Corporate Finance - Corporate Governance

8:30 AM

Corporate governance
Using Schweser notes for this - CFAI materials just too long and boring

Corporate governance is the system of internal controls and procedures by which companies are managed.  Firm's checks and balances.

Duty of board is to protect shareholders' long term interests.  Investors should consider:

• Is a majority of board independent members
• Board meets regularly outside presence of mgmt
• Is chairman CEO or former CEO - this could impair judgment
• Independent board members have a leading member in cases where chairman is not independent
• Board members have no conflicting relations - can excuse themselves when needed

Frequency of board elections

• Should be able to approve or reject board members annually
• Classified board - may need a multiple yr term perhaps as a takeover defense
• Is the board the proper size?

Board independence

• Board = independent IF decisions are not controlled or biased by mgmt
• No material relationships
• No groups with a controlling interest
• No advisors etc
• Any entity which has a cross directorship
• Need independence, experience and resources
• Avoid having compensation for finders' fees and consulting fees
• Firm should disclose any material relationships

Experience

• Consider any public statements of board members
• Necessary experience/qualifications
• Have they served on board long enough/too long?
• Capable in technologies etc.
• Attendance records

Code of ethics - have one

Board Committees

• Audit - make sure accounting is all good
• All audit committee members must be independent
• Proper accounting
• Compensation
• Link compensations to performance and profitability
• Compensation appropriate levels
• Nominations
• Recruiting of new board members
• Review experience/quals/performance of current members
• Other
• These typically fall outside normal governance codes, so be wary of these
• Independence is critical

Voting procedures

• Make sure company doesn't require attendance at meetings to vote
• Can use share blocking (good thing) - prevents those who want to vote from trading shares for a set period before annual meeting
• Confidential Voting
• This is a good thing apparently
• Can encourage unbiased voting
• Cumulative Voting
• Shareholders may be able to cast cumulative votes allotted for one or a limited number of board nominees
• Be cautious if there is a considerable minority shareholder group that may vote cumulatively together
• Voting for other corporate changes
• Articles, bylaws, voting rights, poison pill, provisions for change in control
• Shareholders should be able to vote in all matters
• Also review share buybacks and issuance of new stock

Shareowner sponsored nominations/resolutions - how can a shareholder nominate a board member and/or proposals for management changes

• Consider whether mgmt is actually bound/likely to implement these suggestions

Different classes of common equity

• Some classes of shares may separate voting rights from economic value
• Typically harder to raise capital when this is the case
• Should consider whether inferior equity's interest is still protected

Shareowner legal rights - should have legal recourse to their ownership through regulators etc.  'Dissenters' rights' require a firm to repurchase shares at FMV in the event of a problem

Takeover defenses

• Golden parachutes - rich compensation packs for execs who would lose jobs
• Poison pills - provisions that grant rights to existing shareholders in the event a certain percentage of shares are acquired
• Greenmail - use of corporate funds to buy back shares of acquiror at a premium
• All of these could decrease shareholder value
• Consider whether investors need to approve such measures

End

9:15 am

0.75 hrs

Corporate Finance - Financial Statement Analysis

6:00 pm

Reading 41 of CFAI Materials
Review of Dupont Analysis

• ROA = Net profit margin * revenues/avg total assets
• Net profit margin breaks down further
• Net profit margin = operating profit margin * income before taxes / operating income * (1 - taxes / income before taxes)
• Income before taxes / operating income is the effect of nonoperating expenses - critical value is 1
• ROE = Net income / average shareholders' equity
• ROE = net profit margin * revenue / average total assets * average total assets / average shareholders' equity
• Can again expand out net profit margin
• This is the 5 part dupont
• Can compare Duponts of different companies to compare what they do differently and how ROA and ROE are composed

Pro Forma Analysis

• Forecasting income statements and balance sheets
• Some factors are tied to revenues, others are not
• Sales driven factors
• COGS as a percent of sales
• Opex as a percent of sales
• Current assets and current liabilities as a percent of sales
• Fixed burdens
• Primarily interest and taxes
• Taxes as a percent of taxable likely to remain same
• Interest is a function of capital structure - if it will not change, just use past interest expense
• Revenues
• Strictly using growth from past periods does not take into account other factors that impact revenues
• Product mix might change
• Try to build up by forecasting segment by segment

Interest/iterations

• Will depend on capital structure - need some assumption about what happens with excess funds and how deficits are financed
• Using a surplus to pay down debt will also decrease interest expense, and there will still be a small surplus - so you have to use this surplus to again pay down the debt
• If the assumption instead was that you would maintain total debt/total equity relationship, you would use the surplus to buy back stock and it would balance

End

7:00 pm

1 hour

Corporate Finance - Working Capital Management

2:45 pm

Working Capital Management
Reading 40 in CFAI Materials

Liquidity - extent to which a company can meet its short term obligations

• Focus on type of asset and speed at which it can be converted to cash, either by sale or financing
• Primary sources
• Cash
• Short term funds - trade credit, bank lines, short term investments
• Cash flow mgmt - more centralized/quicker is better
• Secondary sources
• Main difference is primary source not likely to interfere with normal operations
• Renegotiating debt contracts
• Liquidating assets
• Bankruptcy protection/reorgs
• Drag and Pull
• Drag - when receipts lag
• Long AR, obsolete inventory, and tight credit are all drags
• Pull - when expenditures are sped up
• Making pmts early, reduced credit limits, limits on short term lines of credit, and low liquidity positions

Measuring liquidity

• Company's cash flows ultimately determine solvency
• Liquidity should neither be too high nor too low - too much capital in non-earning assets is not a good thing
• Current Ratio
• Current ratio = current assets / current liabilities
• Quick Ratio
• Same as above but exclude inventory
• Must compare these to comps to see what is normal
• AR Turnover
• AR Turnover = credit sales / average receivables
• Days = AR / (credit sales / 365)
• Inventory Turnover
• Inv Turnover = COGS / Avg Inventory
• Days = Inventory / (COGS / 365)
• Days Payables
• Days = AP / (Purchases / 365)
• Operating cycle = days inventory + days receivables
• Net operating cycle = days inventory + days receivables - days payables

Managing the cash position is a complex task

Measuring yields on short term investments

• Money Mkt Yield = (Face value - purchase price) / purchase price * (360 / days to maturity)
• Bond equivalent - same as above but with 365

Risks

• Credit/default risk
• Market/interest rate risk
• Liquidity - security hard to sell
• Foreign exchange risk - adverse movements in currency

Strategies

• Passive - just use a few rules.  Less agressive
• Active
• Matching - match timing of cash outflows with investment maturities
• Mismatching - more aggressive - might use derivatives
• Laddering - somewhere in between - spread investments over the term of the ladder

Accounts Receivable Management

Cash Float Factor = average daily float / (total amount of checks deposited / number of days)

• Measures how long it takes checks to clear

AR Ageing Schedule - shows how much and for how long AR have been outstanding

• Can also calculate a wtd average days receivables

Managing inventory

• Transactions motive - need inventory as part of routine production cycle
• Precautionary stocks - keep these to avoid missing out on profit opportunities (stockout losses)
• Strategy 1: Economic Order Quantity
• Reorder at a certain quantity to meet expected demand based on how long it takes to replenish
• Must have a reliable short term forecast
• Probably use a safety stock as well
• Strategy 2: Just in Time Inventory
• Minimize in process inventory stocks
• Incorporate production planning into inventory management
• Can be used in conjunction with EOQ
• Inventory costs
• Ordering, carrying/storage, stockout (lost sales), policy (gathering data)

Managing AP

• Basically two countering forces - paying too early is costly unless company can take advantage of discounts, and paying late affects the company's perceived creditworthiness

Trade discounts

• Implicit rate of return:
• cost of trade credit = (1 + (discount / (1-discount)))^(365/number of days beyond discount) - 1
• Since cost of funds is 0, it is beneficial for customer to pay at the last moment
• Ex: terms are 1/10, net 30
• Paid on 20th day:
• (1 + (0.01/(1-0.01)))^(365/10) - 1 = 44.32%
• Paid on 30th day:
• (1 + (0.01/(1-0.01)))^(365/20) - 1 = 20.13%

Managing cash disbursements

• Delay funding bank accounts until checks clear
• Checkguards against fraud
• Pay electronically

Evaluating AP Management

• Days payable = AP / average day's purchases

Managing short term financing

• Sources
• Banks - secured/unsecured loans
• Committed lines of credit - prepayable without penalty, good for 364 days 
• Revolvers - good for multiple yrs, larger amounts usually
• Short term borrowing approaches
• Consider peak cash needs
• Maintain sources so you can fund ongoing needs
• Get a good rate
• Strategies can be active or passive, just like investing strategies

Asset based loans

• Shorter term ABLs can be secured by inventory and AR - challenge for the lender
• Lenders might have blanket lien on current and future assets of company
• AR can be collateralized (company still administers collections) or factored (shift off to a third party)
• Inventory can also be a source of liquidity
• Inventory blanket lien - company can still sell in ordinary course of business
• Trust receipt arrangement - company must certify goods are held in trust, proceeds of any sale remitted to lender immediately
• Warehouse receipt arrangement - similar to above but third party supervises the inventory

Computing costs of borrowing

• Divide total cost of borrowing by amount received
• Account for any commitment fees etc.

