FSA M2 - Analysing Balance Sheets

Five-step revenue recognition model (IFRS 15/ASC 606)

Converged standards issued by IASB/FASB, May 2014. Core principle: recognize revenue to depict transfer of promised goods/services in an amount reflecting expected consideration. Steps: (1) identify the contract — requires collectability to be probable (IFRS: more likely than not; US GAAP: likely to occur, so treatment can differ); (2) identify distinct performance obligations — distinct if the customer can benefit from it alone/with readily available resources AND it's separable from other promises; (3) determine the transaction price; (4) allocate price to obligations; (5) recognize revenue as each obligation is satisfied. Steps 3–4 = amount, step 5 = timing.

Unearned revenue & revenue reversal

Unearned/deferred revenue = liability recorded when cash is received before goods/services are delivered; recognized as revenue as the obligation is fulfilled. Revenue is only recognized when it's highly probable it won't be reversed — otherwise the seller records minimal revenue at sale plus a refund liability and a right-to-returned-goods asset (based on inventory carrying amount less recovery costs).

Control transfer & balance sheet treatment

Control (and thus revenue recognition) has passed when: entity has present right to payment, customer has legal title, customer has physical possession, customer bears the risks/rewards of ownership, and/or customer has accepted the good/service. If no payment contingency, revenue + a receivable are recognized; if payment is conditional on future performance, a contract asset is recognized instead; if cash is received before transfer, a contract liability is recognized.

Performance obligations satisfied over time

Satisfied over time if ANY of: customer simultaneously receives/consumes benefits as entity performs (e.g., routine services); entity's performance creates/enhances an asset the customer controls; or the asset has no alternative use to the entity and the entity has an enforceable right to payment for work completed to date. Progress measured by output methods (e.g., units completed) or input methods (e.g., cost-to-cost: revenue = costs incurred/total estimated costs × contract price, with profit recognized proportionally).

Principal vs. agent, and software/license revenue

Principal (controls product before transfer): records revenue as total consideration received. Agent (arranges transfer of third-party-controlled product): records revenue only as its fee/commission — lower revenue, higher margins. Software licenses: recognize over the license term if the provider will keep undertaking activities that significantly affect the software (e.g., upgrades) that expose the customer to related impacts without transferring goods/services — otherwise recognize at point of transfer. Cloud/SaaS (no possession) is typically recognized over the contract term.

Bill-and-hold arrangements & disclosures

Bill-and-hold: revenue may be recognized before physical delivery only if ALL of — the arrangement is substantive (e.g., customer-requested), the product is separately identified as the customer's, it's currently ready for transfer, and the entity can't use it or redirect it to another customer. IFRS 15 disclosures: revenue disaggregated by category (product, region, customer/channel, pricing terms, duration, or timing), contract asset/liability balances and changes, remaining performance obligations, and significant judgments — typically in a "Revenue" note.

Expense recognition — general principles & the three models

A company recognizes an expense when it consumes the economic benefits of an expenditure or loses a previously recognized benefit. Three models: (1) matching principle — expenses (e.g., COGS) recognized in the same period as the associated revenue, regardless of when the related purchase occurred (IFRS calls this a "matching concept," not a "matching principle"); (2) period costs — expenditures that don't directly match revenue (admin, managerial, IT, R&D, maintenance/repair) are expensed as incurred; most payroll is a period cost, except compensation treated as a product cost (capitalized as inventory, later COGS) or capitalized items like sales commissions expensed with the related sales; (3) capitalization with subsequent depreciation/amortization.

Capitalizing vs. expensing — financial statement effects

Capitalized expenditures sit on the balance sheet as assets (an investing cash outflow) and are expensed over useful life as depreciation/amortization (non-cash; no CFS impact except via taxes) — except land and indefinite-life intangibles. For a one-time purchase: capitalizing raises profit and CFO in the purchase year but lowers profit in later years versus expensing; cumulative net income converges to be identical either way, though equity is higher earlier under capitalizing. For ongoing/recurring purchases, capitalizing's profit-enhancing effect persists as long as new expenditures exceed the depreciation being charged on prior capitalized amounts. Discretion between the two impedes comparability; motivations include hitting earnings targets (favors capitalizing) or enhancing the future profit trend (favors expensing now). Where tax and financial reporting depreciation must match, expensing has a more favorable cash flow impact (lower taxes now → interest income on cash saved).

