Why is the income statement prepared on an accrual basis?
To match revenues with expenses in the period they are incurred, providing a more accurate representation of financial performance.
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How does the choice between LIFO and FIFO inventory valuation impact financial statements?
LIFO results in higher COGS and lower net income in inflationary periods; FIFO results in lower COGS and higher net income.
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What is the Matching Principle in Accounting?
Expenses should be recorded in the same period as the revenues they help generate.
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What are Non-GAAP Measures?
Alternative earnings metrics (e.g., EBITDA) used to exclude irregular items. They can be helpful but may be misleading if used for earnings management.
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Why is EBITDA criticized?
It excludes depreciation, amortization, interest, and taxes, which can hide true financial risks.
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How do restructuring costs affect financial statements?
Recorded as one-time expenses, reducing net income in the short term but improving future profitability.
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What is an example of a contingent liability?
A potential legal settlement that may require payment if certain conditions occur (e.g., ongoing lawsuits, warranty liabilities).
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What is Off-Balance-Sheet Financing?
Financial arrangements that avoid appearing as liabilities, such as operating leases (before IFRS 16) or special-purpose entities.
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Key Financial Ratios - Efficiency
Asset Turnover Ratio = Revenue / Total Assets, Inventory Turnover Ratio = COGS / Average Inventory.
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What is the effect of high accruals on earnings quality?
High accruals suggest that earnings may not be sustainable, as they rely on estimates rather than cash transactions.
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What is the Altman Z-Score?
A model used to predict a company's bankruptcy risk using financial ratios.
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How do earnings management techniques affect cash flows?
Accrual-based earnings management affects net income without changing cash flows, while real earnings management impacts cash flows directly.
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What is a Cookie Jar Reserve?
Overstating expenses in a good year to release them in a bad year, making future earnings look better.
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How does changing an accounting estimate differ from changing an accounting principle?
Estimates (e.g., bad debt allowances) impact current & future periods, while principles (e.g., switching from FIFO to LIFO) require retrospective application.
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What is a capitalized cost?
An expenditure recorded as an asset rather than an expense, spreading cost recognition over time (e.g., development costs meeting IFRS 38 criteria).
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What is the impact of goodwill impairments?
A direct hit to net income, but no cash effect. It signals overpayment in acquisitions.
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What are the two primary ways to test for goodwill impairment?
1. Qualitative test: Is there reason to believe goodwill is impaired? 2. Quantitative test: Compare the recoverable amount to the carrying value of the asset.
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What does a rising debt-to-equity ratio indicate?
Higher financial risk due to increased leverage.
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What is window dressing in financial reporting?
Actions taken to temporarily enhance financial statements, such as delaying expenses or accelerating revenue recognition before an earnings announcement.
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What is the role of an audit in financial statement analysis?
Audits provide reasonable assurance (but not absolute assurance) that financial statements are free from material misstatements.
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What are the risks associated with relying on analyst forecasts?
Analysts may bias projections due to corporate relationships, fail to account for earnings management, or be overly optimistic in bull markets.
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How does IFRS differ from US GAAP in revenue recognition?
IFRS 15 follows a principles-based approach (5-step model), while US GAAP uses specific rules for different industries.
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Why might a company use fair value accounting?
Provides real-time asset valuation, making statements more relevant, but can introduce volatility.
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How does IFRS 16 change the way leases impact financial statements?
Leases are now capitalized, increasing assets & liabilities, while shifting lease expenses to depreciation & interest.
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What is the impact of an operating lease under IFRS 16 on EBITDA?
EBITDA increases because lease expenses are now split into depreciation & interest, which are excluded from EBITDA calculations.
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Why are financial analysts interested in Free Cash Flow (FCF)?
FCF shows actual cash available for dividends, debt repayment, and reinvestment, making it a better indicator of financial health than net income.
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What is a common sign of fraudulent financial reporting?
🚩 Unexplained inventory build-ups 🚩 Sharp increases in accounts receivable 🚩 Frequent changes in auditors 🚩 Unrealistically smooth earnings growth.