End

4:30 pm

1.75 hrs

Corporate Finance - Dividends and Share Repurchases

12:00 pm

Reading 39 of CFAI materials
Dividends and Share Repurchases: Basics

Intro

• Dividends and share repurchases are the two ways a company can distribute cash to its shareholders
• Dividends are not legally required and may be bound by other restrictive covenants
• Sometimes taxed at both corporate and shareholder level
• Dividends + shares repurchased = company's payout for the year
• Dividends can be an important source of return when stock prices are volatile

Forms of dividends

Regular

• Usually quarterly, semiannual, or annual
• Regular and especially increasing dividends signal to investor that company is growing and will share profits

Dividend Reinvestment Plans (DRP or DRIP)

• Automatically reinvests dividends into additional shares of the company
• Shareholders must indicate intent to participate
• Open Mkt DRP - company purchases shares in open mkt to give to plan participants
• New Issue DRP - issue new shares instead of repurchasing
• Some plans do both
• Can avoid flotation costs to issue new shares
• Allow for cost averaging and no transaction costs
• Note that nonparticipants will get diluted
• Disadvantage: changes cost basis for capital gains purposes - must keep records
• Also fully taxed in year granted - so might be best off in a 401k

Extra or Special (Irregular) Dividends

• Can be used to get rid of excess cash
• Can also help moderate during a downturn - only pay out specials when things go well

Liquidating Dividend - three definitions:

• Company goes out of business and net assets are distributed to shareholders
• Sells portion of business for cash and distributes proceeds
• Pays a dividend that exceeds accumulated RE and thus impairs stated capital

Stock Dividend

• Non-cash form of dividend
• Issues typically 2-10% of then shares outstanding and issues to shareholders
• Total cost base remains same, but price per share decreases
• Generally not taxable - just divides the pie further
• Does not change fractional ownership or value of position - kind of a nothing move
• Increase in shares is perfectly offset by decrease in price
• Advantage: for company, it expands to a broader shareholder base; lower stock price attracts more investors
• Stock dividend has no effect on capital structure
• Cash dividends reduce assets (cash) and retained earnings/equity, thus affecting ratios
• Decreases liquidity and increases leverage
• Stock dividends DO reduce retained earnings but contributed capital rises by same amt
• Does not affect ratios

Stock Splits

• Assuming same P/E and dividend payout ratio, dividend yield (dividends/share price) is also unchanged
• Does not affect ratios
• 2:1 stock split is basically the same thing as a 100% stock dividend
• Difference in accounting treatment tho
• Stock dividend switched equity from RE to Cont Capital - Stock Split doesn't affect this
• Can announce at any time
• Not in and of itself a meaningful predictor of future price action
• Reverse Stock Splits
• Same but in reverse - intended to increase prices of shares
• Important for some institutional investors

Dividends: Payment chronology

• Declaration date - dividend is declared
• Also announce holder of record date and record and payment dates
• Ex-dividend date - usually 2 days before holder of record date
• This is the first date the shares trade without the dividend
• Signified in quotes with an x in the volume column that indicates the dividend value has been removed from share price
• Determined by exchange
• Holder of Record Date
• Two days before ex-dividend date
• Determined by corporation, not exchange
• Payment Date
• Can occur on a weekend or holiday
• Company actually mails out/send electronically the dividend
• Which ex and record date are always 2 days apart, the other timings can vary greatly

Share Repurchases

• Company buys back its own shares
• Alternative to cash dividends - uses company cash
• Repurchased shares are called treasury stock
• When an amount of share repurchases is authorized, it is not an obligation to repurchase
• Different than declaring a dividend, which is binding
• Motivators
• Signal to market that company thinks shares are undervalued or provide price support
• Flexibility - amount and timing are not perceived as a establishing an expectation of future actions
• Tax advantages - cash dividends might be taxed harder than capital gains
• Absorb increases in share dilution from exercise of employee stock options
• Maybe just has too much cash too

Share Repurchase Methods

• Buy in open market (most common)
• Maximum flexibility, no shareholder approval required (in US - in Europe, companies get preapprovale), no minimum commitment amount
• Buy back fixed number at fixed price
• Make a fixed price tender offer
• If oversubscribed, by a pro rata amount from each seller
• Dutch Auction
• Company states a range of acceptable prices
• Shareholder's bid up and then once you have met the stated amount with the qualifying bids you buy shares from all those who bid to that amount (e.g. $39 per share will get you 5 mm shares)
• Repurchase by Direct Negotiation
• Negotiate directly with large shareholders to buy back at a premium
• Prevent activist shareholding/large block overhang
• Sometimes takeover attempts end in target company buying suitor's shares back at a premium, to detriment of other shareholders ('greenmail transaction')
• Many transactions however are at discounts - driven by liquidity needs of large holders

Financial Statement Effects of Repurchases

• Can affect both balance sheet and IS
• A and E both decline if financed with cash
• Leverage will increase even more if repurchase is financed with debt
• Fewer shares out might increase EPS depending how and at what cost purchase is financed
• EPS
• May increase, stay, or decrease
• In case of internal financing, repurchase increases EPS ONLY IF funds used would NOT earn their cost of capital if retained by the company
• If externally financed (debt), improves EPS only if earnings yield (E/P) exceeds after tax cost of borrowing
• Book Value of Shares
• If shares on book are below market, book value per share decreases - you are buying cheaper shares in the market
• Reverse case is also true

Valuation equivalence of Cash Dividends and Share Repurchases

• All other things equal, cash dividends and share repurchases in same amount should have same economic impact
• Negotiated share repurchases at a premium essentially transfer wealth from other shareholders to the beneficiary of the repurchase

End

1:15 pm

1.25 hours

Corporate Finance - Measures of Leverage

5:30 pm

Measures of Leverage
Reading 38 in CFAI materials

Intro

• Leverage is use of fixed costs in a company's cost structure
• High operating costs = operating leverage
• High financial costs = financial leverage
• Leverage can magnify earnings both up and down
• Helps assess risk/return, interpret mgmt signals, and in valuation/discount rate selection

Greater leverage, greater risk, and greater discount rate should be applied

• Cost structures have fixed and variable components
• Risk can be very different for two companies with the same net income
• Variability in net income is higher for more levered companies

Components of risk

• Revenue risk, economy, competition, etc - 'sales' risk (uncertainty wrt price/quantity of goods sold)
• As illustrated by standard deviations of unit sales prices
• Operating risk - cost structure risk, esp fixed costs.   
• Greater fixed to variable, greater operating risk
• Degree of Operating Leverage - measure of elasticity of income to sales
• DOL = %change in operating income / %change in units sold
• This changes for different unit sales levels
• Another form:
• DOL = [Q * (P - V)] / [Q * (P - V) - F]
• Business risk = sales risk + operating risk

Operating Risk

• Operating income = number of units * per unit contribution margin - fixed operating costs
• In practice you don't have a clean breakdown of fixed and variable
• You can regress changes in operating income on changes in revenue
• Higher coefficient = higher operating leverage

Financial Risk

• Risk of a security is affected by both business risk and financial risk
• Financial risk is a product of taking on debt
• Degree of Financial Leverage:
• DFL = %change in net income / %change in operating income
• DFL = [Q * (P - V) - F] / [Q * (P - V) - F - C]
• DFL is NOT affected by tax rate - it cancels out of the equation
• Also different at different levels of income
• DFL is usually a choice of management (unlike DOL)
• Companies with high ratios of tangible assets to total assets might be able to use more leverage

Total Leverage

• Combined effect of operating and financial leverage
• Degree of Total Leverage
• DTL = %change in net income / %change in number of units sold
• DTL = DOL * DFL
• DTL = [Q * (P-V)] / [Q * (P-V) - F - C]

Breakeven Points

• Quantity where total revenues = total costs
• PQ = VQ + F + C
• Qbreakeven = (F + C) / (P - V)
• Operating preakeven point
• Rather than net income, can exclude financing costs
• PQ = VQ + F
• Qbreakeven = F / (P - V)

Risks of Creditors and Owners

• Lenders have a prior claim over investors - higher security but lower returns
• Equity owners may get a lot, or may get nothing
• Get right to hire, fire, and guide managers
• Chapter 11 and liquidation - difference between the two is often difference between financial and operating leverage
• High operating leverage can't be fixed in bankruptcy
• High financial leverage can be alleviated by changing capital structure

End

6:30 pm

1 hour

Corporate Finance - Cost of Capital

12:45 pm

Cost of Capital
CFAI Reading 37

Intro

• If a company returns at less than the rate it borrows at it actually destroys value
• Cost of capital must be estimated, and this is difficult
• Rough measure of risk
• Companies should evaluate each project on its own cost of capital; in practice they use one cost of capital throughout, and add/subtract based on project's relative risk to typical project

Cost of Capital

• Rate of return that supplier of capital (bondholders and owners) require as compensation
• Also equates to the suppliers' opportunity cost of capital - they will not willingly invest unless it is good enough return for risk
• We are concerned with marginal - what it would cost to raise additional funds
• WACC
• WACC = WdRd(1-t) + WpRp + WeRe
• Taxes
• After tax cost of debt ex. debt rate is 6% and rate is 40%, effective rate = 6% (1-.4) = 3.6%
• Two ways to estimate Re
• CAPM
• Dividend Discount Model
• Weights
• Should use the target capital structure the company is trying to attain
• If you don't explicitly know the target, 3 options:
• Assume current weight IS target (baseline)
• Examine trends in cap structure or statements by mgmt to infer target
• Use averages of comparables (unweighted, arithmetic mean - can also use wtd average to give more weight to bigger cos)
• Transform D/E into a weight by dividing D/E by (1 + D/E)

Applying Cost of Capital

• Marginal cost of capital (MCC) might rise as capital is raised, whereas returns to opportunities may decrease (Investment Opportunities Schedule)
• Optimal capital structure is where MCC intersects IOS
• For an average project, cost of capital is WACC
• Riskier projects should have ad hoc higher WACC and vv
• Using WACC to evaluate a project assumes project has same risk as average risk project of the company and the project will have constant target capital structure throughout its life
• Security valuation
• If cash flows are to all suppliers of capital, use WACC
• If cash flows are strictly to owners (FCFE) use Re

