FR Chap 15-20

what to consider for the intrinsic value of a firm’s equity

the current FS as it can be useful for forecasting. a firm’s value is forward looking so historical FS wouldn’t be very useful. valuation focuses on earnings

clean surplus relation

considers the book value of equity in both the beginning and the end of the period as well as the accounting net income not considering dividends

difference between variable residual income and residual income

variable residual income considers the accounting income and equity book values while residual income is the excess income that comes from the normal income. the normal income would be the net accounting income.

why mean reversion should be considered for valuation

cus firms with very high profits are expected to converge towards the mean, and so it can differentiate the more successful firms. when there is an excess of book returns compared to the cost of capital, the firm can be considered to have high economic value

relationship between profitability and mean reversion

those with high profitability would have lower mean reversion of profits as they would be more stable and can protect themselves from competition

ceteris parabis

while considering all other factors to be equal

competitive advantage

capabilities or resources that give a firm an advantage over their rivals. as long as it isn’t affected by competition it’ll be beneficial

4 factors affecting profitability

barriers to entry, firm size, capital intensity and product type

what do supply or cost advantages represent

low durability because they use low cost materials or designs, making it imitable for competitors

what can demand advantages represent

economies of scale and strong entry barriers for competitors because it’ll be harder for competition to match your level of demand

relationship between barriers of entry, competition and market stability

high barriers of entry reduce competition and lower competition improves stability.

3 sources of barriers of entry

product differentiation, advertising intensity and contracting such as patents

what happens to firms with abnormally high profitability rates

they will experience lower profitability rates in the future unless there is a sustainable competitive advantage

how does accounting choice affect ARR

it can make it less reliable as it could affect the earnings management which tends be different in different firms

why do accounting choices affect equity investors

cus when they are looking at the current profitability numbers, they need to know if it's been influenced by opportunistic behavior and so this would be a key distortion that would need to be sorted out

should the depreciation method be updated over time

it should be done when changes or updates occur over time as it can impact the method's results and method changes can heavily influence the accuracy of the annual earnings at times of change

how does the treatment of the goodwill affect a firm’s valuation

it can affect the goodwill impairment charges which could affect the income statement and therefore the firm's valuation. and so accounting choices no matter in which department, can affect valuation and the understanding of profitability

what are the two components DuPont decompose into

profit margin (PM) and asset turnover (ATO). they have different time series properties

RNOA, PM and ATO formulae

RNOA = PM x ATO where PM = operating income / sales and ATO = sales / net operating assets

how does leverage affect ROCE and RNOA

it increases the profitability to shareholders (ROCE) but does not affect RNOA. this is due to leverage (debt + equity) being directly correlated with the ROCE ratio while RNOA has no correlation with debt + equity

3 factors to consider when using ratios to further investigate a firm

1 - the specific definition/interpretation you are using of a ratio as it can be different for different people. so it's imp to state it when solving.

2 - don’t look at ratios individually only as they are meant to be compared

3 - within the ratio, the numerator and denominator should also be looked at individually as they can provide different info

what does PM measure

how the firm controls the costs incurred to generate sales and interprets the sensitivity of operating income to product price and cost structure.

what does ΔPM measure

measures the growth rate in operating income relative to the growth rate in sales.

what does ATO measure

the firm’s efficiency in using operating assets to generate sales and is often interpreted as a measure of asset utilisation by managers

what does ΔATO measure

reflects change in the productivity of the firm’s assets, evaluates sales growth while controlling for growth in net operating assets

what do large profit margins encourage

new businesses to enter the market and to revert to normal levels unless they maintain it with different kinds of promotion

how does competition affect the ATO and PM

competition doesn't affect the asset turnover as much since production processes are harder to imitate as compared to profit margin which comes from ideas that can be imitated by others

ATO and PM relationship with variance/volatility

the ATO compare variables of low variance while PM compares variables that would have high volatility. and so ATO is more likely to be affected by external forces rather than internal while PM can be affected by both

what does the CFS show

if the company is generating enough cash inflow from operating activities to fund their finances, pay taxes and maybe invest. it would also show cash details about acquiring new assets, financing or if any debts have been repaid or loans restructured

trend analysis

analyzes the change and trends in key figures in the five-year or 10-year summaries

vertical analysis

uses statements that express all items in a FS as a percentage of a specific figure. with it, you can draw comparisons between companies regardless of size

the 5 reasons for financial reporting standards differences and development

legal systems differences, choice in financing, tax system differences, accounting choices and historical events

why are different legal systems a reason for FRS differences

different countries include national legal systems where different law systems may have limited or specific legislation compared to other countries

why are different tax systems a reason for FRS differences

some countries may have different tax and accounting systems that have different requirements

why are different financing sources a reason for FRS differences

some rely on equity more than debt financing due to how the separation of ownership and control can be recognized.

