheet indicates that inventory increased by $9,782, which means that the amount
of purchases is more than the amount of merchandise sold.
The increase (the extra goods purchased) must be subtracted from net income to convert to
cash flow from operating activities. (A decrease is added.)
Example
ΔCash From Operations =
= NI + Depreciation – Gains on Inv. Sales + Losses on Inv. Sales – Δ Current Op. Assets +
ΔCurrent Operating Liabilities
Assume a car dealer had only two transactions for the year.
• A car is sold for $50,000 for cash. The carrying amount of the car in the car dealer
inventory equaled $40,000
• During the FY, the car dealer purchased a car for cash from its supplier for an amount of
$15,000
• What are the journal entries?
1. Cash (A+)
50000
Sales Revenues (R+,SE-)
50000
2. Cost of Sales (E+,SE-)
Inventory (A-)
3. Inventory (A+)
Cash (A-)
40000
40000
15000
15000
The eYect on Net Income is 50.000-40.000 = 10.000
Cash Flow from Operating Activities is -(-40.000+15.000) = 35.000
The indirect cash flow from operations adjustment is 25000 (35.000 – 10.000) (-Delta Current
Operating Assets)
Change in Prepaid Expenses
The balance sheet indicates a $5,676 decrease in prepaid expenses, which means that new
cash prepayments are less than the amount of expenses.
The decrease (the extra prepayments) must be added to net income. (An increase is
subtracted.)
Example
ΔCash From Operations =
= NI + Depreciation – Gains on Inv. Sales + Losses on Inv. Sales – Δ Current Op. Assets +
ΔCurrent Operating Liabilities
Assume a company had the following transactions for the year.
26
•
•
A prepayment of $9,000 for a legal risk insurance was made at the start of the FY. The
overall insurance coverage period is 3 FYs
A rent expense incurred for $2,000. The expense relates to a 2-year rent contract which
was paid in full at the beginning of the previous fiscal year (overall cash outflow: $4,000)
What are the journal entries?
•
2/1)
Prepaid Expense (A+) 9000
Cash (A-)
9000
31/12
Insurance Expense (E+, SE-)
3000 (1/3 of insurance)
Rent Expense (E+, SE-)
2000
Prepaid Expense (A-)
5000
What is the eYect on IS? -5,000
What was Cash Flow From Operating Activities? -9,000 (-5000 – 4000)
What is the Indirect cash flow from operations adjustment? -4,000, i.e. -Δ Current Op. Assets
(-9000 + 5000)
Change in Accounts Payable
The balance sheet indicates accounts payable decreased by $8,651, which means that cash
payments were more than purchases on account.
This decrease (the extra purchases on account) must be subtracted from net income. (An
increase is added.
Example
ΔCash From Operations =
= NI + Depreciation – Gains on Inv. Sales + Losses on Inv. Sales – Δ Current Op. Assets +
ΔCurrent Operating Liabilities
Assume a company had only one transaction for the year.
• Outstanding accounts payable of $10,000 was paid
• What is the journal entry?
Accounts Payable (L-)
10000
Cash (A-)
1000
The eYect on Net Income is 0
The Cash Flow from Operating Activities is 0 – 10,000 = -10,000
The Indirect cash flow from operations adjustment is -10,000
Change in Accrued Expenses
The balance sheet indicates accrued expenses increased by $1,018, which indicates that cash
paid for the expenses is less than accrual basis expenses.
The increase (the lower cash paid) must be added to net income. (A decrease is subtracted.)
Example
ΔCash From Operations =
= NI + Depreciation – Gains on Inv. Sales + Losses on Inv. Sales – Δ Current Op. Assets +
ΔCurrent Operating Liabilities
Assume a company had no business operations in a given year. It only incurred costs related to
limited electric power consumption used to maintain baseline operations in the company’s
oYices.
- The electricity invoice is billed at the end of every other month. On 31/12, $50 of
expenses related to electricity consumed in December have accrued.
27
- What is the journal entry?
Utilities Expense (E+, SE-)
50
Utilities Payable (L+)
50
The eYect on net income is -50
The cash flow from operations is -50+50 = 0
The adjustment is 50
We can summarize the typical additions and subtractions that are required to reconcile net
income with cash flow from operating activities as follows:
Recall that to reconcile net income to cash flow from operating activities I should:
- Add the change when an
operating
asset
decreases
or
an
operating
liability
increases
- Subtract the change
when an operating
asset increases or an
operating
liability
decreases.
Example
ΔCash From Operations =
= NI + Depreciation – Gains on Inv. Sales + Losses on Inv. Sales – Δ Current Op. Assets +
ΔCurrent Operating Liabilities
Assume a company had the following transactions for the year.
• Outstanding accounts payable of $10,000 was paid
• On 31/12, $1,000 of new raw materials were purchased on credit.
• What are the journal entry?
Account Payable (L-) 10,000
Cash (A-)
10,000
Inventory (A+)
1000
Account Payable (L+)
1000
The eYect on net income is 0
The cash flow from operating activities is 0 - 1000 – 9000 = -10,000
The adjustment is -10,000 à -9000 + -1000 (change in current operating liabilities – change in
current operating assets)
Classification of Interest on the Cash Flow Statement
U.S. GAAP and IFRS diYer in the cash flow statement treatment of interest received and
interest paid.
28
Interpreting Cash Flows from Operating Activities
A common rule of thumb followed by financial and credit analysts is to avoid firms with rising
net income but falling cash flow from operations. The operating activities section of the cash
flow statement focuses attention on the firm’s ability to generate cash internally through the
operations of its management of operating assets and operating liabilities (operating working
capital). It is considered the most important section of the cash flow statement, mainly
because, in the long run, operations are the only source of cash!
- Investors will not invest in a company if they do not believe that cash generated from
operations will be available to pay them dividends or expand the company.
- Creditors will not lend money if they do not believe that cash generated from operations
will be available to pay back the loan.
Fraud and Cash Flow from Operations
The cash flow statement often gives outsiders the first hint that financial statements may
contain errors and irregularities.
Unethical managers sometimes attempt to reach earnings targets by manipulating accruals
and deferrals of revenues and expenses to inflate income. Because these adjusting entries
do not aQect the cash account, they have no eQect on the cash flow statement.
A growing diYerence between net income and cash flow from operations can be a sign of such
manipulations.
Reporting and Interpreting Cash Flows from Investing Activities
Preparing this section of the cash flow statement requires an analysis of the accounts related
to
- property, plant, and equipment;
- intangible assets;
- and investments in the securities of other companies.
Remember that:
• Only purchases paid for with cash or cash equivalents are included.
• The amount of cash that is received from the sale of assets is included, regardless of
whether the assets are sold at a gain or loss.
The following relationship are the ones more frequently encountered:
29
From this equation, we are know interested in the highlighted part:
ΔCash =
= NI + Depreciation – Gains on Inv. Sales + Losses on Inv. Sales – Δ Current Op. Assets +
ΔCurrent Operating Liabilities
– Purchases + NetBVSold + Gains on Inv. Sales – Losses on Inv. Sales
+ ΔFinancial Liabilities + ΔCommon Stock + ΔAdditional Paid In Capital - Dividends
What are the elements?
• - Purchases = cash outflows for the purchase of investments (either PPE or securities)
• + Net Book Value Sold + Gains on Investment Sales = cash inflows if an asset is sold at
more than book value
• + Net Book Value Sold – Loss on Investment Sales = cash inflow if asset is sold at less
than book value
Example
- We must report individually the cash used to purchase equipment and the cash
proceeds received from the sale of equipment.
- Although short-term investments is a current asset, it is reported in the investing
section on the statement of cash flows. The company purchased short-term
investments for $1,252. The company also sold short-term investments for $3,685.
Changes in long-term investments would be treated in the same fashion.
Managers and analysts often calculate free cash flow as a measure of a firm’s ability to
pursue long-term investment opportunities.
Free Cash Flow = Cash Flow from Operating Activities – Dividends – Capital Expenditures
Any positive free cash flow is available for additional capital expenditures, investments in
other companies, and mergers and acquisitions without the need for external financing or
reductions in dividends to shareholders. While free cash flow is considered a positive sign of
financial flexibility, it can also represent a hidden cost to shareholders.
Sometimes managers use free cash flow to pursue unprofitable investments just for the sake
of growth or to obtain perquisites, that do not benefit shareholders. In this case, shareholders
would be better oY if free cash flows were paid as additional dividends or used to repurchase a
company’s stock on the market.
Reporting Cash Flows from Financing Activities
Financing activities are associated with generating capital from creditors and owners. This
section of the cash flow statement reflects changes in 2 current liabilities, Notes Payable to
Financial Institutions, Current Maturities of Long-Term Debt, as well as changes in longterm liabilities and stockholders’ equity accounts. These accounts relate to the issuance and
retirement of debt and stock, and the payment of dividends.
30
Remember that:
• Cash repayments of principal are cash flows from financing activities.
• Interest payments are cash flows from operating activities. Because RECALL that
interest expense is reported on the income statement, the related cash flow is shown in
the operating section.
• Dividend payments are cash flows from financing activities. They are not reported in
the income statement because they represent a distribution of income to owners, so
they are shown in the financing section.
• If debt or stock is issued for other than cash, it is not included in this section.
ΔCash =
= NI + Depreciation – Gains on Inv. Sales + Losses on Inv. Sales – Δ Current Op. Assets +
ΔCurrent Operating Liabilities
– Purchases + NetBVSold + Gains on Inv. Sales – Losses on Inv. Sales
+ ΔFinancial Liabilities + ΔCommon Stock + ΔAdditional Paid In Capital - Dividends
Inflows
ΔFinancial Liabilities > 0
(Issuance of Loans and Bonds)
ΔCommon Stock > 0 & ΔAdditional Paid In
Capital > 0
(Issuance of Capital; Sale of Treasury
Stock)
Ouflows
ΔFinancial Liabilities < 0
(Principal Repayment on Loans and Bonds)
ΔCommon Stock < 0 & ΔAdditional Paid In
Capital < 0
(Purchase of Treasury Stock)
Dividends > 0
(Cash Dividends, enter the equation with
negative sign)
Interpreting Cash Flows from Financing Activities
The long-term growth of a company is normally financed from three sources:
1. Internally generated funds (cash from operating activities)
2. The issuance of stock
3. Money borrowed on a long-term basis.
The statement of cash flows shows how management has elected to fund its growth. This
information is used by analysts who wish to evaluate the capital structure and growth potential
of a business.
Supplemental Cash Flow Information
Two additional required cash flow disclosures are normally listed at the bottom of the
statement or in the notes.
31
1. Noncash investing and financing activities, such as the purchase of a building with a
mortgage given by the former owner. These activities are important investing and
financing speaking but have no cash flow eQects. Supplemental disclosure of these
transactions is required (either narrative or schedule form)
2. Cash paid for interest and cash paid for income taxes (for companies that use the
indirect method, because otherwise they are part of operating cash flow).
Chapter Supplement B - Adjustment for Gains and Losses on Sale of Long-Term Assets—
Indirect Method
The Operating Activities section of the cash flow statement prepared using the indirect method
may include an adjustment for gains and losses on the sale of long-term assets reported on
the income statement.
If property, plant, and equipment with an original cost of $10,000 and accumulated
depreciation of $4,000 is sold for $8,000 cash, the following entry is made.
The whole $8,000 inflow of cash is an investing cash inflow, but the reported gain is also shown
on the income statement!
So, it is necessary to remove (subtract) the $2,000 gain from the Operating Activities section of
the statement to avoid double counting.
If we had a loss on disposal, it should be added back in the computation of cash from operating
activities.
32
4 – Income Taxes
"Income taxes" are a sub-category of taxes, which are of many diYerent kinds (income tax,
VAT, sales tax, registry tax, stamps...).
Income taxes are a cost to companies à the cost is debited, and a liability towards tax
authority is credited. The cost and the debt arise due to the simple generation of a positive
income. In other words, as the company has been able to earn money, it can contribute to
public expenses by paying taxes. In Italy, the highest-ranking law governing taxes is Article 53
of the Constitution.
During the fiscal year: down payments
In order to simplify, from now on it is assumed that the accounting period coincides with the
calendar year. During the year, down payments for taxes are required by law. The size of down
payments and payment dates vary from country to country. In Italy, broadly (i.e. with many
possible exceptions), these advance payments are due in two instalments:
- June 30: 40% of the gross tax liability of the precedent fiscal year
- November 30: 60% of gross tax liability of the precedent fiscal year.
At the date of each down payment, the JE is (example: June 30, 2018):
Advance Tax Payments (A+)
Bank Account (A-)
XXXX
XXXX
The «advance tax payment» is a current asset and, if no income tax payables are due at the end
of the year, it may be either carried forward, or claimed back for a refund, or used to oQset
other tax payables (ex. VAT).
An «advance payment» is a sort of «prepaid expense», the diQerence is that the «advance
payment» can be claimed back if the conditions for which it was paid are not met (in the case
of taxes, if no tax payments are due).
End of fiscal year: tax liability
At year end, after the adjusting entries are made, it is possible to compute income tax expense
(according to the methods set out in the following slides); then, the "tax liability" and the “tax
receivable for down payments made" are oQset.
This journal entry is the last one before closing the books and preparing the financial
statements. The reason is simple à these are "income taxes”, hence before calculating them
you shall compute all the other positive and negative income statement items
(revenues/expenses); otherwise, the “income before taxes” would be inaccurate and so would
be the “income taxes”!
Once income taxes are computed, the journal entries to record the accrual of income taxes
and the oQset are as follows (example: December 31, 2018):
Income Tax Expense (E+)
Income Tax Payable (L+)
Income Tax Payable (L-)
Advance Tax Payments (A-)
33
Subsequent year: oQsetting the outstanding balance
As mentioned before, the "tax liability" and the “tax receivable for down payments made" are
oYset on December 31 every year, in a way that only the net receivable/payable is included in
the balance sheet. What happens in the next year?
If the “tax receivable“ exceeds the liability, then the tax asset will be carried forward and used
in the future (or asked for reimbursement or used to oYset other taxes owed to any
Governmental agency). If instead, the liability exceeds the down payment, then the
outstanding balance due is paid on June 30th of the year (example: 2019), together with the first
instalment of the down payment due for the year (example: 2019).
Income Tax Payable (L-)
Bank Account (A-)
June 30, 2019 - Journal entry to pay the outstanding balance due for 2018. After the payment
of the balance for 2018, the first instalment for 2019 is paid.
EXAMPLE
30.11.2018: down payment € 50.000
Advance Tax Payments (A+)
50000
Bank Account (A-)
50000
31.12.2018: income taxes are computed: € 65.000. OQsetting, the liability is greater:
Income Tax Expense (E+, SE-)
65000
Income Tax Payable (L+) 65000
Income Tax Payable (L-)
50000
Advance Tax Payments (A-) 50000
30.06.2019: payment of the outstanding balance (65.000 – 50.000), and then the first 2019
down payment:
Income Taxes Payable (L-)
15.000
Bank Account (A-)
15.000
Advance Tax Payment (A+)
Bank Account (A-)
(65.000 * 40% = 26.000)
26.000
26.000
Taxable Income and Income Tax Expense
In the precedent section, we explained the chronological sequence and the journal entries
concerning the payment of taxes. In this section, it is explained how income taxes are
computed. In every Country around the world (except tax heavens where taxes are zero), the
method to compute income taxes is the same, and it is not “intuitive” for the following reason.