Cost of Debt

• YTM Approach
• Equates annual return if investor buys today and holds to maturity - use financial calculator and don't forget to do semi annual, and then multiply rate by two
• Debt Rating Approach
• Use yield on comparably rated bonds for maturities that closely match that of company's existing debt
• Remember to consider other factors like seniority/collateral - debt ratings are of the issue itself
• Sometimes called evaluated pricing or matrix pricint
• Issues
• Fixed vs. floating - might have to forecast future interest rates
• Debt with call/conversion/put options - callable (option for issuer) will have greater yield, buyer put option will have lower yield
• If company already uses calls/puts and will continue in future, just use this rate
• Adjusting for other approaches is beyond the exam
• Nonrated debt - might not have debt, or rates available; synthetic ratings might be available but these are rough at best
• Leases - if company uses leasing as a source of capital, should include this in the cost of capital

Cost of Preferred

• For nonconvertible, noncallable: P = D / r  and r = D / P
• D is dividend, r is cost of preferred stock
• NOT tax deductible
• If has option features, must adjust (use markets or other approaches again outside scope of exam)

Cost of Common Equity

• CAPM
• Er = Rf + beta * (Rm - Rf)
• Use matching t-bill for project life in years
• Multifactor model
• Er = Rf + B1 (factor risk premium) + B2 (factor risk premium) + ... on and on
• Idea is that CAPM might not capture all relevant risks
• Estimating MRP
• Historical Equity Risk Premium Model
• Use a whole market cycle, examine markets
• Limitations: level of risk of a stock index may change over time, risk aversion of investors may change over time, estimates are sensitive to methods of estimation and period covered
• Dividend Discount Model
• P = D1 / (r - g)
• r = D1/P + g      solve this for the whole index
• Then subtract Rf to get ERP
• Survey Approach
• Just ask people - one US survey found ERP was 5.5 to 7.0%
• Dividend Discount Model Approach (for estimating Ke)
• P = D1 / (r - g)
• Re = D1/P + g
• Must estimate next dividend and growth rate
• Growth
• Use published forecast OR
• Sustainable growth rate = plowback ratio * ROE
• Bond Yield plus Risk Premium Approach
• Re = Rd + risk premium
• Can estimate risk premium using historical spreads between stock/bond yields

Estimating Beta and Determining Project Beta

• Issues: estimation period, daily/weekly/monthly (periodicity), selection of index, smoothing technique, small cap stocks
• Private company beta estimation is difficult
• Beta is impacted by business risk (sales/operating risk) and financial risk
• Sales risk impacted by elasticity of demand, cyclicality, competition
• Operating is impacted by fixed vs. variable cost - higher fixed is riskier
• Financial risk - greater use of debt financing to produce cash flows is riskier
• Pureplay Method - same industry and a single line of business
• Using comparable public company and adjusting for leverage differences
• Must first unlever the beta of the public co - this gives 'asset' beta
• Then relever beta to arrive at estimate of equity beta for project or company of interest
• Unlevered = Levered / [1 + (1 - t) * D/E]

Country Risk

• Simplest estimate is sovereign yield spread
• Difference in yield of govt bond in the country, denominated in developed country, and the yield on the bond in the developed country
• But too coarse generally
• More refined: take this and then multiply by [sdev(equity index) / sdev(sovereign bond mkt in terms of developed mkt currency)]
• Note - this is the likely testable approach
• Can also use country credit ratings to get expected ERP for countries with debt ratings but no equities markets - use comparable countries that DO have equities markets to estimate reward to credit risk measures and then apply it to subject country

Marginal Cost of Capital Schedule

• As mentioned before the cost of capital rises as you raise more due to covenants, provisions, leverage etc. - might have to issue equity which is even pricier than debt
• Also deviation from ideal capital structure is an issue but in practice capital issuance is lumpy
• Generally the schedule has step-up points called break points - you can issue a lot at the same cost, then it jumps up
• Break points for debt and equity:
• Divide break amount by target D/V or E/V to get total capital raised

Flotation Costs

• Fees to bankers
• Usually quite small for debt so not included in cost of capital
• But can be big for equity
• One view is to account for this in Ke
• Ke = (D1 / P (1 - f)) + g
• f is percent of share that issuance cost is
• But this doesn't work...reduces initial project cash flow
• Alternative way: adjust cash flows in valuation computation
• Be sure to note whether flotations costs are tax deductible
• We still see the first way in practice a lot because it is hard to identify what specific financing is going to project, and it is easier to show how projects change when you go from using internally generated equity to using external equity financing

What do CFOs do

• Most popular for Ke is CAPM
• Few companies use dividend cash flow model
• Public cos are more likely to use CAPM than private
• Majority use a single WACC in evaluating projects, but a large portion apply some type of risk adjustment for individual projects

End

2:30 pm

1.75 hrs

Corporate Finance - Capital Budgeting

11:45 AM

Capital Budgeting
Reading 36 of CFAI Materials

Learning objectives look to contain quite a bit of repetition from quantitative methods section

Intro

• Capital budgeting is 1 year or more in timeframe
• Can ultimately decide future of corporation
• Mistakes are costly
• Close relationship to portfolio mgmt
• Used in a variety of contexts - mergers, refinancing, etc

Capital budgeting process

• Step 1 Generating ideas
• Step 2 Analyze individual proposals - forecast CFs and evaluate profitability
• Step 3 Plan capital budget - put into context of whole, evaluate timing, prioritize
• Step 4 Monitor and post-audit - compare plan to actual

Categories

• Replacement projects - replacing worn out equipment, evaluating new equipment choices, etc
• Expansion - more complex/uncertain than replacement
• New products/services - even more uncertain than expansion - will involve more people
• Regulatory/safety/environment
• Other - some projects are not easy to analyse with NPV etc.  R&D is an example as are pet projects (e.g. should CEO get a plane)

Principles

• Decisions are based on cash flows, not net income.  Intangibles ignored - if they are real, they should result in cash at some point
• Timing of cash flows is crucial
• Cash flows are based on opportunity costs
• Taxes are fully reflected
• Financing costs are ignored
• Financing costs are reflected in the required rate of return
• Cash flows are not accounting net income
• Noncash charges like D&A skew net income
• Concept of economic income versus accounting income (return to later)

Unless an investment earns more than the cost of funds from its suppliers of capital the investment should not be undertaken

Further concepts

• Sunk cost - one that has already occured - cannot change and therefore should not affect future decisions
• Opportunity cost - what is a resource worth in its next best use
• Incremental cash flow - cash flow with a decision minus cash flow without the decision
• Externality - effects of project on other parts of company or outside company
• E.g. cannibalization
• Conventional vs. nonconventional cash flows
• Conventional - outflow followed by series of inflows
• Nonconventional - can flip back and forth pos/neg
• Independent vs. mutually exclusive projects (obvious)
• Project sequencing - investing creates option to invest in other projects
• Unlimited funds vs. capital rationing
• Unlimited funds assumes company can raise as much capital as it needs to fund good projects
• Rationing is when company has fixed amount of funds to invest

Covered NPV rule and IRR rule

• Invest if NPV > 0, do not invest if NPV < 0
• Positive NPV investments are wealth increasing, negative are wealth decreasing
• IRR - discount rate that makes NPV = 0
• Invest if return is greater than your discount rate

Payback period

• Calculate how many yrs it takes to pay back
• For partial years assume linear cash flow
• Ignores time value of money and ignores pmts after payback is completed
• Simplicity is an advantage, and may indicate project liquidity
• No decision rule - must use in conjunction with NPV/IRR

Discounted payback period

• Same but uses discounted cash flows - partially addresses the problem with payback
• If a project has negative NPV, will not have a discounted payback period
• Still ignores cash flows after payback has been reached
• There might be negative CFs after payback has been reached too

Average Accounting Rate of Return

• AAR = avg net income / avg book value
• Ex you have a 5 yr project and an asset worth 200,000 depreciating to 0
• Average the 5 net incomes, and average the asset, and divide to get the return
• Advantage: easy to calculate
• Disadvantage: based on accounting, not cash flows, and doesn't account for TVM
• No conceptually sound cutoff for what is a good AAR
• Analysts should know it but rely more on NPV and IRR

Profitability Index

• PI = present value future cash flows / initial investment = 1 + NPV / initial investment
• Invest if PI > 1, do not invest if PI < 1
• Indicates value you are receiving for one unit of currency invested

NPV Profile

• Shows NPV graphed as a function of various discount rates

Ranking conflicts b/w NPV and IRR

• Differing cash flows can cause conflicts between NPV and IRR rankings
• When they differ and two projects are exclusive, defer to NPV
• Both approaches assume you can reinvest at a certain rate - NPV uses discount rate and is more reliable
• Scale can also be a factor - a small project may have high IRR but lower overall NPV
• NPV shows amount of wealth gained

Multiple IRR Problem and No IRR Problem

• IRR profiles can be parabolic and might either touch 0 NPV twice or not at all
• No IRR does not necessarily mean a bad investment - NPV might be very high
• For conventional projects - outlays followed by inflows - multiple IRR problem cannot occur
• Nth degree polynomial might had n solutions - but does not mean that you WILL have n solutions

Impact of a project on stock price is not straightforward

End of reading

12:45 pm

1 hour

Check In

So at this point we've reviewed materials covering Ethics, Quantitative Methods, Economics, and Financial Reporting & Analysis.

CFAI divides material into 18 'study sessions' each consisting of about 2-7 readings.  At this point, we have covered 10 of the 18 study sessions.

