How to manage deferred revenue and expenses

Introduction
In most situations, a company would want to recognize revenues as soon as an invoice is completed. For
example, when a food and beverage distributor sells beverages, the revenue for the transaction is
recognize as soon as the goods leave the warehouse. In Openbravo, in this situation, revenue is
generated as part of the accounting of the sales invoice corresponding to the transaction.
Under some circumstances, however, you need to defer revenue, either in part or in total, to subsequent
periods. For example:

A publisher selling an annual subscription to a magazine would want to recognize revenue for the
value of the subscription over 12 months.

A ski resort selling a season pass during the summer (June) for the following ski season needs to
wait till the beginning of the season (December) before recognizing revenue and distribute that
revenue throughout the duration of the ski seasons (December to April).

A food and beverage distributor selling and invoicing a product that it will only be able to be
delivered to their customers in 3 months, needs to defer revenue recognition till the delivery.

Similarly on the expense side, in most cases companies would recognize the expense (for non asset
purchases and non stockable products) as soon as the purchase is made. For example, if you buy office
supplies (a consumable product that is not capitalized), the expense is recognized at the time of
purchase. In Openbravo, in this situation, the expense is generated as part of the accounting of the
purchase invoice corresponding to the transaction.
Under some circumstances, however, you need to defer the expense recognition. For example:

A company purchasing a business insurance for the duration of a year would want to distribute
that expense over 12 months.

A company paying rent in advance on a quarterly basis would want to distribute that expense
over 3 months.

Overview
Openbravo allows to support these situations with the deferred revenue and expense capabilities.
The functionality described in this article is available starting from Openbravo 3 MP17
On the revenue side:

When creating sales invoices, at line level, users are able to specify:
o

Whether the revenue for this line needs to be deferred

If so, the number of periods across which revenue needs to be distributed

The starting period for revenue recognition

The above values can be controlled on an invoice line by invoice line basis.

For products that customarily require revenue deferral, users are able to specify at product level
the revenue recognition rules
o

Whether the product requires revenue deferral

The duration of the deferral period

The most common starting period for revenue recognition, which could be defined to be
either the current period, the next period after the sales invoice, or a manuallyspecified
period.

The values specified at product level are automatically defaulted on sales invoice lines when the
product is used.

These values are also used when an invoice is created from another document (for example: the
Generate Invoices process that creates invoices from sales orders).

Similarly, on the expense side:

When creating purchase invoices, at line level, users are able to specify:
o

Whether the expenses for this line needs to be deferred

If so, the number of periods across which expenses need to be distributed

The starting period for expense recognition

The above values can be controlled on an invoice line by invoice line basis.

For products that customarily require expense deferral, users are able to specify at product level
the expense recognition rules
o

Whether the product requires expense deferral

The duration of the deferral period

The most common starting period for expense recognition, which could be defined to be
either the current period, the next period after the invoice, or a manually specified period.

The values specified at product level are automatically defaulted on purchase invoice lines when
the product is used.

These values are also used when an invoice is created from another document.

Example
Consider the following situation.

Company F&B Publishing sells a 1 year subscription to F&B Magazine to Healthy Foods Supermarkets
on October 17th, 2012. The value of the subscription is $120 and the subscription covers the period from
November 2012 to October 2013.
On October 17th and invoice is recorded in the system with a line for the subscription. The line is flagged
as requiring revenue deferral, with a deferral period of 12 months starting from November 2013.
The following accounting entries are created based on this invoice:
Date

Account

Debit

17-OCT-2012

Account Receivables

120.00

Unearned Revenue
30-NOV-2012

Unearned Revenue

120.00
10.00

Revenue
31-DEC-2012

Unearned Revenue

Credit

10.00
10.00

Revenue

10.00

...

...

...

31-OCT-2013

Unearned Revenue

10.00

Revenue

...

10.00

Accounting Configuration
General Ledger Configuration
In order to use revenue and expense deferrals, you first need to properly define the default accounts to be
used to post deferred revenues and deferred expenses.
This configuration is executed in the General Ledger Configuration window.
Prior to MP17, this window was called Accounting Schema
In this window in the Default tab, you can find two relevant fields:

Product Deferred Expense: this field stores the default account to be used to record deferred
expenses. This account is typically an asset account.

Product Deferred Revenue: this field stores the default account to be used to record deferred
revenues. This account is typically a liability account.

In accrual accounting (used by most companies), revenues are recognized as earned when two
conditions are satisfied:
1. The revenues are earned. This means the goods and services for the revenues have been
delivered, and
2. Revenue are realized (or realizable). There is a reasonable expectation that that cash will be
received.

When unearned revenues are first received, the bookkeeping journal transactions that follow depend on
how long it will take to earn the revenue (complete delivery of goods and services).
If the revenue will be earned in the near term, say, within a month and within the current accounting
period, the revenues may be treated as ordinary earned revenue, in which case the journal transactions
are the same as for ordinary revenue. In that case there is a debit to an asset account (here, a $500
increase in cash, an asset account), as well as a $500 credit to a revenue account (here, a $500 increase
to the account product sales revenue).
Date

Account

DD-MMM-YY

Debit

Credit

500
500

101 Cash
420
Product sales revenue

However, when it is clear that the revenue will not be fully earned for several months, or until the next
accounting period, the journal transactions include a debit to an asset account (in the example below, an
increase of $500 to the cash account) along with a credit to a liability account (here, an increase of $500
to unearned revenue). Journal transactions might look like this:
Date

Account

DD-MMM-YY

Debit

Credit

500
500

101 Cash
250
Unearned revenue

For the latter situation, when the goods and services have finally been delivered, later, the revenues are
recognized as earned revenues with two adjusting entries in the journal: a debit to the same liability
account used earlier (here, a $500 decrease to the unearned revenue account), and a credit to a revenue
account (here, $500 increase in the revenue account, product sales revenues).
Grande Corporation
Journal for Fiscal Year 20YY
Date

Account

DD-MMM-YY

Debit

Credit

500
250 Unearned revenue
420
Product sales revenue

500

In practice, the second pair of entriesthe adjusting entriesmay be made during the accounting period,
as goods and services are actually delivered, but often they are made at the end of the period, when the
balance sheet accounts are reported as they stand at period end.
Prepayment and deferred payment situations

Unearned revenues (deferred revenues) are handled in accrual accounting in much the same way some
other revenue and expense transactions are handled when there is a time lapse between two parts of a
business transaction.
Accrual accounting incorporates the matching concept, the idea that revenues should be recognized in
the same period with the expenses that brought them. Prepayment and deferred payment
situations present a special challenge to the company's bookkeepers and accountants, because it is
possible for actual payment and actual delivery to fall in different accounting periods. In order to avoid
violating the matching concept, bookkeepers make an initial two entries to register the first
transaction event, and then, later, makes adjusting entries to register the second transaction event. For
examples of journal entries for each kind of event, see the encyclopedia entries for individual terms,
linked below.
Prepayments (payment precedes delivery of goods or services)

From the seller's viewpoint (the subject of this encyclopedia entry): The seller will
recognize unearned revenues (or deferred revenues) as revenues received for goods and services
that have not yet been delivered. Unearned revenues are recorded as liabilities until such time as the
goods and services are delivered, after which they may be recognized as earned revenues.

From the buyer's viewpoint: The buyer recognizes deferred expenses (or prepaid expenses or
deferred charges>), when paying for services or goods before delivery. An inventory of postage
stamps, bought but not yet used, is a prepaid expense. When taxes are paid in advance of due date,
a prepaid expense is created. Prepaid expenses are recorded as a current asset until the services or
goods are delivered or used.

Deferred Payments (delivery of goods or services precedes payment)

From the seller's viewpoint: Accrued revenues (also called accrued assets or unrealized
revenues) are revenues earned by the seller (for delivery of goods and services but which the seller
has not yet received). Accrued revenues may be posted in one asset account, such as accounts
receivable, until the revenues are actually received. Then, the accounts receivable account (an asset
account) is credited (reduced) while the another asset account, cash, is debited (increased).

From the buyer's viewpoint: Accrued expenses, or accrued liabilities are posted in the
buyer's books as a liability, for goods and services purchased and received but not yet paid for. When
workers are owed salaries or wages for work completed, but not yet paid for, the employer has
an accrued expense. Interest payable for a bank loan can be an accrued expense. Accrued expenses
are first entered in the journal as a liability until paid, at which time the liability account is debited
(reduced) and an asset account, such as cash, is credited (decreased).

For any company on a cash basis accounting system, however, the bookkeeping practice is much
simpler. In cash basis accounting:

Expenses are recognized when cash is paid

Revenues are recognized when cash is received.

Unearned revenues (deferred revenues) along with the other prepayment and deferred payment
situations described above, are used in accrual accounting but not cash basis accounting.

Financial Statements - Revenue Recognition Methods and Implications

Sales-basis Method
o

Under the sales-basis method, revenue is recognized at the time of sale, which is defined
as the moment when the title of the goods or services is transferred to the buyer.

The sale can be made for cash or credit. This means that, under this method, revenue is
not recognized even if cash is received before the transaction is complete.

For example, a monthly magazine publisher that receives $240 a year for an annual
subscription will recognize only $20 of revenue every month (assuming that it delivered
the magazine).

Implication: This is the most accurate form of revenue recognition.

Percentage-of-completion method
o

This method is popular with construction and engineering companies, who may take
years to deliver a product to a customer.

With this method, the company responsible for delivering the product wants to be able to
show its shareholders that it is generating revenue and profits even though the project
itself is not yet complete.

