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dr A. Kocia 1
Agata Kocia, Ph.D., MBAWarsaw UniversityDepartment of Economic Sciences email: [email protected]
Financial Statement Analysis-additional topics
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Income taxes
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Accounting versus tax code (1)
Financial accounting standards are often different than income tax laws and regulations
Therefore, the amount of income tax expense recognized in the income statement may differ from the actual taxes owed to the taxing authorities
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Accounting versus tax code (2)
The timing of revenue and expense recognition is different
Certain revenues and expenses are recognized in the income statement but never on the tax return and vice versa
Assets and/or liabilities have different carrying amount and tax bases
Gain or loss recognition in the income statement differs from the tax return
Tax losses from prior periods may offset future taxable income
Financial statement adjustments many not affect the tax return or may be recognized in different periods
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Tax return terminology
Taxable income – income subject to tax based on the tax code
Taxes payable – tax liability on the balance sheet caused by taxable income also known as current tax expense
Income tax paid – actual cash flow from income taxes including payments and refunds
Tax loss carryforward – a current or past loss that can be used to reduce taxable income in the future
Tax base – net amount of an asset or liability used for tax reporting purposes
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Financial reporting terminology (1)
Accounting profit – pretax financial income based on financial accounting standards also known as income/earnings before tax
Income tax expense – expense recognized in the income statement that includes taxes payable and changes in deferred tax assets (DTA) and liabilities (DTL)
Deferred tax assets – balance sheet amount that results from an excess of taxes payable over income tax expense can also result from tax loss carryforward
Deferred tax liabilities – balance sheet amount that results from an excess income tax expense over taxes payable
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Financial reporting terminology (2)
Valuation allowance – reduction of deferred tax assets based on the likelihood that the assets will not be realized
Carrying value – net balance sheet value of an asset or liability
Permanent difference – a difference between taxable income (on tax form) and pretax income (on income statement) that will not reverse in the future
Temporary difference – a difference between tax base and the carrying value of an asset or a liability that will result in either taxable amounts or deductible amounts in the future
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Deferred tax liability
Is created when income tax expense (from income statement) is greater than taxes payable (from tax return) due to temporary differences
Occurs when: revenues or gains are recognized in the income
statement before they are included on the tax return expenses or losses are tax deductible before they are
recognized in the income statement They are expected to reverse and result in the future
tax outflows when the taxes are paid Commonly, created when different depreciation
methods are used for tax and financial statement purposes
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Deferred tax asset
Is created when taxes payable (from tax return) are greater than income tax expense (from income statement) due to temporary differences
Occurs when: revenues or gains are taxable before they are
recognized in the income statement expenses or losses are recognized in the income
statement before they are tax deductible tax loss carry forwards are available to reduce future
taxable income They are expected to reverse and result in the future
tax savings Commonly, created due to post-employment benefits
and warranty expenses
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Tax base of assets
Is the amount that will be expensed (deducted) on the tax return in the future as the economic benefits of the assets are realized
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Tax base of assets: Depreciable equipment
The cost of equipment is $100 000. In the income statement depreciation expense of $10 000 is recognized each year for 10 years
On the tax return, the asset is depreciated at $20 000 per year for 5 years
At the end of the 1st year, tax base is $80 000 and carrying value is $90 000
A deferred tax liability is created at $10 000*t due to timing difference
Sale of this asset at $100 000 will reverse the deferred tax liability as a gain of $10 000 would be recognized in income statement and a gain of $20 000 would be recognized on tax return
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Tax base of assets: Accounts receivable
Gross receivables totaling $20 000 are outstanding at year-end
The firm recognizes bad debt expense of $1 500 in the income statement
For tax purposes, bad debt expense cannot be deducted until the receivables are deemed worthless
At the year end, tax base of the receivables is $20 000 since no bad debt expense has been deducted on the tax return but the carrying value on income statements is $18 500
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Tax base of liabilities
Is the carrying value of the liability minus any amounts that will be deductible on the tax return in the future
Tax base of revenue received in advance is the carrying value minus the amount of revenue that will not be taxes in the future
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Tax base of liabilities: Customer advance
At year end, $10 000 was received from a customer for goods that will be shipped next year
The carrying value of the liability is $10 000 yet it will be reduced when the goods are shipped next year