After starting with the CFAI materials, I switched to Schweser beginning with probability and used Schweser to get through Economics and FR&A.  I'm feeling a bit conflicted about using Schweser; I do feel that the materials are good, but I also feel like I should perhaps be spending more time with the CFAI materials as they are more thorough and will probably do a better job of getting a complete picture.

So I'm going to compromise a bit and spend the next few study sessions with the CFAI materials on Corporate Finance and Portfolio Management.  These represent study sessions 11 and 12.  Corporate finance is about 7 readings and Portfolio Management is 4.  I'll be curious during this to quickly flick back and forth between CFAI and Schweser and see how the two compare.

My little Excel spreadsheet says I have logged about 67 hours so far studying for the CFA, averaging about 3.7 hours per day.  This was a little lower than my usual average on account of 3 full days off of studying while I had company in town - my projected total hours has fallen from a comfy 350 to a 310, still probably safe but I will likely be putting in some extra hours this week to try and up the average.

On the whole, I think another 60 hours or so should get me through the rest of the material, at which point I can exclusively work on practice questions, exams, and mastery of the material.

FR&A - Financial Statement Analysis: Applications

11:00 AM

Trends in past financial ratios should relate to the firm's business strategy

Forecasting growth

• Start with GDP forecast, relate this to industry growth
• If firm keeps same market share, growth of firm sales will be same as growth in industry sales
• If market share will increase, then multiply new mkt share by total estimated industry sales for next period to get forecast of firm sales for period
• Analyst usually uses some single indefinite growth rate after a certain period

To forecast cash flows

• Analyst must make assumptions about future sources/uses of cash
• Working capital, capex, issuance/repmt of debt/stock
• Noncash WC as percent of sales is usually constant
• Model might indicate need for future cash - can be met by borrowing
• Interest expense in future periods must also be adjusted for any increase in debt

Credit analysis - Three C's

• Character - mgmt's professional reputation, history of debt repayment
• Collateral - ability to pledge specific collateral
• Capacity to repay - requires close examination of financial statements/ratios
• S&P/Moody's essentially rate using a wtd average of several specific accounting ratios
• Scale/diversification (larger is better)
• Operational efficiency (margins)
• Margin stability
• Leverage - the most important component

Screening

• Can use financial ratios to screen for low PE or low Price/Sales
• Use multiple criteria because screens on a single factor can include undesirable results
• Might include/exclude all firms of a particular industry
• Backtesting
• Seeing how investments would have performed
• Prone to survivorship bias, datamining, and lookahead bias

Adjustments

• Must be prepared to make accounting adjustments to make firm's statements comparable
• Change in depreciation method for example would affect profitability down to EPS
• Differences in GAAP/IFRS
• Treatment of effect of exchange rate differences
• Certain securities held by the firm
• Inventory cost flows
• LIFO/FIFO
• Operating leases/take or pays - increase both assets and liabilities

11:30 AM

0.5 hrs

FR&A - Accounting Shenanigans on CF Statement

10:30 am

One technique is to reclassify financing cash flows as operating, and vice versa
Management also has discretion over timing of cash flows

Stretching accounts payable

• Delaying payments to suppliers - effectively no cost financing
• Not sustainable - suppliers can't allow it forever
• Examine number of days' sales in payables
• days' sales in payables = (AP / COGS) * days in period
• This is the number of days on average it takes a co to pay its suppliers

Financing accounts payable

• Entering into a financing agreement with a third party, usually a financial institution
• Allows firm to manage timing - delay an outflow of cash
• Example a mfg firm purchase raw materials on credit
• In indirect CF, operating cash flow not affected
• Increase in inventory (use) offset by increase in AP (source)
• When AP comes due, a financial institution makes the payment for the company
• Company moves liability from AP to short-term debt
• Makes CFO lower and CFF higher, but total cash flow is same
• Enables them to manage against high CFO - e.g. stabilise CFO
• When firm repays financial institution, outflow is from financing activity
• Financial institution will charge a fee to handle

Securitization of AR

• Converting AR to cash by borrowing against or by selling or securitizing AR
• When borrowing, cash flow is financing activity
• When securitized, AR are transferred to bankruptcy remote SPE
• SPE pools and sells securities representing an interest in the pool
• Treated just like a collection/sale - operating cash flow
• Essentially enables acceleration of collection
• Not sustainable because company has only limited amounts of AR
• Might also recognize gains on receivables - mkt value is higher than book
• GAAP does not tell where these gains should be placed on income statement
• Some firms are aggressive and report it as revenue
• Other firms reduce opex by the gains
• Some report gains as nonoperating income

Repurchasing stock to offset dilution

• Higher the stock price relative to exercise, more shares firm must issue, diluting EPS
• Firms buy back stock to offset dilutive effects of options
• Cash received from exercise and outflow from share repurchase are both financing activities
• There is a tax benefit when options are exercised - increases CFO
• Net cash outflow for share repurchases should be reclassified to CFO
• Employee stock options are part of compensation

11:00 AM

0.5 hrs

FR&A - Red Flags/Warning Signs (cont.)

10:15 AM

Common earnings manipulation tactics/signs of abuse (cont.)

• Delaying expense recognition = capitalizing opex.  Look for increases in strange assets (Deferred Marketing Charges, Deferred Customer Acquisition Costs, etc.)
• Op leases instead of capital leases -  compare practices to peers.
• Hiding expenses under 'extraordinary' to boost EBIT
• LIFO liquidations - when a LIFO firm dips into old inventory, this reduces COGS and juices net income - such profits are not sustainable.  Effects of LIFO reserve liquidation should be noted in footnotes.
• Abnormal margins compared to industry peers
• Extending useful lives of long term assets - compare lives to peers
• Aggressive pension assumptions - result in lower pension expense and liability
• Year end surprises - high earnings in Q4 that cannot be explained by seasonality
• Equity method investments and off balance sheet SPEs
• Equity method investments are not consolidated but pro rata share of investee's earnings are included in net income
• Watch for extensive use of nonconsolidated SPEs
• Other off balance sheet arrangements inc. debt guarantees
• Must disclose these in footnotes
• Consider increasing liabilities to account for this

Note: Remember these are warning signs of low quality earnings, and not necessarily indications that fraud has occured or will occur

Enron Scandal

• Insufficient operating cash flow
• Much of its true financing activities fell under operating as well
• Did not make enough CFO to fund investments, and relied on financing for the rest
• Pressure to support stock price/ratings
• Additional collateral requirements in form of Enron stock if debt dropped below investment grade
• Wanted to keep compliance with covenants
• Revenues reported using mark to market accounting
• In some cases there were no established markets for the underlying contracts
• Excessive revenues reported in latter half of year
• Disproportional to previous years' trends
• Inflated sales to SPEs
• Use of mark to market accounting for equity method investments
• Recorded gains on equity investments rather than just their net income
• Use of barter transactions
• Enron would sell cable capacity to a party and simultaneously purchase capacity from another party
• Related party transactions - probably most egregious use
• LPs whereby an Enron employee served as general partner
• LPs engaged in billions of dollars of derivatives transactions with Enron
• Primary assets of the LPs included receivables from Enron and Enron securities
• Senior mgmt compensation and turnover

Sunbeam Accounting Scandal

• Created 'cookie jar' reserves
• Recognize losses and charges in early year, but loss turns to profit when inventory is sold in later years
• Receivables increased faster than sales
• Negative operating cash flow
• Primarily a result of increasing inventories and receivables
• Bill and hold sales arrangements
• Revenue recognized before goods are shipped
• Inappropriate reduction of bad debt expense
• Bad debt expense decreased even though sales and receivables both increased greatly
• Increased Q4 revenues
• Sunbeam was a nonseasonal business - Sunbeam initiated an early buy program for certain products

End

10:30 AM

0.25 hrs

FR&A - Financial Reporting Quality: Red Flags/Accounting Warning Signs

3:30 pm

Motivations for managing earnings - overstating

• Meet expectations
• Compliance with lending
• Compensation

Understating

• Obtain trade relief in form of quotas/tariffs
• Negotiate favorable terms from creditors/union contractors

Balance sheet - appear more solvent or less solvent to negotiate concessions with creditors or juice performance ratios

Low quality of earnings

• Can select 'acceptable' accounting methods that misrepresent true economics of a transaction.  Ex, selecting units of production method when straightline is more representative
• Structuring terms of a lease to keep it operating and not finance
• Lengthening lives or increasing salvage values of depreciable assets (lower depr exp, higher earnings)
• Exploiting the intent of an accounting principle = applying a narrow rule to a broad range of transactions

Fraud triangle

• Incentive/Pressure <> Opportunity <> Attitudes/rationalization
• Note that not all have to be present for fraud to occur
• Incentives/pressure
• Threats to financial stability - competition, declining demand, etc
• Third party pressures - listing requirements, covenants, expectations
• Personal net worth of management/board in danger
• Internal financial goals - sales/profit targets
• Opportunities
• Nature of firm's operations - complex transactions, tax havens, ability to dictate terms/conditions, significant related party transactions (nonaudited e.g.)
• Ineffective management monitoring - mgmt is dominated by a small group, or there is ineffective oversight
• Complex org structure - high turnover, difficulty determining who has control, unusual lines of authority
• Deficient internal controls - acct systems and staff etc.
• Additudes/rationalizations
• Insufficient ethical standards
• Participation by nonfinancial mgmt in selection of accounting standards
• Known history of violations
• Obsession with maintaining/increasing earnings/stock price trend
• Making commitments to third parties to achieve aggressive results
• Failing to correct known reportable conditions in a timely manner
• Inappropriately minimizing taxable income for tax purposes
• Management continually citing materiality to justify inappropriate accounting methods
• Strained relation b/w mgmt and auditors

