Agata Kocia Ph D MBA Warsaw University Department

Agata Kocia, Ph. D. , MBA Warsaw University Department of Economic Sciences email: akocia@wne. uw. edu. pl Financial Statement Analysis -additional topics dr A. Kocia 1

Income taxes dr A. Kocia 2

Accounting versus tax code (1) n Financial accounting standards are often different than income tax laws and regulations n Therefore, the amount of income tax expense recognized in the income statement may differ from the actual taxes owed to the taxing authorities dr A. Kocia 3

Accounting versus tax code (2) n The timing of revenue and expense recognition is n n n 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 dr A. Kocia 4

Tax return terminology n Taxable income – income subject to tax based on the tax code n Taxes payable – tax liability on the balance sheet caused by taxable income n also known as current tax expense n Income tax paid – actual cash flow from income taxes including payments and refunds n Tax loss carryforward – a current or past loss that can be used to reduce taxable income in the future n Tax base – net amount of an asset or liability used for tax reporting purposes dr A. Kocia 5

Financial reporting terminology (1) n Accounting profit – pretax financial income based on financial accounting standards n also known as income/earnings before tax n Income tax expense – expense recognized in the income statement that includes taxes payable and changes in deferred tax assets (DTA) and liabilities (DTL) n Deferred tax assets – balance sheet amount that results from an excess of taxes payable over income tax expense n can also result from tax loss carryforward n Deferred tax liabilities – balance sheet amount that results from an excess income tax expense over taxes payable dr A. Kocia 6

Financial reporting terminology (2) n Valuation allowance – reduction of deferred tax assets based on the likelihood that the assets will not be realized n Carrying value – net balance sheet value of an asset or liability n Permanent difference – a difference between taxable income (on tax form) and pretax income (on income statement) that will not reverse in the future n 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 dr A. Kocia 7

Deferred tax liability n Is created when income tax expense (from income statement) is greater than taxes payable (from tax return) due to temporary differences n Occurs when: n n 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 n They are expected to reverse and result in the future tax outflows when the taxes are paid n Commonly, created when different depreciation methods are used for tax and financial statement purposes dr A. Kocia 8

Deferred tax asset n Is created when taxes payable (from tax return) are greater than income tax expense (from income statement) due to temporary differences n Occurs when: n n n 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 n They are expected to reverse and result in the future tax savings n Commonly, created due to post-employment benefits and warranty expenses dr A. Kocia 9

Tax base of assets n Is the amount that will be expensed (deducted) on the tax return in the future as the economic benefits of the assets are realized dr A. Kocia 10

Tax base of assets: Depreciable equipment n The cost of equipment is $100 000. In the income n n 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 1 st 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 dr A. Kocia 11

Tax base of assets: Accounts receivable n Gross receivables totaling $20 000 are outstanding at year-end n The firm recognizes bad debt expense of $1 500 in the income statement n For tax purposes, bad debt expense cannot be deducted until the receivables are deemed worthless n 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 dr A. Kocia 12

Tax base of liabilities n Is the carrying value of the liability minus any amounts that will be deductible on the tax return in the future n Tax base of revenue received in advance is the carrying value minus the amount of revenue that will not be taxes in the future dr A. Kocia 13

Tax base of liabilities: Customer advance n At year end, $10 000 was received from a customer for goods that will be shipped next year n The carrying value of the liability is $10 000 yet it will be reduced when the goods are shipped next year n $10 000 is taxed but not recognized in an income statement, instead a deferred tax asset is created dr A. Kocia 14

Tax base of liabilities: Notes payable n 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 n 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 dr A. Kocia 15

Impact of tax rate changes (1) n When the income tax rate changes: n deferred tax assets and liabilities are adjusted to the new rate n adjustment can also affect income tax expense n An increase (decrease) in the tax rate, will increase (decrease) deferred tax liabilities and deferred tax assets n income tax expense = taxes payable + ∆DTL ∆DTA dr A. Kocia 16

Impact of tax rate changes (2) n 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 n 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 n In case of DTL we add a negative change and in case of DTA we subtract a negative change dr A. Kocia 17

Permanent difference n Permanent difference is a difference between taxable income and retax income do not crease deferred tax assets/liabilities n can be caused by revenue that is not taxable, expenses that are not deductible or tax credits that reduce taxes n n Permanent differences will cause firm’s effective tax rate to differ from the statutory tax rate n Tax rateeff= income tax expense/pretax income dr A. Kocia 18

Temporary difference n 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 n example: investment in other firms – parent company can recognize earnings from the investment before dividends are received n dr A. Kocia 19

Valuation of DTL and DTA n 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 n Valuation allowance is a contra account that reduced DTA value on the balance sheet n Increasing the valuation allowance increases income tax expenses and reduces earnings – if circumstances change, DTA can be revalued upward dr A. Kocia 20

Disclosure information n Typically the following deferred tax information are disclosed: n n n 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 dr A. Kocia 21

Usefulness of data n Analyzing trends in individual reconsiliation items can aid in understading past earnings trends and in predicting future effective tax rates n Then can also help in predicting future earnings and cash flows or for adjusting financial ratios dr A. Kocia 22

