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Agata Kocia, Ph.D., MBAWarsaw UniversityDepartment of Economic Sciences email: akocia@wne.uw.edu.pl

Financial Statement Analysis-additional topics

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Income taxes

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Accounting versus tax code (1)

Financial accounting standards are often different than income tax laws and regulations

Therefore, the amount of income tax expense recognized in the income statement may differ from the actual taxes owed to the taxing authorities

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Accounting versus tax code (2) The timing of revenue and expense recognition is

different Certain revenues and expenses are recognized in the

income statement but never on the tax return and vice versa

Assets and/or liabilities have different carrying amount and tax bases

Gain or loss recognition in the income statement differs from the tax return

Tax losses from prior periods may offset future taxable income

Financial statement adjustments many not affect the tax return or may be recognized in different periods

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Tax return terminology Taxable income – income subject to tax based on the

tax code Taxes payable – tax liability on the balance sheet

caused by taxable income also known as current tax expense

Income tax paid – actual cash flow from income taxes including payments and refunds

Tax loss carryforward – a current or past loss that can be used to reduce taxable income in the future

Tax base – net amount of an asset or liability used for tax reporting purposes

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Financial reporting terminology (1) Accounting profit – pretax financial income based on

financial accounting standards also known as income/earnings before tax

Income tax expense – expense recognized in the income statement that includes taxes payable and changes in deferred tax assets (DTA) and liabilities (DTL)

Deferred tax assets – balance sheet amount that results from an excess of taxes payable over income tax expense can also result from tax loss carryforward

Deferred tax liabilities – balance sheet amount that results from an excess income tax expense over taxes payable

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Financial reporting terminology (2) Valuation allowance – reduction of deferred tax

assets based on the likelihood that the assets will not be realized

Carrying value – net balance sheet value of an asset or liability

Permanent difference – a difference between taxable income (on tax form) and pretax income (on income statement) that will not reverse in the future

Temporary difference – a difference between tax base and the carrying value of an asset or a liability that will result in either taxable amounts or deductible amounts in the future

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Deferred tax liability Is created when income tax expense (from income

statement) is greater than taxes payable (from tax return) due to temporary differences

Occurs when: revenues or gains are recognized in the income

statement before they are included on the tax return expenses or losses are tax deductible before they are

recognized in the income statement They are expected to reverse and result in the future

tax outflows when the taxes are paid Commonly, created when different depreciation

methods are used for tax and financial statement purposes

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Deferred tax asset

Is created when taxes payable (from tax return) are greater than income tax expense (from income statement) due to temporary differences

Occurs when: revenues or gains are taxable before they are

recognized in the income statement expenses or losses are recognized in the income

statement before they are tax deductible tax loss carry forwards are available to reduce future

taxable income They are expected to reverse and result in the future

tax savings Commonly, created due to post-employment benefits

and warranty expenses

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Tax base of assets

Is the amount that will be expensed (deducted) on the tax return in the future as the economic benefits of the assets are realized

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Tax base of assets: Depreciable equipment

The cost of equipment is $100 000. In the income statement depreciation expense of $10 000 is recognized each year for 10 years

On the tax return, the asset is depreciated at $20 000 per year for 5 years

At the end of the 1st year, tax base is $80 000 and carrying value is $90 000

A deferred tax liability is created at $10 000*t due to timing difference

Sale of this asset at $100 000 will reverse the deferred tax liability as a gain of $10 000 would be recognized in income statement and a gain of $20 000 would be recognized on tax return

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Tax base of assets: Accounts receivable

Gross receivables totaling $20 000 are outstanding at year-end

The firm recognizes bad debt expense of $1 500 in the income statement

For tax purposes, bad debt expense cannot be deducted until the receivables are deemed worthless

At the year end, tax base of the receivables is $20 000 since no bad debt expense has been deducted on the tax return but the carrying value on income statements is $18 500

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Tax base of liabilities

Is the carrying value of the liability minus any amounts that will be deductible on the tax return in the future

Tax base of revenue received in advance is the carrying value minus the amount of revenue that will not be taxes in the future

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Tax base of liabilities: Customer advance

At year end, $10 000 was received from a customer for goods that will be shipped next year

The carrying value of the liability is $10 000 yet it will be reduced when the goods are shipped next year

$10 000 is taxed but not recognized in an income statement, instead a deferred tax asset is created

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Tax base of liabilities: Notes payable

