Chapter_4 How to cope with the most complex points.v2

8/7/2019 Chapter_4 How to cope with the most complex points.v2

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From : Vernimmen , Theory & practise

Chapter 4

HOW TO COPE WITH THE MOSTCOMPLEX POINTS IN FINANCIAL

ACCOUNTS


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Accruals Deferred tax assets and

liabilities Exchangeable bonds Mandatory convertible bonds Goodwill Impairment losses Intangible fixed assets Inventories

TOPICS

Leases Off-balance-sheet commitments Pensions and other employee

benefits Preference shares Provisions Tangible fixed assets Treasure shares


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ACCRUALS and DEFERRALS

Accruals revenues and costs booked in one period butrelating to another period

=

DEFERRALS prepaid expenses are costs relating to goods or services to be

supplied later. They are an asset, because they provide afuture benefit to the owner.

prepaid revenues are revenues accounted for before therelated goods or services have been delivered or carried out

ACCRUALS accrued income and costare the reversal of prepaid costs and

income

Accounting:

they are part of the operating working capital


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ACCRUALS and DEFERRALS

What are accruals? Accruals and deferred are used to recognise revenues and

expenses booked in one period but relating to another period.How are they accounted for? prepaid expenses, i.e. charges relating to goods or services to

be supplied later. For instance, three-quarters of a rental charge

payable in advance for a 12-month period on 1 October eachyear will be recorded under prepaid expenses on the asset sideof the balance sheet at 31 December.

prepaid income, income accounted for before thecorresponding goods or services have been delivered or carriedout. For instance, a cable company records three-quarters ofthe annual subscription payments it receives on 1 Octoberunder prepaid income on the liabilities side of its balance sheetat 31 December.

How should Finance Analysts treat them? Prepaid income and expense often form part of operating

working capital


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LONG TERM CONTRACTS

1 What are LT contracts? In some cases, it may take more than a year for a company to complete a

project. For instance, a group that builds dams or ships may work forseveral years on a single project.

2 How are they accounted for? LT contracts are accounted for using the percentage of completion

method, which consists in recognising at the end of each financial yearthe sales and profit/loss anticipated on the project in proportion to thepercentage of the work completed at that time.

3 How should financial analysts treat them? In order to assess the earnings quality of a company, analysts need to

check whether or not a change in method has occurred recently. Projects in progress are part of the operating working capital. The

percentage of completion method results in less volatile profits as they are

spread over several fiscal years even if the completed contract methodmay seem more prudent. Analysts should beware of changes inaccounting methods for LT contracts as such change may indicate anattempt to improve artificially the published net income for a given year.


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DEFERRED TAX ASSETS AND LIABILITIES

Deferred tax assets and liabilities deferred taxation=

They can derive from:

Differences between the taxable and book value of assets andliabilities in the balance sheet

Differences in period in which the income or cost is recognisedfor tax and accounting purposes in the income statement

if the difference is due to the method used to derivetaxable profit from accounting profit accelerateddepreciation for tax purposes


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Exchangeable bonds bonds that may be redeemed atthe request of their holders intoshares of a companyother thanthe issuerof the bonds or in cash

=

they are financial debt

Accounting:

As financial debtNo equity component

EXCHANGEABLE BONDS


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MANDATORY CONVERTIBLE BONDS

Mandatory convertiblebonds

bonds paying a rate of interestnot linked to the companysprofitability and are redeemedin shares of the issuer

=

Accounting:

Mandatory convertible bonds are compound financialinstruments (bond + deferred issue of shares) at issue, theyare allocated between debt and equity

they are going to become equity


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GRANTS and SUBSIDIES

GrantsBalance sheet

Asset side: write the amount of the assets towhich the forgivable loan is allocated.Liabilities: insert a fund whose value will be

reduced every year by the amount expensed ineach period

Income statementSubtract the annual quota of the deferred from the annual

depreciation and amortization

Subsidies: subtract the amount of the subsidies from thecosts for which the subsidy has been obtained


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IMPAIRMENT LOSSES

Impairment losses provisions set aside to cover capitallosses or other losses that may bereasonably anticipated on assets

=

Accounting:

Impairment losses are computed based on the value of CashGenerating Units (CGU). The firm needs to define a maximumnumber of largely independent CGUs and allocates assets foreach one. Each year, the recoverable value of the CGU is

computed if there is indication that there might be a decrease invalue or if it includes goodwill. If the recoverable value of theCGU is lower than the carrying amount, an impairment lossneeds to be recognized. Impairment is first allocated to goodwill(if any) and then between the other assets.


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IMPAIRMENT LOSSES

Accounting:

The recoverable value is defined as the highest of: the value in use, i.e. the present value of the cash flows

expected to be realised from the asset; the net selling price, i.e. the amount obtainable from the saleof an asset, less the costs of disposal.