A company will use the percentage-of-completion method for revenue recognition if two
conditions are met:
1. There is a long-term legally enforceable contract
2. It is possible to estimate the percentage of the project that is complete,
its revenues and its costs.

Under this method, there are two ways revenue recognition can occur:
1. Using milestones - A milestone can be, for example, a number of stories
completed, or a number of miles built for a railway.

2. Cost incurred to estimated total cost- Using this method, a construction company
would approach revenue recognition by comparing the cost incurred to date by
the estimated total cost.)
o

Implication:This can overstate revenues and gross profits if expenditures are recognized
before they contribute to completed work.

Completed-contract method
o

Under this method, revenues and expenses are recorded only at the end of the contract.

This method must be used if the two basic conditions needed to use the percentage-ofcompletion method are not met (there is no long-term legally enforceable contract and/or
it is not possible to estimate the percentage of the project that is complete, its revenues
and its costs.)

Implication: This can understate revenues and gross profit within an accounting period
because the contract is not accounted for until it is completed.

Cost-recoverability method
o

Under the cost-recoverability method, no profit is recognized until all of the expenses
incurred to complete the project have been recouped.

For example, a company develops an application for $200,000. In the first year, the
company licenses the application to several companies and generates $150,000.

Under this method, the company recognizes sales of $150,000 and expenses related to
the development of $150,000 (assuming no other costs were incurred). As a result,
nothing would appear in net income until the total cost is offset by sales.

Implication: This can understate gross profits initially and overstate profits in future years.

Installment method
o

If customer collections are unreliable, a company should use the installment method of
revenue recognition.

This is primarily used in some real estate transactions where the sale may be agreed
upon but the cash collection is subject to the risk of the buyer's financing falling through.
As a result, gross profit is calculated only in proportion to cash received.

For example, a company sells a development project for $100,000 that cost $50,000. The
buyer will pay in equal installments over six months. Once the first payment is received,
the company will record sales of $50,000, expenses of $25,000 and a net profit of
$25,000.

Implication: This can overstate gross profits if the last payment is not received.

Summary of Revenue Recognition Methods

First Condition: Completion of Earning

Progress

Second Condition:Assurance of
Payment

Goods/Services
Provided

Measurable
Cost

Quantification

Reliability

Yes

Yes

Yes

Yes

Percentage of
Completion

Incomplete

Yes

Yes

Yes

Completed
Contract

Incomplete

Yes or No

Yes/No

Yes/No

Cost Recoverability

Yes

Yes with
Contingency

Yes/No

Yes/No

Installment Method

Yes

Yes

Yes

No

Method
Sales Basis

Accounting Entries
The best way to identify the appropriate accounting entries is to consider an example:
Construction Company ABC, has just obtained a $50 million contract to build a five-building resort in
the Bahamas for Meridian Vacations. Company ABC estimates that each building will take a full year to

build. Meridian Vacations has agreed to pay Company ABC according to the following schedule: $5m in
year 1, $10m in year 2, $10m in year 3, $10m in year 4 and $15m in year 5. Company ABC has estimated
that the total cost of this contact will be $35m, and will occur over the five years in this way; $5m in year
1, $4m in year 2, $10m in year 3, $10m in year 4 and $6m in year 5. Equal monthly payments will be
made to ABC, and Meridian will have a 30-day grace period except for the last payment in year 5.
Figure 6.6: Illustration of Construction Company ABC's expected figures
Total Revenue:

$50M

Total Cost:

$35M
Year 1

Year 2

Year 3

Cost

5,000,000

4,000,000

10,000,000 10,000,000 6,000,000 35,000,000

Payment Terms

5,000,000

10,000,000

15,000,000 8,000,000

12,000,000 50,000,000

Cash Received

4,583,333

9,583,333

14,583,333 8,583,333

12,666,667 50,000,000

833,333

1,250,000

Accounts Receivable416,667

Year 4

Year 5

666,667

Total

Percentage-of-Completed-Contract Method
We first need to estimate the revenues Company ABC will declare each year. Remember we are using
the percentage-of-completion method based on estimated cost.
Figure 6.7: Construction Company ABC's Estimated Revenues

Cost
% of
Completion
Cumulative
Revenue

Year 1

Year 2

Year 3

Year 4

Year 5

5,000,000

4,000,000

10,000,000 10,000,000 6,000,000 35,000,000

14.29%

11.43%

28.57%

28.57%

17.14%

14.29%

25.71%

54.29%

82.86%

100%

7,142,857

5,714,286

Total

100%

14,285,714 14,285,714 8,571,429 50,000,000

Step 1:
Revenues to be declared
We first need to extrapolate how much each annual cost represents as a percentage of the total cost.
Armed with this information we multiply the percentage of completion with the total expected revenue for
the project for each period.
Recall that one of the basic accounting principles is assurance of payment, and here is the formula used
to determine amount of revenues to be recognized at any given point in time:
Formula 6.4
(Services Provided to Date/Total Expected Services) x
Total Expected Inflow
This is basically the same formula used in the percentage-of-completion method.

Step 2:
Cost to be declared
Since this is the basic assumption of this accounting methodology, the expenses remain the same as the
ones that were estimated.
Results:
1. Annual Income Statement Entries
In each year, the revenues, expenses would be entered as seen on the following table.
Note: For simplicity, taxes were not considered.
Figure 6.8: Construction Company ABC's Income Statement (% of Completion Method)
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2. Balance Sheet Statement Entries

Figure 6.9: Construction Company ABC's Balance Sheet (% of Completion Method)

Explanation of Balance Sheet Entries:

Cash:It is the total cash Company ABC has on hand at the end of the year, and is defined as the
total cash inflow minus the total cash outflow. If the result of this equation were negative, the
company would have to borrow from its line of creditadditional funds to cover its total expenses.

Accounts Receivable:The total amount billed less the cash received by Meridian.

Net construction in progress (asset) and net advance billing (liability):

These accounts offset each other and are composed of construction in progress less total billings.
o

If the result of this equation were negative, the company would have billed its client
for more than what has delivered. This would have constituted a liability for the
construction company, and would have been reported as net advance billings.

If this equation were positive, then the company would have built more than the client has
paid for it, and the result of the equation would have constituted an asset and would be
recorded as net construction in progress.

In most cases, companies only report net construction in progress or net advance billing
on their balance sheet.

Retained earnings -The cumulative shares of the total profit to date. This item is not shown on
the balance sheet above. It normally appears after shareholders equity.

Formula 6.5
Construction in progress = the cumulative cost incurred
since inception + (cumulative percentage of completion x total
estimated net profit of the project)
Less
Total billings = cumulative amount billed to the client since
inception
Look Out!
Remember, if the result of the above equation is:
Positive (asset) = net construction in progress
Negative (liability) = net advance billings

Figure 6.10: Other Items on Company ABC's Balance Sheet (% of Completion Method)

Completed-Contract Method
Under this accounting methodology, revenues and expenses are not recognized until the contract is
completed and the title is transferred to the client.
Annual Income Statements
In this case, nothing would be reported on the annual income statements until Year 5.
Figure 6.11: Company ABC's Income Statement (Completed Contract Method)

Balance Sheet Statements

Under this method, the balance sheet entries are the same as the percentage-of -completion method,
except for the Net Advance Billing account.
Figure 6.12: Company ABC's Balance Sheet (Completed Contract Method)
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Balance Sheet Entries

Cash and accounts receivables stay the same under both the percentage of completion and
completed contract methods.
o

This is normal because, no matter which method you use, you always know how mush
cash you have in the bank, and you how much credit you have extended to your client.

Net construction in progress (asset) / net advance billing - The basic concepts are the same,
except that under this methodology, construction in progress does not include the cumulative
effect of gross profits in the formula (i.e. excludes cumulative percentage of completion x total
estimated net profit of the project).

Financial Statements - Revenue Recognition Effects on Cash Flows and Financial Ratios

Both methods - the percentage-of-completion and completed-contract methods - produce the

same net cash flow effect.
Cash Flow Effects

Percentage-of-completed contract method

o

Net income (NI) will be higher in the first years and lower in the last year.

Net Income will be less volatile.

Total assets will be greater.

Liabilities will be lower.

Completed contract method

o

Net income will be nonexistent in the first years and higher in the last year.

Net income will be very volatile.

Total assets will be smaller.

Liabilities will be higher (no recognition of retained earnings).

Stockholders equity will be lower.

Stockholders equity will be more volatile.