why are different accounting choices a reason for FRS development

accounting choices can affect the accounting practice and therefore the development of accounting standards

why are different historical events a reason for FRS development

historical company failures and scandals also have an impact on the development of accounting standards as it's always trying to learn and improve

4 questions to consider when classifying an accounting system

is whether experience matters more than the law, if fixed or flexibility is better, if realism or optimism encouraged and if confidentiality or disclosure better

7 accounting differences and gaps to consider

income taxes, pensions, leases, foreign currency, financial instruments, business combination and measuring NCA

double declining balance method (DDB)

an accelerated depreciation approach that records higher expenses in an asset's early life, doubling the straight-line rate. book value x (2 x straight line rate)

proportional method

an accounting method for joint ventures where an investor reports its pro-rata share of a venture’s assets, liabilities, revenue, and expenses line-by-line, rather than as a single net amount

acquisition accounting

the mandatory standard for recording mergers and acquisitions, where the buyer recognizes the acquired company's assets and liabilities at fair value on the acquisition date. involves calculating goodwill, the diff between the purchase price and fair value of assets

why the pooling of interest method in merging is no longer allowed

companies would use the pooling of interest method as it was easy to manipulate and allowed them to opt for mergers

what the ASB states about merger accounting

merger accounting should be applied to only a few rare instances of business combinations that were properly regarded as mergers and that the vast majority of business combinations were more appropriately accounted for as acquisitions

what FRS 6 defines a merger as

when there’s a mutual agreement between two (or more) companies to merge or pool their resources as equal partners, trading as a combined group

aim of merger accounting

to present the group accounts as if the companies that have been combined have always been operating as a single group

merger relief

allows a company to avoid recording a share premium account when issuing shares to acquire at least 90% equity in another company. Instead of recognizing share premium, the excess value is recorded in a merger reserve. this is to avoid fake share premium accounts and reflect better economic substance

4 steps for merger accounting

1. Add S in H accounts at nominal value (i.e. no share premium).

2. Add S and H together line by line.

3. Eliminate the investment and ordinary shares exchanged (at nominal value).

4. If there is any difference arising from step 3 then a capital reserve/ merger reserve needs to be included in the group’s accounts.

4 differences between acquisition and merger accounting

• acquisition uses fair market value while merger uses historical book value.

• acquisition records goodwill while merger doesn't.

• acquisition records FS from the date of acquisition while merger treats the companies as they're combined, often requiring restatements.

• acquisition is standard for most transactions while merger is rare and restricted

IAS 28 requirement for the equity method

the investment in an associated company being shown at cost (less any amounts written off as permanent diminutions in value) in the investing company SoFP, and the IS including only dividends received and receivable

what a group's consolidated statements must include

the investing group's share of net assets and any premium paid on acquisition of the interests in the associated companies

what the consolidated IS must include

immediate operating results and the share of operating PnL

what group interest tax includes

the share of the interest and taxation attributable to the profit and loss of the associated companies.

the 3 joint ventures IAS 31 identifies

operations, assets and entities

what IAS 31 states regarding jointly controlled entities

a venturer shall recognize its interest in a jointly controlled entity using proportionate consolidation or the equity method (if they 20-50% ownership at least)

why would intercompany transaction get canceled in a consolidated income statement

otherwise the group earnings can be inflated by one within the group earning from another and the same amount would get double counted both as income and expense

consolidated income statement (CIS)

a line by line addition of the income statements of the holding company and subsidiaries

why post acquisition profits should only be included in the statement of changes in equity (SOCE)

as pre acquisition profits may be to do with the subsidiary separately which could cause misleading and inaccurate info

from when can the CIS include info

the date of exchange onwards

where does IAS 10 require dividends to be stated

disclosure of the dividends proposed in the notes to the accounts and not as a liability in the SoFP

what IAS 28 defined associates as

entities that have the power to participate in the financial and operating policy decisions of the investee but are not in control or joint control over those policies

how much holding does an entity need to have to exert power

an entity holding 20% or more of the voting rights should be presumed to exercise a significant influence unless the contrary is shown

IFRS 12 on disclosure of interest in other entities

requires investors to disclose information to enable investors to evaluate the risks of the parent company’s dealings with its associates. can take form as info in FS or narrative disclosures

what the investing group’s consolidated SoFP should include

the investing group's cost of investment of the associated companies, with fair values at the time of acquisition and the investing group's share of post acquisition PnL

what IFRS 11 states a joint arrangement is

an arrangement of which two or more parties have joint control

difference between IFRS 11 and IAS 31 regarding joint arrangements

 IFRS 11 requires the equity method of consolidation to be applied, superseding the use of proportional consolidation under IAS 31

joint operation

a joint arrangement where they share the rights to the assets, and obligations for the liabilities and don’t require a separate legal entity

joint venture

the parties that have joint control of the arrangement have rights to the net assets of the arrangement.