$10 000 is taxed but not recognized in an income statement, instead a deferred tax asset is created
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Tax base of liabilities: Notes payable
The firm as an outstanding promissory note with a principal balance of $30 000; interest accrues at 10% and is paid at the end of the quarter
The note is treated the same on tax return and in financial statements, so with no difference in timing, no defered tax items are created
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Impact of tax rate changes (1)
When the income tax rate changes: deferred tax assets and liabilities are adjusted
to the new rate adjustment can also affect income tax
expense An increase (decrease) in the tax rate, will
increase (decrease) deferred tax liabilities and deferred tax assets
income tax expense = taxes payable + ∆DTL - ∆DTA
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Impact of tax rate changes (2)
If tax rates increase, the increase in DTL is added to taxes payable and the increase in DTA is subtracted from taxes payable to arrive at income tax expense
If tax rates decrease, the decrease in DTL will result in lower income tax expense and the decrease in the DTA would results in higher income tax expense In case of DTL we add a negative change and
in case of DTA we subtract a negative change
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Permanent difference
Permanent difference is a difference between taxable income and retax income do not crease deferred tax assets/liabilities can be caused by revenue that is not taxable,
expenses that are not deductible or tax credits that reduce taxes
Permanent differences will cause firm’s effective tax rate to differ from the statutory tax rate
Tax rateeff= income tax expense/pretax income
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Temporary difference
Temporary difference is a difference between that tax base and the carrying value of an asset or a liability that will result in taxable amounts or deductible amounts in the future can be a taxable temporary difference that
results in expected future taxable income or deductible temporary difference that results in expected future tax deductions
example: investment in other firms – parent company can recognize earnings from the investment before dividends are received
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Valuation of DTL and DTA
If it is more likely than not that some or all DTA will not be realized (for example, because of insufficient future taxable income to recover the tax asset), then DTA must be reduced by valuation allowance
Valuation allowance is a contra account that reduced DTA value on the balance sheet
Increasing the valuation allowance increases income tax expenses and reduces earnings – if circumstances change, DTA can be revalued upward
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Disclosure information
Typically the following deferred tax information are disclosed: deferred tax liability/asset, valuation allowance any unrecognized deferred tax liability for undistributed
earnings of subsidiaries and joint ventures current-year tax effect of each type of temporary
difference components of income tax expense reconciliation of reported income tax expense and the
tax expense based on statutory rate tax loss carry forwards and credits
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Usefulness of data
Analyzing trends in individual reconsiliation items can aid in understading past earnings trends and in predicting future effective tax rates
Then can also help in predicting future earnings and cash flows or for adjusting financial ratios
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US GAAP versus IFRS
Accounting treatment of income taxes under US GAAP and IFRS are similar
One major difference relates to valuation of fixed assets and intangible assets
US GAAP prohibits upward valuation, whereas it is permitted under IFRS and any resulting effects on deferred tax are recognized in equity (see p.236)
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Part II
Inventories
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Cost of Goods Sold (COGS)
Refers to beginning balance of inventory, purchases and the ending balance of inventory under IFRS also known as Cost of Sales
(COS)
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Inventory valuation methods
Under IFRS the following methods are permissible: specific identification – each unit sold is matched with the
unit’s actual cost first-in, first-out (FIFO) – the first item purchased is assumed
to be the first item sold ending inventory is based on the most recent purchases and
COGS based on earliest purchases weighted average cost – average cost per unit is computed
by dividing total cost of goods available for sale by total quantity available for sale
US GAAP also allows last-in, first-out method (LIFO), not permitted under IFRS last-in, first-out – the item purchase most recently is
assumed to be the first item sold in an inflationary environment, COGS are higher, earning lower
and income tax also lower
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Periodic inventory system
In a periodic inventory system, inventory values and COGS are determined at the end of accounting period
No detailed records of inventory are maintained Inventory acquired during the year is recorded
in a Purchases account At the end of the period:
purchases are added to beginning inventory to arrive at cost of goods available for sale
ending inventory is subtracted from goods available for sale to calculate COGS
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Perpetual inventory system
In perpetual inventory system, inventory values and COGS are updated continuously
Inventory purchased and sold is recorded in Inventory account as transactions occur Purchases account is not used
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Periodic versus perpetual system