If the value of the CGU increases again, the impairment can be

reversed on all assets butgoodwill.


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INTANGIBLE FIXED ASSETS

IFRS:

Intangible assets have to be recognised if and only if:

Their future economic benefits will flow to the company The cost of the asset can be reliably measured

No recognition as intangible assets for: internally generatedbrands, publishing titles and customer lists

Expense as incurred for: internally generated goodwill andcosts on starting up a business, on training, on advertising, onrelocating or reorganizing a company

Intangible assets are generally noteworthy!


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Some intangibles goodwill, licences, trademarks have indefinite lives and, therefore, are not subject toamortization. But they are subject to a write-down whentheir value decreases.

Every year the company determines whether theintangibles have increased or decreased in value. If theintangible is worth more at the end of the year than at thebeginning, no increase in the asset is permitted.

But if the intangibles has decreased in value, then thecompany will record a loss entirely in the period in which itoccurs.


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C

orporateFINA

NCE.Theorya

ndpractice

Chapter 7 HOW TO COPE WITH THE MOST COMPLEX POINTS IN FINANCIAL ACCOUNTS

2009 - John Wiley & SonsQuiry, Dallocchio, LeFur, Salvi - Corporate Finance. Theory and Practice

AMORTIZED

Patents

Government grants giving the holder the exclusive right (USA & France:20 yrs) to produce and sell an invention for a specific period of time. Thislength corresponds to the amortization period.

Copyrights

Exclusive rights to reproduce and sell a book, musical composition, or

other work of art. Copyrights also protect computer software programs.In USA copyrights extend 50 years beyond the authors life. However,because the useful life of a copyright is usually no longer than 2to 3 years, each period amortization amount is a high proportionof the copyright cost (when purchased from the owner)

R&D costs

US GAAP requires companies to expense R&D costs as they incur them.

Only in limited circumstances may the company capitalize Dev costs asan asset.

NON AMORTIZED

Trademarks & Brands

If the trademark is expected to generate cash flow for the indefinitefuture, the business should not amortize the trademarks cost

Franchises& licences

The useful lives of many franchises and licences are indefinite and,therefore, are not amortized

Goodwill

Excess of the cost of purchasing another company over the sum of themarket values of its net assets. Goodwill has special features, as follows:

1.Is recorded only when is purchased in the acquisition of anothercompany

2.Is not amortized because the goodwill of many entities may increasein value


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book value market value

IFRS: relevant intangible assets (both with finite and indefinitelives) must be assessed by an yearly impairment test to verifythat:

book value > recoverable value

otherwise the asset have to be written down

Recoverable value the highest of the value in use andthe net selling price

=

Intangible assets with indefinite lives are not amortisedIntangible assets with finite lives are amortised over their usefullife


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INTANGIBLE FIXED ASSETS Startup Costs

Startup costs costs incurred in relation to the creationand the development of a company

=

In Finance Analysis, they have no value deduction from shareholders equity

Accounting:IFRS: startup costs are to be expensed as incurred

US GAAP: startup costs are included in Other nonrecurrentassets and amortised over 3-5 years


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INTANGIBLE FIXED ASSETS Research and

Development CostsResearch anddevelopment costs

costs incurred by a company onresearch and development for itsown benefit

=

they have considerable value cannot be ignored

Accounting:

IFRS: capitalisation allowed only for development costs (undercertain circumstances).

US GAAP: capitalisation is not possible


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INTANGIBLE FIXED ASSETS Research and

Development Costs Research costs are expensed as incurred in line with theconservatism principle governing the unpredictable nature of suchactivities.

Development costs can be capitalised on the balance sheet ifthe following conditions are satisfied:

the project or product is clearly identifiable and its costsmeasurable; the products feasibility can be demonstrated; the company intends to produce, market or use the product or

project; the existence of a market for the project or product can be

demonstrated;

the utility of the product for the company, where it is intended forinternal use, can be demonstrated; the company has or will have the resources to see the project

through to completion and use or market the end product.

The recommended amortisation period is not longer thantwenty years and shorter if the useful economic life is known.


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INTANGIBLE FIXED ASSETS Brands and

Market ShareBrands andmarket share

brands or market share purchased fromthird parties and valued upon their first-time consolidation by the parent company

=

These intangible fixed assetsneed continual monitoring

Accounting:Capitalisation of brands only if they are acquired otherwise,

accounting deficiency

Capitalisation of market share only if the company can protect orcontrol its customer relationship


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INVENTORIES

Inventories items used as part of the companysoperating cycle

=

Accounting:

used up in the production process raw materials and goods for

resale sold as they are finished goods

sold at the end of a transformation process underway/not yet started work in progress

Raw materials and goods for resale: accounted for at full

acquisition costFinished products and work in progress: accounted for atproduction cost

Costs must be calculated based on normal levels of activity


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INVENTORIESValuation methods

Weighted average cost consists in valuing items withdrawnfrom the inventory at their weighted average cost, which is the totalpurchase cost divided by quantities purchased. FIFO values inventory withdrawals at the cost of the item thathas been held in inventory for the longest.