The firm as an outstanding promissory note with a principal balance of $30 000; interest accrues at 10% and is paid at the end of the quarter

The note is treated the same on tax return and in financial statements, so with no difference in timing, no defered tax items are created

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Impact of tax rate changes (1) When the income tax rate changes:

deferred tax assets and liabilities are adjusted to the new rate

adjustment can also affect income tax expense

An increase (decrease) in the tax rate, will increase (decrease) deferred tax liabilities and deferred tax assets

income tax expense = taxes payable + ∆DTL - ∆DTA

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Impact of tax rate changes (2)

If tax rates increase, the increase in DTL is added to taxes payable and the increase in DTA is subtracted from taxes payable to arrive at income tax expense

If tax rates decrease, the decrease in DTL will result in lower income tax expense and the decrease in the DTA would results in higher income tax expense In case of DTL we add a negative change and

in case of DTA we subtract a negative change

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Permanent difference Permanent difference is a difference between

taxable income and retax income do not crease deferred tax assets/liabilities can be caused by revenue that is not taxable,

expenses that are not deductible or tax credits that reduce taxes

Permanent differences will cause firm’s effective tax rate to differ from the statutory tax rate

Tax rateeff= income tax expense/pretax income

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Temporary difference Temporary difference is a difference between

that tax base and the carrying value of an asset or a liability that will result in taxable amounts or deductible amounts in the future can be a taxable temporary difference that

results in expected future taxable income or deductible temporary difference that results in expected future tax deductions

example: investment in other firms – parent company can recognize earnings from the investment before dividends are received

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Valuation of DTL and DTA If it is more likely than not that some or all DTA will

not be realized (for example, because of insufficient future taxable income to recover the tax asset), then DTA must be reduced by valuation allowance

Valuation allowance is a contra account that reduced DTA value on the balance sheet

Increasing the valuation allowance increases income tax expenses and reduces earnings – if circumstances change, DTA can be revalued upward

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Disclosure information Typically the following deferred tax information are

disclosed: deferred tax liability/asset, valuation allowance any unrecognized deferred tax liability for undistributed

earnings of subsidiaries and joint ventures current-year tax effect of each type of temporary

difference components of income tax expense reconciliation of reported income tax expense and the

tax expense based on statutory rate tax loss carry forwards and credits

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Usefulness of data

Analyzing trends in individual reconsiliation items can aid in understading past earnings trends and in predicting future effective tax rates

Then can also help in predicting future earnings and cash flows or for adjusting financial ratios

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US GAAP versus IFRS

Accounting treatment of income taxes under US GAAP and IFRS are similar

One major difference relates to valuation of fixed assets and intangible assets

US GAAP prohibits upward valuation, whereas it is permitted under IFRS and any resulting effects on deferred tax are recognized in equity (see p.236)

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Part II

Inventories

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Cost of Goods Sold (COGS)

Refers to beginning balance of inventory, purchases and the ending balance of inventory under IFRS also known as Cost of Sales

(COS)

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Inventory valuation methods

Under IFRS the following methods are permissible: specific identification – each unit sold is matched with the

unit’s actual cost first-in, first-out (FIFO) – the first item purchased is assumed

to be the first item sold ending inventory is based on the most recent purchases and

COGS based on earliest purchases weighted average cost – average cost per unit is computed

by dividing total cost of goods available for sale by total quantity available for sale

US GAAP also allows last-in, first-out method (LIFO), not permitted under IFRS last-in, first-out – the item purchase most recently is

assumed to be the first item sold in an inflationary environment, COGS are higher, earning lower

and income tax also lower

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Periodic inventory system

In a periodic inventory system, inventory values and COGS are determined at the end of accounting period

No detailed records of inventory are maintained Inventory acquired during the year is recorded

in a Purchases account At the end of the period:

purchases are added to beginning inventory to arrive at cost of goods available for sale

ending inventory is subtracted from goods available for sale to calculate COGS

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Perpetual inventory system

In perpetual inventory system, inventory values and COGS are updated continuously

Inventory purchased and sold is recorded in Inventory account as transactions occur Purchases account is not used

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Periodic versus perpetual system

FIFO and specific indentification methods produce the same values for ending inventory and COGS regardless of method used

LIFO and weighted average cost methods can produce different results depending on which system is used

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Net realizable value (NRV) Under IFRS inventory is reported on the balance

sheet at the lower of cost or net realizable value Net realizable value (NRV) is equal to expected sales

price less the estimated selling costs and completion costs

If NRV is less than the balance sheet value of inventory, the inventory must be written down to NRV and loss is recognized in an income statement