FIFO and specific indentification methods produce the same values for ending inventory and COGS regardless of method used
LIFO and weighted average cost methods can produce different results depending on which system is used
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Net realizable value (NRV)
Under IFRS inventory is reported on the balance sheet at the lower of cost or net realizable value
Net realizable value (NRV) is equal to expected sales price less the estimated selling costs and completion costs
If NRV is less than the balance sheet value of inventory, the inventory must be written down to NRV and loss is recognized in an income statement
If there is a subsequent recovery in value, the inventory can be written up and gain recognized
However, inventory cannot be written up by more than it was previously written down
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Lower of cost
Under US GAAP inventory is reported on balance sheet at the lower of cost or market
Market cost is equal to replacement cost but cannot be greater than NRV or less than NRV minus a normal profit margin If replacement cost exceeds NRV, then market is NRV If replacement cost is less than NRV minus a normal
profit margin, then market if NRV minus a normal profit margin
If cost exceed market, the inventory is written down to market on the balance sheet and a loss is recognized in the income statement
If there is a subsequent recovery in value, no write ups are allowed under US GAAP
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Reporting
In some industries e.g. producers and dealers of agricultural products, mineral ores and precious metals, reporting inventory above historical cost is permitted unders IFRS and US GAAP inventory is reported at NRV and any
unrealized gains or losses are recognized in income statement
if an active market exists for the commodity, the quoted market price is used to value the inventory; otherwise, recent market transactions are used
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Disclosure of inventory
Under US GAAP and IFRS required inventory disclosures include: cost flow method used total carrying value of inventory and carrying value by
classification carrying value of inventories reported at fair value less
selling costs amount of inventory write downs reversals of inventory write downs, including the
circumstances of reversal carrying value of inventories pledged as collateral
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Inventory changes (1)
Change in inventory cost method is usually made retrospectively – that is, the prior years’ financial statements are recast based on the new cost flow method
Cumulative effect of the change is reported as an adjustment to the beginning retained earnings of the earliest year presented under IFRS, the firm must demonstrate that the change
will provide reliable and more relevant information under US GAAP, the firm must explain why the change
in cost flow method is preferable
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Inventory changes (2)
If a firm changes to LIFO, change is applied prospectively, that is, no adjustments are made to the prior periods carrying vale of inventory under the old method
becomes the first layer of inventory under LIFO in the period of change
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Implications of inventory method
Inventory turnover (also in days) and gross profit margin can be used to evaluate the quality of firm’s inventory management
Inventory turnover that is too low – many be an indication of slow-moving or obsolete inventory
High inventory turnover together with low sales growth relative to the industry may indicate inadequate inventory levels and lost sales because customer orders could not be fulfilled
High inventory turnover together with high sales growth relative to the industry average suggests that high inventory turnover reflects greater efficiency rather than inadequate inventory
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Part III
Long-lived assets
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Capitalized versus expensed costs (1)
When a firm makes an expediture, it can either capitalize the cost as an asset on a balance sheet or expense the cost in the income statement in the period incurred expenditure that is expected to provide a future
economic benefit over multiple accounting periods is capitalized
if the future economic benefit is unlikely or highly uncertain, the expenditure is expensed in the period incurred
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Capitalized versus expensed costs (2)
Expenditure that is capitalized is initially recorded as an asset on balance sheet at cost
Except for land and intangible assets with indefinite lives, the cost is allocated to income statement over the life of the asset as depreciation expense (for tangible assets) and amortization expense (for intangible assets)
If an expenditure is immediately expensed, current period pretax income is reduced by the amount of the expenditure
The choice affects net income, shareholder’s equity, total assets, cash flows and numerous financial ratios
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Capitalized versus expensed costs (3)
Capitalizing results in: higher assets higher equity higher operating cash flow higher earnings in the first year but lower
earnings in subsequent years as the asset is depreciated
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Capitalized interest (1)
When a firm constructs an asset for its own use (or for resale but under specific circumstances), the interest that accrues during the construction period is capitalized as a part of the asset’s cost this is done to accurately measure the cost of the asset
and to better match the cost with revenues the treatment of construction interest is similar under
IFRS and US GAAP The interest rate used to capitalize interest is based
on debt related to construction of an asset If no construction debt is outstanding, the interest
