Study Set for Financial Statement Analysis Exam

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.