The Accounting System, that collects and processes (also) revenues and expenses, is based
on a number of concepts, Accounting Standards (US GAAP, IFRS, or local GAAP...) and, most of
all, on a number of estimates and conjectures (mainly for the adjusting entries), which give
rise to revenues and expenses that are uncertain and the result of subjective opinion.
For example: the computation of a “depreciation expense” is the outcome of an evaluation
process; bad debt expense requires estimates; a contingent liability is “probable” or “possible”
based on subjective opinions; and so on.
34
Consequently, Profit Before Taxes, that is the algebraic diQerence between revenues and
expenses (before taxes) in the Income Statement, is the result of assumptions, subjective
hypothesis and assessments that could be manipulated, with the goal of decreasing
“income before tax” and pay then less taxes. Moreover, some expenses may not pertain to
the business but may be borne for private interest, using the company’s money.
For this reason (avoid manipulations), in every Country around the word, Income Tax Laws do
exist and are in force. In Italy, the main Income Tax Law is the Presidential Decree n° 917 of
1986.
Income Tax Law (no matter the Country as this is a worldwide principle) states provisions
aimed at excluding some revenues and expenses from the computation of income taxes; for
Income Tax Law purposes, some revenues shall not be taxed (non-taxable revenues, or
revenues exempt from taxes), and some expenses are not recognized (non-deductible
expenses).
Therefore:
TAXABLE INCOME (that is: revenues minus expenses recognized by Tax Law)
Usually does not coincide with
INCOME BEFORE TAXES (that is: revenues minus expenses included in the Income Statement
according to the applicable GAAP).
Taxable Income is the amount to which the tax rate is applied, in order to compute the
income tax expense (and income tax payable) to be recorded in the financial statements.
Therefore, when calculating income taxes, one must first "calculate taxable income",
according to the rules established by the tax authority.
If Income Before Taxes is computed according to the GAAP, using assumptions and hypothesis;
and Taxable income is computed according to the Income Tax Laws, do we have to use two
diYerent Accounting Systems, one for GAAP purposes and one for tax purposes? Absolutely
NOT.
The Accounting System is ONLY ONE. The Accounting System is NOT influenced by Income
Tax Law eYects. To compute Taxable Income it is necessary, OUTSIDE AND SEPARATELY from
the accounting system (i.e., not using the double-entry bookkeeping method), to «exclude»
non-taxable revenues and non-deductible expenses, according to the method in the
example.
EXAMPLE
The Mosquito Ltd company sells water bottles. Its two directors, Mark and Carla, buy (for their
own personal use) a gold watch and a diamond ring using the company's credit card.
Q: Is it correct that this cost is recorded in the general journal of the company (and so, in
the financial statements)?
A: Yes, of course. If these items were paid with the credit card assigned to the Company, no
doubt the change in cash must be credited at the date of payment, and consequently no doubt
an expense shall be debited.
35
Q: which are the revenues and expenses included in the income statement at the end of
the year?
A: The revenues and expenses accounted during
the year according to the local GAAP applicable
are the following:
From the Income Statement Mosquito LTD – Profit before tax = Euro 7,000.
Q: according to the Tax Laws in force, are all the revenues and expenses recognized for tax
purposes?
A: NO, not all revenues and expenses are recognized for tax purposes. More in details:
• Revenues are recognized (taxable revenue)
• Cost of goods sold is recognized (deductible expense)
• Watch and ring are not needed to generate revenues of the company, therefore are «not
pertinent» to the business activity.
A general principle of the Tax Law of each Country is that a cost, that is not inherent to the
business activity, "does not exist” for tax purposes and therefore shall be discarded when
computing Taxable Income.
Q: Stated the above, how is taxable income calculated?
A: as we said before, the Accounting System is only one. It doesn’t exist a diYerent «Accounting
System for tax purposes», where the «watch and ring» are not recorded.
Taxable income is computed as follows:
1. First, you start from the Profit Before Taxes;
2. Then, You ADD BACK all non-deductible costs and
3. You SUBTRACT BACK all non-taxable revenues,
to achieve the same result that would have occurred if we had "canceled" all the costs and
revenues, not recognized by tax law, from the income statement. So we add back 9000.
Therefore, Taxable income is 16.000.
Once the taxable income is calculated,
the tax rate is applied (for example:
30%) and so is calculated the Income
Tax Expense and the Tax liability.
... it is as if we made a «fiscal income statement»
and had "canceled" the non-deductible costs! à
We compute the Income Tax Expense:
Taxable income: Euro 16,000
Income Tax Rate: 30%
Income Tax Expense = 16,000*30% = 4,800
Journal Entry:
Income Tax Expense (E+, SE-) 4800
Income Tax Payable (L+)
4800
36
So, we include the Income Tax Expense in our Income Statement:
We conclude that Net Profit is 2.200 (100.000 – 84.000 – 9.000 – 4.800)
We have seen that Income Before Taxes ≠ Taxable Income. To move from one another we talk
about adjustments, variations or diQerences.
Permanent and Temporary Variations
We referred to the "variations" to be made to the Profit Before Taxes in order to calculate the
Taxable Income. These «variations» are of two types:
- Permanent changes: when a cost or revenue is recorded in the general journal, but the
tax legislation does not recognize it nor in the financial year in which it is recorded,
nor in any future year. In other words, for the tax authorities this kind of revenues or
costs "do not exist". NO IMPACT on the future.
- Temporary changes: when a cost or revenue is recorded in the general journal but the
tax legislation does not recognize it in the same period in which they are registered,
but will recognize it in the future. These misalignments between the accrual period
for accounting purposes and the accrual period for tax purposes generate, alternatively
(FUTURE IMPACT):
o Deferred tax assets
o Deferred tax liabilities
In our course these concepts are not studied in depth. However, consider the following:
• When there is an increasing temporary variation à a "deferred tax asset" is
generated, not to be confused with an “advance tax payment”. The “deferred tax asset”
is recorded in the assets part of balance sheet.
• When there is a temporary decrease à a "deferred tax liability" is generated, not to
be confused with a "tax payable”. The "deferred tax liability" is recorded in the liabilities
part of balance sheet.
Therefore, consider that when a
balance sheet is analyzed and these
items are identified ("deferred tax
asset" and "deferred tax liability"),
they are generated by the
misalignment between civil law and
tax legislation.
37
VARIATIONS (Non-Deductible Costs and Non-Taxable Revenues)
EXERCISE SET 1
- AmberCo recorded a “loss due to impairment” on an asset, worth Euro 35.000.
o Losses due to Impairment are NON-DEDUCTIBLE
o any loss is deductible ONLY WHEN REALIZED (i.e. loss on disposal of the asset
is deductible only when realized);
o Temporary Increasing Variation à Deferred Tax Asset
- AmberCo recorded Euro 100.000 as “interest expense” on a bond issued;
o Interest expense is DEDUCTIBLE ONLY up to 30% of the EBITDA of the year;
o NON DEDUCTIBLE PORTION IS: Interest Expense – (30%*EBITDA)
o any interest expense exceeding the threshold may be deducted in future years
(so, currently, is non-deductible), if and when 30% of the EBITDA will be
superior than interest expenses;
o Temporary Increasing Variation à Deferred Tax Asset
- AmberCo recorded Euro 40.000 as “Board of Directors’ salaries” but didn’t pay these
wages payable before the year end;
o The wages expense due to the members of the Board of Directors are
DEDUCTIBLE ONLY in the year in which the related wages payable is actually
PAID;
o Not Paid = Non-Deductible
o Temporary Increasing Variation à Deferred Tax Asset
- AmberCo purchased some equipment and accounted for a depreciation expense
worth Euro 50.000 using a 33.3% depreciation rate (gross book value Euro 150.000);
o The MAXIMUM DEPRECIATION RATE allowed by Income Tax Law for that
equipment is 20%; the exceeding amount will be deductible when the
depreciation for accounting purposes will be lower (or ended) (so, the amount
exceeding the treshold is currently non-deductible);
o OVER 20% is NON-DEDUCTIBLE
o The depreciation is an increasing temporary variations, because the expense
will be deducted in years 2021 and 2022 (depreciation for accounting purposes
will continue in 2019 and 2020 and further increasing adjustments will be
required: +20.000, +20.000, +20.000, -30.000, -30.000 between 2018 and 2022.
As a consequence, the company shall account for this adjustment a deferred
tax asset.
EXERCISE SET 2
- during year X, ABC has borne costs for Euro 2.500 for the only private benefit of ABC’s
sole shareholder, Mr. Majin Bu;
o Only private benefit of shareholders are NON-DEDUCTIBLE;
o Permanent increasing variation
- during year X, ABC has benefited of subsidies from the local Government for Euro
9.500; these subsidies were paid by the Government to restore all the Italian limited
liability companies from negative eYect of Covid-19
o the subsidies received from the Government to restore from Covid-19 are
EXEMPT FROM TAXATION;
o Permanent decreasing variation
- during year X, ABC has recorded Euro 14.000 as a “contingent litigation payable”
(contingent liability) set up considering risks existing in connection with the legal
38
-
-
-
-
-
proceedings brought against ABC itself by a former employee à the discussion in Court
of the legal proceedings above is still ongoing at the end of the accounting period;
o expenses related to contingent liabilities are deductible only in the fiscal
year in which the loss becomes certain (i.e. when the Court issues the verdict);
o Temporary increasing variation à deferred tax asset
The verdict related to the litigation against the former employee is issued; Company ABC
is condemned to pay Euro 15.000 to restore the former employee. In this case, in this
fiscal year, the cost of year X becomes tax deductible FOR THE AMOUNT: 14,000.
o REVERSAL of 14.000:
o From a tax standpoint, the 14.000 expense in year X was “neutralized” (=
increasing variation, non-deducted), but in 20X+1 the company can deduct a
total of 15.000, out of which:
§ 1.000 are already included in the income statement, so already
included in profit before tax, so don’t require any further adjustment to
compute taxable income.
§ 14.000 are NOT in the X+1 income statement so they need to be
reversed.
Company ABC recorded Euro 16.000 as “unrealized gain on trading securities” à
o the GAINS ON SECURITIES are TAXED ONLY WHEN REALIZED (i.e. when
securities are sold); changes in fair value of securities are unrealized, therefore
irrelevant for tax purposes up to the date of the sale à exempted from taxation.
o Temporary Decreasing Tax Adjustment (Deferred Tax Liability)
Company ABC recorded Euro 6.000 as “advertising expenses” à
o Deducted only up to 1% of the revenues of the year.
o EXCESS NON-DEDUCTIBLE (6000 – rev*1%)
o Permanent Increasing Variation
Company MUXY’s telephone expenses total Euro 10.000 for the year.
o DEDUCTIBLE only for 80% of their amount, 20% is NON-DEDUCTIBLE!
o Permanent Increasing Variation
Company MUXY has start-up costs related to a new factory for Euro 5.000
o Startup costs may either be fully deducted in the year when incurred, or
deducted, ONLY for tax purposes, over 5 years in equal instalments; MUXY opts
to depreciate them for tax purposes over 5 years.
o NON DEDUCTIBLE COST IS = 4000 (5000 – 1/5*5000).
o Temporary Increasing Adjustment (deferred tax asset) à In year 202X there is an
increasing tax adjustment, because taxable income results to be higher than
profit before tax, but in the next years, there won’t be any expense aYecting profit
before tax, but 1.000 expense will be recognized for tax purposes (REVERSAL).
Company MUXY did a charitable donation to the new Hospital of the city for Euro 7.000
o Donations are deductible up to 1% of the revenues of the year
o The exceeding amount is NON-DEDUCTIBLE (7000 – 1%*Rev)
o Permanent Increasing Variation
REVIEW SESSION
- during year X, ABC has borne costs for Euro 32.000 for the use of company vehicles
that are also enjoyed by the employees during their oY-work time à 20% deductible.
- 80% NON-DEDUCTIBLE
o Permanent Increasing Variation
39
-
-
-
during year X, ABC has benefited of a dividend distribution from the controlled
Company XYZ for Euro 23.000 à 95% of DIVIDEND REVENUES is exempted from tax.
o Permanent Decreasing Variation
o N.B. DIVIDENDS PAID DO NOT GIVE RISE TO AN EXPENSE à NO INCOME TAX
EFFECT!!!!!!
during year X, ABC has recorded Euro 6.000 as a bad debt expense / allowance for
doubtful accounts (the allowance is set up for the first time during year X)
o DEDUCTIBLE WITHIN 0,5% of a Company’s outstanding trade receivables,
the exceeding amount is deductible only in case of (and in the fiscal year when)
the uncollectible account is written oQ (the loss occurs).
Company ABC sold some equipment during the year, and recorded a "gain on disposal
of assets" of Euro 17.500 à the “gain on disposal of assets” can be taxed either in a
single tax year, or in 5 equal instalments (one per tax year, in 5 years) and the
management opts to use the instalment approach: 1/5 is taxed every year à exempted
from taxation is the rest.
o Temporary Decreasing Tax Variation à Deferred Tax Liability!!
40
5 – Income Taxes PT 2: Accounting and taxation: transfer pricing & profit
shifting
Transfer pricing (TP) refers to the pricing of cross-border transactions between entities in a
group of companies (associated enterprises). It applies to transactions between associated
enterprises operating in diQerent tax jurisdictions.
Cross border transactions between associated enterprises (international transactions) can
be of a very diQerent nature: transfer of goods, services rendered, sale of intangibles, royalties
on intangibles, financial loans, etc.
Every time associated enterprises operating in diYerent tax jurisdictions enter into a
transaction, both shall measure and record the transaction in their accounting system.
As a result, both have a simultaneous (ex.: sale of goods) or postponed (ex.: financial loan
interest-bearing) impact on the income statement, because one of the two records revenues
and the other associated company records expenses.
Hence, transactions between associated enterprises give rise to the profit shifting, i.e. the
profit is shifted from one company (located in a certain Country) pertaining to a group to
another (located in a diYerent Country).
From the Taxpayer’s perspective
Assume that the Group operates in the fashion industry
producing and selling diYerent brands, registered and
owned by one of the Subsidiaries, which is located in
Singapore.
According to the royalty contract between the Parent
and the Subsidiary, the latter is entitled to ask for
royalties yearly, at a 10% royalty rate based on the
sales recorded by the parent in the previous accounting
period.
From the Tax Authority Perspective
Tax authorities in Country A (ex. Australia) might question the rationale of profit shifting and/or
the related amount (is 10% of the sales “fair”?) whilst in Country B (e.g. Singapore), there would
be no adverse implication.
There is a very subtle line between
- A “fair price” for the intra-group transactions and
- A transaction created, or measured, with the purpose of tax avoidance (à illegal profit
shifting)!