Common warning signs

• Aggressive revenue recognition
• Bill and hold - recognizing before shipped
• Holding accounting period open past yr end
• Sales type leases
• Recognizing before fulfilling all terms and conditions of sale
• Recognizing revenue from swaps/barters with other third parties
• Different growth rates b/w operating cash flow and earnings
• This should over time be pretty stable - if not, earnings manipulation may be occurring
• Growing earnings without growing cash flow may indicate they are recognizing revenue too soon and/or delaying recognition of expense
• Cash Flow Earnings Index
• CFO / net income
• If consistently less than 1, it is suspect
• Abnormal growth vis a vis industry/peers - increasing AR collection period is a sign of fraud danger
• Abnormal inventory growth vis a vis sales growth
• Could be overstating inventory, decreasing COGS and inflating earnings
• Signalled by a declining inventory turnover ratio
• Boosting revenue with nonoperating income/nonrecurring gains

Break

End

4:00 pm

0.5 hrs 

FR&A - Long-term Liabilities and Leases

Start 12:45 pm

Long Term Liabilities and Leases

Bonds

• Balance sheet liability of a bond = PV of remaining cash flows discounted at market rate of interest at time of issuance
• At maturity, liability = face value of bond
• Balance sheet liability also called book value or carrying value
• Interest expense = book value at beginning of period * market rate of interest when bond issued
• Market = coupon means bond issued at par
• Market > coupon means bond issued at discount
• Market < coupon means bond issued at premium

Bond issued at par

• At issuance both assets and liabilities increase by amount of bond proceeds
• On income statement, interest expense equal to coupon interest paid since market and coupon rate are same
• CF statement, issue proceeds are an inflow in financing, coupon payments are outflows from operating.  At maturity, repayment is an outflow in financing.

Bonds issued at discount/premium

• PV is not equal to face value
• Assets and liabilities again increased by amount of bond proceeds
• Book value at any point will equal PV of remaining future cash flows discounted at market rate of interest at issuance
• Bonds at premium are reported at higher than face, and decrease over time until it reaches face value at maturity
• Discount bonds reported on BS at less than face and increase over time.

Interest expense

• Must INCLUDE amortization of any discount/premium
• Effective Interest Rate method
• Book value of bond at beginning of period * market rate at time of issuance
• For a premium bond:
• Coupon interest lower than effective rate
• Difference is amortization - amort is then subtracted from balance sheet amount
• Interest expense will decrease over time
• For a discount bond:
• Coupon interest higher than effective rate
• Difference is added to balance sheet amount
• Interest expense will increase over time

Impact on cash flow

• Amortization is noncash - so any indirect method presentation must remove this from net income
• GAAP - interest expense is a cash flow operating activity
• IFRS - operating or financing
• Might need to reclassify interest exp to make firms comparable
• For a premium bond, cash component of interest expense is overstated
• CFO is understated because you subtract coupon of full amount when true interest expense is smaller
• While CFO is understated, CFF will be overstated
• Over life of bond, CFO is understated by same amount CFF is overstated

Zero coupon bonds

• Similar to discount but impact is even larger because discount is larger
• If two companies are similar but one uses zero coupons, you need to make them comparable somehow otherwise in early years the zero coupon will seem to have far better cash flows

Amortization methods

• EIR is required under IFRS
• GAAP - one may use straightline if results are not materially different

Issuance costs

• IFRS - included in measure of liability, therefore increasing EIR
• GAAP - firms capitalize issuance costs (prepaid exp) and amortize over life of bond

Extinguishing Debt

• When redeemed before maturity, gain/loss is recognized
• Subtract redemption price from book value of bond liability at acquisition date
• US GAAP - any remaining unamortized issuance costs must also be written off
• No writeoff necessary in IFRS - already included in book value of liability
• Gain or loss is recorded in income statement (continuing ops)
• Not usually part of day to day - so you eliminate gain/loss for forecasting purposes
• Gain/loss is accounted for in indirect method
• Reacquisition price is reported as an outflow in financing activities

Interest rate changes

• Balance sheet value no longer equals market
• Increase in interest rate will decrease fair value of a liability
• IFRS and GAAP allow companies to report at fair value
• Decreasing value to market will increase equity

Convertible debt

• Converts have additional right to exchange for stock
• Option has value so converts will get lower interest rate (all else equal)
• US GAAP, there is no difference in reporting
• If later converted, stock is recorded at book value of extinguished bond liability
• Simply transfer from debt to equity
• No gain or loss
• Conversion has no cash flow effects
• IFRS, bond liability and conversion option are separated
• Value of conversion option can be derived from subtracting value of the bond without the convert
• Value of conversion option is recorded in equity
• Converts should be treated as equity (likely to convert) when stock price is well above exercise
• Treat as debt when stock price is low
• If close, calculate both; also consider purpose of analysis/timeframe

Debt with warrants

• More common outside the US
• Warrants have value just like convertible option - thus also receive lower rate of interest
• Differences from converts
• Unlike conversion option, warrants can usually be separated
• If warrant exercised, debt component still remains - holder has both debt and equity
• Investor must pay exercise price for warrants - no such payment for convertibles
• Valuation and accounting is same under GAAP/IFRS
• Valuation of warrant = proceeds minus value of straight bond
• Value of warrant is recorded in equity
• Bond with warrants basically results in lower leverage all else equal because there is some equity component to it rather than all straight debt

Other instruments with debt/equity like components

• If instrument requires repayment of principal in the future, must be reported as liability
• Preferred stock (mandatory redemption) is an example
• Dividend payments are recorded as interest expense
• If firm has issued securities that require equity be repurchased at a specific price the repurchase amount is also a liability

Finance (Capital) Leases and Operating Leases

• Finance lease is in substance purchase of an asset that has been financed with debt
• Lessee should add equal amounts to assets and liabilities at purchase
• Recognize depreciation expense on asset and interest exp on liability
• Operating lease is essentially a rental agreement
• No asset/liability reported
• Lease payments are rental expense
• Benefits of leasing
• Less costly financing - no initial payment
• Reduce risk of obsolescence
• Less restrictive provisions than typical financing
• Operating leases are like off-balance sheet financing - better ratios
• Tax reporting - in US, firms can make a synthetic lease - lease is treated as ownership position for tax purposes
• Can deduct depreciation and interest for tax purposes
• For financials, lease is treated as rental agreement, and there is no liability on the balance sheet
• Classification as Finance Lease: If any ONE of the following apply:
• Title to lease asset is transferred to lessee at end of lease
• Bargain purchase option exists: lessee can purchase at a significant discount to market
• Lease period is 75% or more of asset's economic life
• PV of lease pmts is 90% or more of the fair value of the asset
• Interest rate is lower of lessee's incremental borrowing rate or lessor's implicit lease rate 
• Under IFRS classification is not as clear - depends on economic substance

Reporting by Lessee

• Operating lease
• No entry at inception
• Record rent to income statement expense and operating cash flow
• Finance lease
• PV of future minimum lease pmts = asset and liability on balance sheet
• Asset depreciated on income statement and recognize interest exp
• Int exp = lease liability at beginning of pd * implicit lease interest rate
• On CF statement, lease separated into interest and principal
• Principal portion = total payment less interest expense
• Int exp is in operating cash flow
• Principal payment is in financing

Example

• ABC leases machine for 4 years with annual pmts of $10,000.  Interest rate 6%.  At end of lease, machine is returned to lessor who sells for scrap.
• Calculate impact on IS and BS for each of 4 years.  Assume lease pmts at end of year and straight-line depreciation.

Answer

• Classify as finance lease - we know asset is being leased for 75% or more of useful life because lessor sells it for scrap
• PV = $34,651 record this immediately on balance sheet as both asset and liability
• Important - note that if pmt is at beginning of year, PV calc is different
• Depreciation = $34,651 / 4 = $8,663 per yr
• Interest yr 1 = 6% * 34,651 = 2,079.  Principal = 10,000 - 2,079 = 7,921
• Principal yr 1 = 34,651 - 7,921 = 26,730
• Interest yr 2 = 6% * 26730 = 1,603.8.  Principal = 10,000 - 1,603.8 = 8,396.2
• Principal yr 2 = 26,730 - 8,396.2 = 18,334
• Interest yr 3 = 6% * 18,334 = 1,100.  Principal = 10,000 - 1,100 = 8,900
• Principal yr 3 = 18,334 - 8,900 = 9,434
• Interest yr 4 = 6% * 9,434 = 566.  Principal = 10,000 - 9,434 = 566.
• Principal yr 4 = 566 - 566 = 0

Financial statement effect

• Ratios/balance sheet
• Leverage ratios will be higher for finance leases
• Turnover ratios that use total assets in denominator will be lower for finance leases
• Return on assets also lower
• Principal due w/in one yr = current liability, reduces current ratio and working capital
• Since operating leases don't appear on balance sheet, sometimes called 'off balance sheet financing activities'
• Income statement
• All else equal, EBIT higher for companies that use financing lease
• With operating lease, entire lease pmt is opex
• Finance lease, only depreciation is opex
• Total expense over life will be same - lease expenses equals depreciation plus interest
• In early yrs, finance lease will result in higher total expense, then lower
• Cash flow is unaffected
• Finance lease, CFO is higher and CFF is lower (in op lease, everything is in operations; in finance lease, only interest exp is in CFO, rest is CFF)
• In sum:
• All ratios are worse when lease is capitalized
• Only improvement from financing lease is higher EBIT, higher CFO and higher net income in early years

