Analyzing Balance Sheets

Financial Statement Analysis

Intangible Assets

Learning Outcome Statement:

explain the financial reporting and disclosures related to intangible assets

Summary:

Intangible assets are identifiable non-monetary assets without physical substance, such as patents, licenses, and trademarks. They can be either finite or indefinite in terms of useful life. Finite intangible assets are amortized over their useful life, while indefinite ones are not amortized but tested for impairment annually. Internally generated intangible assets have specific accounting treatments under IFRS and US GAAP, where research costs are expensed and development costs can be capitalized under certain conditions.

Key Concepts:

Intangible Assets

Intangible assets are non-monetary assets without physical substance, identifiable either through separable means or through legal rights. They include patents, trademarks, and copyrights.

Amortization of Intangible Assets

Intangible assets with finite lives are amortized over their estimated useful lives. The amortization method and the useful life are reviewed annually.

Impairment of Intangible Assets

Intangible assets are tested for impairment. Finite life intangibles follow the same impairment rules as tangible assets, while indefinite life intangibles are tested for impairment annually without amortization.

Internally Generated Intangible Assets

Costs incurred during the research phase of internally generated intangible assets are expensed. Costs in the development phase can be capitalized if certain criteria are met, such as technological feasibility and potential for future economic benefits.

Goodwill

Goodwill is an intangible asset arising from business combinations, representing the excess of purchase price over the fair value of identifiable net assets. It is not amortized but tested for impairment annually.

Formulas:

Amortization Expense

A = \frac{C - R}{n}

This formula calculates the amortization expense per period for an intangible asset with a finite useful life, assuming straight-line amortization.

Variables:

$A$ :: Amortization expense per period
$C$ :: Initial cost of the intangible asset
$R$ :: Residual value of the intangible asset
$n$ :: Useful life of the intangible asset in periods

Units: currency unit per period

Goodwill

Learning Outcome Statement:

Explain the financial reporting and disclosures related to goodwill

Summary:

Goodwill arises when a company acquires another company and pays more than the fair value of its identifiable net assets. This excess is recognized as goodwill, an intangible asset on the balance sheet. Goodwill is not amortized but is tested annually for impairment. If impaired, the loss is recorded in the income statement, affecting earnings and total assets. Analysts differentiate between accounting goodwill (based on acquisition and accounting standards) and economic goodwill (based on economic performance and reflected in stock prices). The recognition and impairment of goodwill can significantly affect financial statement comparability, prompting analysts to adjust financial statements to exclude goodwill impacts for clearer analysis.

Key Concepts:

Goodwill Recognition

Goodwill is recognized when the purchase price of an acquired company exceeds the fair value of its net identifiable assets. It represents intangible elements like reputation, potential synergies, or unrecorded intellectual properties.

Goodwill Impairment

Goodwill is tested for impairment annually. If the current fair value of the goodwill is less than its recorded value, an impairment loss is recognized, reducing earnings and total assets.

Accounting vs. Economic Goodwill

Accounting goodwill is recorded only during acquisitions and based on accounting standards. Economic goodwill reflects the actual economic performance and potential of the company, influencing its stock price but not necessarily recorded on the balance sheet.

Financial Statement Adjustments for Goodwill

Analysts often adjust financial statements by excluding goodwill and its impairment losses to assess the core operational performance of a company and ensure comparability across companies.

Formulas:

Goodwill Calculation

Goodwill = Purchase\ Price - Fair\ Value\ of\ Net\ Identifiable\ Assets

This formula calculates the amount of goodwill generated from an acquisition, representing the excess paid over the fair value of the net assets acquired.

Variables:

$Purchase Price$ :: Total cost paid to acquire the target company
$Fair Value of Net Identifiable Assets$ :: Fair value of all identifiable assets minus the fair value of liabilities

Units: currency (e.g., USD, EUR)

Financial Instruments

Learning Outcome Statement:

explain the financial reporting and disclosures related to financial instruments

Summary:

This LOS covers the definitions, recognition, measurement, and reporting of financial instruments under IFRS and US GAAP. It includes details on financial assets and liabilities, their classification, subsequent measurement, and the impact of these on financial statements.

Key Concepts:

Definition of Financial Instruments

A financial instrument is a contract that results in a financial asset of one entity and a financial liability or equity instrument of another entity.

Recognition of Financial Instruments

Financial instruments are recognized when an entity becomes party to the contractual provisions of the instrument.

Measurement of Financial Instruments

Post-initial recognition, financial instruments are measured at either fair value or amortized cost, depending on their classification.