How transfer pricing should be set?
General definitions:
- Transfer Price: amount paid or received by an
enterprise in a transaction with associated
enterprises for the use of property or as
consideration for services.
- Arm’s length price: price at which
independent
enterprises
enter
into
comparable transaction(s).
41
According to the Arm’s Length Principle, the transfer price should not diQer from the
prevailing market price for a comparable transaction. This principle can be considered as:
- The International standard used to compute transfer prices for tax purposes.
- Conditions of commercial and financial relations between associated enterprises
governed by varying market forces
In case the transfer price does not reflect market price / arm’s length principle
- Tax liabilities of AEs and tax revenues of host countries may be distorted – leading to
adjustments.
- Conversely, factors other than tax considerations may distort conditions prevailing
(e.g. governmental pressures relating to customs valuation).
Accounting and transfer pricing are related because:
- Taxes are a huge lever to shift profits, and so the return for investors.
- All profit-shifting agreements must be recorded in the accounting system to generate
their eQects.
- Accounting lays the foundations for building all the transactions, included those intragroup, and for the measurement of the same.
- If you are not strongly familiar with the accounting system, you cannot deal with
transfer price (and more broadly, taxation) issues!
Example – Profit Shifting
Parent Company (PC) controls the 100% of the Subsidiary Company (SC) shares;
PC is located in a high tax jurisdiction (Australia, tax rate 30%) and SC, at the opposite, is
located in a low tax jurisdiction (Singapore, tax rate 17%);
PC sells directly its products in Australia and sells the same products to its SC that is
responsible for selling in Singapore.
The selling price at which PC sells in Australia is 100 AUD/product, at the same time SC sells
in Singapore at 88 SGD/product (exchange rate 1 AUD = 0,88 SGD, so no arbitrage for the final
client buying in Australia or in Singapore, the amount is the same).
PC sells 100 products to Australian clients and 75 products to SC.
1- What if:
- the cost of goods sold for PC is 6.000 AUD,
- the sales price in an arm’s length transaction is 100 AUD/product and
- PC sells to SC at the arm’s length price?
PC Income Statement:
Sales Revenues (100*100) = 10.000
Intragroup Revenues (75*100) = 7500
- COGS = 6000
Profit Before Taxes = 11500
- Tax (30%) = 3450
Net Profit = 8050 AUD
SC Income Statement:
Sales Revenues (100*0.88*75) = 6.600
- COGS (Intragroup Revenues*change = 7500*0.88) = 6.600
Net Profit = 0
Therefore, the total net profit is 8050 AUD.
42
2- What If:
- The cost of goods sold for PC is 6.000 AUD,
- the sales price in an arm’s length transaction is 100 AUD/product and
- PC sells to SC at the HALF OF THE arm’s length price, 50?
PC Income Statement:
Sales Revenues (100*100) = 10.000
Intragroup Revenues (75*50) = 3750
- COGS = 6000
Profit Before Taxes = 7.750
- Tax 30% = 2.325
Net Profit = 5.425 AUD (lower than before)
SC Income Statement:
Sales Revenues (100*0.88*75) = 6.600
- COGS (Intragroup Revenues*Change = 3750*0.88) = 3.300
Profit Before Taxes = 3.300
- Tax 17% = 561
Net Profit 2.739 SGD
Total net profit in AUD 5.425 + 3.112,50(= 2.739/0,88) = 8.537,50 AUD (HIGHER)
The group gained 487,50 AUD (> 5% net profit) only changing the TP applied to associated
enterprises transactions.
REAL LIFE CASES – READ
AMAZON.COM INC. & SUBSIDIARIES (US TAX COURT)
FACTS
In 2005, Amazon US entered into a cost sharing arrangement (“CSA”) with Amazon
Luxembourg (“Amazon Lux”), granting Amazon Lux the right to use certain pre-existing
intangible property (IP) in Europe to operate a website business. Amazon Lux had to make an
upfront “buy-in payment” for the pre-existing intangible property and then annual payments
to fund ongoing intangible development costs (“IDCs”).
In filing its tax return, Amazon US used an unspecified income-based method to determine
that Amazon Lux was required to make a $2254.5 million buy-in payment over seven years.
Upon audit, the Internal Revenue Service (“IRS”) determined that Amazon US’s method was
inappropriate and applied the discounted cash flow (“DCF”) method. Under the DCF
method, the IRS determined that the buy-in-payment should be $3.4 billion. The IRS further
asserted that 100% of technology and content costs constituted IDCs for cost-sharing
purposes. Amazon US disagreed and petitioned the Tax Court, arguing that the IRS’s
determination was contrary to Veritas Software Corp. v. Commissioner, 133 T.C. 297 (2009), a
case in which the Tax Court rejected a method similar to the DCF method for determining buyin payments.
ISSUE
Was the US Tax Court right in applying Veritas decision directly to Amazon’s case? How
should a taxpayer impute useful life of intangibles? Should Comparable uncontrolled
transaction (“CUT”) method be preferred over other methods?
43
DECISION
The Tax Court held that IRS approach to valuing intangible transfers was arbitrary, capricious,
and unreasonable. AYirming its decision on Veritas – Tax Court rejected IRS attempts to
distinguish or overrule Veritas and held:
• The intangibles at issue did not have a perpetual useful life.
• The buy-in payment was not akin to a ‘sale’.
• The workforce in place, goodwill and going concern value should be excluded when
determining buy-in payment.
• Intangibles in at issue should not be valued in aggregate; and
• Transferred website technology decayed in value over its useful life.
Tax Court rejected IRS’s attempt to value transferred intangibles in aggregate, since such
an analysis would have eYectively combined preexisting intangibles and subsequently
developed intangibles. It could also combine the compensable intangibles and noncompensable residual business assets (goodwill, going concern value, etc.).
Tax Court also rejected IRS contention that “realistic alternatives” principle supported IRS’s
application of DCF method. Also supported the use of CUT method over other methods.
The use of perpetual life by taxpayer was also rejected by Tax Court since the same would
include subsequently developed intangibles and preexisting intangibles. Ruled in favor of
Amazon US.
CHEVRON AUSTRALIA HOLDINGS PTY LTD (FEDERAL COURT of AUSTRALIA)
FACTS
Chevron Texaco Funding Corporation (“CFC”) was a wholly owned subsidiary of Chevron
Australia Holdings Pty Ltd (“Chevron Australia”). CFC is a resident of the United States and not
a resident of Australia. CFC borrowed an amount of USD 2.5 billion from the commercial paper
market at rates of interest at or below USD LIBOR (approximately 1.2%).
CFC provided an intercompany loan to Chevron Australia for the AUD equivalent of USD 2.45
billion, under the Credit Facility agreement.
The interest rate under the Credit Facility agreement was AUD LIBOR plus 4.14%
(approximately equivalent to 9%). CFC obtained a guarantee from Chevron Inc, the ultimate
parent of the group for the Fund raised in US bond market by CFC. However, no security was
provided by Chevron Australia and the advance to Chevron Australia was not guaranteed by
Chevron Inc.
Chevron Australia claimed a deduction on interest expense. CFC was not taxable in the US on
the interest income. As a result of the interest diYerential, CFC generated profits and it paid
dividends to Chevron Australia,
which were exempt from tax in
Australia. Chevron Australia in
turn paid dividends to its
shareholder. Commissioner of
Taxation raised assessments in
respect of 2004 – 2008 tax years
of approximately AUD 340m.
ISSUE à Whether the interest paid by Chevron Australia to CFC exceeded the arm’s length
interest rate.
44
DECISION
Chevron Australia was unsuccessful before the Federal Court and appealed to the Full
Federal Court. The Full Federal Court dismissed the appeal.
The main thrust of the decision is that it was necessary to construct a comparable arrangement
in respect of the borrowings that would have been entered into by independent parties dealing
at arm’s length. The Court held that such a comparable arrangement would have included
security and/or a parent company guarantee in respect of external borrowings which would in
turn have a bearing on the interest rate.
The Court contended that a secured and/or guaranteed loan would have been subject to a
lower interest rate than that incurred by Chevron Australia.
The Court eYectively concluded that the taxpayer cannot write the terms of its loan
arrangements with related parties (e.g. to exclude security or a guarantee) and then determine
the arm’s length price according to those terms.
The Court also rejected Chevron’s “orphan theory” which puts forth the argument that Chevron
Australia should be assessed as a stand-alone entity, shorn of all aYiliation to its parent.
Chevron Australia lodged an application for special leave for the matter to be heard by the High
Court (Australia’s superior court). However, Chevron Australia subsequently reached a
confidential settlement with the Commissioner.
45
Analyzing Financial Statements - Part 1
In considering, for example, an investment in a company’s stock, investors should evaluate the
company’s future income and growth potential based on three factors:
- Economy wide factors, represent the environment influencing my company’s
business, therefore the overall health of the economy which often has a direct impact
on the performance of the individual company. Investors should consider data such
as unemployment rate, general inflation rate and changes in interest rates.
- Industry factors, certain events impact a specific industry diYerently than other
industries or the economy as a whole. Contained in the Economy wide factors.
- Individual company factors, inside those, we define the working process of the
company. To properly analyze the company, good analysts do not rely solely on the
information reported in a company’s financial statements and other reports, they visit
the company, buy its products, assess product oYerings and service it provides. In
repeatedly doing so overtime, the company is in good position to assess whether the
company’s statement about price and assortment are true.
Besides analyzing these factors, investors should understand the company’s business
strategy when evaluating financial statements. This directly aYects the financial statement
accounts.
While financial statements reflect
transactions, each of those transactions
is the result of a company’s operating
decisions as it implements its business
strategy.
Provided
that
financial
statements are “THE” document of a company, a comprehensive understanding of the F/S of a
company is crucial to understand its whole business purpose and mission!
Financial statements provide information to:
• External Decision Makers
o Present and potential owners
o Investment analysts
o Creditors
o Banks
o Tax Authority
• Internal Decision Makers
o Board of Directors
o Managers
o Key employees
o Consultants
Financial statements help people make better economic decisions. In particular, published
financial statements are designed primarily to meet the needs of external decision makers.
External decision makers: limited information package available
The external decision makers (potential shareholders, lenders, employees with limited
access to financial information, suppliers, clients…) have access ONLY to the «oQicial»
financial statements of a limited liability company, downloadable from the Public Register
of Companies (and on the website, on a voluntarily basis). These statements show:
• Aggregated data
• Limited information
46
• In many cases, only details required by the applicable law.
Examples: you don’t have information on the list of customers and/or suppliers and
obliviously, on the contractual agreements in terms of discounts, prices, payment time line;
you don’t know which and how many tangible and intangible assets are owned and used by
the company apart from the broad reclassification in the statements, you don’t know the value
in use of an asset unless it is impaired and in any case how this is calculated,...
Financial statements are presented under standard formats, for US GAAP (the so-called 10K filing) or for IAS/IFRS companies (ESEF format) or for ITA GAAP (the so-called XBRL format
à Extensible Business Reporting Language).
Which is the content of a full set of financial statements?
Income Statement and Balance Sheet are always compulsory, everywhere. All the other
statements, notes, reports may be required or not, based on several factors (mainly, the size
of the entity).
DiYerent types of financial statements:
- U.S Financial Statements (10-K filings)
o required by the U.S. Securities and Exchange Commission (SEC).
o one of the most comprehensive and most important documents a public
company can publish on a yearly basis.
o information includes corporate history, financial statements, earnings per
share, and any other relevant data.
o Requires XBRL tagging.
- EU Financial Statements
o From 2020, issuers on EU regulated markets are required to prepare their IFRS
annual financial reporting in a European Single Electronic Format (ESEF)
according to the XBRL format.
Content diYers on the basis on the type of financial statement:
U.S Financial Statements (10-K filings) à 5 distinct sections:
1. Business: overview of the company’s main operations.
2. Risk factors: outline of any and all risks the company faces or may face in the future.
3. Selected financial data: financial information about the company over the last five
years.
4. Management’s discussion and analysis (MD&A): financial condition and results of
operations.
5. Financial statements and supplementary data: company’s audited financial
statements (the income statement, balance sheet, and statement of cash flows). A
letter from the company’s independent auditor certifying the scope of their review is
also included in this section.
Plus, other reports (non-financial statements), like ESG report/Sustainability report etc.
EU Financial Statements à Distinct documents (related to the type and size of the
company):
1. Company’s separate financial statements (IS, BS, statement of cash flows and
statement of stockholders’ equity).
2. Consolidated Financial Statements.
3. Minutes of the shareholders’ meeting with the approval of the F.S.
4. Directors’ management report.
5. Board of auditors’ report
47
6. List of company associates.
7. Audit (firm’s) report.
Internal Decision Makers: Full Information Package Available
Internal decision makers (Board of Directors, auditors, key managers, and also consultancy
companies in charge for projects, ...) have access to the full financial information package.
What do we mean with «full information package»? IT DEPENDS ON THE TECH QUALITY OF
THE ACCOUNTING SYSTEM. The larger is the company, the more crucial is the accounting
system: the IT infrastructure shall be adequate to the number and complexity of transactions.
Main issues:
1. Sometimes, IT systems are not adequate / timely for reporting purposes.
2. Interrelations between diYerent accounting software can cause relevant reporting
issues (example of diQerent software in the same company: one to issue invoices to
customers, one to match credit card sales with invoices, one to keep track of orders
from clients, one to record inventory increase and decrease, one to allocate properly the
employees ‘expenses...)
3. To use an accounting software, employees must be trained, and training takes time,
and it is expensive!
F/S Reclassification
As we pointed out before, the «external user» has a limited dataset available, whilst the
«internal user» has full access to the financial information of the company.
All the activities related to the F/S analysis can be carried out by both categories of users;
nevertheless, obviously, the output generated by an «internal user» can be much more
accurate than the output of an «external user», due to the limited information the external
user is provided with.
This is the reason why in the M&A transactions there is the due diligence period, during which
professionals appointed by the buyer (sometimes in contraposition with the professionals
appointed by the seller) get access to full set of data of the Target.
The main F/S analysis activities are:
1. F/S reclassification
2. Calculation of component percentage
3. Ratio analysis.
The main purpose of the Financial Statements Analysis is
the ASSESSMENT OF THE PERFORMANCE AND THE
SOUNDNESS OF THE FIRM, ACCORDING TO THE
FOLLOWING MAIN DIMENSIONS
Some typical questions:
• Is the profit that is being earned satisfactory?
• Is the company able to face its liabilities?
• Is the long-term capital structure suitable?
• Is eYicient use being made of assets and resources?
• Is the company growing?
Financial Statements Reclassification/Reformulation
When we talk about diQerent “formats” of financial statements drawn up by reclassification,
we mean diQerent ways to arrange (i.e. to put in order) the items inside the balance sheet and
the income statement.
48
Preparing the financial statements according to diYerent formats helps the user to determine
intermediate/partial results (or ratios) which are meaningful to understand the performance
and the soundness of the business entity.
Preparing financial statement formats is sometimes called “reformulation of financial
statements”. It follows best practices, and some approaches are well established.