Notes

• Adding an equal amount of assets and liabilities will tend to worsen ratios because companies typically have greater assets than debt; thus adding equal amounts to numerator and denominator will make the denominator proportionally larger
• W/r/t current ratio and working capital, you are recognizing a current liability with no corresponding current asset

Required disclosures

• Must disclose future lease payments
• Can use this and present value of future minimum lease payments to derive interest rate
• Can then use this to see what would happen if you converted operating leases to finance leases

From lessor's perspective: sales type and direct financing leases

• Both fall under category of financing lease

Sales type

• Treated as if lessor sold asset and provided the financing to the buyer
• PV of lease payments exceeds carrying value of asset
• At inception, lessor recognizes sale equal to present value of lease payments and COGS equal to carrying value of asset
• Difference is gross profit
• Removed asset (inventory) and create a lease receivable equal to PV of lease pmts
• As pmts are received, principal portion of pmt reduces the receivable
• Also recognizes interest revenue of lease receivable balance * interest rate
• Interest revenue is an inflow in operating activities
• Principal reduction is an inflow from investing, just like any loan

Direct Financing lease

• No gross profit recognized by lessor at inception
• Simply providing a financing function to lessee
• PV of lease pmts = carrying value of the asset
• At inception, lessor removes asset from BS and makes lease receivable in same amt
• As pmts received, principal portion reduces lease receivable
• Income statement - recognize interest income, calculated same way as above
• CF - interest revenue is an inflow in operating, principal inflow is inflow from investing

Operating Lease

• Lessor simply treats lease payments as rental income
• Lessor keeps asset on balance sheet and depreciates over time
• Income statement effect versus direct financing lease is basically the same
• Direct financing, you just have interest income
• Op lease, you have rental income, depreciation, and difference is op lease income
• Total op lease income = total interest income
• However total interest income is higher in beginning yrs, then reverses
• Total cash flow is same
• However in direct financing, most of CF returns is in investing
• In op lease, it is all in CFO
• Note: from lessee's perspective, principal is a financing outflow - thus from lessor's perspective, principal is a return of capital invested in the lease - thus it is an investing inflow

Off balance sheet agreements

• Operating leases are just one example

Take or Pay Contract (aka throughput arrangement)

• Buyer commits to buying a minimum quantity of input or specified period of time
• Pmts must be made even if they don't want the product
• Must be disclosed in MD&A
• Should add the sum of required purchase amts to both debt and total capital in the debt/capital ratio
• Can also take present value to be more precise

Sale of receivables with recourse

• Sell AR to an unrelated party but continue to service and remit collections to buyer of receivables
• Buyer of receivables has not taken on risk of non-pmt - seller retains credit risk
• In essence this is just borrowing collateralized by the receivables
• Should treat sale of receivables as collateralized borrowing
• Before computing ratios, AR and current liabilities should be increased by amt of receivables sold
• In CF statement, classify sale of receivables as cash from financing, not cash from ops

Off balance sheet financing

• Should add PV of minimum purchase obligations to both LT assets and LT liabilities
• Sale of receivables reduces AR and ST borrowings
• Leverage ratios too low, AR turnover too high, and current ratio is too high
• Receivables and ST debt should be added back to AR and current liabilities
• Say a company sells $170,000 of AR with recourse, debt interest rate 9%
• Add back debt
• Reinstate receivables
• Increase both interest income and expense by $170,000 * 9% = $15,300
• Net income not affected - just EBIT and int expense are both higher
• Cash flow
• Reduce operating by $170,000, increase financing by $170,000

End

3:30 pm

2.75 hrs

FR&A - Income Taxes (Cont.)

11:15 AM

Continuing on Income Taxes

Summarize:

If taxable income (Tax Return) is less than pretax income (Income Statement), a deferred tax liability is created.

If taxable income (Tax Return) is greater than pretax income (Income Statement), a deferred tax asset is created.

Both assume that the difference is expected to eventually reverse.

Think: If you pay LESS IN CASH than you are showing, you're going to have to make up for it - or lower tax return = liability.

Impact of Change in Tax Rate on Statements and Ratios

• Increase in tax rate will increase both DTL and DTA
• Decrease in tax rate will decrease both DTL and DTA
• This is because new tax rate is expected to be in force when liability/asset is reversed
• Income tax expense in the current period:
• income tax expense = taxes payable + change DTL - change DTA

Example

• Firm owns $200,000 carrying value equipment
• Tax base of $160,000 at year end
• Tax rate 40%
• Taxable income is less so you have a liability - (40,000) * 40% = $16,000 DTL
• Firm also has $10,000 from bad debt expense - 0 carrying value
• DTA = $10,000 * 40% = $4,000
• Calculate income tax expense if tax rate decreases to 30%

 Answer

• Income tax expense = taxes payable + change DTL - change DTA
• Change DTL = 40,000 * 0.3 - 40,000 * 0.4 = 12,000 - 16,000 = -4,000
• Change DTA = 10,000 * 0.3 - 10,000 * 0.4 = 3,000 - 4,000 = -1,000
• Change in income tax exp = -4,000 - (-1,000) = -3,000
• Income tax expense decreases by 3,000

Temporary vs. Permanent

• Permanent = will not reverse in future.  Do NOT create DTA or DTL.  Caused by nondeductible expenses, nontaxable revenue, or tax credits
• Cause effective tax rate to differ from statutory
• Effective tax rate comes from income statement:
• effective = income tax exp / pretax income
• Temporary = Difference bw tax base and carrying value that will result in taxable or deductible amounts in the future
• Expected to reverse in the future

Examples

• Depreciable equipment - has tax base $10,000 lower than carrying value
• Taxable income lower than income statement income - need to pay this in the future
• Therefore it makes a DTL
• R&D - tax base $50,000, no carrying value
• Tax base greater than carrying value - you pay taxes on full amount but not on income statement - creates DTA
• Accounts Receivable - tax base $20,000, CV $18,500
• Had to expense $1,500 on income statement, but not on tax return
• Tax return income is higher than IS - so creates a DTA
• Muni bond interest - Tax base and CV both $5,000
• Permanent - muni bond interest is not taxable - no DTA/DTL
• Customer Advance - $0 tax base, $10,000 carrying value
• Temp difference - have to pay taxes on it, taxable income greater than income statement, so this is a DTA
• Warranty liability - $0 tax base, $10,000 carrying value
• Temp - it will be reverse
• Will be deductible in future, so this makes a DTA
• Officers' life insurance
• Not tax deductible, permanent difference

Investments in other firms

• DTL's can arise when parent co recognizes earnings from investments before dividends are actually received
• HOWEVER if the parent can control timing of the dividend and it is probable the temporary difference will not reverse, no DTL is reported
• Will only result in a DTA if temporary difference is expected to reverse, and sufficient taxable profits are expected to exist when reversal occurs

Valuation Allowance for DTA

• Without future taxable income, a DTA is worthless
• US GAAP - if it is more than 50% likely that some or all of a DTA will not be realized, DTA must be reduced by a valuation allowance
• This is a contra account - reduces value of DTA
• Increasing this decreases DTA, increasing tax expense, decreasing net income
• Can be decreased in future if circumstances change
• It is up to mgmt to defend their DTA assumptions
• Can sometimes manipulate earnings this way
• Analysts should always examine likelihood of large deferred tax assets realization
• Also should scrutinize changes in valuation allowance

Common balance sheet examples/sources of temporary differences

• Use of accelerated depreciation for tax and straightline for income
• Analyst should consider growth rate and capital spending levels when determining whether the difference will actually reverse
• Impairments
• Usually make a DTA - writedown is immediately recognized in income statement, but deduction is not allowed until asset is actually sold
• Restructuring
• DTA - costs are recognized when restructuring announced, but not deducted until actually paid
• LIFO / FIFO
• US GAAP, firms that use LIFO for financials must do so for tax
• Other countries tho might have temporary differences from choice of cost flow assumption
• Post employment benefits/deferred comp
• Both are recognized when earned, but not taxable until paid
• Results in DTA that will reverse when actually paid
• Available for sale mkt securities
• Future tax impact of unrealized gains/losses
• No DTL added to balance sheet for future tax liability when gains/losses are realized

IFRS/GAAP - too much detail for now.  Review later.

End

12:30 PM

1.25 hrs

FR&A - Income Taxes

Aaaaaaaargh taxes

10:30 AM

Taxable Income - income that will be subject to tax based on the tax return
Taxes Payable - aka current tax expense - tax liability on balance sheet created by taxable income
Income tax paid - actual cash flow
Tax loss carryforward - current or past loss that can be used to reduce taxable income
Tax base - net amount of an asset or liability used for tax reporting purposes

Accounting profit - EBT
Income tax expense - includes taxes payable AND change in deferred tax assets/liabilities
DTL - Excess of income taxes over taxes payable, leading to future cash outflows
DTA - opposite
Valuation allowance - reduction of DTA based on likelihood asset will not be realized
Carrying value - net balance sheet value of an asset/liability
Permanent difference - a difference in tax return income and income statement income that will not reverse in the future
Temporary difference - a difference between tax base and carrying value of an asset/liability that will result in taxable or deductible amounts in the future

Deferred Tax Liabilities

• Income tax expense > taxes payable
• Happens when:
• Revenues (or gains) are recognized on income statement before included on tax return due to temporary differences
• Expenses (or losses) are tax deductible before they hit the income statement
• Expected to reverse
• Most common way they are created is through differing depreciation methods between tax return and income statement

Deferred Tax Assets

• Taxes payable > income tax expense
• Happens when:
• Revenues (gains) taxable before they hit income statement
• Expenses (losses) hit income statement before they are tax deductible
• Tax loss carryforwards are available to reduce future taxable income
• Also expected to reverse
• Common causes - post-employment benefits, warranty expenses, tax loss carryforwards