LIFO values inventory withdrawals at the cost of the mostrecent addition to the inventory.

IFRS : Clear preference for the weighted average cost andFIFO methods. US GAAP permits all methods. During periods of inflation, the FIFO method enables a company to

post a higher profit than under the LIFO method. Analysts need to be particularly careful when a companychanges its inventory valuation method.

If the inventories market value is lower than the carrying amount, animpairment loss has to be recognised


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EXAMPLESuppose a division of IBM that handles computer components has these

inventory records for January

Date Item Quantity Unit cost Totalcost

Jan 1 Beginning

inventory

100 8 800

Jan 6 Purchase 60 9 540

Jan 21 Purchase 150 9 1,350

Jan 27 Purchase 90 10 900


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LEASES

Leases contracts allowing companies to use some fixedassets under a rental system, usually with theoption to purchase them at the end of thecontract for a predetermined amount

=

Accounting:

lease that transfers substantially all the risk and rewards incident toownership of an asset finance lease

lease that is not a finance one operating lease

IFRS: capitalisation of finance lease recording of fixed assets

and financial debt; recording of financial and depreciation costs;no rental costs. Treatment as rentals for operating leases.

consider all leases as finance leases


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LEASES

Steps for financial lease accounting treatment:

BALANCE SHEET Insert the present value of the asset among the fixed assets:

this value is obtained by discounting the sum of periodicalinstalments + redemption price (discount rate should be theinternal rate of return of the leasing)

Insert a depreciation fund of the leased fixed assets that willbe subtracted from the value of the assets

Insert the value of debt (named: leasing) among thefinancial liabilities: subtract the current instalment from thepresent value of the asset and add the interest expense of the

periodINCOME STATEMENT1) Divide the annual lease rental into 2 parts:

Asset depreciation Interest expenses


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PENSIONS AND OTHER EMPLOYEE BENEFITS

Pensions andother employeebenefits

include severance payments,special retirement plans, lifeinsurance and similar entitlements

=

Accounting:

A distinction is made between: defined benefit plans

defined contribution plans

Defined benefit plans require detailed specific information

disclosures in accounts. A defined benefit plan gives rise to aliability corresponding to the actuarial present value of all thepension payments due at the balance sheet closing date(Defined benefit obligation or, in US GAAP, Projected BenefitObligation PBO).


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PREFERENCE SHARES

Preference shares shares that combine characteristicsof shares and bonds

=

Accounting:

IFRS: the preference share is considered as financial debt if either(substance over form analysis):

it provides for mandatory redemption by the issuer in the future if the holder has the right to put the preference share to the issuer in

the future or if the preference share pays a fixed dividend

Otherwise it is considered as equity

US GAAP: preference share are as equity

they are equity if and only if:1. returns linked solely to the companys earnings2. no repayment commitment3. claims on the company ranking last in the event of liquidation


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PROVISIONS Restructuring Provisions

Restructuring charges costs related to a futurerestructuring programme

=

Accounting:

If derived from an obligation towards third parties or workforce,they represent a liability.

except for SMEs, they are operating coststhe corresponding liability is a financial debt


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TANGIBLE ASSETS

Tangible assets land, buildings, technical assets,industrial equipment and tools,other tangible fixed assets andtangible fixed assets in progress

=

Accounting:Recording at acquisition cost (including financial expense) anddepreciation over time (except for land)

IAS: it is possible to revaluate at fair value

NB: historical cost not always reflects tangible assets value

they have significant impacton different parameters

close analysis and monitoring of changes


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TANGIBLE ASSETS

Straight line: an equal amount of depreciation is assigned toeach year of asset use.Units-of-production. A fixed amount of depreciation isassigned to each unit of output, or service, produced by theasset. Depreciable cost is divided by useful life, in units of

production, to determine this amount. The pre-unit depreciationis then multiplied by the number of units produced each year tocompute depreciation. The FedEx truck depreciation per unitcould be:

Cost Residual value = 40,000 - 1,000= 0,39 x km.

Useful life, in units of production = 100,000 km.

Accelerated depreciation. This method writes off a largeramount of the assets cost near the start of its useful life thanthe straight-line method does.


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TREASURY SHARES

Treasury shares shares that a a company or itssubsidiaries own in the company itself

=

Accounting:

IFRS: deduction from shareholders equity

they are the same as capital reduction deduction from assets and equity


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CONCLUSIONS

Accounting rules not always reflect the economic andfinancial standpoint.

In these cases, financial analysts must have in mindthe differences between them in order to deal withcomplex issues.

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Chapter_4 How to cope with the most complex points.v2