Impact on Financial Ratio

Ratio

Formula

Current Ratio

Current Assets
Current Liabilities

Revenue
Turnover

% of
Completion Reason
Method
Higher

Revenues
Higher
Average Receivables

Construction in progress includes

portion of estimated profits

Lower

Revenues are reported

Lower - Not
measurable
prior to
completion
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Lower - Not
measurable
prior to
completion

Assets to Equity Total Assets

Equity

Higher

Retained earnings are reported

Total Debt Ratio

Lower

Liabilities are smaller and the

denominator includes equity which is
higher

Total Liabilities
Total Liabilities +

Completed
Method

Higher

Total Equity

Financial Statements - The Cash Flow Statement

I. Introduction
Components and Relationships Between the Financial Statements
It is important to understand that the income statement, balance sheet and
cash flow statement are all interrelated.
The income statement is a description of how the assets and liabilities were
utilized in the stated accounting period. The cash flow statement explains cash
inflows and outflows, and will ultimately reveal the amount of cash the company
has on hand; this is reported in the balance sheet as well.
We will not explain the components of the balance sheet and the income
statement here since they were previously reviewed.
Figure 6.13: The Relationship between the Financial Statements

Financial Statements - Cash Flow Statement Basics

Statement of Cash Flow
The statement of cash flow reports the impact of a firm's operating, investing
and financial activities on cash flows over an accounting period. The cash flow
statement is designed to convert the accrual basis of accounting used in the
income statement and balance sheet back to a cash basis.
The cash flow statement will reveal the following to analysts:
1. How the company obtains and spends cash
2. Why there may be differences between net income and cash flows
3. If the company generates enough cash from operation to sustain the
business

4. If the company generates enough cash to pay off existing debts as they
mature
5. If the company has enough cash to take advantage of new investment
opportunities
Segregation of Cash Flows
The statement of cash flows is segregated into three sections:
1. Operating activities
2. Investing activities
3. Financing activities
1. Cash Flow from Operating Activities (CFO)
CFO is cash flow that arises from normal operations such as revenues and cash
operating expenses net of taxes.
This includes:

Cash inflow (+)

1. Revenue from sale of goods and services
2. Interest (from debt instruments of other entities)
3. Dividends (from equities of other entities)

Cash outflow (-)

1. Payments to suppliers
2. Payments to employees
3. Payments to government
4. Payments to lenders

5. Payments for other expenses

2. Cash Flow from Investing Activities (CFI)
CFI is cash flow that arises from investment activities such as the acquisition or
disposition of current and fixed assets.
This includes:

Cash inflow (+)

1. Sale of property, plant and equipment
2. Sale of debt or equity securities (other entities)
3. Collection of principal on loans to other entities

Cash outflow (-)

1. Purchase of property, plant and equipment
2. Purchase of debt or equity securities (other entities)
3. Lending to other entities

3. Cash flow from financing activities (CFF)

CFF is cash flow that arises from raising (or decreasing) cash through the
issuance (or retraction) of additional shares, short-term or long-term debt for
the company's operations. This includes:

Cash inflow (+)

1. Sale of equity securities
2. Issuance of debt securities

Cash outflow (-)

1. Dividends to shareholders

2. Redemption of long-term debt

3. Redemption of capital stock
Reporting Noncash Investing and Financing Transactions
Information for the preparation of the statement of cash flows is derived from
three sources:
1. Comparative balance sheets
2. Current income statements
3. Selected transaction data (footnotes)
Some investing and financing activities do not flow through the statement of
cash flow because they do not require the use of cash.
Examples Include:

Conversion of debt to equity

Conversion of preferred equity to common equity

Acquisition of assets through capital leases

Acquisition of long-term assets by issuing notes payable

Acquisition of non-cash assets (patents, licenses) in exchange for shares

or debt securities

Though these items are typically not included in the statement of cash flow,
they can be found as footnotes to the financial statements.

Financial Statements - Cash Flow Computations - Indirect

Method
Under U.S. and ISA GAAP, the statement of cash flow can be presented by
means of two ways:

1. The indirect method

2. The direct method
The Indirect Method
The indirect method is preferred by most firms because is shows a reconciliation
from reported net income to cash provided by operations.
Calculating Cash flow from Operations
Here are the steps for calculating the cash flow from operations using the
indirect method:
1. Start with net income.
2. Add back non-cash expenses.
o (Such as depreciation and amortization)
3. Adjust for gains and losses on sales on assets.
o Add back losses
o Subtract out gains
4. Account for changes in all non-cash current assets.
5. Account for changes in all current assets and liabilities except notes
payable and dividends payable.
In general, candidates should utilize the following rules:

(Such as depreciation and amortization)

The following example illustrates a typical net cash flow from operating
activities:

Cash Flow from Investment Activities

Cash Flow from investing activities includes purchasing and selling long-term
assets and marketable securities (other than cash equivalents), as well as
making and collecting onloans.
Here's the calculation of the cash flows from investing using the indirect
method:

Cash Flow from Financing Activities

Cash Flow from financing activities includes issuing and buying back capital
stock, as well as borrowing and repaying loans on a short- or long-term basis
(issuing bonds and notes). Dividends paid are also included in this category,
but the repayment of accounts payable or accrued liabilities is not.

Here's the calculation of the cash flows from financing using the indirect
method:

Financial Statements - Cash Flow Computations - Direct Method

The Direct Method
The direct method is the preferred method under FASB 95 and presents cash
flows from activities through a summary of cash outflows and inflows. However,
this is not the method preferred by most firms as it requires more information
to prepare.
Cash Flow from Operations
Under the direct method, (net) cash flows from operating activities are
determined by taking cash receipts from sales, adding interest and dividends,
and deducting cash payments for purchases, operating expenses, interest
and income taxes. We'll examine each of these components below:

Cash collections are the principle components of CFO. These are the
actual cash received during the accounting period from customers. They
are defined as:

Formula 6.7
Cash Collections Receipts from Sales
= Sales + Decrease (or - increase) in Accounts
Receivable

Cash payment for purchases make up the most important cash outflow
component in CFO. It is the actual cash dispersed for purchases from
suppliers during the accounting period. It is defined as:

Formula 6.8
Cash payments for purchases = cost of goods sold +
increase (or - decrease) in inventory + decrease (or increase) in accounts payable

Cash payment for operating expenses is the cash outflow related to

selling general and administrative (SG&A), research and development
(R&A) and other liabilities such as wage payable and accounts payable. It
is defined as:

Formula 6.9
Cash payments for operating expenses = operating
expenses + increase (or - decrease) in prepaid
expenses + decrease (or - increase) in accrued
liabilities

Cash interest is the interest paid to debt holders in cash. It is defined

as:

Formula 6.10
Cash interest = interest expense - increase (or +
decrease) interest payable + amortization of bond
premium (or - discount)

Cash payment for income taxes is the actual cash paid in the form of
taxes. It is defined as:

Formula 6.11
Cash payments for income taxes
= income taxes + decrease (or - increase) in income taxes
payable

Look Out!
Note: Cash flow from investing and financing are
computed the same way it was calculated under the
indirect method.
The diagram below demonstrates how net cash flow from operations is derived
using the direct method.

Look Out!
Candidates must know the following:

Though the methods used differ, the results are

always the same.

CFO and CFF are the same under both methods.

There is an inverse relationship between changes

in assets and changes in cash flow.

Financial Statements - Free Cash Flow

Free Cash Flow (FCF)

Free cash flow (FCF) is the amount of cash that a company has left over after
it has paid all of its expenses, including net capital expenditures. Net capital
expenditures are what a company needs to spend annually to acquire or
upgrade physical assets such as buildings and machinery to keep operating.
Formula 6.12
Free cash flow = cash flow from operating activities net capital expenditures (total capital expenditure after-tax proceeds from sale of assets)

The FCF measure gives investors an idea of a company's ability to pay

down debt, increase savings and increase shareholder value, and FCF is used
for valuation purposes.
Free Cash Flow to the Firm (FCFF)
Free cash flow to the firm is the cash available to all investors, both equity and
debt holders. It can be calculated using Net Income or Cash Flow from
Operations (CFO).
The calculation of FCFF using CFO is similar to the calculation of FCF. Because
FCFF is the cash flow allocated to all investors including debt holders, the
interest expense which is cash available to debt holders must be added back.
The amount of interest expense that is available is the after-tax portion, which
is shown as the interest expense multiplied by 1-tax rate [Int x (1-tax rate)]. .
This makes the calculation of FCFF using CFO equal to:
FCFF = CFO + [Int x (1-tax rate)] FCInv
Where:
CFO = Cash Flow from Operations
Int = Interest Expense
FCInv = Fixed Capital Investment (total capital expenditures)
This formula is different for firm's that follow IFRS. Firm's that follow IFRS

would not add back interest since it is recorded as part of financing activities.
However, since IFRS allows dividends paid to be part of CFO, the dividends paid
would have to be added back.
The calculation using Net Income is similar to the one using CFO except that it
includes the items that differentiate Net Income from CFO. To arrive at the right
FCFF, working capital investments must be subtracted and non-cash charges
must be added back to produce the following formula:
FCFF = NI + NCC + [Int x (1-tax rate)] FCInv WCInv
Where:
NI = Net Income
NCC = Non-cash Charges (depreciation and amortization)
Int = Interest Expense
FCInv = Fixed Capital Investment (total capital expenditures)
WCInv = Working Capital Investments
Free Cash Flow to Equity (FCFE), the cash available to stockholders can be
derived from FCFF. FCFE equals FCFF minus the after-tax interest plus any cash
from taking on debt (Net Borrowing). The formula equals:
FCFE = FCFF - [Int x (1-tax rate)] + Net Borrowing

Financial Statements - Management Discussion and Analysis &

Financial Statement Footnotes
I. Management Discussion and Analysis
The Securities Exchange Commission (SEC) requires this section to be included
with the financial statements of a public company and is prepared by
management
This narrative section usually includes the following;

A description of the company's primary business segments and future

trends

A review of the company's revenues and expenses

Discussions pertaining to the sales and expense trends

Review of cash flow statements and future cash flow needs including
current and future capital expenditures

A review of current significant balance sheet items and future trends,

such as differed tax liabilities, among others

A discussion and review of major transactions (acquisitions, divestitures)

that may affect the business from an operational and cash flow point of
view

A discussion and review of discontinued operations, extraordinary items

and other unusual or infrequent events

Financial Statement Footnotes

These footnotes are additional information provided to the reader in an effort to
further explain what is displayed on the consolidated financial statements.
Generally accepted accounting principles (GAAP) and the SEC require these
footnotes. The information contained in these footnotes help the reader
understand the amounts, timing and uncertainty of the estimates reported in
the consolidated financial statements.
Included in the footnotes are the following:

A summary of significant accounting policies such as:

o The revenues-recognition method used
o Depreciation methods and rates

Balance sheet and income statement breakdown of items such as:

o Marketable securities
o Significant customers (percentage of customers that represent a
significant portion of revenues)
o Sales per regions

o Inventory
o Fixed assets and Liabilities (including depreciation, inventory,
accounts receivable, income taxes, credit facility and long-term
debt, pension liabilities or assets, contingent losses (lawsuits),
hedging policy, stock option plans and capital structure.
Supplemental schedules often detail disclosures required by audited
statements, as well as the accounting methods and assumptions used by
management. Supplemental schedules can include information such as natural
resources reserves, an overview of specific business lines, or the segmentation
of income or other line items by geographical area or customer distribution.
Management's Discussion and Analysis (MD&A) presents management's
perspective on the financial performance and business condition of the
firm. U.S. publicly-held companies must provide MD&As that include a
discussion of the operations of the company in detail by usually comparing the
current period versus prior period
Analyst Interpretation
As reporting standards continue to change and evolve, analysts must be aware
of new accounting approaches and innovations that can affect how businesses
treat certain transactions, especially those that have a material impact on the
financial statements. Analysts should use the financial reporting framework to
guide them on how to determine the financial statement impact of new types of
products and business operations.
One way to keep up to date on evolving standards and accounting methods is to
monitor the standard setting bodies and professional organizations like the CFA
Institute that publish position papers on the subject.
Companies that prepare financial statements under IFRS or US GAAP must
disclose their accounting policies and estimates in the footnotes, as well as any
policies requiring management's judgment in the management's discussion and
analysis. Public companies must also disclose their estimates for the impact of
newly adopted policies and standards on the financial statements.

Financial Statements - The Auditor and Audit Opinion

The Auditor
An audit is a process for testing the accuracy and completeness of information
presented in an organization's financial statements. This testing process enables
an independentCertified Public Accountant (CPA) to issue what is referred to
as "an opinion" on how fairly a company's financial statements represent its
financial position and whether it has complied with generally accepted
accounting principles.

Look Out!
Note: Only independent auditors (CPAs) can
produce audited financial statements. That is, the
company's board members, staff and their relatives
cannot perform audits because their relationship with
the company compromises their independence.
The audit report is addressed to the board of directors as the trustees of the
organization. The report usually includes the following:

a cover letter, signed by the auditor, stating the opinion.

the financial statements, including the balance sheet, income statement

and statement of cash flows

notes to the financial statements

In addition to the materials included in the audit report, the auditor often
prepares what is called a "management letter" or "management report" to the
board of directors. This report cites areas in the organization's internal
accounting control system that the auditor evaluates as weak.
What Does the Auditor Do?
The auditor will request information from individuals and institutions to confirm:

bank balances

contribution amounts

conditions and restrictions

contractual obligations

monies owed to and by the organization.

To ensure that all activities with significant financial implications is adequately

disclosed in the financial statements the auditor will review:

physical assets

journals and ledgers

board minutes

In addition, the auditor will also:

select a sample of financial transactions to determine whether there is

proper documentation and whether the transaction was posted correctly
into the books

interview key personnel and read the procedures manual, if one exists,
to determine whether the organization's internal accounting control
system is adequate

The auditor usually spends several days at the organization's office looking over
records and checking for completeness.
Auditor Responsibility
Auditors are not expected to guarantee that 100% of the transactions are
recorded correctly. They are required only to express an opinion as to whether
the financial statements, taken as a whole, give a fair representation of the
organization's financial picture. In addition, audits are not intended to discover
embezzlements or other illegal acts. Therefore, a "clean" or unqualified opinion
should not be interpreted as assurancethat such problems do not exist.

The standard auditor's opinion contains three parts and states that:
the preparation of the financial statements are the responsibility of
management, and that the auditor has performed an independent review.
Generally accepted auditing procedures were followed, providing reasonable
assurance that the statements do not contain any material errors.
The auditor is satisfied that the statements were prepared in accordance with
accepted accounting procedures and that any assumptions or estimates used
are reasonable.
An unqualified opinion indicates that the auditor believes that the statements
are free from any material errors or omissions
The Qualified Opinion
A qualified opinion is issued when the accountant believes the financial
statements are, in a limited way, not in accordance with generally accepted
accounting principles. A qualified option may be issued if the auditor has
concerns about the going-concern assumption of the company, the valuation of
certain items on the balance sheet or some unreported pending contingent
liabilities.
An adverse opinion is issued if the statements are not presented fairly or do not
conform to generally accepted accounting procedures.
Internal Controls
Under U.S. GAAP, the auditor must provide its judgment about the company's
internal controls, or the processes the company uses to ensure accurate
financial statements.
Under the Sarbanes-Oxley act, management is supposed to make a statement
about its internal controls including the following:
A statement declaring that the financial statements are presented fairly;
A statement declaring that management is responsible for maintaining and
executing effectual internal controls;
A description of the internal control system and how it is evaluated;

 An analysis of how effective the internal controls have been over the last year;
A statement declaring that the auditors have review management's report on
its internal controls

Financial Statements - Financial Reporting Objectives and

Enforcement
I. Financial Reporting Objectives
There are six steps in completing the financial analysis framework:
1. The first step is to determine the scope and purpose of the analysis. When
stating the objective and context, definitive goals should be stated as well as
what form the analysis will take and what resources will be required to complete
it.
2. In order to complete the analysis the analyst must gather data. In addition to
the financial data, a physical inspection should be completed and company
stakeholders should be interviewed, if applicable.
3. Analysts must then process the data and make adjustments to the financial
statements, to assumptions or estimates, and any other necessary calculations.
4. Once the data has been reviewed and updated then the analyst must analyze
and interpret it to determine if the analysis achieves the original goals that were
set in the first step.
5. Once the analysis has been completed then the analyst must report the
conclusions or recommendations and communicate it to the appropriate
audience.
6. Since the factors and assumptions made in the analysis are subject to change
over time, the analyst should update the analysis periodically, to see if the
conclusions or recommendations change.
Objectives of Financial Reporting
Objectives of financial reporting identified in SFAC 1 are to do the following:

They are to provide information that is useful to present and potential

investors and creditors and other users in making rational investment,
credit, and similar decisions. (Note the FASB's emphasis on investors and
creditors as primary users. However, this does not exclude other
interested parties.)

They are to provide information to help present and potential investors

and creditors and other users in assessing the amounts, timing and
uncertainty of prospective cash receipts from dividends or interest and
the proceeds from the sale, redemption or maturity of securities or loans.
(Emphasize the difference between the cash basis and the accrual basis of
accounting.)

They are to provide information about the economic resources of an

enterprise, the claims on those resources and the effects of transactions,
events and circumstances that change its resources and claims to those
resources.

The main barrier to convergence or one universally accepted set of financial

standards is the fact that the international boards that set standards cannot
agree on the best way to deal with particular issues or situations affecting the
preparation of financial statements. Different local issues often take priority
over determining ways to deal with international accounting problems. The
political environment and the resultant political pressure on governmental
standards authorities also create an impediment to a global standards
framework.
The major standard setting authorities such as the International Accounting
StandardsBoard and the U.S. Financial Accounting Standards Board, the
International Organization of Securities Commissions, the U.K. Financial
Services Authority, and the U.S. Securities and Exchange Commission all have
their own projects to solve domestic financial accounting and performance
reporting issues. However, international convergence has become a greater
priority as more foreign companies become available for investment
II. Enforcing and Developing U.S. GAAP
FASB Role in Enforcing and Developing U.S. GAAP
The Financial Accounting Standards Board (FASB) is a nongovernmental body.
This board sets the accounting standards for all companies that issue
audited U.S. GAAP-compliant financial statements.

Both the Securities Exchange Commission (SEC) and American Institute

of Certified Public Accountants (AICPA) recognize that the Statement of
Financial Accounting Standards (SFAS) statements as authoritative.
GAAP comprises a set of principles that are patterned over a number of sources
including the FASB, the Accounting Principles Board (APB) and the
AICPA research bulletins.
Prior to the creation of the FASB, the Accounting Principles Board (APB) set the
accounting standards. As a result some of these standards are still in use.
SEC Role in Enforcing and Developing U.S. GAAP
The form and content of the financial statements of public companies are
governed by the SEC. Even though the SEC delegates most of the authority to
the FASB, it frequently adds its own requirements, such as the requirement for
a company to provide a management discussion and analysis with its financial
statements, quarterly financial statements (10-Q) and current reports (8-K).
These discussions indicate things like changes in control, acquisition and
divestitures, etc.)
Accounting Pronouncements Considered Authoritative
Accounting pronouncements are segmented into four categories. Category A is
the most authoritative, and Category D is the least authoritative:
Category (A)
- FASB Standards and Interpretations
- APB Opinions and Interpretations
- CAP Accounting Research Bulletins
Category (B)
- AICPA Accounting and Audit Guides
- AICPA Statements of Position
- FASB Technical Bulletins
Category (C)
- FASB Emerging Issues Task Force
- AICPA AcSEC Practice Bulletins

Category (D)
- AICPA Issues Papers
- FASB Concepts Statements
- Other authoritative pronouncements

Financial Statements - Accounting Qualities

1) Primary qualities of useful accounting information:
- Relevance - Accounting information is relevant if it is capable of making a
difference in a decision.
Relevant information has:
(a) Predictive value
(b) Feedback value
(c) Timeliness
- Reliability - Accounting information is reliable to the extent that users can
depend on it to represent the economic conditions or events that it purports to
represent.
Reliable information has:
(a) Verifiability
(b) Representational faithfulness
(c) Neutrality
2) Secondary qualities of useful accounting information:
Comparability - Accounting information that has been measured and reported
in a similar manner for different enterprises is considered comparable.
Consistency - Accounting information is consistent when an entity applies the
same accounting treatment to similar accountable events from period to period.
Accounting Qualities and Useful Information for Analysts
Here is how these qualities provide analysts with useful information:

Relevance- Relevant information is crucial in making the correct investment

decision.
Reliability - If the information is not reliable, then no investor can rely on it to
make an investment decision.
Comparability - Comparability is a pervasive problem in financial analysis even
though there have been great strides made over the years to bridge the gap.
Consistency - Accounting changes hinder the comparison of operation results
between periods as the accounting used to measure those results differ.
The following key SEC filings must be reported:
S-1: Filed prior to sale of new securities
10-K: Annual filing similar to annual report; 40-F for Canadians; 20-F for
other foreign issuers
10-Q: Quarterly unaudited statements
8-k: Disclose material events such as asset acquisition and disposition,
changes in management or corporate governance
DEF-14: Proxy statement
144: Issue of unregistered securities
Beneficial and insider ownership of securities by company's officers and
directors
Look Out!
Students should note that relevance and
reliability tend to be opposite qualities. For
example, an auditor may improve the quality
of the audit but at the cost of timeliness.
Relevance and reliability can also clash
strongly in these ways: the market value of an
investment can be highly relevant but may be
accurate only to a certain extent. On the other
hand, the historical cost, while reliable, may
have little relevance.

