FSA Midterm

Efficient Market Hypothesis (EMH)

The theory that stock prices fully reflect all available information, making it impossible to consistently outperform the market.

Types of Market Efficiency

Weak Form (prices reflect past info), Semi-Strong Form (prices reflect all public info), Strong Form (prices reflect all public & private info).

Under EMH, which type of earnings news impacts share prices the most?

Unexpected earnings information, as expected earnings are already reflected in stock prices.

Revenue Recognition (IFRS 15) - 5-Step Model

1. Identify the contract, 2. Identify performance obligations, 3. Determine transaction price, 4. Allocate price to obligations, 5. Recognize revenue when performance obligation is satisfied.

How is revenue from software licenses recognized under IFRS 15?

At the point in time when control of the license is transferred to the customer.

How is revenue from post-purchase support recognized?

Evenly over the support period (deferred revenue).

What happens if a company shifts more revenue to post-purchase support?

More revenue is deferred, increasing contract liabilities on the balance sheet.

Earnings Management

The use of managerial discretion in accounting choices and economic decisions to influence reported earnings.

Accruals Earnings Management

Adjusting accounting estimates (e.g., depreciation, bad debt provisions) to manipulate reported earnings.

Real Earnings Management

Changing actual business operations (e.g., delaying R&D, cutting marketing) to influence financial results.

Big Bath Earnings Management

Taking large write-offs in a bad year to make future earnings look better.

Income Smoothing

Adjusting income to reduce volatility over multiple periods.

Classificatory Earnings Management

Reclassifying items within financial statements to make performance appear better (e.g., moving operating expenses to R&D).

Income Shifting Earnings Management

Moving income or expenses between different periods to influence reported earnings.

Goodwill

The excess of purchase price over the fair value of net assets in an acquisition.

How is goodwill treated under IFRS?

Not amortized, but tested for impairment annually at the cash-generating unit (CGU) level.

When is a goodwill impairment loss recognized?

When the recoverable amount of a CGU is less than its carrying amount.

Internally Generated Intangible Assets (IFRS 38)

Research costs must be expensed; development costs can be capitalized if they meet recognition criteria.

Lease Accounting (IFRS 16) - Key Change

Requires all leases to be recorded on the balance sheet as a right-of-use asset and a lease liability.

How is a lease asset initially measured?

Present value of lease payments is recognized as a right-of-use asset.

How is a right-of-use asset measured over time?

Depreciated over the lease term.

How are lease liabilities reduced?

As lease payments are made, the liability is reduced, and interest expense is recorded.

How does IFRS 16 impact the income statement?

Increases depreciation and interest expense, instead of a single lease expense.

Defined Benefit vs. Defined Contribution Pension Plans

Defined Benefit (employer bears risk, fixed payout); Defined Contribution (employee bears risk, payout depends on investment performance).

When is a pension liability recognized on the balance sheet?

When pension obligations > pension assets (pension deficit).

Fair Value Accounting (IFRS 13) - Measurement Hierarchy

Level 1: Market prices, Level 2: Observable inputs, Level 3: Unobservable inputs.

Deferred Tax Liabilities (DTL)

Arise when taxable income is lower than accounting income due to temporary differences (e.g., accelerated tax depreciation).

Deferred Tax Assets (DTA)

Arise when taxable income is higher than accounting income (e.g., tax loss carryforwards).

Key Financial Ratios - Profitability

ROE (Return on Equity) = Net Income / Equity; ROA (Return on Assets) = Net Income / Total Assets.

Key Financial Ratios - Liquidity

Current Ratio = Current Assets / Current Liabilities; Quick Ratio = (Cash + Receivables) / Current Liabilities.

Key Financial Ratios - Leverage

Debt-to-Equity = Total Debt / Shareholder Equity; Interest Coverage = EBIT / Interest Expense.

Impact of Reclassifying Operating Expenses as R&D

Artificially increases operating income without affecting total earnings.

Why do companies engage in income smoothing?

To reduce earnings volatility and make performance appear more stable.

How does reducing the useful lives of non-current assets impact depreciation?

Increases depreciation expense, shifting income to the future.

What happens when a company changes depreciation from straight-line to accelerated?

Higher depreciation in early years, lower reported profits initially.

Which Bloomberg function provides Management Guidance?

GUID function in Bloomberg.

Where is management guidance typically found?

In quarterly earnings releases, NOT in the annual report or income statement.

How does IFRS 16 impact financial ratios?

Increases leverage ratios (higher liabilities), and reduces return on assets (higher assets).

What does an increase in contract liabilities indicate?

More revenue is deferred to future periods, decreasing current period earnings.