NOTE: there is no rule or law regulating how to prepare reclassified financial statement
formats.
If you look at diYerent handbooks on financial statement analysis, you find diYerent formats,
using diYerent labels or, even worse, using the same label with a diYerent meaning. What is
important is CONSISTENCY in the definitions used and a clear understanding of what is behind
each of them.
BS Reclassification
DiQerent formats provide diQerent information. As for the Balance sheet there are formats
which focus on:
- Liquidity and Solvency: items on the BS are divided in short/long term assets and
liabilities.
- Business Functions: this reclassification classifies the BS items according to the
company’s business (e.g. investment, operations, and financing).
Reclassified balance sheet format with focus on liquidity and solvency: assets are
classified according to their liquidity; liabilities are classified according to their maturity.
49
IS Reclassification
Income statements formats, for FSA purposes, can assume numerous and diQerent
formats. This will depend on specific needs of the analysis and of the analyst.
For the income statement most of the formats required by the standards are a good starting
point for making the FSA analysis (i.e. with no needs to change them). US GAAP and IFRS
formats report most of the information that it is used for carrying out the analyses.
One standard format that represents a good example of an Income Statement where all
relevant info for a proper basic FSA is reported.
NET SALES: this is always the first item in a multiple step income statement, and it consists
of total sales net of returns and allowances.
COST OF GOODS SOLD: this is often reported in a more detailed way.
- In particular: for a merchandising company, CGS is:
o Purchases (i.e. cost of merchandise purchased) +/- Δ inventory.
- for a manufacturing company, CGS is:
o Production costs (typically listed in detail) +/- Δ inventory.
GROSS PROFIT (OR GROSS MARGIN) gives an idea of how profitable the core of the business
activity is. The profitability at this level must be able to cover all the other expenses the
company has to bear. Problems at this level are very alarming!
OTHER OPERATING REVENUES include other revenues arising from the operating activity,
such as rentals, license fees, etc.
GENERAL AND ADMINISTRATIVE EXPENSES typically include, for example:
- Administrative staQ salaries, bonuses etc. and related costs (including social security
and pensions costs).
- Directors’ executive salaries and related costs.
- Costs related to fixed assets used for the G&A activity (e.g. depreciation and
maintenance of buildings, etc.).
- Research costs.
- Professional fees.
SELLING EXPENSES typically include:
- Sales salaries, commissions and bonuses and related costs (including social security
and pension costs).
- Advertising and promotion costs.
- Warehousing costs.
- Transportation costs.
- Costs related to fixed assets used in the selling activity (including depreciation and
maintenance costs).
50
EBITDA is the operating income without considering depreciation and amortization
expense. This is the most important item of the whole F/S.
DEPRECIATION AND AMORTIZATION are the depreciation and amortization of long-lived
assets.
OPERATING INCOME is often called EBIT, that is “Earnings before interest and taxes”. O.I.
is one of the most important pieces of information on which one should focus to analyze
financial statements: it shows if and how profitable is the core activity of the company, apart
from the way such activity is financed.
- O.I. tends to be stable in time, if no change in the strategy of the company takes
place.
- If O.I. is negative or too low, a restructuring process is probably needed to save the
company.
Then we have the financial revenues and expenses, the Earnings Before Taxes (EBT), taxes
and Net Income.
The importance of comparability
Analyzing financial data without a basis for comparison is not informative à financial results
cannot be evaluated in isolation. To properly analyze the information reported in financial
statements it’s necessary to develop appropriate comparisons. Two general methods for
making financial comparisons:
- Comparison Across Time or Time-series Analysis. Information for a single company
is compared overtime.
- Comparison Across Companies or Cross-sectional analysis. Information for multiple
companies is compared at a point in time or across time. We have seen that financial
51
results are often aQected by industry and economy wide factors, by comparing
companies in the same line of business, an analyst can gain better insight on the
company’s performance. Typically, information regarding key competitors and
industry average is compared.
Comparisons can be developed through 2 approaches:
- Horizontal Approach:
o Line-by-line comparison of the
accounts with those of the
previous year.
o It provides, over a number of years,
a trend of changes, decline or
growth (i.e. «time series analysis»)
- Vertical Approach:
o It provides evidence of structural
changes in the accounts: i.e.
increased profitability through
more eYicient production, or
greater dependence on borrowing
to finance new investment.
o “Component percentage”: expression
of each item on a financial statement as
a percentage of a single base amount.
In this case the base amount is Sales.
52
Analyzing Financial Statements – Part 2
Ratios: general overview
Ratio analysis is an analytical tool that measures the proportional relationship between two
financial statements amounts. Ratios are then to be interpreted, and it requires experience
and judgement! Financial Analysis is NOT A MECHANIC PROCESS!
REMEMBER: when you compute ratios:
- Balance sheet amounts are as of a SPECIFIC POINT IN TIME
- Income statement amounts relate to A PERIOD OF TIME
To adjust for this diYerence, most analysts use the AVERAGE Balance Sheet Amount when
comparing a balance sheet number to an income statement number.
Among many ratios that can be computed using a company’s financial statements, analysts
focus on THOSE THAT ARE MOST USEFUL IN A GIVEN SITUATION.
The clearer are the questions analysts want to be answered (based on the sector and on the
research question), the easier to select the most appropriate ratios to compute. Ratios can
be grouped in the following categories:
A. profitability ratios + profitability metrics
B. eQiciency ratios (also called: asset turnover ratios)
C. liquidity ratios
D. solvency ratios
E. market ratios
Profitability Ratios
Profitability is a primary measure of the overall success of a company. These ratios focus
mainly on net income and how it compares to other items reported in financial statements.
- Return on Equity (ROE) = Net Income/Average Total Stockholders Equity,
o Measures the income earned on the shareholder's investment in the business.
It reflects that investors expect to earn a return on the money they invest in a
company.
o Ability of the company in earning profits for its shareholders.
o Influenced by the financing decisions and other factors non-profitability
related (ex.: treasury shares).
Example: suppose company A earned 390.00 percent on the owners’ investment.
Another way to interpret this is to say that, for every 1$ equity investors contributed
to Company A, the company earned $3.90 in fiscal year 2020. To check whether this
return is good or bad, we need to compare it with prior years or with other
competitors’ ROE in 2020. Company B had registered in 2020 a ROE of 406.50
percent, indicating it produced a better return on its owners’ investment than
company A. But this ratio needs to be taken with caution.
- Return on Assets Ratio (ROA) = Net Income/Average Total Assets,
o Measures how much the firm earned for each dollar of investment in assets.
o It is the broadest measure of profitability and management eYectiveness,
independent from the financing strategy.
o Firms with higher levels of ROA are performing better, all other things equal. It
means that these companies are using their assets to generate income more
eYectively.
o If ROA > Cost of debt, the company takes advantage of the financial leverage.
o Sometimes it is modified by adding interest expense NET OF TAXES to the
numerator.
53
-
Gross Profit Margin Ratio = Gross Profit/Net Sales Revenue,
o Recall that Gross Profit = Net Sales – Cost of Sales
o Measures a company’s ability to charge premium prices and produce goods ad
service at low cost.
o Good measure of operating eQiciency
o All other things equal, a higher gross profit results in higher net income.
Example: If company A has a gross profit margin ratio of 33.01 percent, it means that,
after subtracting cost of sales, the company has between 33 and 34 cents of each
dollar of sales remaining to cover the other expenses. The fact that Company A
and B might have the same GPMR indicates that the companies likely follow similar
business strategies, sell similar products and perhaps even sourced from same
suppliers.
- Net Profit Margin Ratio = Net Income/Net Sales Revenues,
o Measures how much of every sales dollar generated during the period is profit.
o The higher is, the more eQicient is the management of sales and expenses,
so it is a great measure of operating eYiciency.
N.B. “Gross profit margin” and “net profit margin” should never be analyzed in isolation
because they do not consider the resources needed to earn income; specially for these two
ratios, you shall always compare companies operating in the same industries (i.e. food
industries/jewelry industries). For example, profit margins are low for the food industry while
are high in the jewelry industry. BUT Both can however be profitable because high sales
volume can compensate for a low profit margin. We cannot say that one is more profitable
than the other if they belong to two diQerent industries!! Grocery stores generate high sales
volume from a broad customer base that tends to purchase on a daily basis. Instead, luxury
stores have low sales volume because fewer people purchase it, and almost always
occasionally.
- Earnings per Share (EPS) = Net Income/Weighted Average Number of Common
Shares Outstanding,
o Measure of return on investment based on the number of common shares
outstanding à Emphasizes the amount of earnings attributable to a single
share of outstanding common stock. Like a ROE but based on the number of
Common Shares Outstanding.
o There is a base EPS and a diluted EPS.
o A comparison across companies might be misleading due to the diYerent
number of shares issued.
o One of the most widely reported ratio and the only ratio required by GAAP à
weighted average #shares and the EPS can be found at the bottom of the
companies’ income statements.
o EPS could be altered by selling/repurchasing shares of common stock. For
instance, repurchasing shares of common stock reduces the denominator
without aYecting Net Income, therefore, it increases the EPS.
- Quality of Income Ratio = Cash Flow from Operating Activities/Net Income,
o It focuses on the ability to generate cash.
o Shows proportion of net income that was turned into cash.
o It is expected to be > 100%, which means that each dollar of income is
supported by one or more dollars of cash flows; when it is below 100%, the
company has lower-quality income and it is likely that the company is
54
experiencing problems with changes in Net Working Capital (ex: accounts
receivable increase).
o Accounting policies might influence net income, reporting it higher. Because
of that, most financial analysts are concerned about the quality of a
company’s income. For example, a company that uses a short, estimated life
for a depreciable asset will report lower income in the asset’s early years with
respect to a company using long estimated life.
The DuPont Model (ROA and ROE break down)
The DuPont model helps understanding what lays behind the company’s performance and it
is used by analysts to better assess how a company is implementing its business strategy,
trough the examination of ROA and ROE across time:
Examining the additional info on the right side
gives analysts a richer story about the
company’s performance. For instance, the fact
that the ROA can be increased via increasing
a company’s net profit margin or by increasing
revenues generated from its asset base.
For example, if Home Depot ROA in 2019 was 23.61% and in 2020 decreased to 21.12%, what
drove the decrease? The decrease was driven by a decrease in profit margin (from 10.20% to
9.74%) and a decrease in asset turnover (from 2.31 to 2.17). This means that Home Depot was
less eQective at using its assets to generate revenues and less eQective to earn a profit on
the revenues it earned.
Including a third component: financial leverage, we commonly refer to the Dupont Model.
Financial leverage is the
diYerence between ROE and
ROA and reflects how much a
company uses its liabilities to
leverage up its return to
stockholders.
Therefore: ROE = ROA x Financial Leverage = ROA x Assets/Equity.
------------------------------------------------------------------------EXAMPLE of PROFITABILITY RATIOS: THE HOME DEPOT
ROE = Net Income/Average Total SE = $12.866/$3299 = 390.00%
Return on Equity relates income earned to the investment made by the owners. Investors
expect to earn a return on the money they invest. Normally it’s used average equity for
denominator; since it was negative in fiscal 2019 and 2018, in this case we used equity ending
balance for fiscal 2020 (Home Depot had repurchased treasury stock from the market).
On average, for every $1.00 equity investors contributed to The Home Depot, the company
earned $3.90 in fiscal 2020.
ROA = NET INCOME/AVERAGE TOTAL ASSETS = $12.866/$60.909 = 21.12%
This ratio compares income to the total assets used to generate the income. On average, for
every $1.00 of assets reported on The Home Depot’s balance sheet, the company earned just
over 21cents in fiscal 2020.
Gross Profit Margin Ratio = Gross Profit/Net Sales Revenue = $44.853/$132.110 = 33,95%
55
The gross profit margin (also referred to as gross profit percentage) reflects gross profit as a
percent of sales. If not shown separately on a company’s income statement, gross profit is
computed by subtracting cost of sales from net sales.
After subtracting the direct costs associated with selling products, The Home Depot had
approximately 34 cents of each dollar of sales remaining to cover other expenses.
Net Profit Margin Ratio = Net Income/Net Sales Revenue = $12.866/$132.110 = 9,74%
This ratio reflects net income as a percentage of sales. For fiscal 2020, each dollar of The Home
Depot’s sales generated over 9 cents of profit. For each dollar of sales, The Home Depot is
subtracting just around 90 cents in expenses.
EPS = Net Income/Weighted Average Number of Shares Outstanding = $12.866/1.074 =
$11,98
Measure of return on investment that is based on the number of common shares outstanding.
Average number of shares outstanding is reported on the bottom of the income statement.
Earnings per share is probably the most widely reported financial ratio (as just said the only
ratio required by GAAP). Keep in mind that managers can significantly alter EPS by selling or
repurchasing shares of common stock.
Quality of income Ratio = Cash Flow from Operating Activities/Net Income =
$18.839/$12.866 = 1.46
A ratio higher than 1 indicates high-quality income because each dollar of income is supported
by one or more dollars of cash flows.
Some accounting procedures can be used to report higher income: for example, a company
that uses a short estimated life for depreciable asset will report lower income in asset’s early
years relative to an identical company that uses a longer estimated life.
--------------------------------------------------------------------------EQiciency Ratios
Asset turnover ratios, or eYiciency ratios, are crucial to measure the ability of a company:
- To generate revenues in relation to the total assets, and therefore how eYiciently the
company uses its assets;
- To manage eQiciently its payables, inventories and receivables.
In reference to the latter, the terminology worldwide used in the real- world of professions is
DSO, DPO, DIO:
- Days Sales Outstanding,
- Days Payables Outstanding,
- Days Inventory Outstanding.
Excellence in managing the DSO/DPO/DIO can generate high benefits to shareholders (see
next slides). For instance: ability to sell inventory, ability to collect receivables etc.
For the above reasons, mainly internal operators (CFOs; consulting companies) are busy on
their day-by-day activities to improve these ratios.
56
Basically, this is called the working
capital management, because
inventory, accounts receivables
and payables are the main
elements of the working capital.
Management of the company’s
cycles (operations; accrual; cash)
is crucial:
-
Total Asset Turnover Ratio = Net Sales Revenue/Average Total Assets
o Captures how well the company uses all its assets to generate revenues.
o The higher is, the more eQicient is total assets usage.
o A declining asset turnover ratio overtime is something to keep an eye on in the
future.
- Fixed Asset Turnover Ratio = Net Sales Revenue/Average Net Fixed Assets
o Captures how well the company uses its "fixed assets" (PP&E) to generate
revenues.
o The higher is, the more eQicient is net fixed assets usage.
- Receivable Turnover Ratio = Net Credit Sales/Average Net Receivables
o Sometimes, when net credit sales are not specified, net sales are used as an
approximation.
o Being able to eYiciently collect receivables is crucial for a company. This ratio
shows how many times in a year the company collects its accounts receivable.
o The higher is, the faster and the more frequent is the collection of receivables.
o A higher ratio benefits the company because it can invest the money
collected to earn interest income or reduce borrowings to reduce interest
expenses.
o Granting credit to costumers with poor credit and ineQective collection eQorts
will produce a low receivable turnover ratio.
o Very low and very high ratios are both a problem. A very high ratio can be
troublesome because it suggests a stringent credit policy that could cause lost
sales and profits.