Capitalized interest

Companies must capitalize interest on debt used to acquire/construct an asset that takes a long time to prepare for use. For a self-constructed asset for own use: capitalized interest joins the asset's carrying amount and is later expensed as part of depreciation (not interest expense). For an asset built to sell: capitalized interest joins inventory and is expensed as part of cost of sales on sale. Analyst points: capitalized interest is an investing outflow while expensed interest reduces operating cash flow (US GAAP: interest must be operating; IFRS: operating or financing) — compare accordingly. For interest coverage ratios, use total interest (capitalized + expensed) for a true picture, and adjust income to remove any depreciation of interest capitalized in a prior period. Rating agencies (e.g., S&P) include capitalized interest — EBIT ÷ gross interest. Minimum coverage ratios are common loan/bond covenants, so this treatment affects covenant-breach risk.

Capitalizing internal development costs (e.g., software)

Standards require capitalizing software development costs once technological feasibility is established (costs before that are expensed as incurred); judgment in determining feasibility causes real differences in company practice. Expensing (vs. capitalizing) lowers current net income whenever current-period development spend exceeds amortization of prior capitalized development costs (the typical case when spending is growing) — reverses if spending slows below that amortization. Expensing also lowers operating cash flow and raises investing cash flow versus capitalizing. To compare an expensing company with a capitalizing one, adjust the capitalizer's statements: (1) income statement — add back development costs as an expense, remove amortization of prior capitalized costs; (2) balance sheet — remove capitalized software (lower assets and equity); (3) cash flow statement — lower operating CF and lower cash used in investing by the current-period development costs. Ratios involving income, long-lived assets, or CFO (e.g., ROE) are affected.

Implications for analysts: conservatism and estimates

Expense recognition policy sits on a conservatism spectrum — recognizing expenses later rather than sooner is less conservative. Many expenses depend on estimates (uncollectible accounts, warranty expense, useful lives) that can significantly affect net income. Analysts should investigate significant year-to-year changes in a company's own estimates, and large cross-company differences in estimates within an industry, to judge whether they reflect genuine operating differences or possible manipulation of reported income. Accounting policy and estimate disclosures are found in the financial statement notes and the MD&A. Where the monetary effect of a difference can be calculated, adjust for comparability; where it can't, at least qualitatively assess the relative conservatism and likely directional impact.

Return on Equity

Net Income / Shareholder Equity

Net profit margin

Net Income / Total Revenue

Estimate of Remaining Useful Life of Asset

Net Plant and Equipment / Accumulated Depreciation

Net Plant and Equipment

Gross Plant and Equipment - Accumulated Depreciation

Interest Coverage Ratio

EBIT / Interest Expense , If want to remove interest capitalisation effects to compare if interest was expensed, Add Amortization of deferred financing costs to EBIT and Capitalised Interest to Interest Expense

Unusual or infrequent items

Purpose: separating items likely vs. unlikely to continue helps forecast future earnings. IFRS requires separate disclosure of income/expense items material or relevant to understanding financial performance (unusual/infrequent items usually qualify). US GAAP (periods beginning after 15 Dec 2015): material unusual/infrequent items are shown as part of continuing operations but presented separately. Restructuring charges (plant closures, termination costs) and gains/losses on asset or business sales are considered ordinary business activities even though disclosed separately. Analysts should assess the likelihood such items reoccur and their implications for future earnings — not simply ignore them.

Discontinued operations

When a company disposes of, or plans to dispose of, a component with no further involvement, both IFRS and US GAAP require separate income statement reporting as "discontinued," provided the component is separable both physically and operationally. Results are shown net at the bottom of the income statement, including on a per-share basis; remaining line items reflect only continuing operations. Related assets/liabilities are aggregated on the balance sheet as "held for sale." Analysts may exclude discontinued operations when forecasting future performance, since they'll no longer contribute earnings or cash flow.