US GAAP versus IFRS n Accounting treatment of income taxes under US GAAP and IFRS are similar n One major difference relates to valuation of fixed assets and intangible assets n 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) dr A. Kocia 23

Part II Inventories dr A. Kocia 24

Cost of Goods Sold (COGS) n Refers to beginning balance of inventory, purchases and the ending balance of inventory n under IFRS also known as Cost of Sales (COS) dr A. Kocia 25

Inventory valuation methods n Under IFRS the following methods are permissible: n n 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 n 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 n US GAAP also allows last-in, first-out method (LIFO), not permitted under IFRS n last-in, first-out – the item purchase most recently is assumed to be the first item sold n n in an inflationary environment, COGS are higher, earning lower and income tax also lower dr A. Kocia 26

Periodic inventory system n In a periodic inventory system, inventory values and COGS are determined at the end of accounting period n No detailed records of inventory are maintained n Inventory acquired during the year is recorded in a Purchases account n At the end of the period: n n 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 dr A. Kocia 27

Perpetual inventory system n In perpetual inventory system, inventory values and COGS are updated continuously n Inventory purchased and sold is recorded in Inventory account as transactions occur n Purchases account is not used dr A. Kocia 28

Periodic versus perpetual system n FIFO and specific indentification methods produce the same values for ending inventory and COGS regardless of method used n LIFO and weighted average cost methods can produce different results depending on which system is used dr A. Kocia 29

Net realizable value (NRV) n Under IFRS inventory is reported on the balance n n 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 dr A. Kocia 30

Lower of cost n Under US GAAP inventory is reported on balance sheet at the lower of cost or market n Market cost is equal to replacement cost but cannot be greater than NRV or less than NRV minus a normal profit margin n n 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 n If cost exceed market, the inventory is written down to market on the balance sheet and a loss is recognized in the income statement n If there is a subsequent recovery in value, no write ups are allowed under US GAAP dr A. Kocia 31

Reporting n 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 n if an active market exists for the commodity, the quoted market price is used to value the inventory; otherwise, recent market transactions are used n dr A. Kocia 32

Disclosure of inventory n Under US GAAP and IFRS required inventory disclosures include: n n n 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 dr A. Kocia 33

Inventory changes (1) n 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 n Cumulative effect of the change is reported as an adjustment to the beginning retained earnings of the earliest year presented n n 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 dr A. Kocia 34

Inventory changes (2) n If a firm changes to LIFO, change is applied prospectively, that is, no adjustments are made to the prior periods n carrying vale of inventory under the old method becomes the first layer of inventory under LIFO in the period of change dr A. Kocia 35

Implications of inventory method n Inventory turnover (also in days) and gross profit margin can be used to evaluate the quality of firm’s inventory management n Inventory turnover that is too low – many be an indication of slow-moving or obsolete inventory n 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 n 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 dr A. Kocia 36

Part III Long-lived assets dr A. Kocia 37

Capitalized versus expensed costs (1) n 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 n n 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 dr A. Kocia 38

Capitalized versus expensed costs (2) n Expenditure that is capitalized is initially recorded as an asset on balance sheet at cost n Except for land 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) n If an expenditure is immediately expensed, current period pretax income is reduced by the amount of the expenditure n The choice affects net income, shareholder’s equity, total assets, cash flows and numerous financial ratios dr A. Kocia 39

Capitalized versus expensed costs (3) n Capitalizing results in: n higher assets n higher equity n higher operating cash flow n higher earnings in the first year but lower earnings in subsequent years as the asset is depreciated dr A. Kocia 40

Capitalized interest (1) n 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 n n 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 n The interest rate used to capitalize interest is based on debt related to construction of an asset n If no construction debt is outstanding, the interest rate is based on existing unrelated borrowing dr A. Kocia 41

Capitalized interest (2) n Under IFRS, income earned by temporarily investing borrowed funds reduces the interest that is eligible for capitalization n Under US GAAP, there is no such reduction n 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) n Capitalized interest is reported in the cash flow statement as an outflow from investing activities while expensed interest is reported outflow from operating activities dr A. Kocia 42

Financial statement effects of capitalizing versus expensing interest dr A. Kocia 43

Intangible assets created internally (1) n Generally, costs to create intangible assets are expensed as incurred; exceptions are: R&D costs (under IFRS) and software development costs n R&D costs (under IFRS): n n 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 dr A. Kocia 44

Intangible assets created internally (2) n Software development costs: n 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 n under IFRS, treatment is the same regardless of whether the software is developed for sale or firm’s own use n under US GAAP, all R&D costs are capitalized only when the firm develops software for its own use dr A. Kocia 45

Amortization of intangible assets n Intangible assets with finite useful lives are amortized over their useful lives n amortization is identical to the depreciation of tangible assets n estimating useful lives is complicated by many regulatory, legal, contractual, competitive and economic factors that may limit the use of the intangible assets n Intangible assets with infinite useful lives are not amortized but rather tested for impairment at least once a year dr A. Kocia 46