rate is based on existing unrelated borrowing
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Capitalized interest (2)
Under IFRS, income earned by temporarily investing borrowed funds reduces the interest that is eligible for capitalization
Under US GAAP, there is no such reduction When construction interest is capitalized, interest
cost is allocated to the income statement through depreciation expense (if asset is held for use) or COGS (if the asset is held for sale/inventory)
Capitalized interest is reported in the cash flow statement as an outflow from investing activities while expensed interest is reported outflow from operating activities
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Financial statement effects of capitalizing versus expensing interest
Capitalizing ExpensingTotal assets Higher LowerEquity Higher LowerIncome variability Lower HigherNet income (first year) Higher LowerNet income (subsequent years) Lower HigherCash flow from operations Higher LowerCash flow from investing Lower HigherDebt ratio and Debt to equity ratio Lower HigherInterest coverage (first year) Higher LowerInterest coverage (subsequent years) Lower Higher
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Intangible assets created internally (1)
Generally, costs to create intangible assets are expensed as incurred; exceptions are: R&D costs (under IFRS) and software development costs
R&D costs (under IFRS): research costs – costs aimed at discovery of new
scientific or technical knowledge and understanding are expensed as incurred
development costs – costs incurred to translate research findings into a plan or design of a new product or process are capitalized
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Intangible assets created internally (2)
Software development costs: costs incurred to develop software for sale to others
are expensed as incurred until the product’s technological feasibility has been estabilished, after which costs are capitalized
under IFRS, treatment is the same regardless of whether the software is developed for sale or for firm’s own use
under US GAAP, all R&D costs are capitalized only when the firm develops software for its own use
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Amortization of intangible assets
Intangible assets with finite useful lives are amortized over their useful lives amortization is identical to the depreciation of tangible
assets estimating useful lives is complicated by many regulatory,
legal, contractual, competitive and economic factors that may limit the use of the intangible assets
Intangible assets with infinite useful lives are not amortized but rather tested for impairment at least once a year
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Revaluation methods (1)
Under US GAAP, fixed assets are reported on the balance sheet at depreciated cost (original cost less accumulated depreciation and any impairment charges)
Under IFRS, fixed assets are also reported at depreciated cost - fair value as long as active markets exist for the assets so their fair value can be reliably estimated firms must choose the same treatment for
similar assets
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Revaluation methods (2)
Revaluation can result in increase or decrease in fair value from one period to next
Initial revaluation to fair value below historical cost results in a loss reported on the income statement decreasing net income and equity
Subsequent later upward revaluation is reported as a gain in the income statement on to the extent it reverses a previously reported loss
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Revaluation methods (3)
Any increase in an asset’s value above historical cost is not reported as gain on an income statement but is reported as a component of shareholders’ equity in an account called revaluation surplus
Later declines in an asset’s fair value first reduce this surplus and then result in a loss reported in an income statement
Revaluing asset’s value upward leads to: greater total assets and equity higher depreciation expense lower profitability, in periods after revaluation
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Impairment under IFRS (1)
Firm must annually assess whether events or circumstances indicate an impairment of an asset’s value
Asset is impaired when its carrying value exceeds recoverable amount recoverable value is the greater of fair value
less any selling cost and value in use value in use is the present value of future cash
flow stream from continued use
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Impairment under IFRS (2)
If impaired, asset’s value must be written down on the balance sheet to recoverable amount impairment loss – equal to the difference
between carrying value and recoverable amount – is recognized in income statement
Loss can be reversed if the value of impaired asset recovers in the future but it is limited to the original impairment loss
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Impairment under US GAAP
Asset is tested for impairment only when events and circumstances indicate it
Two steps are involved: recoverability: asset is considered impaired if carrying value
is greater than the asset’s future undiscounted cash flow stream
loss measurement: if impaired, asset’s value is written down to fair value on the balance sheet and a loss is recognized in the income statement
Loss recoveries are not permitted
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Impairment of held for sale assets
Held for sale assets are not depreciated or amortized but tested for impairment
If asset is impaired, the asset is written down to net realizable value and loss is recognized in the income statement
Loss can be reversed (under IFRS and US GAAP) if the asset’s value recovers in the future but it is limited to the original impairment loss
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Disclosure of long-term assets
There are many differences in disclosure requirements under IFRS and US GAAP.