The receivables turnover ratio is often converted to reflect the number of days on average it
takes for a company to collect its receivables.
- DSO = Days of Sales Outstanding = Average Days to Collect Receivables =
365/Receivables Turnover
o Indicates the average time (numbers of days) it takes receivables to convert in
cash.
o The higher is, the greater the time needed to collect cash (so it is good when it is
low), therefore the less the eYiciency.
o Sometimes it is not meaningful.
- Inventory Turnover Ratio = Cost of Goods Sold/Average Inventory
o Like the receivables turnover ratio, it’s a measure of operating eQiciency.
o Reflects how many times average inventory was produced and sold during the
period.
57
o A higher ratio indicates that inventory moves more quickly through the
production process to the ultimate customer, reducing storage and
obsolescence costs.
o Company usually realizes profits each time inventory is sold so an increase in
this ratio is usually favorable. But if it is too high, it might indicate that sales
were lost because desired items were not in stock. A company must balance the
cost of holding inventory and the potential cost of losing a sale.
o Turnover ratios vary significantly among industries. Grocery stores usually
have high inventory turnover ratio because their inventory is subject to rapid
deterioration. While those companies that sell expensive merch have lower
inventory turnover ratios because sales are less frequent.
Like receivable turnover, this ratio is converted to reflect the number of days it takes for a
company to sell its inventory.
- DIO = Days inventory outstanding = Average Days to Sell Inventory = 365/Inventory
Turnover
o Indicates the average time (days) it takes the company to sell its inventory
o The higher is, the less eQicient is the production process (so it is good when it is
low). (Same with DSO)
- Payables Turnover Ratio = CGS/Average Accounts Payable
o Shows how many times in a year the company pays its suppliers.
o A higher ratio normally suggests that the company is paying its suppliers in a
timely manner.
- DPO = Average Number of Days Payables are Outstanding = 365/Accounts Payable
Turnover
o Indicates the average time it takes payables to be paid in cash
o The higher is, the greater the time (days) the company takes to pay back its
accounts payable, so BETTER.
RECALL: The Operating Cycle is the time it takes for a company to pay cash to its suppliers,
sell goods to customers and collect cash from costumers. It is considered a measure that helps
analysts to evaluate the company’s cash needs and operating eYiciency. Ceteris paribus, the
optimal management of DPO, DSO and DIO is a leverage to increase the value of a
company. WHY?
• DSO: the sooner the company collects cash from its customers à the higher cash is
available. à THE LOWER THE BETTER
• DIO: the less time products stay in inventory à the less time it takes then to get cash
from sales à THE LOWER THE BETTER
• DPO: THE HIGHER THE BETTER
o the longer it may take to pay the suppliers, the better it is
o If a company has low DPO, it likely needs external short-term financing (banks)
which is interest-bearing (so reduces profit).
o If a company has good DSO and DIO, it can opt to pay sooner the best suppliers
(good suppliers = good operations) and/or it can ask for discounts (= more
profit!).
The above (specially for DSO and DIO) is valid for any company, in any business sector.
58
For example, Home Depot has:
- DPO = 40.56
- DIO = 65.17
- DSO = 7.04
So it pays suppliers for inventory on average 40 days AFTER it received it. It takes 72 days
(DIO + DSO = 65.17 + 7.04) to sell inventory and collect cash from the sale. Therefore, the
company must invest cash in its operating activities 32 days (72 – 40), between the time it
pays the suppliers and the time it collects cash from costumers. Companies prefer to
minimize this time because it gives the possibility to use cash for other productive purposes.
How could it reduce it? By slowing payments to creditors (increasing DPO) or increasing how
quickly it turns over its inventory.
Liquidity Ratios
Liquidity ratios focus only on current assets (or specific assets among the current assets)
and current liabilities, because most short-term obligations will be paid with current assets.
These ratios are usually analyzed across years and/or in comparison with other companies
operating in the same sectors.
- Current Ratio = Current Assets/Current Labilities
o It measures to what extent a company’s total current assets cover its total
current liabilities on a specific date.
o A ratio < 1 and decreasing generally gives concerns. Analysts would want to
know how the company intends to meet its short-term obligations.
o Broadly speaking It should be between 1 and 2 (time for converting stocks and
receivables in cash should be considered as payments of taxes, dividends, so
on), it implies that a company’s current assets are suYicient to cover its short
term obligations.
o What matters the most is that it should be stable during the years.
o To optimally use it, analysts need to understand the nature of the company’s
business. Many manufacturing companies have developed a sophisticated
system to minimize the amount of inventory they must hold. These are called
just-in-time inventory, designed to have an inventory item arrived when
needed. However, it doesn’t work well for retail companies, as customers expect
to find merchandise at the store when they want, and customer behavior is
diYicult to predict. Therefore, retail companies have high current ratios because
they carry high inventories.
o Optimal level depends on the business environment in which a company
operates. If cash flows are predictable and stable, the current ratio can be low,
even below one. Instead, when cash flows are highly variable, a higher current
ratio is desirable.
o If a company current ratio is high compared to that of other companies in its
industry is a concern. If a firm ties up too much money in inventory or account
receivable is operating ineQiciently. Moreover, recall that current assets other
than cash need to be converted to cash BEFORE they can be used to satisfy
current obligations.
59
-
Quick Ratio (acid test) = (Marketable Securities + Cash & Cash Equivalents + Net
Accounts Receivables)/Current Liabilities
o Current ratio criticized because inventory is not readily convertible in cash. In
fact, this ratio doesn’t include Inventory (because of uncertainty related to the
timing of cash flows) and Prepaid Expenses.
o This ratio provides a stricter test of short-term liquidity, as it compares quick
assets (cash and near cash assets) to current liabilities. Again, it measures
whether the highly liquid assets (converted quickly into cash) are suYicient to
cover current liabilities.
o It should not fall below 1, same reasons as current ratio.
o Important to know the extent to which unused loans and overdrafts are available.
- Cash Ratio = Cash&Cash Equivalents/Current Liabilities
o Cash is the lifeblood of a business. Without it, it couldn’t pay salaries or meet
obligations to creditors. Even a profitable business would fail without suYicient
cash.
o It’s the most stringent test of liquidity; it relates cash on hand to the total
current liabilities recorded in the statements.
o Measures how much a company can pay oY its current liabilities with only cash
and cash equivalents.
o A cash ratio > 1 is unusual. Investors are not concerned if the cash ratio is low:
this is because not all the current liabilities need to be paid immediately, so the
company doesn’t need to keep cash at hand at a given point in time so that it
suYiciently covers all the short-term obligations. Instead, holding excessive
amount of cash means that the company is not investing the cash in more
productive assets to grow the business.
Stability across years and similarity across companies are appreciated by analysts. On the
opposite, a changing ratio (decreasing or increasing), or a ratio diQerent from the
competitors, may be a warning.
Examples:
1) Company ABC’s current ratio is higher than the competitors’, but quick ratio is same.
This means that the inventory management is not eQicient (too much inventory
outstanding!!)à need to work on DIO.
2) Company ABC’s cash ratio is decreasing. Is the company improving its DPO or is it less
able to meet its short term obligations because of lower cash generation?
3) ABC’s quick ratio is increasing. Is there any uncollectible receivable not recorded?
Solvency Ratios
Solvency ratios are very important for banks and for external analysts because they
represent in a nutshell the balancing between liabilities and stockholders ‘equity and they
are a good proxy of the possibility for the company to ask for further debt, especially the D/E
ratio.
Some analysts focus only on the interest-bearing debt (excluding wages payable, accounts
payable, contingent liabilities...) to calculate solvency ratios.
Also, these analysts are very interested to the amount of interest-bearing debt because it is
used to calculate NFP, Net Financial Position, which – together with EBITDA – is the most
important item worldwide that can be found in the financial statements.
There is not an optimal structure of debt and equity for all companies and/or all sectors of
activity, but broadly speaking, the higher is the leverage à the riskier is the company.
60
Solvency refers to the company’s ability to meet its long-term obligations.
- Times Interest Earned Ratio = (Net Income + Interest Expense + Income Tax
Expense)/Interest Expense
o This ratio represents the importance of companies to meeting interest
payments. If a company fails to meet interest payments, creditors can force it
into bankruptcy.
o Relation between interest obligation and profit available to pay it in the same
period. Interest Expense and Income Tax expense are added because these
amounts are available to pay interest.
o It is a margin of protection for creditors. High ratio = secure position for
creditors. à THE HIGHER THE BETTER.
o Many analysts though believe that this ratio is flawed because interest expense
is paid in cash and not with net income. These analysts prefer to use the cash
coverage ratio.
- Cash Coverage Ratio = Cash Flows from Operating Activities/Cash Paid for interest
o It states the number of times the cash flows from operations cover the interest
payment to lenders
o Some analysts modify it by adding back to the numerator interest paid and
income taxes paid. These are typically disclosed separately below the cash flow
statement of the company.
- Debt-To-Equity Ratio = Total Liabilities/Total Stockholders’ Equity
o Express a company’s debt as a proportion of its stockholders’ equity
o A high ratio indicates that a company relies heavily on debt financing relative
to equity financing. Heavy reliance on debt financing increases the risk that a
company may not be able to meet contractual financial obligation. With debt
financing, specific interest payments need to be paid even if the company
hasn’t generated suYicient income to pay them. Dividends are instead at the
company’s discretion and are not legally enforceable unless declared by the
BoDs. Borrowing money however has some advantages, indeed, most
companies obtain significant number of resources from creditors. For instance,
interest expense is deductible on a company’s income tax return. These benefits
together with the contractual obligations result in companies using a mix of debt
and equity financing, which is evaluated via the ratio.
o This ratio is also influenced by the policies of dividends payment of a company.
o Broadly speaking, a D/E ratio between 2 and 4 is considered reasonable.
Market Ratios
These ratios relate the current price per share of a company’s stock with the return that accrues
to shareholders (earnings or dividends per share).
- Price-Earnings Ratio (PE) = Market Price per Share/EPS
o Measures the relationship between current market price and EPS
o Market price reflects the expectations of the market for future earnings. The ratio
reflects the stock market’s assessment of a company’s future performance.
o High ratio à earnings are expected to grow rapidly. But there is a risk: when a
company with high P/E does not meet the level of earnings that are expected by
the market, then its stock is negatively aQected.
o It is based on future subjective expectations, not on actual past figures,
because the value of the stock is the expected present value of the company’s
61
-
future earnings. So a company that expects to increase its earnings is worth more
than a company that cannot grow its earnings.
Dividend Yield Ratio = Dividends per Share/Market Price per Share
o Measures how much a company pay out in dividends relative to its share price
o Reflects the return on investment absent any capital appreciation (i.e. the
return attributed solely to the dividends a company pays). RECALL: when an
investor buys a company’s stock it can either earn via dividends or stock price
appreciation.
o The cash dividend is not always reported (search their 10-K)
o The dividend yield for most stocks is not high compared to alternative
investments:
§ Investors accept low dividend yield if they expect the stock price to
increase while they own it.
§ Instead, stocks with low growth potential tend to oYer much higher
dividend yields than stocks with high growth potential. Usually, the
former appeals to retired investors who need current income.
62
RATIOS RECAP
RATIOS
PROFITABILITY RATIOS
ROE
ROA
Gross Profit Margin Ratio
Net Profit Margin Ratio
Earnings Per Share
Quality of Income
Net Income/Average Total Stockholder Equity
Net Income/Average Total Assets
Gross Profit/Net Sales Revenues
Net Income/Net Sales Revenues
Net Income/Weighted Average Common Shares Outstanding
Cash Flow from Operating Activities/Net Income
EFFICIENCY RATIOS
Total Asset Turnover Ratio Net Sales Revenues/Average Total Assets
Fixed Asset Turnover Ratio Net Sales Revenues/Average Total FIXED Assets
Receivable Turnover Ratio Net Credit Sales/Average Net Receivables
DSO
365/Receivable Turnover Ratio
Inventory Turnover Ratio
Cost of Goods Sold/Average Inventory
DIO
365/Inventory Turnover Ratio
Payables Turnover Ratio
Cost of Goods Sold/Average Accounts Payable
DPO
365/Accounts Payable Turnover
LIQUIDITY RATIOS
Current Ratio
Quick ratio (Acid Test)
Cash Ratio
Current Assets/Current Liabilities
(Merketable Securities + Cash&Cash Equivalents + Net Accounts Receivables)/Current Liabilities
Cash&Cash Equivalents/Current Liabilities
SOLVENCY RATIOS
Times Interest Earned Ratio (Net Income + Interest Expense + Income Tax Expense)/Interest Expense
Cash Coverage Ratio
Cash Flow from Operating Activities/Interest Paid
Debt-To-Equity Ratio
Total Liabilities/Total Stockholders Equity
MARKET RATIOS
Price-Earnings Ratio (PE)
Dividend Yield Ratio
Market Price per Share/EPS
Dividends Per Share/Market Price per Share
63
Analyzing Financial Statements – PT 3
Forecast, Budget and Business Plan
Mastering Accounting is necessary to prepare three fundamental documents:
- Forecast
- Budget
- Business plan.
The Forecast consists in the prediction of income statement and cash flow statement for
the ongoing year (example: in March 2024 the forecast contains the monthly, or quarterly,
predictions until December). Sometimes balance sheet is not included in the forecast
because its purpose is to monitor only in the short term:
- monthly net income
- cash available.
The Budget is the prediction of IS, BS and CFS for the subsequent accounting period and
usually it is prepared in the second half of the year (example: in October 2024 the budget 2025
is approved by the Board). Its purpose is to set the financial targets for the next year.
The Business Plan is the prediction of IS, BS and CFS for the subsequent three or five years,
and it is a key document for a number of purposes: impairment test (it is used to estimate
future cash flows), long-term investment decisions (if we buy a new production plant, will it
generate profits and cash inflows?), estimate of the company’s market value.
All the three documents are prepared after an accurate analysis of the historical IS, BS, CFS
and after a component percentage calculation. These documents, and specially the
Business Plan, are formally approved by the Board of Directors.
An example of a Business Plan prepared in 2011 (Budget 2011, plan from 2012 on)
64
Rating agencies and analyst reports
Rating agencies and Financial Analysts are:
• Expert in firms’ valuation
• Highly visible and qualified
• Provide Recommendations and Target Prices
What do they do?
They “Filter” the information released by the firms and insert it in their own evaluation
process. The elaboration of the information ends with the output of the specific activity of an
analyst: the production of the analyst reports.
What is an “analyst report”? Basically, the analyst’s work can be represented as a “step by
step” procedure:
• from the collection and the elaboration of the information,
• to the conversion of the forecasts into the estimation of the firm value
• and the formulation of target prices and stocks recommendations that can influence
the market behavior.
The main output is a simple question with a multifaceted – yet always incomplete – answer:
Would you invest into Company X, do you have some money to do so?