Revaluation methods (1) n Under US GAAP, fixed assets are reported on the balance sheet at depreciated cost (original cost less accumulated depreciation and any impairment charges) n 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 n firms must choose the same treatment for similar assets dr A. Kocia 47

Revaluation methods (2) n Revaluation can result in increase or decrease in fair value from one period to next n Initial revaluation to fair value below historical cost results in a loss reported on the income statement decreasing net income and equity n Subsequent later upward revaluation is reported as a gain in the income statement on to the extent it reverses a previously reported loss dr A. Kocia 48

Revaluation methods (3) n 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 n Later declines in an asset’s fair value first reduce this surplus and then result in a loss reported in an income statement n Revaluing asset’s value upward leads to: n n n greater total assets and equity higher depreciation expense lower profitability, in periods after revaluation dr A. Kocia 49

Impairment under IFRS (1) n Firm must annually assess whether events or circumstances indicate an impairment of an asset’s value n 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 n value in use is the present value of future cash flow stream from continued use n dr A. Kocia 50

Impairment under IFRS (2) n If impaired, asset’s value must be written down on the balance sheet to recoverable amount n impairment loss – equal to the difference between carrying value and recoverable amount – is recognized in income statement n Loss can be reversed if the value of impaired asset recovers in the future but it is limited to the original impairment loss dr A. Kocia 51

Impairment under US GAAP n Asset is tested for impairment only when events and circumstances indicate it n Two steps are involved: n n 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 n Loss recoveries are not permitted dr A. Kocia 52

Impairment of held for sale assets n Held for sale assets are not depreciated or amortized but tested for impairment n If asset is impaired, the asset is written down to net realizable value and loss is recognized in the income statement n 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 dr A. Kocia 53

Disclosure of long-term assets n There are many differences in disclosure requirements under IFRS and US GAAP. n The generally required are: n n n 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 dr A. Kocia 54

Part IV Long-term liabilities dr A. Kocia 55

Bond n Is a contractual promise between a borrower (bond issuer) and a lender (bondholder) that obligates the bond issuer to make payments to the bondholder n Typically, two types of payments are involved: n n periodic interest payments repayment of principal at maturity dr A. Kocia 56

Cash flow impact of issuing a bond Issuance of debt Cash flow from Financing Cash flow from Operations Increased by cash received (present value of bond at market interest rate) No effect Decreased by interest paid (coupon rate * face value) Decrease by face value No effect Periodic interest payments Payment at maturity dr A. Kocia 57

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 = cash paid - amortization of premium Interest expense = cash paid + amortization of premium Interest expense decreases over time Interest expense increases over time Interest expense = coupon rate * face value = cash paid Interest expense is constant * interest expense = market rate at issue * balance sheet value of liability at beginning of period dr A. Kocia 58

Balance sheet impact of issuing a bond Issued at par Issued at premium Issued at discount Carried at face value plus premium Carried at face value less discount Liability decreases as the premium is amortized to interest expense dr A. Kocia Liability increases as the premium is amortized to interest expense 59

Derecognition of debt (1) n 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 n Cash outflow to repay a bond is reported in the cash flow statement as a financing cash flow n Firm may choose to redeem bonds before maturity, for example, because interest rates have fallen dr A. Kocia 60

Derecognition of debt (2) n Firm may choose to reedem bonds before maturity, for example, because interest rates have fallen n 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 n Under US GAAP any remaining unamortied bond issuance costs must be written off and included in the gain or loss calculation n No write-offs are necessary under IFRS because issuance costs are already accounted for in the book value of the bond liability dr A. Kocia 61

Derecognition of debt (3) n Gain or loss from redeeming debt is reported in the income statement and additional information are disclosed n Analysts often eliminated gain or loss from income statement for analysis and forecasting dr A. Kocia 62

Disclosure relating to debt n Firms often report all their outstanding long-term debt on a single line on balance sheet n Portion that is due within next year is reported as current liability n Footnotes disclosure usually include: n n n n a 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 dr A. Kocia 63

Operating versus financial leases n 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 n Otherwise, the lease is an operating lease n Under US GAAP, lessee must treat lease as a finance (capital) lease if any one of the following criteria are met: n title to leased asset is transferred to lessee at the end of lease period n bargain purchase option exists n lease period is 75% or more of asset’s economic life n present value of lease payments is 90% or more of the fair value of leased asset n 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 dr A. Kocia 64

Reporting by Lessee (1) n Operating lease: n n 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 n Finance lease: n n 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 dr A. Kocia 65

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 Operating income Higher Lower Cash flow from operations Higher Lower Cash flow from financing Lower Higher Total cash flow Same dr A. Kocia 66

Reporting by Lessor (1) n Under US GAAP, a capital lease is treated as either n n 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 dr A. Kocia 67

Reporting by Lessor (2) n For the operating lease, lessor recognizes the lease payment as rental income n Lessor also keeps the leased asset on its balance sheet and depreciates it over its useful life dr A. Kocia 68

Disclosure of leases n Both lessees and lessors are required to disclose useful information about leases: n n n 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 dr A. Kocia 69

Thank you for your attention! dr A. Kocia 70