Analytical approach

• If DTL expected to reverse in future, treat as a liability
• If NOT expected to reverse, count it as EQUITY
• Key question: "When or will the total DTL be reversed in the future???"
• Treatment varies case by case

Depreciation example

• Take difference between tax and book depreciation and multiply difference by the tax rate to get the liability
• Sale of the machine for example would result in a different gain between the two - this would reverse the DTL

R&D

• $75,000 was expensed during year, but on tax return, it's amortized over 3 years, straightline
• End of yr 1, tax base is $50,000, and carrying value = 0 (it was all expensed!)
• Earnings on income statement will be LOWER than earnings on tax report
• Creates a deferred tax ASSET - you pay lower taxes than your tax expense on the income statement

Accounts receivable

• Bad debt expense - for tax purposes this cannot be expensed until receivables are deemed WORTHLESS
• Results in deferred tax ASSET

Tax base of liabilities

• Equals carrying value minus any amounts that will be tax deductible in the future
• Exception: revenue received in advance is carrying value minus amount of revenue that will NOT be taxed in the future

Customer Advance

• $10,000 received at year end for goods to be shipped next year - i.e. it is not revenue yet
• Carrying value of liability: $10,000
• Will be reduced when goods ship next yr
• Customer advance has already been taxed - so $10,000 will NOT be taxed in the future
• Thus tax base is 0
• Since it has been taxed but not yet reported as revenue on IS, this creates a deferred tax asset

Warranty liability

• Warranty expense is not deductible until the warranty work is done
• Say you have a $5,000 warranty liability - this will all be deductible in future (when work is done) so the carrying value is zero
• Delayed recognition of this expense for tax purposes results in deferred tax asset

Note payable

• Principle of $30,000, interest at 10% paid quarterly
• Treated same way on income statement and tax return
• No timing difference, so there is no DTA or DTL

Example of DTL

• Original cost of an asset is $600,000
• 3 year life, no salvage
• Depreciation of $300,000, $200,000 and $100,000 for tax purposes
• Income statement uses straightline $200,000 per year
• EBITDA = $500,000 each yr, tax rate is 40%

Answer

• Income tax expense (IS) will be higher in first year than actual taxes payable - this means you'll have to pay more in the future so you have a DTL
• CV and tax base of the asset after yr 1:
• CV = $600,000 - $200,000 = $400,000
• Tax Base = $600,000 - $300,000 = $300,000
• Difference = $100,000
• Difference * tax rate = $40,000 of DTL
• In yr two, book and tax depreciation are the same, so there is no difference in tax expense and tax payable
• There is also therefore no change in the DTL 
• In yr three, you will pay more taxes than shows up as expense on the IS
• DTL will reverse

Example of DTA

• Firm has sales of $5,000 for each of two yrs
• Estimates warranty expense to be 2% of annual sales ($100 each yr)
• Actual expenditure of $200 was not made until second yr
• Tax rate 40%

Answer

• Cannot deduct for tax purposes in year 1
• Results in higher taxable income than IS income
• You pay more taxes in year 1
• Creates a $40 DTA in year 1
• In year 2, this will reverse

Impact of tax rate change on financial statements/ratios

• When tax rate changes, DTA and DTL are adjusted to reflect
• Increase in tax rate increases BOTH DTAs and DTLs
• Decrease does opposite
• Changes in balance sheet values affect income tax exp in current period
• income tax exp = taxes payable + change DTL - change DTA

Example

• Firm owns equipment with carrying value $200,000
• Tax base of $160,000 at year end
• Tax rate 40%
• (200,000 - 160,000) * 40% = $16,000
• Deferred tax liability - will have to pay it in future years
• Firm also has DTA of $10,000 from bad debt (recognized as expense on income, but not yet taxed)
• Creates a DTA of (10,000 - carrying value of zero) * 40% = $4,000
• Now tax rate decreases to 30%

Answer

• DTL is decreased to (200,000 - 160,000) * 30% = 12,000
• Change in DTL is -4,000
• DTA is decreased to (10,000 - 0) * 30% = 3,000
• Change in DTA is -1,000
• Income tax exp = taxes payable + (-4,000) - (-1,000)
• Total change in income tax exp = -3,000

Break

11:30 AM

1 hour

FR&A - Long-Lived Assets

Start 12:30 pm

Long-Lived Assets

Capitalized Interest

• Accrues while a company constructs an asset for its own use
• Objective is to accurately measure the cost of the asset
• Treatment is required by both GAAP and IFRS
• Interest rate used to capitalize interest is based on debt directly related to asset
• If no specific construction debt, based on existing unrelated borrowings
• Interest costs on general corporate debt beyond project construction costs are expenses
• Capitalized interest is NOT expensed
• Eventually goes to depreciation or to COGS
• Capitalized interest is reported as an outflow from investing activities
• Normal interest is reported as an outflow in operating activities

Effects of capitalizing (vs. expensing) on various accounts

• Net income
• Delays recognition of expense.  Higher NI in short term, lower in long term.
• Reduces variability of NI because cost is spread over time
• Total net income is unaffected (does this hold with taxes?)
• Shareholders eq
• Higher net income = higher equity (retained earnings)
• As cost is allocated in future, lower NI = lower equity
• Cash from Operations
• Cap ex is usually reported under investing section
• If expensed, it will fall under operating
• Capitalizing therefore leads to higher op cash flow and lower investing cash flow as compared to expensing
• Assuming not taxes, total cash flow is same
• Remember, when capitalized, depreciation is recognized in subsequent pds - depreciation is noncash and aside from taxes does not affect cash from operations
• Financial ratios
• Capitalizing causes higher assets and equity
• ROA and ROE will initially be higher due to Net Income increase but then lower
• Interest coverage
• Higher when capitalized - Higher EBIT, and less interest expense
• Smaller after year 1
• For expanding firms, this may continue for some time because capitalized interest exceeds depreciation from previously capitalized interest

Analyst implications

• May want to add capitalized interest to total interest expense - many bond ratings agencies do this
• Be aware of how debt covenants are calculated
• Interest capitalized during the year should be added to interest expense
• Allocation of interest capitalized in previous years should be removed from depreciation expense
• Reclassify capitalized interest from investing to operating

Intangible assets - long term assets that lack physical substance (patents etc.)

• Value based on rights/privileges granted to the firm over the useful life
• Cost is amortized over useful life
• Not always reported on balance sheet
• An unidentifiable intangible asset cannot be purchased separately and may have an indefinite life
• Most common is goodwill

Intangibles created internally

• With few exceptions, these costs are expensed as incurred - R&D, software e.g.
• GAAP - both are expensed
• IFRS - Research expensed, development capitalized
• For software, costs expensed until product's feasibility has been established
• Under GAAP, capitalize subsequent expenses
• Costs for developing own internal software are also capitalized

Intangibles purchased externally

• Initially recorded at cost

Obtained in business acquisition

• Purchase method - purchase price is allocated to 'identifiable' assets and liabilities at fair value
• Any remaining excess is goodwill (unidentifiable)
• Only goodwill from business acquisition is capitalized; internally generated goodwill is not
• US GAAP
• Must calculate fair value of a firm's in-process R&D
• Expensed in the period incurred (is this the amount invested, or yet to be invested?)
• Usually not a recurring item - analysts add back
• IFRS
• IPR&D is not immediately expensed
• Firm may report as a separate finite-lived asset
• Can alternatively be included as part of goodwill
• NB CHECK TO SEE IF THIS STANDARD STILL APPLIES IN CFAI MATERIALS

Economic depreciation - actual decline in fair value of the asset over time

Depreciation methods

• Straightline = (original cost - salvage value) / useful life
• Accelerated DDB = (2 / asset life in yrs) * beginning book value
• Remember, may switch to straight line later
• No more expense charged once salvage value is reached
• Units of Production
• Depreciation = (original cost - salvage value) / total number of units it will produce ever * units produced that period
• Choice of Method
• US GAAP - may use different depreciation for tax and for financial reporting
• Many countries do NOT allow this
• US also allows MACRS

For a firm using straightline for reporting and accelerated for tax:

• Income tax expense does NOT change
• The difference between tax expense and taxes payable is added to deferred tax liability
• In later years, there will be more taxes payable than tax expense
• TOTAL depreciation expense is the same under all three methods
• NB - for DDB method, how do you know when to switch to straight line?