Changes in accounting estimates

Unlike a change in accounting policy, a change in accounting estimate (e.g., useful life of a depreciable asset) is handled prospectively: it affects only the period of change and future periods. No prior-period restatement is made, and the impact is not shown separately on the face of the income statement — though significant changes must be disclosed in the notes.

Correction of a prior-period error, and changes in scope/exchange rates

Correcting an error in prior financial statements cannot be handled via the current period's income statement — it requires restating the balance sheet, statement of owners' equity, and cash flow statement for all prior periods presented, with required disclosures about the error (worth scrutinizing for signs of control weaknesses). Separately: acquiring a controlling interest consolidates the target as of the closing date, which can materially affect comparability with prior periods; a strengthening functional currency vs. the reporting currency increases translated revenues, a declining one decreases them. Standards do not require disclosure of scope or FX effects, though issuers often voluntarily disclose growth rates excluding the

Simple vs. complex capital structure & basic EPS

Ordinary shares (IFRS) / common stock (US GAAP): the equity class EPS is presented for — subordinate to all other equity, paid last in liquidation, benefits most when the company does well. Complex capital structure = company has instruments potentially convertible into common stock (convertible bonds, convertible preferred, employee stock options, warrants — a warrant is an equity call option issued by the company, giving the right but not obligation to buy new shares at the exercise price). Simple structure = no such instruments. Basic EPS = (Net income − Preferred dividends) / Weighted average number of shares outstanding, where the weighted average is a time-weighting of shares outstanding (repurchases/issuances weighted by the fraction of the period outstanding). Stock dividends/splits are reflected retroactively to the beginning of all periods presented.

Diluted EPS overview & antidilution rule

Diluted EPS = the EPS that would result if all dilutive potentially convertible instruments were converted; basic EPS uses only actual reported earnings and actual weighted average shares. If the capital structure is simple, diluted EPS = basic EPS. Diluted EPS is always ≤ basic EPS by definition, since it must reflect the maximum potential dilution. Some potentially convertible securities are antidilutive (inclusion would raise EPS above basic EPS) — under both IFRS and US GAAP, antidilutive securities are excluded from the diluted EPS calculation entirely.

If-converted method — convertible preferred stock

Assumes the preferred converts to common at the beginning of the period. Effects: weighted average shares outstanding increases by the new common shares issued on conversion, and net income available to common is higher because the preferred dividend that would otherwise be subtracted is not paid (no longer outstanding). Diluted EPS = Net income / (Weighted average number of shares outstanding + New common shares that would have been issued at conversion) — note the numerator is undiminished by that preferred's dividend.

If-converted method — convertible debt

Assumes the convertible debt converts to common at the beginning of the period. Effects: weighted average shares outstanding increases by the additional common shares issued on conversion, and net income available to common increases by the after-tax interest expense on the converted debt (since that interest would no longer be paid). Diluted EPS = (Net income + After-tax interest on convertible debt − Preferred dividends) / (Weighted average number of shares outstanding + Additional common shares that would have been issued at conversion).

Treasury stock method — options and warrants

Assumes options/warrants are exercised and the company uses the exercise proceeds to repurchase as many shares as possible at the average market price during the period. Weighted average shares outstanding increases by the incremental shares (shares issued at exercise minus shares repurchasable with the proceeds), weighted by the proportion of the period the instrument was outstanding; net income is unaffected (no numerator adjustment). Called the "treasury stock method" under US GAAP. IFRS uses the same underlying method without that name: assumed proceeds are treated as issuing new shares at the average market price ("inferred shares"), which are disregarded, and only the excess of shares issuable under the options over the inferred shares is added to the share count — numerically identical to the treasury stock method result. Diluted EPS = (Net income − Preferred dividends) / [Weighted average shares outstanding + (New shares issued at exercise − Shares purchasable with exercise proceeds) × (proportion of year outstanding)].