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Term
Definition
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Principal vs. Agent Considerations
A company acts as a principal if it controls the goods/services before transferring to the customer; as an agent if it arranges for another party to provide them.
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Contract Costs
Incremental costs of obtaining a contract (e.g., sales commissions) can be capitalized and amortized over time.
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Contract Modifications
If a contract is modified, it must be reassessed to determine if it creates a separate contract or an adjustment to the existing one.
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Sale and Leaseback Transactions
If a company sells an asset and immediately leases it back, IFRS 16 requires recognition of a right-of-use asset and a lease liability unless control is lost.
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Low-Value Asset Exception
IFRS 16 allows leases of low-value assets (e.g., laptops, office furniture) to be expensed directly.
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Discount Rate in Lease Liability Calculation
If the implicit lease rate is not available, companies use their incremental borrowing rate to discount lease payments.
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Indicators of Impairment
IFRS requires annual goodwill impairment testing, but an impairment review should also occur if there are triggering events like declining cash flows or legal issues.
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CGU (Cash-Generating Unit) Allocation
Goodwill is allocated to CGUs for impairment testing, and impairment losses cannot be reversed.
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Finite vs. Indefinite Life Intangibles
Finite-life intangibles (e.g., patents) are amortized; indefinite-life intangibles (e.g., brands) are tested for impairment.
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Temporary vs. Permanent Differences
Temporary differences (e.g., accelerated tax depreciation) create deferred tax adjustments, while permanent differences (e.g., non-deductible expenses) do not.
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Deferred Tax Liabilities
A Deferred Tax Liability (DTL) arises when taxable income is lower than accounting income (e.g., faster tax depreciation).
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Deferred Tax Assets
A Deferred Tax Asset (DTA) arises when taxable income is higher than accounting income (e.g., tax loss carryforwards).
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Actuarial Assumptions
Defined benefit obligations are calculated using estimates like salary growth, discount rates, and mortality rates.
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Net Pension Asset vs. Net Pension Liability
A company reports a pension liability if obligations exceed plan assets, and a pension asset if the opposite is true.
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Revenue Inflation Techniques
Aggressive revenue recognition tactics include channel stuffing (forcing distributors to buy more inventory than needed) and bill-and-hold sales (recognizing revenue before delivery).
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Accrual Quality & Earnings Manipulation
Companies with high accruals relative to cash flows may be manipulating earnings.
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Beneish M-Score
A statistical model used to detect earnings manipulation based on financial ratios.
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Adjusted EBITDA
Excludes non-recurring, irregular, or non-cash items to better reflect core profitability.
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Enterprise Value (EV) Calculation
EV = Market Cap + Total Debt – Cash & Equivalents. Used for valuation multiples (EV/EBITDA, EV/Revenue) to compare companies.
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Z-Score (Bankruptcy Predictor)
A model assessing financial distress risk based on leverage, liquidity, profitability, and solvency ratios.
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Revenue Recognition (IFRS 15 vs. ASC 606)
Similar 5-step model, but US GAAP has more industry-specific rules.
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Leases (IFRS 16 vs. ASC 842)
IFRS 16 requires all leases on balance sheet; US GAAP allows operating leases to remain off-balance-sheet for lessees.
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Goodwill Treatment (IFRS vs. US GAAP)
Under US GAAP, private companies can amortize goodwill; IFRS requires annual impairment testing.
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Inventory Valuation (IAS 2 vs. US GAAP)
IFRS does not allow LIFO (Last-In, First-Out). US GAAP permits LIFO, which lowers taxable income during inflation.
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Off-Balance-Sheet Financing
Risks include lack of transparency, increased leverage, and potential financial misrepresentation.
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Impairments: Goodwill vs. Tangible Assets
Goodwill impairments cannot be reversed, but tangible asset impairments can be reversed under IFRS.
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Impact of Leverage on Risk
Higher leverage increases financial risk and can make a company more vulnerable to downturns.
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