The generally required are: carrying value of each class of assets accumulated depreciation and amortization title restrictions and assets pledged as collateral for impaired assets, loss and amount and
circumstances it caused for revalued assets (IFRS), revaluation date, how fair
value was determined and the carrying value
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Part IV
Long-term liabilities
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Bond
Is a contractual promise between a borrower (bond issuer) and a lender (bondholder) that obligates the bond issuer to make payments to the bondholder
Typically, two types of payments are involved: periodic interest payments repayment of principal at maturity
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Cash flow impact of issuing a bond
Cash flow from Financing
Cash flow from Operations
Issuance of debt
Increased by cash received (present value
of bond at market interest rate) No effect
Periodic interest payments No effect
Decreased by interest paid (coupon rate * face
value)
Payment at maturity Decrease by face value No effect
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Income statement impact of issuing a bond
Issued at par Issued at premium Issued at discount
Market rate = Coupon rate
Market rate < Coupon rate
Market rate > Coupon rate
Interest expense = coupon rate * face value = cash paid
Interest expense = cash paid - amortization
of premium
Interest expense = cash paid + amortization
of premium
Interest expense is constant
Interest expense decreases over time
Interest expense increases over time
* interest expense = market rate at issue * balance sheet value of liability at beginning of period
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Balance sheet impact of issuing a bond
Issued at par Issued at premium Issued at discount
Carried at face valueCarried at face value
plus premiumCarried at face value
less discount
Liability decreases as the premium is
amortized to interest expense
Liability increases as the premium is
amortized to interest expense
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Derecognition of debt (1)
At maturity any original discount or premium is fully amortized, so the book value of a bond liability and its face value are the same
Cash outflow to repay a bond is reported in the cash flow statement as a financing cash flow
Firm may choose to redeem bonds before maturity, for example, because interest rates have fallen
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Firm may choose to reedem bonds before maturity, for example, because interest rates have fallen
When bonds are redeemed before maturity, gain or loss is recognized by subtracting redemption price from the book value of the bond liability at the reacquision date
Under US GAAP any remaining unamortied bond issuance costs must be written off and included in the gain or loss calculation
No write-offs are necessary under IFRS because issuance costs are already accounted for in the book value of the bond liability
Derecognition of debt (2)
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Derecognition of debt (3)
Gain or loss from redeeming debt is reported in the income statement and additional information are disclosed
Analysts often eliminated gain or loss from income statement for analysis and forecasting
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Disclosure relating to debt
Firms often report all their outstanding long-term debt on a single line on balance sheet
Portion that is due within next year is reported as a current liability
Footnotes disclosure usually include: nature of liabilities maturity dates stated and effective interest rates call provisions and conversion privileges restrictions imposed by creditors assets pledged as securities amount of febt maturing in each of next five years
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Operating versus financial leases
Under IFRS, if substancially all rights and risks of ownership are transferred to the lessee, the lease is treated as a finance lease by both the lessee and the lessor
Otherwise, the lease is an operating lease Under US GAAP, lessee must treat lease as a finance (capital)
lease if any one of the following criteria are met: title to leased asset is transferred to lessee at the end of lease
period bargain purchase option exists lease period is 75% or more of asset’s economic life present value of lease payments is 90% or more of the fair
value of leased asset Under US GAP, lessor capitalizes lease if any one of
finance lease criteria are met and if lease payments are certain and lessor has substantially completed performance
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Reporting by Lessee (1)
Operating lease: at inception of the lease, the balance sheet is unaffected during the term of the lease, rent expense equal to tease
payment is recognized in income statement and an outflow from operating activities
Finance lease: at inception, lower of the present value of future minimum
lease payments or fair value of the leased asset is recognized as an asset and liability
over the term of the lease, asset is depreciated in income statement and interest expense is recognized
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Reporting by Lessee (2)
Finance Lease Operating Lease
Assets Higher Lower
Liabilities Higher Lower
Net income (in early years) Lower Higher
Net income (in later years) Higher Lower
Total net income Same Same
Operating income Higher Lower
Cash flow from operations Higher Lower
Cash flow from financing Lower Higher
Total cash flow Same Same
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Reporting by Lessor (1)
Under US GAAP, a capital lease is treated as either a sales-type lease or a direct financing lease
In both cases, at the inception of the lease, a lease receivable is created equal to the present value of lease payments
Lease payments are treated as part of interest income (CFO) and part principal reduction (CFI)
With a sales-type lease, lessor recognizes gross profit at the inception of the lease and interest income over the life of the lease
With a direct financing lease, lessor recognizes interest income only
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Reporting by Lessor (2)
For the operating lease, lessor recognizes the lease payment as rental income
Lessor also keeps the leased asset on its balance sheet and depreciates it over its useful life
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Disclosure of leases
Both lessees and lessors are required to disclose useful information about leases: general description of leasing arrangements nature, timing and amount of payments to be paid or
received in each of next five years (later payments can be aggregated)
amount of lease revenue and expense reported in income statement for each period presented
amounts receivable and unearned revenue under lease arrangements
restrictions imposed by lease arrnagements
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Thank you for your attention!