If there is a subsequent recovery in value, the inventory can be written up and gain recognized

However, inventory cannot be written up by more than it was previously written down

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Lower of cost Under US GAAP inventory is reported on balance

sheet at the lower of cost or market Market cost is equal to replacement cost but cannot

be greater than NRV or less than NRV minus a normal profit margin If replacement cost exceeds NRV, then market is NRV If replacement cost is less than NRV minus a normal

profit margin, then market if NRV minus a normal profit margin

If cost exceed market, the inventory is written down to market on the balance sheet and a loss is recognized in the income statement

If there is a subsequent recovery in value, no write ups are allowed under US GAAP

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Reporting In some industries e.g. producers and dealers

of agricultural products, mineral ores and precious metals, reporting inventory above historical cost is permitted unders IFRS and US GAAP inventory is reported at NRV and any

unrealized gains or losses are recognized in income statement

if an active market exists for the commodity, the quoted market price is used to value the inventory; otherwise, recent market transactions are used

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Disclosure of inventory Under US GAAP and IFRS required inventory

disclosures include: cost flow method used total carrying value of inventory and carrying value by

classification carrying value of inventories reported at fair value less

selling costs amount of inventory write downs reversals of inventory write downs, including the

circumstances of reversal carrying value of inventories pledged as collateral

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Inventory changes (1) Change in inventory cost method is usually made

retrospectively – that is, the prior years’ financial statements are recast based on the new cost flow method

Cumulative effect of the change is reported as an adjustment to the beginning retained earnings of the earliest year presented under IFRS, the firm must demonstrate that the change

will provide reliable and more relevant information under US GAAP, the firm must explain why the change

in cost flow method is preferable

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Inventory changes (2) If a firm changes to LIFO, change is applied

prospectively, that is, no adjustments are made to the prior periods carrying vale of inventory under the old method

becomes the first layer of inventory under LIFO in the period of change

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Implications of inventory method Inventory turnover (also in days) and gross profit

margin can be used to evaluate the quality of firm’s inventory management

Inventory turnover that is too low – many be an indication of slow-moving or obsolete inventory

High inventory turnover together with low sales growth relative to the industry may indicate inadequate inventory levels and lost sales because customer orders could not be fulfilled

High inventory turnover together with high sales growth relative to the industry average suggests that high inventory turnover reflects greater efficiency rather than inadequate inventory

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Part III

Long-lived assets

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Capitalized versus expensed costs (1) When a firm makes an expediture, it can either

capitalize the cost as an asset on a balance sheet or expense the cost in the income statement in the period incurred expenditure that is expected to provide a future

economic benefit over multiple accounting periods is capitalized

if the future economic benefit is unlikely or highly uncertain, the expenditure is expensed in the period incurred

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Capitalized versus expensed costs (2) Expenditure that is capitalized is initially recorded as

an asset on balance sheet at cost Except for land and intangible assets with indefinite

lives, the cost is allocated to income statement over the life of the asset as depreciation expense (for tangible assets) and amortization expense (for intangible assets)

If an expenditure is immediately expensed, current period pretax income is reduced by the amount of the expenditure

The choice affects net income, shareholder’s equity, total assets, cash flows and numerous financial ratios

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Capitalized versus expensed costs (3)

Capitalizing results in: higher assets higher equity higher operating cash flow higher earnings in the first year but lower

earnings in subsequent years as the asset is depreciated

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Capitalized interest (1) When a firm constructs an asset for its own use

(or for resale but under specific circumstances), the interest that accrues during the construction period is capitalized as a part of the asset’s cost this is done to accurately measure the cost of the asset

and to better match the cost with revenues the treatment of construction interest is similar under

IFRS and US GAAP The interest rate used to capitalize interest is based

on debt related to construction of an asset If no construction debt is outstanding, the interest

rate is based on existing unrelated borrowing

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Capitalized interest (2) Under IFRS, income earned by temporarily investing

borrowed funds reduces the interest that is eligible for capitalization

Under US GAAP, there is no such reduction When construction interest is capitalized, interest

cost is allocated to the income statement through depreciation expense (if asset is held for use) or COGS (if the asset is held for sale/inventory)

Capitalized interest is reported in the cash flow statement as an outflow from investing activities while expensed interest is reported outflow from operating activities

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Financial statement effects of capitalizing versus expensing interest