key difference is in joint operations and joint ventures

in joint operations all parties have a share in the output of the venue while in a joint venture they have a share in the overall PnL earned by separate company

depreciation for an asset formula

(Value of the right-to-use asset – residual value)/shorter of the lease term or useful life

PPE right-of-use asset formula

first payment at the start + NPV of lease payments

how are fixed assets treated in a holding company's accounts

treated the same in the holding company’s accounts in the case of investments being treated based on their classification in the consolidated accounts

a group

when a parent/holding company and subsidiary are regarded as one due to the parent company holding a fixed asset investment (a subsidiary undertaking) from the subsidiary company

reasons for acquiring include

growth, preventing takeover, synergies that cause economies of scale, new sources, improving financial strength, acquiring undervalued assets, reducing competition, fashion, ego or managerial motives

why the account needs to reflect the parent's ownership over the subsidiary and their trading activities

it's seen as part of their company. shareholders would also want access to such info for decision making

what a parent company's IS would reflect

income as the dividends received and receivable from the subsidiary company, causing the expenses to relate to the parent company’s management costs

what a parent company's SoFP would reflect

the cost or valuation of the investment in the subsidiary company as an asset and the liabilities would relate to the equity and loans of the parent company only

how are economic activities regarded in the financial information

while trading activities should be reflected, economic activities aren't expected to, and are instead included as additional information

what consolidation shows shareholders

info about the aggregate PnL as well as the total assets and liabilities under the holding company’s control. This shows shareholders how well the holding company is performing

IAS 27 definition of a parent

an entity including an unincorporated entity such as a partnership which is controlled by another entity, emphasized control of a parent company over its subsidiary and their rights regarding it

difference between de facto and de jure

de facto control refers to the reality of the control while de jure refers to theoretical control. De facto is how much control there actually is while de jure control is how much control should be there by law.

IFRS 3 definition of a business combination

the union of separate entities or businesses as one reporting entity

what's included in the consolidated account

group IS, group SoFP, the group CFS and the holding company’s SoFP

advantages of the understanding that a holding company's profit is included as the dividends received

investor protection, better prediction and accountability

IFRS 10's conditions for presenting consolidated financial statements

• whether the parents is a wholly or partly owned subsidiary itself

• whether it has the right to vote or not, the parent’s debt or equity instruments aren’t traded in a public market

• the parent doesn’t have a securities commission for issuing instruments in the public market reported in their financial statements or the ultimate parent produces consolidated financial statements available for public use that complies with the IFRS

3 types of business combinations

economic entity, parent entity and proprietary models

economic entity model includes

all the assets, liabilities and equity of both the parent and subsidiary companies. The non controlling interest (NCI) is treated as part of the group’s equity.

economic entity model equation

100% B + 100% S = 100% B’s equity + 60% S’s equity that’s owned by B + 40% NCI’s equity included in S

parent entity model

all the assets, liability and equity of both the parent and subsidiary companies are included in the group, but the NCI is considered as part of the group's liability this time rather than as part of the group’s equity

parent entity model equation

100% B’s net assets + 100% S’s net assets - 40% NCI’s equity as group liability = 100% B’s equity + 60% S’s equity

proprietary model

all of the parent company’s assets, liabilities and equity and 60% of the subsidiary’s assets, liabilities and equity is included. However, the NCI which is 40% of S is not shown in the group accounts

proprietary model equation

100% B’s net assets + 60% S’s net assets = 100% B’s equity + 60% S’s equity owned by B

where does the current IFRS 3 say to present the nci

NCI is shown in the equity section of the balance sheet which is the economic entity while goodwill on consolidation relates only to the parent's share of the subsidiary which is the parent entity

4 methods for accounting business combinations

acquisition method, the merger/pooling of interest method, equity method and proportional method

line by line method

when the assets, liabilities, income and expenses are combined with similar items on a line by line basis

separate line items

when the share of assets, liabilities, income and expenses of the jointly controlled entity are shown

adjustments needed for IS and SoFP figures done on a line by line basis

recognizing the date of acquisition, dealing with goodwill, dealing with fair value adjustments, dealing with NCI, adjusting individual figures of subsidiaries, eliminating intra-group transactions

what must the acquiring company do when allocating the acquisition cost

• identify the assets and liabilities of the subsidiary and attribute fair values to them rather than just relying on the subsidiary accounts’ book values

• Once fair values of both are given and the net assets acquired have been measured, the difference between the two represents purchased goodwill needs to also be accounted for

IFRS 3 definition of goodwill

an asset from the acquisition date and is initially measured as the excess of the cost of the business combination - the acquirer’s share of the net fair values of the acquirer's identifiable assets, liabilities and contingent liabilities

cost of business combinations

sum of the fair values at the date of exchange rather than its historical cost. This restates assets and liabilities at their fair value to try and provide a realistic measurement of the assets and liabilities of the acquired transaction