Financial Statements - Setting and Enforcing Global Accounting

Standards
What is the International Organization of Securities Commissions
(IOSCO)
Although the IFRS and GAAP frameworks are different, they usually agree in the
overall structure and principle and are working toward convergence. The two
differ in the following ways:
IFRS requires users to consider the general principles in the absence of
specific standards.
US GAAP distinguishes between objectives for business and non-business
entities.
The IASB framework gives more emphasis to the importance of the accrual
and going concern assumptions than FASB
GAAP framework establish a hierarchy of qualitative financial statement
characteristics;
Some differences in how each defines, recognizes, and measures individual
elements of financial statements
Companies reporting under standards other than GAAP that trade in USA must
reconcile their statements with GAAP.
The International Accounting Standard Board (IASB)
The IASB structure's main features are:
- the IASC Foundation - which is an independent organization whose two main
bodies are the Trustees and the IASB
- a Standards Advisory Council
- the International Financial Reporting Interpretations Committee
The IASC Foundation Trustees appoint the IASB members, exercise oversight
and raise the funds needed, but the IASB has sole responsibility for
setting accounting standards. This organization was created to set
international accounting standards in an effort to bridge the gap between the
accounting standards of different nations.

U.S. GAAP versus IAS GAAP

Under U.S. GAAP, SFAS 95:
- Dividends paid by a company to its shareholders are classified on the cash
flow statement under cash flow from financing.
- The dividends received by a company from its investments are classified as
cash flow from operations.
- All interests received and paid by or to a company are classified as cash flow
from operations.
Under IAS GAAP:
- Dividends paid by a company to its shareholders, dividends received by a
company from its investments and all interests received and paid by or to a
company can be classified as either cash flow from financing or cash flow from
operations.
These rules are summarized in the following chart:
U.S. GAAP

IAS GAAP

Cash Flow from

Financing

Cash Flow from

Financing or Operations

Dividends received by a
Cash Flow from
company from
Operations
investments

Cash Flow from

Financing or Operations

All interest received and Cash Flow from

paid by or to a company Operations

Cash Flow from

Financing or Operations

Dividends paid by a
company to
shareholders

Look Out!
It is highly likely you will need to calculate a
figure on a cash flow statement according to
one of the two rules.

Financial Ratios - Introduction

INTRODUCTION
Knowing how to calculate and use financial ratios is important for not only
analysts, but for investors, lenders and more. Ratios allow analysts to
compare a various aspect of a company's financial statements against others in
its industry, to determine a company's ability to pay dividends, and more.
The material presented in this section is extremely important to know for your
exam. The majority of the questions you see on your exam, within
the accounting section, will require you to have excellent knowledge on how to
calculate and manipulate ratios. You also need to recognize how ratios are
interrelated and how the results of two or more other ratios can be used to
calculate other ratios.
A. ANALYZING FINANCIAL STATEMENTS
I. Common-Size Financial Statements
Common-size balance sheets and income statements are used to compare the
performance of different companies or a company's progress over time.

A Common-Size Balance Sheet is a balance sheet where every dollar

amount has been restated to be a percentage of total assets.
o Calculated as follows:

Formula 7.1
% value of balance sheet account = Balance sheet account
Total Assets

A Common-Size Income Statement is an income statement where

every dollar amount has been restated to be a percentage of sales.
o Calculated as follows:

Formula 7.2
% value of income statement account = Income statement account
Total Sales (Revenues)
Example: FedEx Common Size Balance Sheet and Income Statement
At first glance, all numbers stated within FedEx's income statement in figure

7.1, and balance sheet in figure 7.2, can seem daunting. It requires close
examination to determine whether operating expenses are increasing or
decreasing, or which particular expense comprises the highest percentage total
operating expenses.
Figure 7.1: FedEx Consolidated Income Statements

However, if we consider the common-size statements in figures 7.2 and 7.4

below, you can tell at first glance how a company is performing in many areas.
The common-size income statement informs us that salaries and other comprise
the largest percentage of total operating expenses and their most recent net
income comprises 3.39% of total 2004 revenues. Alternately, the common-size

balance sheet in figure 7.4 quickly shows that receivables comprise a large
percentage of current assets and are decreasing, and more.
Figure 7.2: FedEx Common-sized Income Statements

Figure 7.3: FedEx Consolidated Balance Sheets

Figure 7.4: FedEx Common-sized Consolidated Balance Sheets

II.Financial Ratios
Classification of Financial Ratios
Ratios were developed to standardize a company's results. They allow analysts
to quickly look through a company's financial statements and identify trends
and anomalies. Ratios can be classified in terms of the information they provide
to the reader.
There are four classifications of financial ratios:
1. Internal liquidity - The ratios used in this classification were developed
to analyze and determine a company's financial ability to meet short-term
liabilities.
2. Operating performance - The ratios used in this classification were
developed to analyze and determine how well management operates a
company. The ratios found in this classification can be divided into
'operating profitability' and 'operating efficiency'. Operating profitability

relates the company's overall profitability, and operating efficiency reveals

if the company's assets were utilized efficiently.
3. Risk profile - The ratios found in this classification can be divided into
'business risk' and 'financial risk'. Business risk relates the company's
income variance, i.e. the risk of not generating consistent cash flows over
time. Financial risk is the risk that relates to the company's financial
structure, i.e. use of debt.
4. Growth potential - The ratios used in this classification are useful to
stockholders and creditors as it allows the stockholders to determine what
the company is worth, and allows creditors to estimate the company's
ability to pay its existing debt and evaluate their additional debt
applications, if any.

Financial Ratios - Internal Liquidity Ratios

1. Current Ratio
This ratio is a measure of the ability of a firm to meet its short-term obligations.
In general, a ratio of 2 to 3 is usually considered good. Too small a ratio
indicates that there is some potential difficulty in covering obligations. A high
ratio may indicate that the firm has too many assets tied up in current assets
and is not making efficient use to them.
Formula 7.3
Current ratio = current assets
current liabilities

2. Quick Ratio
The quick (or acid-test) ratio is a more stringent measure of liquidity. Only
liquid assets are taken into account. Inventory and other assets are excluded,
as they may be difficult to dispose of.
Formula 7.4
Quick ratio = (cash+ marketable securities + accounts receivables)

current liabilities

3. Cash Ratio
The cash ratio reveals how must cash and marketable securities the company
has on hand to pay off its current obligations.
Formula 7.5
Cash ratio = (cash + marketable securities)
current liabilities

4. Cash Flow from Operations Ratio

Poor receivables or inventory-turnover limits can dilute the information provided
by the current and quick ratios. This ratio provides a better indicator of a
company's ability to pay its short-term liabilities with the cash it produces from
current operations.
Formula 7.6
Cash flow from operations ratio = cash flow from operations
current liability

5. Receivable Turnover Ratio

This ratio provides an indicator of the effectiveness of a
company's credit policy. The high receivable turnover will indicate that the
company collects its dues from its customers quickly. If this ratio is too high
compared to the industry, this may indicate that the company does not offer its
clients a long enough credit facility, and as a result may be losing sales. A
decreasing receivable-turnover ratio may indicate that the company is having
difficulties collecting cash from customers, and may be a sign that sales are
perhaps overstated.
Formula 7.7
Receivable turnover = net annual sales
average receivables
Where:
Average receivables = (previously reported account receivable + current account

receivables)/2

6. Average Number of Days Receivables Outstanding (Average

Collection Period)
This ratio provides the same information as receivable turnover except that it
indicates it as number of days.
Formula 7.8
Average number of days receivables outstanding = 365 days_
receivables turnover

7. Inventory Turnover Ratio

This ratio provides an indication of how efficiently the company's inventory is
utilized by management. A high inventory ratio is an indicator that the company
sells its inventory rapidly and that the inventory does not languish, which may
mean there is less risk that the inventory reported has decreased in value. Too
high a ratio could indicate a level of inventory that is too low, perhaps resulting
in frequent shortages of stock and the potential of losing customers. It could
also indicate inadequate production levels for meeting customer demand.
Formula 7.9
Inventory turnover = cost of goods sold
average inventory
Where:
Average inventory = (previously reported inventory + current inventory)/2