How does earnings management impact investor decisions?

Misleading earnings can misrepresent financial health, affecting stock valuation.

Users of Financial Statements

Investors, creditors, management, analysts, regulators.

The Four Pillars of Financial Statement Analysis

1. Strategy Analysis (business environment, industry trends), 2. Accounting Analysis (assess financial reporting quality), 3. Financial Modeling (trend analysis, forecasting), 4. Valuation Analysis (determining intrinsic value).

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.

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.

What is the Matching Principle in Accounting?

Expenses should be recorded in the same period as the revenues they help generate.

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.

Why is EBITDA criticized?

It excludes depreciation, amortization, interest, and taxes, which can hide true financial risks.

How do restructuring costs affect financial statements?

Recorded as one-time expenses, reducing net income in the short term but improving future profitability.

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).

What is Off-Balance-Sheet Financing?

Financial arrangements that avoid appearing as liabilities, such as operating leases (before IFRS 16) or special-purpose entities.

Key Financial Ratios - Efficiency

Asset Turnover Ratio = Revenue / Total Assets, Inventory Turnover Ratio = COGS / Average Inventory.

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.

What is the Altman Z-Score?

A model used to predict a company's bankruptcy risk using financial ratios.

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.

What is a Cookie Jar Reserve?

Overstating expenses in a good year to release them in a bad year, making future earnings look better.

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.

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).

What is the impact of goodwill impairments?

A direct hit to net income, but no cash effect. It signals overpayment in acquisitions.

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.

What does a rising debt-to-equity ratio indicate?

Higher financial risk due to increased leverage.

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.

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.

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.

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.

Why might a company use fair value accounting?

Provides real-time asset valuation, making statements more relevant, but can introduce volatility.

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.

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.

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.

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.

Term

Definition

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.

Contract Costs

Incremental costs of obtaining a contract (e.g., sales commissions) can be capitalized and amortized over time.

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.

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.

Low-Value Asset Exception

IFRS 16 allows leases of low-value assets (e.g., laptops, office furniture) to be expensed directly.

Discount Rate in Lease Liability Calculation

If the implicit lease rate is not available, companies use their incremental borrowing rate to discount lease payments.

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.

CGU (Cash-Generating Unit) Allocation

Goodwill is allocated to CGUs for impairment testing, and impairment losses cannot be reversed.

Finite vs. Indefinite Life Intangibles

Finite-life intangibles (e.g., patents) are amortized; indefinite-life intangibles (e.g., brands) are tested for impairment.

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.

Deferred Tax Liabilities

A Deferred Tax Liability (DTL) arises when taxable income is lower than accounting income (e.g., faster tax depreciation).

Deferred Tax Assets

A Deferred Tax Asset (DTA) arises when taxable income is higher than accounting income (e.g., tax loss carryforwards).

Actuarial Assumptions

Defined benefit obligations are calculated using estimates like salary growth, discount rates, and mortality rates.

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.

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).

Accrual Quality & Earnings Manipulation

Companies with high accruals relative to cash flows may be manipulating earnings.

Beneish M-Score

A statistical model used to detect earnings manipulation based on financial ratios.

Adjusted EBITDA

Excludes non-recurring, irregular, or non-cash items to better reflect core profitability.

Enterprise Value (EV) Calculation

EV = Market Cap + Total Debt – Cash & Equivalents. Used for valuation multiples (EV/EBITDA, EV/Revenue) to compare companies.

Z-Score (Bankruptcy Predictor)

A model assessing financial distress risk based on leverage, liquidity, profitability, and solvency ratios.

Revenue Recognition (IFRS 15 vs. ASC 606)

Similar 5-step model, but US GAAP has more industry-specific rules.

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.

Goodwill Treatment (IFRS vs. US GAAP)

Under US GAAP, private companies can amortize goodwill; IFRS requires annual impairment testing.

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.

Off-Balance-Sheet Financing

Risks include lack of transparency, increased leverage, and potential financial misrepresentation.

Impairments: Goodwill vs. Tangible Assets

Goodwill impairments cannot be reversed, but tangible asset impairments can be reversed under IFRS.

Impact of Leverage on Risk

Higher leverage increases financial risk and can make a company more vulnerable to downturns.

Working Capital Manipulation

Delaying supplier payments (increasing accounts payable) or accelerating customer payments (reducing accounts receivable).

Related Party Transactions & Earnings Manipulation

They can be used to manipulate revenue or hide liabilities, especially if not disclosed properly.

Earnings Smoothing via Reserves & Provisions

Overestimating provisions in good years and releasing them in bad years makes earnings appear stable.