Forecast Firms’ Future Value
Three main types of “analyst report”:
• Initial Coverage – first time an analyst issues a report.
• Analyst Report – regular reports on a constant basis.
• Updates – needed when firms’ related event might influence firms’ value.
Focusing on Analyst reports:
Use - and elaborate on - firms financials.
In the middle the Conventional Perspective:
Accounting reflects Economic Reality.
Recall:
Would you invest into company X, had you
some money to do so?
65
The valuation multiples
The valuation multiples are one of the two most common ways to calculate the market value
of a company (= to evaluate a company) starting from the data of the financial statements.
Multiples are a very quick method to calculate a broad range of a company’s market value, as
follows (see also the example in next slide):
• First, you shall select an accounting item in the statements of the company that shall
be evaluated (“Target”). (Example: net income, also called net earnings, of a
company).
• Second, you shall select a sample of comparable companies operating in the same
industry, with public data available (example: listed companies), and it shall be
calculated a ratio in which:
o the numerator is the market value (price),
o and the denominator is the same accounting item selected for the non-listed
company
Example: Price/Earnings, also called P/E ratio. The P/E ratio is an equity side multiple
• Third, you shall multiply:
o [accounting item selected for the Target] X [market multiple] = [market value
of the Target].
------------------------------------------------------------------------EXAMPLE
ABC is a company operating in the sector of consumer health care products. ABC’s average
earnings for the last three years and for the next three years according to the business plan is €
70.000 with no significant variance.
Which is the market value of ABC’s shares in case anyone wants to purchase the company?
Assume Pfizer’s P/E is in line with its competitors and reliable for the purpose:
In light of the data provided before, ABC shares’ market value is as follows:
€ 70.000 x 15,27 = € 1.068.900
--------------------------------------------------------------------------This is an Accounting course and not a finance and/or valuation course. We simply want to point
out that if the market value of a company is calculated starting from the financial
statements, then the financial statements of the target company must be reliable and
adjusted (= “normalized”) and only if you master Accounting, your evaluation can be
reliable.
Following are just few examples of the above:
• Which are the depreciation policies of the company?
• Any impairment loss was recorded?
66
•
•
•
•
Is there any non-recurring/unusual/exceptional revenue or expense?
Any recurring, but non-monetary item, was recorded? (example: allowance for doubtful
accounts)
All the adjusting entries were properly recorded?
The targets of the Business Plan are reasonable or too ambitious?
Valuation of companies in an M&A transaction
As said before, this is not a valuation course, though it is useful to point out which are the two
most important figures of the financial statements worldwide for any kind of transaction. Just
before that, it is important to know the following: the market value of a company can be
estimated either ASSET SIDE or EQUITY SIDE.
- Asset side: when you calculate the market value of a company “asset side” you are
calculating the ENTERPRISE VALUE, which is the market value of the assets of a
company i.e. the amount that a buyer should pay to purchase all the assets of a
company together, leaving then the target as a “box” full only of cash and debt.
- Equity side: when you calculate the market value of a company “equity side” you are
calculating the EQUITY VALUE, which is the market value of the shares of a company.
The enterprise value or the equity value can be calculated using two methods (among the
others but with the highest frequency):
- Multiples (already seen)
- DCF, Discounted Cash Flows: first you prepare a Business Plan, then you calculate
free cash flows and then you calculate the present value of the cash flows in the plan,
plus a terminal value.
EBITDA AND EBIT ARE MOSTLY USED
To calculate the Enterprise Value and the Equity Value, the two most important data of the
financial statements are:
- EBITDA
- NET FINANCIAL POSITION (NFP)
Equity Value = Enterprise Value (Asset Value) – Net Financial Position
Focus on the EBITDA (and EBIT)
In the first FSA session in the standard format example of an Income Statement format, we
calculated: EBITDA AND EBIT à they are both measures of a business's profitability.
Because EBIT and EBITDA are each independent of discretionary capital structure decisions
(i.e. the financing mix) and pre-tax measures of profitability, they can be used for
comparability purposes between diYerent companies.
In particular, the EBITDA is a metric used to evaluate a company's operating performance,
indicating if the company is able to generate operating income and cash flows excluding any
investments, extraordinary, financing and fiscal eQect.
67
The magnitude of the diYerence between EBIT vs. EBITDA is contingent on the industry in
which the company in question operates, including other discretionary management
decisions (for example, the useful life assumption of fixed assets (PP&E) and management’s
eQiciency at capital spending, or lack thereof).
The variance between EBIT and EBITDA is further expanding as of late due to the rise in usage
of the “Adjusted EBITDA” metric, which is the traditional EBITDA metric but with even more
discretionary adjustments. The rationale for applying the adjustments to EBITDA, at least in
theory, is to portray a company’s operating performance more accurately to oYer investors
more transparency, even if with the risk of greater management discretion and less
standardization.
In practice, EBIT and EBITDA are two of the most prevalent metrics, particularly for
performing valuation analyses, such as in the context of fundamental investing in the public
markets and mergers and acquisition (M&A) transactions.
The usage of EBITDA is more common in the context of M&A transactions because the cash
flow profile of the target is what is being negotiated (and amicable adjustments can be
determined).
Please note that cash flow profile of the target must be normalized in order to make a better
“x” year cash flow projection; all those distorting elements to be included and excluded, thus
leading to the normalized EBITDA, should be clearly identified.
EBIT and EBITDA metrics are frequently used to perform relative valuation, in which the two
metrics coincide with the enterprise value (TEV) metric.
- EV (Enterprise value)/EBITDA
- EV (Enterprise value)/EBIT
These are two of the most common valuation multiples used in relative valuation – such as
comparable companies’ analysis (or “trading comps”) and precedent transactions analysis
(or “transaction comps”).
For a valuation multiple to be practical, the numerator (i.e. the value measure) and
denominator (i.e. the value driver) must match concerning the stakeholders represented.
Hence, EBIT and EBITDA both correspond to enterprise value, rather than equity value, since
the profit metrics have not yet been adjusted for any payments to lenders, namely the periodic
interest expense payment owed on outstanding debt.
Following are some of the most frequent valuation multiples.
ASSET SIDE
• EV/Sales: enterprise value is calculated as a multiple of the sales. Example:
pharmacies, between 1,3x and 1,5x.
• EV/EBITDA: this is the most common valuation multiple used worldwide; enterprise
value is calculated as a multiple of EBITDA. Example: healthcare sector between 10x
and 15x
• EV/EBIT: enterprise value is calculated as a multiple of EBIT. EQUITY SIDE
• P/E and P/BV (market ratios)
IF you use an asset-side multiple, to calculate the value of the shares (equity value) you have
to subtract from enterprise value Net Financial Position or add it, if cash > financial debt
(and therefore if the NFP is negative)).
68
NET FINANCIAL POSITION
As said before, NFP is subtracted from Enterprise Value to compute Equity Value. It is
calculated as follows: NFP = financial liabilities - cash and cash equivalent = D - C.
It’s measured at the end of each reporting period (normally year or quarter). Financial assets
and liabilities are valued at market value.
Nonetheless, within an M&A operation, there are a series of elements which impact this
value, and in this case the indicator is called normalized NFP.
Please note that in M&A operations, a Financial Due Diligence examines and analyses in
depth, among other things, three key elements:
- EBITDA,
- Net Financial Position and
- Net Working Capital.
These actually represent the basis to determine the value of a company (or group of
companies or business unit) object of the transaction.
Once again, and in conclusion, we stress that if the calculation of the market value of a
company is based on Accounting figures, it is decisive to master Accounting to make proper
investment decision, strategic decisions, operating decision, M&A transactions, financing
decisions and whatever else.
In fact, accounting policies (or accounting frauds) can have a huge impact on the returns of
any stakeholder involved.
What if the inventory’s book value shall be written down? What if too many expenses were
capitalized, influencing then the EBITDA? What if an impairment test was too “optimistic” and
an intangible asset was not impaired? What if a debt instrument was not measured properly?
What if an unusual transaction was not described as such in the notes, resulting then as a
component of a normalized EBITDA? What about the calculation of income taxes and
contingent liabilities?
The knowledge of the correct accounting rules of recording and measurement will guide all of
you who will be future CEOs, CFOs, consultants, analysts, fund managers, advisors to assume
proper decisions.
69
CONSOLIDATION – PT 1
A little preface:
With reference to business, we are aware that firms grow (or they attempt- wish) to grow/expand
over time. In doing so, they might expand horizontally (i.e. getting in businesses) or vertically
(i.e. integrating parts of their production processes).
In doing so, firms make usually a very simple choice, they can:
• grow internally
• grow externally (which means that they buy other firms...)
In the latter case, we usually have what is called broadly speaking “Business Combinations”.
In a Business Combination a company (the acquirer) achieves control of another company
(acquiree) through shareholders rights (i.e. buys the shares of another firm). The acquirer
takes control over the acquiree’s assets and assumes the obligations resulting from its
liabilities. This process is commonly known also as: Merger and Acquisitions.
- Merger is when one company (Acquirer) buys another company (Target) (normally by
acquiring its shares), and the Target operations are incorporated into the acquirer. The
Target does NOT exist as individual entity anymore.
- Acquisition is when one company (Acquirer) buys another company (Target) (normally
by acquiring its shares), but the Target continues to exist as a separate entity and to
keep its own assets and liabilities.
Anytime one firm “acquires“ another one, accounting for Merger and Acquisition is identical.
The only diYerence will be that:
- If there is a Merger, the accounting process will take place once
- If there is an Acquisition, the accounting process will happen at the end of each
accounting period as the Target continues to exist.
Nowadays almost all Publicly listed firms are organized as Business groups. Group structure
is mostly a function of size...Therefore, most of the firms you will be looking at report
Consolidated Statements. Hence, it of crucial importance to get familiar with Consolidation
Accounting.
EXAMPLES
70
Consolidation and the Concept of “control”
Ownership:
- 0-20% à Passive Investment (Fair Value etc.), doesn’t require the preparation of
consolidated financial reports.
- 20-50% à Significant Influence (Equity Method), investment in an “associate entity” or
in a joint venture.
- > 50% à Control (Consolidation), the investment is consolidated in full as a subsidiary
and any non-controlling-interests are recognized.
Consolidation “issues” arises when one company controls another company (normally by
acquiring its shares), but the latter continues to exist as a separate entity and to keep its own
assets and liabilities (therefore we are talking about acquisitions). From an accounting point of
view, this is the case in which we have a “group of companies”, and we have to prepare
consolidated financial statements.
IFRS 10 deals with control, and assumes that control exists (and therefore consolidation is
required) when the investor:
- possesses power over the investee;
- has exposure to variable returns from its involvement with the investee, and
- has the ability to use its power over the investee to aYect its returns.
If all the three conditions simultaneously hold, we face a situation of control: «the power to
govern the operating and financial policies of an entity so as to obtain benefits from its
activities». However, it provides only limited operative indications on how to proceed with the
preparation of consolidated statements: which, instead, is dealt by the IFRS 3.
IFRS 10 and 3 are linked: any transaction or event in which a reporting entity obtains
control over one or more businesses is a business combination to which IFRS 3 applies.
N.B à the control gained must be over a business, not only over an asset or group of
assets.
Consolidated statements combine the balance sheet, income statement and other financial
statements of the holding with those of the subsidiaries into an overall set of statements as if
the parent and its subsidiaries were a single entity.
In diYerent words, the assets, liabilities, revenues and expenses of each subsidiary are
added to the parent’s accounts as if the parents had acquired directly the assets and liabilities
of the subsidiary instead of investing in its shares.
Therefore, the consolidation process doesn’t consist only in adding up the individual
companies’ financial statements, but also in making them consistent with each other and in
eliminating all those items that wouldn’t be there if the activities were actually performed by
the parent company only (thus avoiding double counting) à “Do these statements look like as
if the consolidated companies were operating as a single company?”.
Suppose a company wants to acquire your company, and oYers two deals:
1. buy all of your shares
2. buy all assets, including unrecognized ones (intangibles and goodwill)
and take care of the liabilities
You would be indiYerent between the two: the shares of the company represent, in fact, all of
its assets and liabilities. This holds both for market values and for accounting values.
However, the relationship is not 1:1, the two deals have diYerent accounting impact on the
financial statements.
Consolidation accounting will always treat any investment as if you had chosen deal #2.
71
Terminology:
- A parent is an entity that has one or more subsidiaries.
- A subsidiary is an entity, including an unincorporated entity such as a partnership, that
is controlled by another entity (known as the parent).
- A group is a parent and all its subsidiaries.
- Non-controlling [or minority] interest is the equity in a subsidiary not attributable,
directly or indirectly, to a parent. These are the shareholders of the Target.
- Separate financial statements (also Stand Alone) are those statements presented by
companies as single legal entities.
- Consolidated financial statements are the financial statements representing the
group as a unique economic entity.
Consolidation method(s)
When? Combination of entities or businesses obtaining control of acquiree.
What? Fair value of acquired assets and liabilities, even those not recorded yet.
How: In its financial statements, the acquiring company accounts all the target’s
assets/liabilities identified at 100% of their fair value, regardless of the share held by parent
and considering the deferred tax eQect.
Accounting:
- Recognition of consolidation diQerence (if positive, “goodwill” = purchase price – fair
market value of the target’s net assets).
- Separate recognition non-controlling interests accounted at fair value.
Goodwill and hence non-controlling interests accounted will change depending on the
method used: Acquisition Method or Full Goodwill approach.
Accounting for Consolidation is addressed by IFRS 3 “Accounting for Business
Combinations”.
Consolidation can be carried out using diYerent approaches – accounting standard. Methods
diYer with reference to the value given (and reported) to non-controlling shareholders in the
Consolidated Statements. The methods apply under IFRS:
- The Acquisition Method. All the identifiable assets and liabilities of the subsidiary must
be recognized and measured at 100% of their fair values at the time of the acquisition,
even if the investment is less than 100%. In the latter case, a non-controlling interest
must be recognized separately in consolidated statements. This method includes
assets and liabilities not previously recognized in the financial statements of the
subsidiaries (intangibles such as goodwill, trademarks etc.)
- The Full Goodwill Approach
They diYer in the non-controlling shareholders that is generated by the identified Goodwill.
Fair value is defined as “The amount for which an asset could be exchanged, or a liability
settled, between knowledgeable, willing parties in an arm’s length transaction.”
- If paid price exceeds total Equity in fair value à GOODWILL, asset to be impaired each
year.
- If paid price is lower than total Equity in fair value à BADWILL, Negative Consolidation
DiQerence, to be allocated to IS as a gain.
Goodwill will be recorded:
• in full, according to the Full Goodwill Approach, (we add to the consideration paid the
N.C. interests).
72
•
only for the part acquired by the parent, according to the Acquisition Method
(proportional goodwill).
IMPORTANT: No tax eQect is recorded on goodwill!!!
The Consolidation Process:
1. Collect the individual companies’ financial statements
2. Make them uniform as concerns (PRE-CONSOLIDATION)
a. the accounting period’s dates,
b. the accounting policies,
c. the reporting currency
d. the layout.