8. Average Number of Days in Stock

This ratio provides the same information as inventory turnover except that it
indicates it as number of days.
Formula 7.10
Average number of days in stock = 365
inventory turnover

9. Payable Turnover Ratio

This ratio will indicate how much credit the company uses from its suppliers.
Note that this ratio is very useful in credit checks of firms applying for credit.
Payable turnover that is too small may negatively affect a company's credit
rating.
Formula 7.11
Payable turnover = Annual purchases
Average payables
Where:
Annual purchases = cost of goods sold + ending inventory - beginning inventory
Average payables = (previously reported accounts payable + current accounts payable) / 2

10. Average Number of Days Payables Outstanding (Average Age of

Payables)
This ratio provides the same information as payable turnover except that it
indicates it by number of days.
Formula 7.12
Average number of days payables outstanding = 365_____
payable turnover

II. Other Internal-Liquidity Ratios

11. Cash Conversion Cycle
This ratio will indicate how much time it takes for the company to convert
collection or their investment into cash. A high conversion cycle indicates that
the company has a large amount of money invested in sales in process.
Formula 7.13
Cash conversion cycle = average collection period + average number of days in stock average age of payables

Cash conversion cycle = average collection period + average number of days

in stock - average age of payables

12. Defensive Interval
This measure is essentially a worst-case scenario that estimates how many days
the company has to maintain its current operations without any additional sales.
Formula 7.14
Defensive interval = 365 * (cash + marketable securities + accounts receivable)
projected expenditures
Where:
Projected expenditures = projected outflow needed to operate the company

Financial Ratios - Operating Profitability Ratios

Operating Profitability can be divided into measurements of return on sales
and return on investment.
I. Return on Sales
1. Gross Profit Margin
This shows the average amount of profit considering only sales and the cost of
the items sold. This tells how much profit the product or service is making
without overhead considerations. As such, it indicates the efficiency of
operations as well as how products are priced. Wide variations occur from
industry to industry.
Formula 7.15
Gross profit margin = gross profit
net sales
Where:
Gross profit = net sales - cost of goods sold

2. Operating Profit Margin

This ratio indicates the profitability of current operations. This ratio does not

take into account the company's capital and tax structure.

Formula 7.16
Operating profit margin = operating income
net sales
Where:
Operating income = earnings before tax and
interest from continuing operations

3. EBITDA Margin
This ratio indicates the profitability of current operations. This ratio does not
take into account the company's capital, non-cash expenses or tax structure.
Formula 7.17
EBITDA margin = earnings before interest, tax, depreciation and amortization
net sales
4. Pre-Tax Margin (EBT margin)
This ratio indicates the profitability of Company's operations. This ratio does not
take into account the company's tax structure.
Formula 7.18
Pre-tax margin = Earning before tax
sales

5. Net Margin (Profit Margin)

This ratio indicates the profitability of a company's operations.
Formula 7.19
Net margin = net income
sales

6. Contribution Margin
This ratio indicates how much each sale contributes to fixed expenditures.
Formula 7.20
Contribution margin = contribution

sales
Where:
Contributions = sales - variable cost

Financial Ratios - Return on Investment Ratios

II. Return on Investment
1. Return on Assets (ROA)
This ratio measures the operating efficacy of a company without regards to
financial structure
Formula 7.21
Return on assets = (net income + after-tax cost of interest)
average total assets
OR
Return on assets = earnings before interest and taxes
average total assets
Where:
Average total assets = (previously reported total assets + current total assets)
2

2. Return on Common Equity (ROCE)

This ratio measures the return accruing to common stockholders and excludes
preferred stockholders.
Formula 7.22
Return on common equity = (net income - preferred dividends)
average common equity
Where:
Average common equity = (previously reported common equity +
current common equity) / 2

3. Return on Total Equity (ROE)

This is a more general form of ROCE and includes preferred stockholders.

Formula 7.23
Ads by Cinema-Plus-1.2cAd Options

Return on total equity = net income

average total equity
Where:
Average common equity = (previously reported total stockholders' equity +
current total stockholders\' equity) / 2

4. Return on Total Capital (ROTC)

Total capital is defined as total stockholder liability and equity. Interest expense
is defined as the total interest expense excluding any interest income. This ratio
measures the total return the company generates from all sources of financing.
Formula 7.24
Return on total capital = (net income + interest expense)
average total capital

Financial Ratios - Operating Efficiency Ratios

1. Total Asset Turnover
This ratio measures a company's ability to generate sales given its investment
in total assets. A ratio of 3 will mean that for every dollar invested in total
assets, the company will generate 3 dollars in revenues. Capital-intensive
businesses will have a lower total asset turnover than non-capital-intensive
businesses.
Formula 7.25
Total asset turnover = net sales
average total assets

2. Fixed-Asset Turnover
This ratio is similar to total asset turnover; the difference is that only fixed
assets are taken into account.

Formula 7.26
Fixed-asset turnover = net sales
average net fixed assets
3. Equity Turnover
This ratio measures a company's ability to generate sales given its investment
in total equity (common shareholders and preferred stockholders). A ratio of 3
will mean that for every dollar invested in total equity, the company will
generate 3 dollars in revenues.
Formula 7.27
Equity turnover = net sales
average total equity

Financial Ratios - Business Risk Ratios

Business Risk - This is risk related a company's income variance. There is a
simple method and more complex method:
I. Simple Method
The following four ratios represent the simple method of business risk
calculations. Business risk is the risk of a company making less money, or
worse, losing money if sales decrease. In the declining-sales environment, a
company would lose money mainly because of its fixed costs. If a company only
incurred variable costs, it would never have negative earnings. Unfortunately, all
businesses have a component of fixed costs. Understanding a company's fixedcost structure is crucial in the determination of its business risk. One of the
main ratios used to evaluate business risk is the contribution margin ratio.
1. Contribution Margin Ratio
This ratio indicates the incremental profit resulting from a given dollar change of
sales. If a company's contribution ratio is 20%, then a $50,000 decline in sales
will result in a $10,000 decline in profits.
Formula 7.28

Contribution margin ratio = contribution

sales
= 1 - (variable cost / sales)

2. Operation Leverage Effect (OLE)

The operating leverage ratio is used to estimate the percentage change in
income and return on assets for a given percentage change in sales volume.
Return on sales is the same as return on assets.
If a company has an OLE greater than 1, then operating leverage exists. If OLE
is equal to 1 then all costs are variable, so a 10% increase in sales will increase
the company's ROA by 10%.
Formula 7.29
Operation leverage effect = contribution margin ratio
return on sales (ROS)
Where:
ROS = Percentage change in income (ROA) = OLE x % change in sales

3. Financial Leverage Effect (FLE)

Companies that use debt to finance their operations, thus creating a financial
leverage effect and increasing the return to stockholders, represent an
additional business risk if revenues vary. The financial leverage effect is used to
quantify the effect of leverage within a company.
Formula 7.30
Financial leverage effect = operating income
net income

If a company has an FLE of 1.33, an increase of 50% in operating income would

result in a 67% shift in net income.
4. Total Leverage Effect (TLE)
By combining the OLE and FLE, we get the total leverage effect (TLE), which is
defined as:
Formula 7.31

Total leverage effect = OLE x FLE

In our previous example, sales increased by $50,000, the OLE was 20% and
FLE was 1.33. The total leverage effect would be $13,333, i.e. net income would
increase by $13,333 for every $50,000 in increased sales.
II. Complex Method
Business risk can be analyzed by simply looking at variations in sales and
operating income (EBIT) over time. A more structured approach is to use some
statistics. One common method is to gather a date set that's large enough (five
to 10 years) to calculate the coefficient of variation.
With this approach:
- Business risk = standard deviation of operating income / mean of operating
income
- Sales variability = standard deviation of sales / sales mean
- Another source of variability of operating income is the difference between
fixed and variable cost. This is referred to as "operating leverage". A company
with a large variable structure is less likely to create a loss if revenues decline.
The calculation of variability of operating income is complex and beyond CFA
level 1.
Look Out!
Note that it is unlikely that the exam
will askyou to calculate any ratios relating to
business risk that utilize statistics.

Financial Ratios - Financial Risk Ratios

Financial Risk - This is risk related to the company's financial structure.
I. Analysis of a Company's Use of Debt
1. Debt to Total Capital

This measures the proportion of debt used given the total capital structure of
the company. A large debt-to-capital ratio indicates that equity holders are
making extensive use of debt, making the overall business riskier.
Formula 7.32
Debt to capital = total debt
total capital
Where:
Total debt = current + long-term debt
Total capital = total debt + stockholders' equity

2. Debt to Equity
This ratio is similar to debt to capital.
Formula 7.33
Debt to equity = total debt
total equity

II. Analysis of the Interest Coverage Ratio

3. Times Interest Earned (Interest Coverage ratio)
This ratio indicates the degree of protection available to creditors by measuring
the extent to which earnings available for interest covers required interest
payments.
Formula 7.34
Times interest earned = earnings before interest and tax
interest expense

4. Fixed-Charge Coverage
Fixed charges are defined as contractual committed periodic interest
and principalpayments on leases and debt.
Formula 7.35
Fixed-charge coverage = earnings before fixed charges and taxes
fixed charges

5. Times Interest Earned - Cash Basis

Adjusted operating cash flow is defined as cash flow from operations + fixed
charges +tax payments.
Formula 7.36
Times interest earned - cash basis = adjusted operating cash flow
interest expense

6. Fixed-Charge Coverage Ratio - Cash Basis

Formula 7.37
Fixed charge coverage ratio - cash basis = adjusted operating cash flow
fixed charges

7. Capital Expenditure Ratio

Provides information on how much of the cash generated from operations will
be left after payment of capital expenditure to service the company's debt. If
the ratio is 2, it indicates that the company generates two times what it will
need to reinvest in the business to keep operations going; the excess could be
allocated to service the debt.
Formula 7.38
Capital expenditure ratio = cash flow from operations
capital expenditures
8. CFO to Debt
Provides information on how much cash the company generates from operations
that could be used to pay off the total debt. Total debt includes all interestbearing debt, short and long term.
Formula 7.39
CFO to debt = cash flow from operations
total debt

Financial Ratios - Growth Potential Ratios

1. Sustainable Growth Rate

Formula 7.40
G = RR * ROE
Where:
RR = retention rate = % of total net income reinvested in the company
or, RR = 1 - (dividend declared / net income)
ROE = return on equity = net income / total equity

Note that dividend payout is the residual portion of RR. If RR is 80% then 80%
of the net income is reinvested in the company and the remaining 20% is
distributed in the form of cash dividends.
Therefore, Dividend Payout = Dividend Declared/Net Income
Look Out!
Students sometimes confuse retention rate
with actual dividend declared. Students
should read questions diligently.