Useful lives and salvage values

• Longer life = lower annual depreciation
• Higher salvage = lower annual depreciation
• In excess both will overstate income
• Management tricks:
• Overestimating useful life, and then writing it down in a restructuring process
• Write down and take immediate charge, record less future depreciation 
• Life and or salvage might be overstated, thus increasing profit but then increasing loss once the asset is retired
• Under IFRS, you may increase OR decrease the estimated residual value when new info arises
• Under GAAP, you can revise down but not up
• Depreciation can be allocated between COGS and SG&A - affects gross margin but not overall margin

Calculating average age of a firm's assets

• Helps identify older/less efficient assets which may make firm less competitive
• Can help estimate when major capex will be needed and therefore financing required
• Average age:
• Age = accumulated depreciation / annual depreciation expense
• Average depreciable life = ending gross investment / annual depreciation expense
• Gross is original cost of asset (i.e. does not include accumulated depr OR impairment charges)
• Remaining useful life = ending net investment / annual depreciation expense
• OR average depreciable life - age
• Another useful measure is capex / depreciation

Intangible amortization

• Finite lives - expense should match benefit of ownership over life of asset
• Indefinite lives - no amortization, no expense unless impairment applies

Asset Retirement Obligations (environmental charges)

• When plant closure also requires returning environment to original condition etc.
• ARO = liability reported at NPV with discount based on firm's credit standing
• Same amount is added to carrying value of the specific asset
• This keeps accounting in balance
• ARO is then depreciated over remaining life of the asset
• Accretion expense - increase in liability due to passage of time
• At maturity, ARO liability is equal to full amount of the obligation and asset is fully depreciated
• At this point, obligation has been fully recognized on the income statement

Ratio effect of ARO

• Increases both assets and liabilities by same amount
• Earnings will be lower - you have depreciation plus ARO accretion effect
• You should treat ARO as debt on balance sheet and in calculating ratios
• Accretion expense should be treated as interest

ARO's are a bit confusing - maybe come back to these later

Sales, exchanges, abandonments

• Sale
• Difference between carrying (book) value and sale proceeds is recorded as a gain/loss on the income statement
• Usually part of continuing operations
• Remove from cash flow from operations (should be under investing)
• If it was a 'component' of the business, report below income as a discontinued operation
• Component = cash flows can be clearly distinguished from rest of firm
• Reported net of tax, below net income from continuing operations
• Abandoned
• Similar to sale, but no proceeds
• Carrying value removed from balance sheet, loss of that amount in income statement
• Exchanged
• Gain or loss computed by comparing carrying value of old and fair value of new
• Carrying value of old is removed, fair value of new is put on balance sheet
• For analytical purposes, excluding gains/losses from asset dispositions is recommended

Impairments

• US GAAP: Recoverability and Loss Measurement
• Recoverability
• Asset is impaired if carrying value is greater than asset's future UNDISCOUNTED cash flows
• Loss measurement
• If impaired: loss = excess of carrying value over fair value of asset
• If fair value not known, use DISCOUNTED value of future cash flows 

Impairment of intangibles

• For finite lived, essentially the same as for tangible assets
• For infinite lived - do not amortize, but test annually for impairment
• Goodwill is hard to measure though
• Goodwill is therefore measured at the reporting unit level
• GAAP: Two step test for goodwill
• If carrying value of the reporting unit (including goodwill) > fair value of reporting unit, impairment exists
• Loss is measured as difference between carrying value of goodwill and implied value of goodwill
• IFRS: Similar but done in a single step
• Carrying value of asset is compared to recoverable amount (either by sale or fair value)
• Difference recorded as an asset impairment

Long-lived assets held for sale

• When firm decides to sell, asset is no longer depreciated
• Immediately test for impairment

Reversing an impairment loss

• US GAAP - can reverse on assets held for sale, but not on assets in use or goodwill
• Recoveries reported as component of continuing operations
• Held for use, new value becomes basis for depreciation, but no recoveries are permitted
• IFRS - recoveries are allowed for both

Analytic impact

• Impairment is a reduction of equity and assets
• In year of impairment ROA and ROE both decrease (lower earnings)
• After, ROA and ROE will increase due to higher earnings and lower assets/equity
• Asset turnover will increase (lower assets)
• No impact on cash flow
• No tax savings until sold - decrease in deferred tax liabilities
• Impairment in short means a firm has overstated earnings
• There is considerable discretion in judging impairments

Effect of revaluations on ratios

• Revaluing asset upward will result in:
• Higher total assets/equity
• lower leverage
• Higher earnings in period revaluation occurs
• Higher depreciation (and ergo lower earnings) in periods after
• Lower ROA and ROE in periods after

End

2:30 pm

2 hours

FR&A - Inventory

11:00 AM

Today we get to learn all about inventory!

Goal is to know how to convert between different cost flow assumptions

Remember cost flow is different than valuation.  Valuation is treated same regardless of cost flow assumption.  In valuation:

• IFRS - lower of cost or net realizable value
• GAAP - lower of cost or market.

COGS = beginning inventory + purchases - ending inventory

Ending inventory = beginning inventory + purchases - COGS (this is easiest to remember)

What is capitalized in to inventory:

• Purchase costs
• Conversion costs
• Allocations of fixed production OH based on normal capacity levels
• Other costs necessary to bring inventory to present location/condition (e.g. freight-in)

What is NOT capitalized:

• Unallocated portion of fixed production OH
• Abnormal waste of materials, labor, or OH
• Storage costs (unless required as part of production process)
• Admin OH
• Selling costs

Remember to only allocate the portion of OH that is allocated to production - if you only produce at 80%, only take 80% of the OH to inventory and expense the rest.

IFRS: Net realizable value = estimated sales price - estimated selling costs

• Inventory can be written down OR up
• Loss/gain is recognized in the income statement
• BUT amount of any gain is limited to the previous loss - cannot ever exceed original cost

GAAP: Lower of cost or market

• Market = replacement cost
• BUT market cannot be greater than NRV or less than NRV minus a normal profit margin
• Must fall within a window with size = normal profit margin
• If market > NRV, then market IS NRV
• If replacement cost is lower than NRV minus normal profit margin, market IS NRV minus normal profit margin
• If cost > market, inventory written down, loss recognized in balance sheet
• No subsequent writeup is allowed - mkt value is new cost basis
• You recover this in the form of higher profits in following years

Note - commodities and agriculture may report markups - inventory reported at NRV and unrealized gains/losses are reported in the income statement.  Use either active market prices or if not available use recent mkt transactions.

Cost Flow Methods

• IFRS allows specific id, FIFO, and wtd avg cost
• US GAAP allows all these PLUS LIFO
• Firm may use different assumption for different inventory, but must use same method for inventories of a similar nature/use

Specific Identification - each unit sold is matched with unit's actual cost.  Good for jewelry/autos.  Also appropriate for special orders/projects outside normal course of business.

FIFO

• First purchased is first sold.
• Advantage: ending inventory is based on most recent purchase of inventory, arguably best estimate of replacement cost
• When prices are rising, COGS will be understated compared to current replacement cost, thus earnings overstated

LIFO

• Last in first out
• When prices rising, LIFO COGS will be higher than FIFO
• Earnings will be lower as well - but this means lower income taxes and higher cash flows!
• When prices are rising, LIFO ending inventory is less than replacement value
• LIFO conformity
• Firms using LIFO for tax must also report performance in LIFO
• This is the rare situation where lower reported income is associated with higher cash from operations

Wtd Avg Cost Method

• Cost per unit = Total cost of goods available for sale (beginning + purchases) / quantity available for sale
• Whether prices are rising or falling wtd avg value will be between FIFO and LIFO

Usefulness of COGS and Inventory Data under each

• When prices stable, all three yield same result
• When prices moving, FIFO provides most useful measure of ending inventory
• LIFO is better for income statement information (FIFO for balance sheet)
• Inventory writedowns are LESS likely under LIFO
• They have a bunch of old inventory
• LIFO COGS is higher than FIFO COGS in rising price environment

Inventory turnover

• Turnover = cogs / avg inventory
• Days = 365 / inventory turnover
• Low turnover (coupled with slow sales) might mean slow moving inventory/obseleteness
• High turnover is preferred in places where obsolescence is a concern
• Also minimizes storage costs
• But if TOO high, you might be missing revenue opportunities
• High turnover with slow revenue growth e.g.
• Ratio is directly affected by LIFO/FIFO choice
• So are current ratio, debt/equity, and return on assets

Impact on other ratios (assuming rising prices)

• Profitability
• LIFO - higher cogs, lower profit
• Lower margins overall
• Liquidity
• LIFO = lower inventory
• Decreases current assets, so less liquid
• Quick ratio is not impacted because it excludes inventory
• Activity
• Inventory turnover = Higher for LIFO
• Solvency
• LIFO = lower total assets (inventory is lower)
• Debt ratio and debt/equity ratio are higher under LIFO than FIFO
• Because COGS is higher, net income lower, and equity lower

Converting LIFO to FIFO

• LIFO to FIFO is simple
• Firms using LIFO are required to disclose in footnotes the LIFO reserve
• LIFO reserve = FIFO inventory - LIFO inventory
• Remember FIFO is a better representation of economic value of inventory
• Once converted tho the balance sheet will not balance
• This is due to taxes
• Adjust liabilities for difference in taxes, and adjust equity by LIFO reserve net of tax
• Ex, say LIFO reserve is $150 and tax is 40%
• Increase assets by $150
• Increase liability (taxes) by $150 * 40% = 60
• Increase equity (retained earnings) by $90
• Must also convert COGS
• Difference equal to the CHANGE in the LIFO reserve
• FIFO COGS = LIFO COGS - (ending LIFO reserve - beginning LIFO reserve)
• Note that ideally we would want to convert FIFO cogs to LIFO cogs - because that is a better representation for the income statement actual cost - but this is beyond the test

When does LIFO reserve change

• LIFO reserve will increase each period when prices are increasing and inventory stable or increasing
• If firm is liquidating inventory, or prices falling, LIFO reserve declines
• LIFO liquidation - this is when a LIFO firm's inventory quantities are declining
• Now older, lower cost goods are included in COGS
• This means higher profit and higher taxes
• Higher profit though is phantom - not sustainable
• They are basically recognizing previously unrecognized gains in inventory value as income
• LIFO liquidations can result from strikes, recession or declining demand
• Firms categorizing in to narrow categories are likely to have some LIFO liquidations in certain products
• Pooling can help address this (clump items into inventory pools)
• Analyst should adjust COGS for the decline in LIFO reserve caused by a decline in inventory
• Firms must disclose LIFO liquidation in footnotes to facilitate adjustment

Last note - falling prices

• If prices falling, FIFO is now more accurate than LIFO in providing accurate estimate of economic value of inventory
• COGS is now higher under FIFO than LIFO
• Earlier, higher cost purchases are now reflected in COGS

End

12:30 pm

1.5 hrs