3. Combine like items à each item shall be added according to its accounting category.
The outcome of this process is the ‘aggregate situation’.
4. CONSOLIDATION ADJUSTMENTS
4.1.
a. OQset the carrying amount of the parent’s investment in subsidiaries against
the parent’s portion of equity, recognize any increase in subsidiaries’ assets
and liabilities and account for any related goodwill.
b. Recognize non-controlling interests (share of equity attributable to other
shareholders in non-wholly-owned subsidiaries).
4.2.
c. Depreciate/Amortize any Plus Value/Minus Value.
4.3.
d. Eliminate any intra-group transactions (assets, liabilities, equity, income,
expenses, cashflows).
4.4.
e. Allocate the group’s and minorities’ interest results.
5. Close the consolidation process and prepare the final consolidated statements.
Pre-Consolidation Adjustments
Point 2 of the process is usually called “pre-consolidation adjustments” phase. The purpose
of the pre-consolidation phase is to guarantee the uniformity of all the statements to be
aggregated with regard to:
- Schemes and contents of the financial statements
- Reporting Currency
- Closing dates of the statements
- Accounting principles and policies adopted
If there are:
- DiQerences in formats: all formats must be aligned before starting the consolidation
process, in order to allow “line-by-line” aggregation. DiYerent entities may in fact use
diYerent formats in their financial statements; this could happen even if all consolidated
companies applied IFRS. Of course, the individual financial statements shall be
reformulated according to the group’s format, following the parent’s instructions.
- DiQerence in closing dates (a) They may use a financial statement with a diYerent
closing date as long as, the diYerence in the closing dates does not exceed 3 months,
significant events taking place in the meantime (between the diYerent closing dates)
are accounted for, the duration of the financial year and the diYerence between closing
dates is constant; (b) BUT must prepare ad-hoc financial statements if diQerence is
73
larger than 3 months: in this case, interim financial statements are prepared at the
closing date of the parent company.
- DiQerent Currencies: All Financial statements are “accounted” using the same
currency, method used is the “current exchange rate” method.
o For income statement items, the average exchange rate of the financial year is
used or the eQective exchange rate at the date of each transaction;
o For balance sheet items exchange rate at the "closing“ date is used.
Note: diYerences in the exchange rates used for translating income statement values and
balance sheet values will generate a “currency exchange diQerence” or translation
diQerence, to be reported in the Equity (special owners’ equity reserve called Translation
Reserve).
Step 3 is the: Combine like items - ‘Aggregate Situation’ (PRE-CONSOLIDATION) – Example
Alfa and Beta - FSs and the
aggregate accounts
Next to the aggregate situation
we have the adjustments we
need to make, according to the
steps before.
These
adjustments
are
referred to as consolidation
entries.
Recall that A = L+SE!!!
The consolidated statement is
then the sum, for each item, of
the aggregate situation and all
the consolidation entries.
74
CONSOLIDATION – PT 2
1st ADJUSTMENT: Investment write-oQ, Goodwill Calculation, and Non-Controlling
interests
Step 4:
- OEset the carrying amount of investment in subsidiaries against the parent’s
portion of equity,
- recognize any increase in subsidiaries’ assets and liabilities, (tax eEects!!!)
- account for any related goodwill.
- Recognize non-controlling interests.
The carrying value of the investment is the net fair value of all assets and liabilities of
subsidiary acquired by parent at acquisition date. Therefore, after aggregating line by line the
balances of the target (acquiree) with the one of the acquirers, the investment in the
subsidiary has to be eliminated.
In fact, the value of the investment in the investee reported by the acquirer represents the
summary of the values of individual assets and liabilities of the target.
Steps to be followed:
1. reversal of the value of the investment;
2. write-oQ of subsidiary book value equity at acquisition date;
3. recognition of surplus/minus values at acquisition date;
4. recognition of deferred tax on surplus/minus values at acquisition date;
5. recognition of goodwill (or negative diYerence).
An easy Example to clarify intuitively...
• Let’s assume we are Firm A and we acquire 100% of shares of Firm B.
• B has PP&E that we need and to make it simple, we assume that the value in the Balance
sheet of such assets is equal to the book value.
Do we need to consolidate? We need
to, because A controls B, it acquired
100% of ordinary shares: we are
dealing with a group, in which the
parent company A needs to prepare its
consolidated financial statements
including all its subsidiaries (in this
case only B). Then we apply the steps
of the consolidation process.
To combine the accounting items of B to with those of A, we add the only asset of B, which is
PP&E. So, we obtain the aggregated balance sheet. But since the investment in B already
incorporates the value of B’s assets and liabilities, we need NOT to count these values
twice. Therefore, in the consolidated financial statement, the investment in B, the sum of its
assets and liabilities, needs to be oQset against B’s equity value. We cancel the investment
and also reduce Equity by the same amount (in this case the Investment = Book Value of Equity).
75
In this case we are preparing the CFS at the date of the acquisition. When consolidated
accounts are prepared subsequently to acquisition, the investment in the subsidiaries and
the subsidiaries’ owners’ equity are not the only items to be eliminated in the process. We
will see that we will eliminate all intra-group transactions. In this easy example there are no
non-controlling interests/intragroup transactions to eliminate.
Purchase Price Allocation (PPA)
It’s not often the case (as in the previous example), that company A acquires company B’s
shares at the price that is equal to B’s equity. Let’s break down the price paid for acquisition
with its determinants.
The Purchase Price Allocation is the process through which we determine:
- the fair values of the assets and liabilities of the acquiree, so the purchase price of the
shares of the target company (Fair Value Valuation).
- the Goodwill, and it functions as starting point to determine the Non-Controlling
interests.
The PPA can be broken down in several components:
Purchase Price paid (Investment) Proportionate interest in the FV of acquiree’s net assets:
• Book value of the subsidiary’s equity (on a pro-rata basis)
• +/- Change in assets’ and liabilities’ values (on a pro-rata basis) of subsidiary
• -/+ Tax eYects on those changes
= Goodwill (positive)/Badwill (negative)
Note: Subsidiary’s Equity Value to use is the one at the at acquisition date.
When we find diYerences between the consideration paid and the book value of the
subsidiary equity, we need to understand by which other factors this diYerence is generated,
and therefore, choose the correct accounting treatment for it.
For unrecognized surpluses in assets/liabilities values, we add them to the subsidiary
assets and or liabilities, and we recognize all new assets values which were not recognized in
the subsidiary’s individual financial statements before.
Computation of Non-Controlling Interests
With the Acquisition Method and Full Goodwill approach subsidiaries are consolidated at
100% and Assets and Liabilities are accounted for at Fair Value.
However, if the Parent firm does not own 100% of the shares of the subsidiary consolidated
financial statements, we need to account for third parties’ ownerships’ values.
Such values are to be identified separately. The so called “non-controlling interests”.
The amount will be:
- With the acquisition method: it will be the Fair Value of the non-controlling interests
as a percentage of the net assets that does not belong to the parent (no Goodwill will
be given to the non-controlling shareholders).
- With the Full Goodwill approach: it will be the percentage of the Enterprise Value
that belongs to non-controlling interests (i.e. Including the Goodwill). Non-controlling
interests are viewed as having an equity interest in the consolidated reporting entity.
Notice, in this case the amount will be already provided.
76
Surpluses amortization/depreciation
Step 5: Depreciate/amortize any plus value/minus value.
Positive and negative surpluses on assets and liabilities follow the same treatment of the
assets or liabilities they refer to. So, if they are related to:
- Depreciable assets, the surpluses are amortized over the residual useful life of the
assets to which they relate;
- Non-Depreciable assets, the surpluses may, together with the assets to which they
relate to, be subjected to impairment testing in accordance with IAS 36.
Goodwill shall be tested for impairment every year.
77
Consolidation – PT 3
Pre-Consolidation Adjustments à Accounting Policies
In order to prepare a consolidated financial statement, it is necessary to add together the
balance sheets and the income statements of the parent company and of all the subsidiaries.
There is no room for allowing diYerent accounting policies for similar transactions.
Financial statements are to be prepared using uniform accounting policies (harmonization
of pre-consolidation phase). For instance, similar raw materials cannot be measured using
diYerent standards only because they have been stocked in two diYerent divisions of the same
company. The uniformity of accounting policies may be obtained in diYerent ways...three
main scenarios occur:
A. By subsidiaries (included in the consolidation area) adopting ex-ante in their financial
statement the same accounting policies used by the parent company (i.e. in the
consolidation process). If such standards are compliant with the local regulation.
B. By requiring subsidiaries (included in the consolidation area) to provide financial
statement with the necessary adjustments for the consolidation process. This means
that at local level after stand-alone financial statements are prepared as required by
local rules, an additional “ad hoc” reporting is prepared and sent to the parent for
consolidation purposes only.
C. Harmonization is managed at parent level. This implies all adjustments-changes are
prepared at corporate level, during the consolidation process.
The logic to make adjustments to harmonize accounting principles and valuation criteria is
as follows:
• Identify the accounting actually made by the subsidiary company ("eQective”
accounting). This entry is reflected in the aggregated sheet.
• Identify the accounting that the company would have made to adopt principles and
policies consistent with those followed by the group (“proper" accounting).
• According to the diYerences between the “correct” and "eYective" accounting identify
the Adjustments to Consolidated Financial Statements.
Example 1 – Inventory diQerences
Info:
- Brics Ltd. acquired 100% of shares in company Stones in January 1 2019.
- At the end of 2019, Brics has to consolidate Stones Accounts.
With reference to Inventories:
- Brics’ Inventories are accounted using FIFO;
- in its own accounts Stones accounts inventories using LIFO.
The diYerence in terms of inventory method, should Beta (Stones) have valuated inventory
using FIFO would results in a lower cost of goods sold of 500 euros.
The Issue:
The Consolidation process requires both using the same accounting policies
(Harmonization). The subsidiary (Stones) will need to “adjust” inventory value to stick with the
parent’s (Brics) accounting policy.
Therefore:
Stones accounting at FIFO, means:
- The decrease on Cost of Goods Sold by 500
- An increase in Inventory by 500.
78
Why is so?
When Stones – using LIFO - accounted for Inventory and COGS, recorded an entry as follows:
CGS Inventory (E+) XXXX
Inventory (A-)
XXXX
If FIFO must be used, the COGS would be lower by 500. This means that we need to adjust the
entry above, as follows:
Inventory (A+)
500
CGS Inventory (E-) 500
This is intuitive, as if COGS decreases, this means that the amount “not sold” (so the
adjustment) is actually still on hand. Where is the amount on hand stored? In the inventory
account. This is why we debit inventory.
Note: In this example we do not include tax eQects.
One important thing is worth
mentioning...
When we make the adjustment,
we also indirectly change the
Income...specifically the pre-tax
income. This generates the
following à
So, we need also to take into
account the TAX eQect.
This will always (and only) be
present if through consolidation
adjustments we modify the pretax income.
So let see what happens, with Inventories...considering taxes:
The main adjustment is the same:
Inventory
500
CGS Inventory
500
But we now are aware that this increases pre-tax income by 500. This means that at
consolidation level our taxes should be higher by 500 x Tax Rate.
This means that we need to account for the tax eQect. Such tax eYect will generate Deferred
Taxation. Deferred taxation will work as follows:
In our case: (A) Pre Tax income increases (let’s assume a 30% tax rate). The Entry will be as
follows:
Income Taxes
150
Deferred Tax Liabilities
150
79
Therefore:
The eYect of the tax
adjustment is reported in the
income statement.
Automatically this changes
also the Net Income in the
equity section of the Balance
Sheet.
Speaking about Taxes, the diYerence between the book and fair values of the recognized items
may create “temporary diYerences” that will give rise to taxes in the future. We recognize such
future obligation (or benefit) through the separate recognition of deferred tax liabilities/assets.
80
Consolidation – Intra-Company Transactions
The purpose of consolidation is to have one set of financial statements as if there was only one
reporting subject. In the consolidation adjustments we refer also to the elimination of intracompany transactions. All transaction happening within the group are to be canceled when
preparing consolidated accounts. The elimination of intra-group transactions consists of:
- Elimination of intercompany receivables and payables, and revenue and expense
- Elimination of intercompany profits and losses
o Elimination of intercompany profits and losses included in the value of
inventories.
o Elimination of intercompany profits and losses included in the value of longlived (fixed) assets.
- Elimination of intercompany dividends
The consolidated financial statement provides the representation of the economic and
financial situation of the group as a single entity: a company with many divisions/internal
functions (set up by diYerent companies that are included in consolidation area).
Transactions that occur among companies within the same group are equivalent, in view of
the consolidated financial statement, to transactions between divisions/functions within a
company. Such transactions, therefore, since are not transaction with "third parties", should
not even be recognized in the general accounting system.
The consolidated financial statement should represent only those operations that group
companies have made with third parties outside the group. Those values, which arise from
intra-group transactions, must be eliminated.
Intercompany revenues and expenses, receivables, and payables
Trading or financing operations within companies group determine payables and receivables,
costs and revenues. When individual financial statements are collected, and added up,
payables, receivables, costs and revenues end up in the aggregate statements. The aggregate
situation contains both the revenues and the costs of the same transaction; similarly, for credit
and debit components. For the group, seen as a company, these items are irrelevant (the entity
“group”, in fact, has credit and debt of equal amount, or cost and revenues of equal amount)
and, indeed, cause an undue "swelling" of the items balance: since we add up all the items
line by line, we end up with higher revenues and higher expenses for the same amount,
resulting from the intercompany transaction, even though the net eQect on income is 0.
These items should be reversed in the consolidated financial statement.
In particular, should be removed:
- intra-group revenues and expenses recognized during the financial year;
- intra-group receivables and payables not yet settled at the end of the year.
Adjustments of elimination of intra-group receivables and payables, costs and revenues are
fully operated at 100%.
Elimination of intercompany revenues and expenses:
- Intragroup transactions which give rise to purchase expenses and selling revenues
respectively for the acquiring and selling company: all the items which refer to the
above said revenues and expenses will be written oQ.
- Intragroup grants of financial loans giving rise to financial revenues and expenses
respectively to the financed and financing company: financial revenues and expenses
will be written oQ.
81
These operations do not give rise to deferred tax assets or liabilities. These consolidation
adjustments in fact do not cause changes in the operating result.
Elimination of intercompany receivables and payables
- Intragroup transactions which are still to be settled at the closing date and that have
therefore given rise to trade receivables and liabilities respectively to the selling and
acquiring company: trade receivables and liabilities will be written oQ.
- Intragroup grants of financial loans which at closing date are represented by financial
receivables and liabilities respectively in the financing and financed company:
financial receivables and liabilities will be written oQ.
Again, these operations do not give rise to deferred tax assets or liabilities.
Reconciliation of intra-group transactions
The procedure for removal of intra-group transactions is based on the assumption that there
is equivalence between accounts of each company. This equivalence exists if all group
companies have correctly pointed out such operations. If, by mistake or imperfect
information, there is no equivalence between accounts, we need to "reconcile" the values of
intra-group transactions ensuring that they are properly recognized by all companies.