Capitalizing ExpensingTotal assets Higher LowerEquity Higher LowerIncome variability Lower HigherNet income (first year) Higher LowerNet income (subsequent years) Lower HigherCash flow from operations Higher LowerCash flow from investing Lower HigherDebt ratio and Debt to equity ratio Lower HigherInterest coverage (first year) Higher LowerInterest coverage (subsequent years) Lower Higher

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Intangible assets created internally (1)

Generally, costs to create intangible assets are expensed as incurred; exceptions are: R&D costs (under IFRS) and software development costs

R&D costs (under IFRS): research costs – costs aimed at discovery of new

scientific or technical knowledge and understanding are expensed as incurred

development costs – costs incurred to translate research findings into a plan or design of a new product or process are capitalized

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Intangible assets created internally (2)

Software development costs: costs incurred to develop software for sale to others

are expensed as incurred until the product’s technological feasibility has been estabilished, after which costs are capitalized

under IFRS, treatment is the same regardless of whether the software is developed for sale or for firm’s own use

under US GAAP, all R&D costs are capitalized only when the firm develops software for its own use

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Amortization of intangible assets Intangible assets with finite useful lives are amortized over

their useful lives amortization is identical to the depreciation of tangible

assets estimating useful lives is complicated by many regulatory,

legal, contractual, competitive and economic factors that may limit the use of the intangible assets

Intangible assets with infinite useful lives are not amortized but rather tested for impairment at least once a year

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Revaluation methods (1)

Under US GAAP, fixed assets are reported on the balance sheet at depreciated cost (original cost less accumulated depreciation and any impairment charges)

Under IFRS, fixed assets are also reported at depreciated cost - fair value as long as active markets exist for the assets so their fair value can be reliably estimated firms must choose the same treatment for

similar assets

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Revaluation methods (2) Revaluation can result in increase or

decrease in fair value from one period to next Initial revaluation to fair value below historical

cost results in a loss reported on the income statement decreasing net income and equity

Subsequent later upward revaluation is reported as a gain in the income statement on to the extent it reverses a previously reported loss

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Revaluation methods (3) Any increase in an asset’s value above historical cost

is not reported as gain on an income statement but is reported as a component of shareholders’ equity in an account called revaluation surplus

Later declines in an asset’s fair value first reduce this surplus and then result in a loss reported in an income statement

Revaluing asset’s value upward leads to: greater total assets and equity higher depreciation expense lower profitability, in periods after revaluation

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Impairment under IFRS (1)

Firm must annually assess whether events or circumstances indicate an impairment of an asset’s value

Asset is impaired when its carrying value exceeds recoverable amount recoverable value is the greater of fair value

less any selling cost and value in use value in use is the present value of future cash

flow stream from continued use

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Impairment under IFRS (2) If impaired, asset’s value must be written

down on the balance sheet to recoverable amount impairment loss – equal to the difference

between carrying value and recoverable amount – is recognized in income statement

Loss can be reversed if the value of impaired asset recovers in the future but it is limited to the original impairment loss

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Impairment under US GAAP Asset is tested for impairment only when events and

circumstances indicate it Two steps are involved:

recoverability: asset is considered impaired if carrying value is greater than the asset’s future undiscounted cash flow stream

loss measurement: if impaired, asset’s value is written down to fair value on the balance sheet and a loss is recognized in the income statement

Loss recoveries are not permitted

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Impairment of held for sale assets Held for sale assets are not depreciated or amortized

but tested for impairment If asset is impaired, the asset is written down to net

realizable value and loss is recognized in the income statement

Loss can be reversed (under IFRS and US GAAP) if the asset’s value recovers in the future but it is limited to the original impairment loss

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Disclosure of long-term assets There are many differences in disclosure

requirements under IFRS and US GAAP. The generally required are:

carrying value of each class of assets accumulated depreciation and amortization title restrictions and assets pledged as collateral for impaired assets, loss and amount and

circumstances it caused for revalued assets (IFRS), revaluation date, how fair

value was determined and the carrying value

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Part IV

Long-term liabilities

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Bond Is a contractual promise between a borrower

(bond issuer) and a lender (bondholder) that obligates the bond issuer to make payments to the bondholder

Typically, two types of payments are involved: periodic interest payments repayment of principal at maturity

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Cash flow impact of issuing a bond

Cash flow from Financing

Cash flow from Operations

Issuance of debt

Increased by cash received (present value

of bond at market interest rate) No effect

Periodic interest payments No effect

Decreased by interest paid (coupon rate * face

value)