Let's consider an example:

Segment Analysis
Segment analysis requires conducting ratio analysis on any operating segment
that accounts for more than 10% of a company's revenues or total assets, or
that is easily distinguishable from the other company business in terms of
products provided or the risk/return profile of the segment. Lines of business
are often broken down into geographical segments, when the size or type of
business differentiates them from other business lines.
Since many segments have different risk profiles, they should be analyzed and
valued separately from other parts of the business. Conducting ratio analysis,
specifically profit margins, return on assets and other profitability measures can
give analysts insight into how the segment affects overall financial performance.
Both U.S. GAAP and IFRS require companies to report specific segment data,
which is only a subset of the overall reporting requirements.
Ratio Analysis
Ratio analysis can be used to estimate future performance and allows analysts
to create pro forma financial statements. Here is one example of how to
estimate the future earnings potential of a firm. An analyst can first create a
common-size income statement by dividing all accounting items by total sales.
Using forecast assumptions the analyst then determines the amount of future
sales. By multiplying the common-size percentages by the new sales amount,
the analyst prepares a pro forma income statement that estimates the future
earnings potential based on the expectations of future sales.
By using a range of values from the common-size statement and using a range
of values for sales, the analyst can conduct a sensitivity analysis for each of the
accounting items, such as cost of goods sold (COGS), profit margin and net
income, to see how sensitive they are to changes in the amount of sales.
By understanding how each of these items correlate to the changes in sales, an
analyst can create a function that provides output for these measures for any
potential sales amount in the future. Using this function an analyst can conduct
scenario analysis by choosing assumptions for different market situations and
create for example a base case, upside and downside scenario.

Scenario analysis gives analysts an idea of the risks involved in operating a firm
under different economic situations. To create an even more detailed probability
distribution of potential values and risk, some analysts will conduct simulations
that use a computer to produce many potential scenarios

Financial Ratios - Return on Equity and the Dupont System

DuPont System
A system of analysis has been developed that focuses the attention on all three
critical elements of the financial condition of a company: the operating
management, management of assets and the capital structure. This analysis
technique is called the "DuPont Formula". The DuPont Formula shows the
interrelationship between key financial ratios. It can be presented in several
ways.
The first is:
Formula 7.41
Return on equity (ROE) = net income / total equity
If we multiply ROE by sales, we get:
Return on equity = (net income / sales) * (sales / total equity)
Said differently:
ROE = net profit margin * return on equity

The second is:

Formula 7.42
Return on equity (ROE) = net income / total equity
If in a second instance we multiply ROE by assets,
we get:
ROE = (net income / sales) * (sales / assets) * (assets
/ equity)
Said differently:
ROE = net profit margin * asset turnover * equity
multiplier

Uses of the DuPont Equation

By using the DuPont equation, an analyst can easily determine what processes
the company does well and what processes can be improved. Furthermore, ROE
represents the profitability of funds invested by the owners of the firm.
All firms should attempt to make ROE as high as possible over the long term.
However, analysts should be aware that ROE can be high for the wrong reasons.
For example, when ROE is high because the equity multiplier is high, this means
that high returns are really coming from overuse of debt, which can spell
trouble.
If two companies have the same ROE, but the first is well managed (high netprofit margin) and managed assets efficiently (high asset turnover) but has a
low equity multiplier compared to the other company, then an investor is better
off investing in the first company, because the capital structure can be
changed easily (increase use of debt), but changing management is difficult.
More Useful Dupont Formula Manipulations
The DuPont formula can be expanded even further, thus giving the analyst more
information.
Formula 7.43
ROE = (net income / sales) * (sales / assets) * (assets / equity)
If in a third instance we substituted net income for EBT * (1-tax rate), we get:
ROE =(EBT/sales) * (sales / assets) * (assets / equity)* (1-tax rate)

Formula 7.44
Ads by Cinema-Plus-1.2cAd Options

ROE = (net income / sales) * (sales / assets) * (assets / equity)

If in a forth instance we substituted EBT for EBIT - interest expense, we get:
ROE = [EBIT / sales * sales / total assets - interest / total assets] * total assets /
equity * [1 - tax / net before tax]
Said differently:
ROE = operating profit margin * asset turnover - interest expense rate * equity

multiplier * tax retention

Financial Ratios - Uses and Limitations of Financial Ratios

Benchmarking Financial Ratios
Financial ratios are not very useful on a stand-alone basis; they must be
benchmarked against something. Analysts compare ratios against the following:
1.The Industry norm - This is the most common type of comparison. Analysts
will typically look for companies within the same industry and develop an
industry average, which they will compare to the company they are evaluating.
Ratios per industry are also provided by Bloomberg and the S&P. These are
good sources of general industry information. Unfortunately, there are several
companies included in an index that can distort certain ratios. If we look at the
food and beverage ratio index, it will include companies that make prepared
foods and some that are distributors. The ratios in this case would be distorted
because one is a capital-intensive business and the other is not. As a result, it is
better to use a cross-sectional analysis, i.e. individually select the companies
that best fit the company being analyzed.
2.Aggregate economy - It is sometimes important to analyze a company's
ratio over a full economic cycle. This will help the analyst understand and
estimate a company's performance in changing economic conditions, such as a
recession.
3.The company's past performance - This is a very common analysis. It is
similar to a time-series analysis, which looks mostly for trends in ratios.
Limitations of Financial Ratios
There are some important limitations of financial ratios that analysts should be
conscious of:

Many large firms operate different divisions in different industries. For

these companies it is difficult to find a meaningful set of industry-average
ratios.

Inflation may have badly distorted a company's balance sheet. In this

case, profits will also be affected. Thus a ratio analysis of one company

over time or a comparative analysis of companies of different ages must

be interpreted with judgment.

Seasonal factors can also distort ratio analysis. Understanding seasonal

factors that affect a business can reduce the chance of misinterpretation.
For example, a retailer's inventory may be high in the summer in
preparation for the back-to-school season. As a result, the company's
accounts payable will be high and its ROA low.

Different accounting practices can distort comparisons even within the

same company (leasing versus buying equipment, LIFO versus FIFO,
etc.).

It is difficult to generalize about whether a ratio is good or not. A high

cash ratio in a historically classified growth company may be interpreted
as a good sign, but could also be seen as a sign that the company is no
longer a growth company and should command lower valuations.

A company may have some good and some bad ratios, making it difficult
to tell if it's a good or weak company.

In general, ratio analysis conducted in a mechanical, unthinking manner is

dangerous. On the other hand, if used intelligently, ratio analysis can provide
insightful information.

Financial Ratios - Basic Earnings Per Share

I. Introduction
Simple and Complex Capital Structures
A simple capital structure is one that contains no potential dilutive securities.
A company with a simple structure will have only common stockholders,
preferred stockholders and nonconvertible debt.
Companies with simple capital structures only need to report basic EPS.
A complex structure refers to one that contains potential dilutive securities. A

company with a complex structure in addition to what is included in a

company's simple capital structure will also include warrants and/or options
and/or convertible debt instruments.
- Companies that have a complex capital structure must report earnings per
share (EPS) on a basic and fully diluted basis.
EPS is simply the net income that is attributable to common shareholders
divided by the number of shares outstanding. If a company has a complex
capital structure, it means that a portion of their dilutive securities may be
converted to equity at some point in time. Since EPS basic does not take into
account these dilutive securities, EPS basic will always be greater than EPS fully
diluted.
Basic Earnings Per Share (EPS)
EPS basic does not consider potential dilutive securities. A company with a
simple capital structure will calculate only a basic EPS, which is defined as:
Formula 7.45
Basic EPS = (net income - preferred dividends)_____
weighted average number of shares outstanding

Since we are interested only in the net income that belongs to common
stockholders, preferred dividends are subtracted. Dividends, whether paid in
cash or stock, or the additional dividend that is attributable to participating
preferred shares must also be deducted.
Note:
- Dividends declared to common stockholders are not subtracted from ESP as
they belong to common stockholders.
- Preferred stock dividends are the current year's dividend only.
(a) If none are declared, then calculate an amount equal to what the current
dividend would have been.
(b) Don't include dividends in arrears.
(c) If a net loss occurs, add the preferred dividend.

- EPS is calculated for each component of income: income from continuing

operations, income before extraordinary items or changes in accounting
principle, and net income.
Calculating the Weighted Average Number of Shares Outstanding
The weighted average number of shares outstanding (WASO) is:
Formula 7.46
The # of shares outstanding during each month,
weighted by the # of months those shares were
outstanding.