After the reconciliation, you can proceed with their elimination.
More in detail, the logical path to follow to make adjustments to eliminate intercompany
payables and receivables, revenues and expenses is as follows:
1) identify which values of credit/debt, costs/revenues, arising from intra-group
transactions, are recorded in the financial statements of companies included in
consolidated financial statement.
2) make sure there is mutual equivalence between accounts; if this equivalence is not
present, reconcile intra-group values.
3) delete the mutual accounts (receivables and payables, costs and revenues).
Elimination of intercompany profits and losses
In the consolidated financial statement, group results should be those generated by the group
with any third party and not the one that individual companies have achieved working together.
So, any intra-group profits and losses which relate to assets still included in the heritage group
at year-end, must be removed.
This consolidation adjustment is intended to eliminate the impact of intra-group operation,
as reporting in the absence of the transaction itself.
It should not be eliminated intercompany losses that express an actual decrease in value of
the property that is necessary to represent.
From the elimination of intra-group emerge temporary diQerences, must therefore detect the
deferred tax assets or liabilities arising from these diQerences.
Adjustments to eliminate intercompany profits and losses should be fully operating, at 100%.
The elimination of intercompany profits and losses is achieved by:
- adjusting the carrying value of assets "subject" of the intra-group transaction that are
still in the balance sheet of the acquiring company; the value of these goods must be
"brought back" to that they would have if they wouldn’t have been transferred from one
to another group company.
- adjusting the income items related to those goods that are "generated" by the intragroup transaction. The economic result of companies involved in the transaction, in
82
fact, has changed as a result of intra-group transaction: this change must be
eliminated.
In this process, we deal mainly with two cases.
Elimination of intercompany profits and losses included in the value of inventories
In the case of profits (or losses) included in the value of inventories, intra-group profits (or
losses) must be eliminated in order NOT to account for the assets that are still in the
warehouse of the acquirer at year-end.
The logical path to be followed for the adjustment in question is divided into the following steps:
1. calculate the total intercompany profit (or loss) result;
2. calculate the intercompany profit (or loss) ”that is not made with third parties". That
is: total intercompany result (1) X % of goods that are still in the warehouse of
acquiring company at year-end;
3. reduce (increase) the closing balance of inventory by the amount of intercompany
profit (or loss) “that is not made with third parties”(2).
When dealing with intercompany sales of goods, we can face three situations:
- All inventories are still on hand in the acquiring company at the end of the year. In this
case it is necessary to:
o Decrease aggregate revenues by the full amount of goods at the intercompany
selling price.
o Decrease aggregate CGS by the full amount at the original purchase cost from
third parties.
o Reduce the value of ending inventory by the full amount of intercompany profit.
Or increase it for the loss.
o Account for the related fiscal eQect.
- All inventories have been sold by the buying company at the end if the year. In this case
there is no unrealized profit from the group pov, so we only make two adjustments:
o Decrease aggregate revenues by the full amount.
o Decrease aggregate COGS by the full amount.
- Part of the inventories have been sold from the acquiring company at the end of the
year. In this case, the transaction must be split in two parts: one referring to inventories
still on hand, and the other referring to inventories sold at the end of the year. The steps
are those described in the first two situations.
CASE A:
During year X Alfa (parent company) sells Beta (subsidiary fully owned) inventories, for a price
of €120. In the same exercise, such inventories had been acquired by Alfa from external parties
at a cost of € 100. At the end of the year, ALL inventories are still on hand.
Make the needed consolidation entries in order to eliminate the eYects of this internal
transaction.
What’s happen to the individual financial statements? This transaction will be registered by the
two companies as follows:
Alfa:
- Cost of goods sold 100
- Revenues 120
Beta:
- Beta will register inventories for € 120
In order to eliminate the eQects of this transaction, we need to:
a) Eliminate intragroup profit;
83
b) Record inventories at the group’s value (€ 100);
c) Record the deferred tax eQects.
Therefore, we will have:
- Revenues falling by -120, since no good was sold to third parties.
- COGS (Operating Expenses) falling by -100, since the groups inventory had not
decreased, it is still on hand.
- Inventory falls by -20 since we need to rebuild the original value of inventory, moving
from 120 to 100.
- EBT changes, we need to introduce the tax eQect. Assuming a tax rate of 50%, we
decrease tax expense by -10 and recognize a deferred tax asset of 10.
CASE B
During year X Alfa (parent company) sells Beta (subsidiary) inventories, for a price of €600. In
the same exercise, such inventories had been acquired by Alfa from external parties at a cost
of € 350. At the end of the year, 60% inventories are still on hand.
Make the needed consolidation entries in order to eliminate the eYects of this internal
transaction.
We must split the transaction in two parts:
- 60% referring to inventories still on hand
o The consolidation entries are exactly the same as the previous case, referred to
60% of the transaction. In this case, the impact in the individual financial
statements, are:
o Alfa: Cost of goods Sold 210 (350*60%) and Revenues 360 (600*60%)
o Beta: Beta will register inventories for € 360 (600*60%).
84
These are the consolidation adjustments to make:
Revenues fall by -360
COGS falls by -210
Inventory needs to be adjusted to the
COGS value, and therefore its value
falls by 360-210 = -150. EBT decreases
by -150, we need to account for the tax
eYect, which is -75, and creates a
Deferred Tax Asset of 75.
-
40% referring to inventories sold at the end of the year
o Company Alfa sold 40% of these inventories to external parties. The profit
pertaining to this sale, therefore, must considered as REALIZED. In this case,
the impact in the individual financial statements, are:
o Alfa: Cost of goods Sold 140 (350*40%) and Revenues 240 (600*40%)
o Beta: Inventories 0 (240 – 240)
Operating revenues and expenses fall by the same amount: -240.
Therefore, the consolidated column will be:
450 is the sum of the two consolidation
entries (210 and 240).
When company A sells these goods to third
parties, it will register the following journal
entry:
Cost of goods sold
240
Revenues
240
From the group point of view, the revenues (X) are to be considered as REALIZED, as they derive
from a transaction occurred with an external party. The Cost of Good Sold for the group,
however, is 140 (350 *40%). The diYerence between 450 and 350 (cost of goods sold) is exactly
the diYerence between 240 and 140, that’s to say 100. The total impact on operating profit is
- 150.
85
The Lower-of-cost-or-market rule requires an asset be reported in the financial statements at
whichever is lower – its historical cost or its market value. If the market value falls below its
historical cost, the business unit writes down the value of its goods to market value.
It is possible that two companies belonging to the same group set up a commercial transaction
which gives rise to an intragroup loss. Also in this case, the intragroup loss must be fully
eliminated, if not realized with external parties.
In any case, International Accounting Standards state that the causes underlying the loss
should be examined. If this loss is due to a long-term reduction in the asset’s value, the
intragroup loss must not be eliminated, as it reflects the loss on value of the asset.
Elimination of intercompany profits and losses included in the value of long-lived assets
In case of profits (or losses) included in the value of long-lived assets, you must:
- report the transferred assets (still held by the acquirer at year-end) at the carrying
amount that would have been in absence of intercompany transaction.
- reverse any gains/losses realized as a result of alienation.
- adjust depreciation to report them as there would be in absence of alienation.
From a consolidated viewpoint, depreciation must be based on the cost of the asset to the
consolidated entity, which is the asset’s cost to the related company that originally purchased
it from an outsider.
Eliminating entries are needed in the consolidation workpaper to restate the asset,
associated accumulated depreciation, and depreciation expense to the amounts that
would appear in the financial statements if there had been no intercompany transfer.
The logical process to follow for the adjustment is as follows:
1. identify the accounting eQect that the intercompany transaction has led, with
particular reference to gains/losses, sold assets and their depreciation. This entry is
reflected in aggregated balance sheet.
2. identify the values that the items aYected by the transaction (gains/losses, sold
assets and depreciation) would have had in the absence of operation. This entry is
that which must be reflected in the consolidated financial statement.
3. as a result of diYerences found between values (1) and (2), identify corrections to
be made to the aggregated balance sheet for obtaining the consolidated financial
statement.
With reference to losses on sales, the book value of the asset must be compared with its
value in use.
86
Consolidation Adjustments – Intragroup Dividends
When a subsidiary (Target) pays dividends to a parent (Acquirer) during a certain accounting
period, journal entries prepared by the two entities are the following:
SUBSIDIARY:
Retained earnings (- SE) XXX
Cash (- A)
XXX
PARENT:
Cash (+ A)
XXX
Dividend revenue (+ Rev)
XXX
- The journal entry of the subsidiary has no impact on its income statement. Retained
Earnings are neither a revenue nor an expense.
- The journal entry of the parent has impact on its income statement.
Nevertheless, as you all know, dividend revenues are taxed only for a very small amount (5%)
à for consolidation purposes, we assume taxation on dividends is zero [this is valid not only
in this course, but also in professional practice].
In light of the above, which are the required consolidation adjustments?
Actually, we have to divide the explanation into two blocks:
- the case of wholly owned subsidiary (which is only one adjustment)
- the case of the non-wholly owned subsidiary (which requires the precedent
adjustment, plus another one).
Intra-group Dividends – wholly owned
SEPARATE FINANCIAL STATEMENTS (REAL)
In the accounting records of the companies, we have the transfer of cash between two
diYerent legal entities; the JE mentioned previously are recorded.
CONSOLIDATED FINANCIAL STATEMENTS (SIMULATION)
In the accounting records of the single legal entity, the transfer of cash between two business
units is not recorded in the JE (unless it is a diYerent bank account which in any case doesn’t
change the balance of cash).
87
If consolidation adjustments are required to eliminate the eYect of the double-counting
transactions, which are the accounts that shall be adjusted?
In the case of a wholly owned subsidiary,
Reduce the Dividend Revenue and Increase Retained Earnings
Intra-group Dividends – NON wholly owned
SEPARATE FINANCIAL STATEMENTS (REAL)
In the accounting records of the companies, we have the transfer of cash between two diYerent
legal entities AND the payment goes % to minorities; the JE mentioned previously are
recorded.
CONSOLIDATED FINANCIAL STATEMENTS (SIMULATION)
In the accounting records of the single legal entity, the transfer of cash between two business
units is not recorded in the JE AND we have to adjust the amount of retained earnings
pertaining to minorities.
In the case of a NON wholly owned subsidiary,
- Retained earnings of the Target decrease for a certain amount (example: 200 €)
- Revenues accounted by the Parent (WHICH ARE INFRAGROUP REVENUES) are worth
only the % owned in the subsidiary (example: 130 € if the parent owns 65% of the
shares issued by the subsidiary).
As a consequence, revenues decrease by % owned by the parent and retained earnings
increase same amount.
NEVERTHELESS, THIS IS NOT ENOUGH.
88
Do you remember that, in case of minorities, the first consolidation adjustment (write-oY the
investment) provides for assigning to the minorities a portion of non-controlling interest,
computed at the date of acquisition?
Well, if we assigned (adj #1) to minorities their portion of equity based on the FV of net assets
(“mystery box”) as it was at the date of acquisition, AND during the year the amount changed
(example 70 €), WE ALSO HAVE TO DECREASE THE VALUE OF RETAINED EARNINGS
ASSIGNED TO THE MINORITIES (NCI) AND RESTATE THE AMOUNT OF RETAINED EARNINGS
PERTAINING TO THE GROUP. The amount of dividends received by non-controlling
shareholders reduces their share of equity.
Please keep in mind the following.
1. Although non-wholly owned subsidiary adjustments on dividends are two from a
substantial ;….’/standpoint, formally we use a single consolidation column to make
the whole adjustment.
2. The non-wholly owned adjustment will be clearer when we will be making the
comprehensive example.
3. In the exam, it might be not specified whether dividends are paid throughout the
year or not: be careful.
4. Only intra-group dividends shall be taken into consideration.
89
CONSOLIDATION ADJUSTMENTS – Computation of NC Net Income
According to the rules in force to prepare consolidated financial statements:
In case of non-wholly owned investment,
• Assets are, in any case, accounted by the Parent at 100% in consolidated F/S
• Liabilities are, in any case, accounted by the Parent at 100% in consolidated F/S
• In stockholders ‘equity, in a separate item, we show the value of minorities’ equity %
Actually, if a parent owns 70% of the subsidiary, options to prepare consolidated F/S were two:
• To add up in the aggregate F/S only 70% of assets, 70% of liabilities and 70% of
stockholders’ equity (WRONG).
• To add up in the aggregate F/S 100% of assets, 100% of liabilities, 100% of stockholders
‘equity and then splitting the stockholders ‘equity into two, eliminating 70% and
keeping the 30% owned by the minorities (CORRECT ACCORDING TO IFRS 10).
Recalled that stockholders ‘equity is made of, at least,
I.
Common stock
II.
Retained earnings (of the precedent accounting periods)
III.
Profit / loss of the year,
And recalled that Minorities are assigned I. and II. above in the phase of the elimination of the
investment, the final consolidation adjustment consists in assigning to the minorities a
portion of III = profit/loss of the year.
IMPORTANT REMARK
The REAL profit pertaining to the minorities is computed on a separate F/S basis, in other
words the minorities are actually entitled to receive dividends based on
(i)
the percentage of common stock owned in the Subsidiary,
(ii)
the only profit of Subsidiary. Because non-controlling interests are shareholders of
the latter.
The allocation of profit in the consolidation would be almost impossible, as consolidated
F/S simulate a merger of the companies (how many shares of the merged company the
Minorities would have received?) and minorities would be entitled to receive a portion of profit
generated by the Parent.
PROBLEM: how do we compute NCI portion of profit in our “simulation”? WE USE A
STANDARDIZED FORMULA APPROACH. Even if a standardized formula is NOT super accurate,
we must keep in mind that “real” dividends for minorities are based on “real” profits achieved
by the subsidiary in its separate financial statements.
In other words, the allocation of profit to minorities in consolidated financial statements is
useful only for segnaletic purposes and is made on a standardized, simplified approach.
To compute the NCI share of income, formula is as follows:
NCI NI = (Profit of the Sub +/- Adj) * %NCI
Where:
• NCI NI = Net Income attributable to Non-Controlling Interest
• PrSub = Net profit realized by the Subsidiary in its separate financial statements
• Adj = adjustments to net profit due to consolidation entries, whereas the adjustments
pertain the subsidiary
• %NCI = percentage owned by the minorities in the common stock of the subsidiary
Example: minorities own 10%, profit of the subsidiary is 900 and adjustments are – 150
90
The adjustments that shall be taken into consideration are the following:
1. Adjustments generated by the depreciation / amortization of the surpluses.
2. Adjustments generated by upstream transactions, whereas “upstream transactions”
are all transactions where the seller / provider is the Subsidiary and the
buyer/beneficiary is the Parent.
Once the NCI share of net income is computed, then the consolidation adjustment is:
• Decrease “net profit” in the income statement
• Increase “NCI share of income” in the income statement
• Decrease “net income” in the stockholders’ equity.
• Increase “NCI share of income” in the stockholders’ equity.
91