Payment at maturity Decrease by face value No effect

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Income statement impact of issuing a bond

Issued at par Issued at premium Issued at discount

Market rate = Coupon rate

Market rate < Coupon rate

Market rate > Coupon rate

Interest expense = coupon rate * face value = cash paid

Interest expense = cash paid - amortization

of premium

Interest expense = cash paid + amortization

of premium

Interest expense is constant

Interest expense decreases over time

Interest expense increases over time

* interest expense = market rate at issue * balance sheet value of liability at beginning of period

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Balance sheet impact of issuing a bond

Issued at par Issued at premium Issued at discount

Carried at face valueCarried at face value

plus premiumCarried at face value

less discount

Liability decreases as the premium is

amortized to interest expense

Liability increases as the premium is

amortized to interest expense

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Derecognition of debt (1)

At maturity any original discount or premium is fully amortized, so the book value of a bond liability and its face value are the same

Cash outflow to repay a bond is reported in the cash flow statement as a financing cash flow

Firm may choose to redeem bonds before maturity, for example, because interest rates have fallen

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Firm may choose to reedem bonds before maturity, for example, because interest rates have fallen

When bonds are redeemed before maturity, gain or loss is recognized by subtracting redemption price from the book value of the bond liability at the reacquision date

Under US GAAP any remaining unamortied bond issuance costs must be written off and included in the gain or loss calculation

No write-offs are necessary under IFRS because issuance costs are already accounted for in the book value of the bond liability

Derecognition of debt (2)

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Derecognition of debt (3) Gain or loss from redeeming debt is reported

in the income statement and additional information are disclosed

Analysts often eliminated gain or loss from income statement for analysis and forecasting

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Disclosure relating to debt Firms often report all their outstanding long-term debt

on a single line on balance sheet Portion that is due within next year is reported as

a current liability Footnotes disclosure usually include:

nature of liabilities maturity dates stated and effective interest rates call provisions and conversion privileges restrictions imposed by creditors assets pledged as securities amount of febt maturing in each of next five years

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Operating versus financial leases Under IFRS, if substancially all rights and risks of ownership are

transferred to the lessee, the lease is treated as a finance lease by both the lessee and the lessor

Otherwise, the lease is an operating lease Under US GAAP, lessee must treat lease as a finance (capital)

lease if any one of the following criteria are met: title to leased asset is transferred to lessee at the end of lease

period bargain purchase option exists lease period is 75% or more of asset’s economic life present value of lease payments is 90% or more of the fair

value of leased asset Under US GAP, lessor capitalizes lease if any one of

finance lease criteria are met and if lease payments are certain and lessor has substantially completed performance

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Reporting by Lessee (1) Operating lease:

at inception of the lease, the balance sheet is unaffected during the term of the lease, rent expense equal to tease

payment is recognized in income statement and an outflow from operating activities

Finance lease: at inception, lower of the present value of future minimum

lease payments or fair value of the leased asset is recognized as an asset and liability

over the term of the lease, asset is depreciated in income statement and interest expense is recognized

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Reporting by Lessee (2)

Finance Lease Operating Lease

Assets Higher Lower

Liabilities Higher Lower

Net income (in early years) Lower Higher

Net income (in later years) Higher Lower

Total net income Same Same

Operating income Higher Lower

Cash flow from operations Higher Lower

Cash flow from financing Lower Higher

Total cash flow Same Same

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Reporting by Lessor (1) Under US GAAP, a capital lease is treated as either

a sales-type lease or a direct financing lease In both cases, at the inception of the lease, a lease

receivable is created equal to the present value of lease payments

Lease payments are treated as part of interest income (CFO) and part principal reduction (CFI)

With a sales-type lease, lessor recognizes gross profit at the inception of the lease and interest income over the life of the lease

With a direct financing lease, lessor recognizes interest income only

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Reporting by Lessor (2)

For the operating lease, lessor recognizes the lease payment as rental income

Lessor also keeps the leased asset on its balance sheet and depreciates it over its useful life

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Disclosure of leases Both lessees and lessors are required to disclose

useful information about leases: general description of leasing arrangements nature, timing and amount of payments to be paid or

received in each of next five years (later payments can be aggregated)

amount of lease revenue and expense reported in income statement for each period presented

amounts receivable and unearned revenue under lease arrangements

restrictions imposed by lease arrnagements

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Thank you for your attention!