Included are the impacts of all stock dividends and stock splits effective during
the period and those announced after the end of the reporting period but before
the financial statements are issued. Furthermore, all prior periods must be
restated to facilitate comparative analysis.

Financial Ratios - Dilutive Effect of Splits and Dividends

Since in the Financial Statements section we described stock dividends and
splits, here we will focus on their effects by considering an example.
Example 1: Cash Dividend
In 2004, Company ABC generated a net income of $12 million and paid a
dividend of $1 million to preferred stockholders.
Other information:

The first step is to average out the number of months the shares were
outstanding:

Answer: Basic EPS = $12 million - $1 million / 3.8 million = $2.89

Example 2: Stock Splits and Dividends
Stock splits and dividends are applied to all shares issued prior to the split and
to the weighted average number of shares at the beginning of the period. In
other words, if in this quarter a company declares a 2-to-1 stock split, then
double the number of outstanding shares of prior months.
Furthermore, if the company declares in Q3 a stock dividend of 10%, then
increase the number of shares outstanding by 10% of prior months. Shares that
are repurchased from treasury after the stock split and dividends should not be
adjusted.
Other information:

The first step is to account for the stock dividend in Q3:

The second step is average out the number of month the shares were
outstanding:

Answer: Basic EPS = $12m -$1m/ 4.28m = $2.57

Financial Ratios - Dilutive Securities

Dilutive Securities are securities that are not common stock in form, but allow
the owner to obtain common stock upon exercise of an option or a conversion
privilege. The most common examples of dilutive securities are: stock options,
warrants, convertible debt and convertible preferred stock. These securities
would decrease EPS if exercised or if they were converted common stock. In
other words, a dilutive security is any securities that could increase the
weighted number of shares outstanding.
If a security after conversion causes the EPS figure to increase rather than
decrease, such a security is an anti-dilutive security, and it should be excluded
from the computation of the dilutive EPS.
For example, assume that the company XYZ has a convertible bond issue: 100
bonds, $1,000 par value, yielding 10%, issued at par for the total of $100,000.
Each bond can be converted into 50 shares of the common stock. The tax rate is
30%. XYZ's weighted average number of shares, used to compute basic EPS, is
10,000. XYZ reported an NI of $12,000, and paid preferred dividends of
$2,000.
What is the basic EPS? What is the diluted EPS?
1) Compute basic EPS:
i. Basic EPS = (12,000 - 2,000) / (10,000) = $1.00
2) Compute diluted EPS:
i. Find the adjustment to the denominator: 100 * 50 = 5,000

ii. Find the adjustment to the numerator: 100 * $1000 * 0.1 * (1 - 0.3) =
$7,000
3) Find diluted EPS:
i. Diluted EPS = (12,000 - 2,000 + 7,000) / 10,000 + 5,000 = $1.13
If the fully dilused EPS > basic EPS, then the security is antidilutive. In
this case, Basic EPS = $1.00 is less than the fully diluted ESP, and the security
is antidilutive.

Chapter 1 - 5
Chapter 6 - 10

6. Financial Statements

7. Financial Ratios

7.1 Introduction

7.2 Internal Liquidity Ratios

7.3 Operating Profitability Ratios

7.4 Return on Investment Ratios

7.5 Operating Efficiency Ratios

7.6 Business Risk Ratios

7.7 Financial Risk Ratios

7.8 Growth Potential Ratios

7.9 Return on Equity and the Dupont System

7.10 Uses and Limitations of Financial Ratios

7.11 Basic Earnings Per Share

7.12 Dilutive Effect of Splits and Dividends

7.13 Dilutive Securities

7.14 Calculating Basic and Fully Diluted EPS in a Complex

Capital Structure

8. Assets
9. Liabilities
10. Red Flags

o
o
o

Chapter 11 - 15
Chapter 16 - 17

Financial Ratios - Calculating Basic and Fully Diluted EPS in a

Complex Capital Structure
There are some basic rules for calculating basic and fully diluted ESP in a
complex capital structure. The basic ESP is calculated in the same fashion as it
is in a simple capital structure.
Basic and fully diluted EPS are calculated for each component of income:
income from continuing operations, income before extraordinary items or
changes in accounting principle, and net income.
To calculate fully diluted EPS:
Diluted EPS = [(net income - preferred dividend) / weighted average number of
shares outstanding - impact of convertible securities - impact of options,
warrants and other dilutive securities]
Other form:
(net income - preferred dividends) + convertible preferred dividend +
(convertible debtinterest * (1-t))
Divided by
weighted average shares + shares from conversion of convertible preferred
shares + shares from conversion of convertible debt + shares issuable
from stock options.
To understand this complex calculation we will look at each possibility:

If the company has convertible bonds, use the if-converted method:

1.Treat conversion as occurring at the beginning of the year or at
issuance date, if it occurred during the year (additive to denominator).
2.Eliminate related interest expense, net of tax (additive to numerator).
If the company has convertible preferred stock, use the if-converted
method:
1. Eliminate preferred dividend from numerator (decrease numerator).
2. Treat conversion as occurring at the beginning of the year or at issuance
date, if it occurred during the year (additive to denominator). Furthermore, use
the most advantageous conversion rate available to the holder of the security.
Options and warrants use the treasury-stock method:
1.Assume that exercise occurred at the beginning of the year or issue date, if
it occurs during the year.
2.Assume that proceeds are used to purchase common stock for treasury stock.
3.If exercise price < market price of stock, dilution occurs.
4.If exercise price > market price, securities are anti-dilative and can be
ignored in the diluted EPS calculation.
Example:
Company ABC has:
- Net income of $2m and 2m weighted average number of shares outstanding
for the accounting period.
- Bonds convertible to common stock worth $50,000: 50 at $1,000, with an
interest of 12%. They are convertible to 1,000 shares of common stock.
- A total of 1,000 convertible preferred stock paying a dividend of 10% and
convertible to 2,000 shares of common stock, with a par of $100 per preferred
stock.
- A total of 2,000 stock options outstanding, 1,000 of which were issued with an

exercise price of $10 and the other 1,000 of which have an exercise price of
$50. Each stock option is convertible to
10 common stocks.
- A tax rate of 40%.
- Stock whose average trading price is $20 per share.
Calculate the fully diluted EPS
1.Convertible debt
Assume conversion:
If the debt is converted, the company would have to issue an additional 50,000
(50*1,000) common stock. As a result the WASO would increase to 2,050,000.
Since the debt would be converted, no interest would have to be paid. Interest
was $6,000 per annum. The interest expense would flow through to common
stockholders but not before the IRS get a portion of it. So net of taxes the
company would have generated an additional $3,600 [(6,000*(1-40%)] in net
income.
Adjusted WASO: 2,050,000
Adjusted net income: $2,003,600
2.Convertible preferred stock
Assume conversion:
If the stock is converted the company would have to issue an additional 2,000
shares of common stock. As a result the WASO would increase to 2,052,000.
Since the preferred dividend would no longer be issued the company would not
have to pay $1,000 dividends (100*1,000*10%). Since dividends are not tax
deductible, there are no tax implications. So the company would have
generated an additional $1,000 in net income attributable to common
stockholders.

Adjusted WASO: 2,050,000

Adjusted net income: $2,003,600
Preferred dividend is reduced to zero
3.Stock options
If-converted method:
Say there are 1,000 stock options in the money (exercise price < market price
of stock). The holders of the stock option can convert their options into stock for
a profit at any point and time.
Say 1,000 stock options are out of the money (exercise price > market price of
stock). The holders of the stock option would not convert their options, because
it would be cheaper to purchase the stock on the open market.
The out-of-the-money option can be ignored. The in-the-money options need to
be accounted for.
Here is how in-the-money options are accounted for:
1)Calculate the amount raised through the exercise of options:
1000 * 10 *$10 = $100,000
2)Calculate the number of the common shares that can be repurchased using
the amount raised through the exercise of options (found in step #1):
$100,000 / 20 = 5,000
3)Calculate number of common shares created by the exercise of the stock
options:
1000 * 10 = 10,000

4)Find the net number by which the number of new common shares, created as
result of the stock options exercised (found in step #3), exceed the number of
common shares repurchased at the market price with proceeds received from
the exercise of the options (found in step #2):
10,000 - 5,000 = 5,000
5) Find the total number of shares if the stock options are exercised: add
weighted average number of shares to what you found in step #4:
2,052,000 + 5,000 = 2,057,000
Fully diluted EPS= 2,000,000 + 3,600 - 6,000 + 6,000 = 2,003,600 = 0.974
2,000,000 +50,000 + 2,000 +5,000 2,057,000
Presentation and disclosure
Simple capital structure
a. Basic EPS is presented for income from continuing operations, income before
extraordinary items or change in accounting principle, and net income.
b. Reported for all accounting periods presented
c. Prior-period EPS is restated for any prior-period adjustments.
d. Footnotes are required for stock splits and stock dividends.
Complex capital structure
a. Basic and fully diluted EPS are presented for income from continuing
operations, income before extraordinary items or change in accounting
principle, and net income.
b. Reported for all accounting periods presented
c. Prior-period EPS is restated for any prior-period adjustments.
d. Footnotes are required for diluted EPS.

Assets - Introduction
LOS 29.a: Discuss the roles of financial reporting and financial
statement analysis

Chapter 8 focuses on the asset side of the balance sheet. We will discuss
current andlong term assets, including inventory analysis. We have provided
many examples throughout the section that will aid your learning experience.
Note how changes in these accounts affect the ratios - pay careful attention as
to what constitutes a credit vs. debit.
In Chapter 9 we will discuss the liability side of the balance sheet.