Classification of Financial Instruments

Financial assets can be classified as held-to-maturity, available-for-sale, or at fair value through profit or loss, each with different implications for measurement and reporting.

Impact on Financial Statements

Changes in the fair value of financial instruments can affect the income statement and balance sheet differently, depending on whether they are recognized in profit or loss or other comprehensive income.

Formulas:

Amortized Cost of a Financial Asset

AC = P + \sum (I_t - R_t) - Imp

The amortized cost is the initial recognition amount adjusted for interest, repayments, and impairments.

Variables:

$AC$ :: Amortized cost
$P$ :: Initial principal amount
$I_t$ :: Interest income at time t
$R_t$ :: Principal repayment at time t
$Imp$ :: Impairment losses

Units: currency unit

Non-Current Liabilities

Learning Outcome Statement:

explain the financial reporting and disclosures related to non-current liabilities

Summary:

Non-current liabilities include liabilities not due within the next 12 months. This LOS focuses on understanding the financial reporting and disclosure of non-current liabilities, particularly long-term financial liabilities and deferred tax liabilities. Long-term financial liabilities typically include loans and bonds, reported at amortized cost or fair value. Deferred tax liabilities arise from timing differences between tax reporting and financial reporting, often due to different depreciation methods or recognition of income.

Key Concepts:

Non-Current Liabilities

Liabilities that are not expected to be settled within the next 12 months. These include long-term financial liabilities like loans and bonds, and deferred tax liabilities.

Long-Term Financial Liabilities

These liabilities include loans and bonds that are not due for payment within the next year. They are reported at amortized cost, which aligns the carrying amount with the face value over the bond's life through amortization of discounts or premiums.

Deferred Tax Liabilities

These liabilities occur due to timing differences between the recognition of income and expenses for tax purposes versus financial reporting. Common scenarios include different depreciation methods for tax and accounting purposes, or recognition of income in different periods.

Formulas:

Amortized Cost of Bonds

AC_t = AC_{t-1} + \text{Interest Expense} - \text{Cash Paid}

This formula calculates the carrying amount of a bond over time, adjusting for interest expense and payments made.

Variables:

$AC_t$ :: Amortized cost at time t
$AC_{t-1}$ :: Amortized cost at time t-1
$Interest Expense$ :: Interest expense for the period
$Cash Paid$ :: Interest payments made during the period

Units: currency (e.g., USD, EUR)

Ratios and Common-Size Analysis

Learning Outcome Statement:

calculate and interpret common-size balance sheets and related financial ratios

Summary:

The learning outcome focuses on the use of common-size balance sheets and financial ratios to analyze a company's financial position, particularly its liquidity and solvency. Common-size analysis involves expressing each balance sheet item as a percentage of total assets, facilitating comparisons over time and across companies. Financial ratios further distill this information to assess the company's ability to meet short-term and long-term obligations.

Key Concepts:

Common-Size Analysis

Common-size analysis converts each line item on the balance sheet into a percentage of total assets. This standardization allows for comparison across different companies regardless of size, and over time within the same company, providing insights into changes in financial structure.

Financial Ratios

Financial ratios, derived from balance sheet data, are used to assess liquidity and solvency. These include the current ratio, quick ratio, and debt-to-equity ratios, each providing insights into the financial health and operational efficiency of a company.

Liquidity and Solvency

Liquidity refers to the ability of a company to meet its short-term obligations, while solvency refers to its ability to meet long-term obligations. These concepts are critical in assessing the overall financial stability of a company.

Formulas:

Common-Size Percentage

\text{Common-Size Percentage} = \left(\frac{\text{Item Value}}{\text{Total Assets}}\right) \times 100

This formula is used to convert balance sheet items into a percentage of total assets, facilitating comparison across companies and time periods.

Variables:

$Item Value$ :: The value of the specific balance sheet item.
$Total Assets$ :: The total assets listed on the balance sheet.

Units: percentage

Current Ratio

\text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}}

This ratio measures the liquidity of a company by comparing its current assets to its current liabilities.

Variables:

$Current Assets$ :: Total current assets of the company.
$Current Liabilities$ :: Total current liabilities of the company.

Units: ratio

Debt-to-Equity Ratio

\text{Debt-to-Equity Ratio} = \frac{\text{Total Debt}}{\text{Total Equity}}

This ratio assesses the financial leverage of a company by comparing its total debt to its total equity.

Variables:

$Total Debt$ :: Total debt of the company.
$Total Equity$ :: Total equity of the company.

Units: ratio

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