income statement by cJ70z5

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									Summary - 631

ILO 2

Purchase method: when preparing an acquisition balance sheet, the indirect acquisition of assets and
liabilities of another company through the acquisition of its shares should be recorded in the same way
as a direct acquisition of individual assets and liabilities would have been recorded. In order to use the
purchase method, you must have control (50% >) of the acquired company. Using the pooling method
when you have an acquisition instead of a merger, you can get a hidden reserve.

The pooling method: equity is the difference between the pooled assets and the pooled liabilities.

The full goodwill method: you handle assets/liabilities of the firm that is to be acquired as if you
purchase 100% of the shares. Include Minority interest in the consolidated BS.

The Equity method: mix of full consolidation, i.e. allocation of the purchase method and no
consolidation. Applicable when the Group does not have full control, but substantial influence. The
acquired shares are included in the BS, as well as the new liabilities. Otherwise, BS for the Group is
unchanged. The next period however, this will have changed. In the assets, instead of the reported
acquired shares, you will report holdings in associated company, i.e. acquired shares + net profits from
the associated company. In the Group IS, include your share of the net profits from the acquired
associated company. Use this method when you have between 20-50% of the shares in the associated
company.




* The chapters are in the book by Schuster.

Case 1: Deterioration of the E/A-ratio  increased risk due to acquisition. Higher risk  higher return
(ROE).
Case 2: higher E/A-ratio (smaller assets due to using surplus cash) than in case 1, but still much smaller
than the acquiring company at a standalone basis. Do not forget to include lost interest income! If it is
not given, assume a before tax interest rate that you then adjust to after tax basis. Case 1 and 2 are quite
similar in terms of profitability (ROE) and financial position (E/A).

Case 3: E/A same level as on a standalone basis. No new increase in risk; the equity owners of the
acquired company invest in the new group by accepting shares in the acquiring company. Unchanged
ROE. In this case give the pooling method gives the same effect as the purchase method; this is only
when P=E.

Case 4:

The fair values of the indirectly acquired net assets exceed their book value in the subsidiary’s BS:

Note that shares in subsidiary, before the acquisition is recorded at cost. Form of financing as a higher
effect on financial position than the price does; paying a higher price for the equity makes E/A lower, but
not much lower than in case 1.

The fair values of indirectly acquired assets and liabilities equal their book values in the subsidiary 
Goodwill:

Not possible to “buy” higher profitability by a acquiring a company with higher profitability, when that
has been accounted to in the price (Goodwill). A company pays more for expected abnormal profitability
and/or synergies. Take account of the fact that deferred taxes might exist. Do not forget to reverse DTL
in the IS.

Case 5: Most significant difference in using the pooling method v.s. the purchase method in this case:
effect on profitability (ROE). In case 3 and using the pooling method in case 5, you do not get
amortization or impairment of Goodwill.

Case 6: Include Minority’s in the Group’s Equity, and subtract their share of the profits.

Case 7: Think about if you are required to record assets and liabilities of the acquired company at 100%
or not; this will affect the consolidated BS.

Case 8: we treat the transaction as purely financial (meaning the acquiring company has n influence in
the company it acquires shares from). If the company you have shares in pays a dividend, this will be
included in the IS as an income (x % of the dividend per share). Report acquired shares in the other
company in the Group BS.

Case9: you should take account of amortization in goodwill. You share in the other company should be
reported in the BS as the price paid.

ILO 5

Inventory account affected by two events: the purchase of goods (P) and their subsequent sale (COGS).

BI = Beginning inventory, EI = ending inventory

EI = BI + P – COGS
BI + P =COGS + EI

FIFO = ending inventory made of costs for of the most recent items purchased.

LIFO = ending inventory made of costs for the earliest costs incurred.

Weighted average: ending inventory made up of average costs. Take total costs (BI + P).

For tax purposes, LCM cannot be used with LIFO.

From a balance sheet perspective, inventories based on FIFO are preferable to those presented under
LIFO, as carrying values most closely reflect current cost. In other words, FIFO provides a measure of
inventory that is closer to its current (economic) value.

During periods of changing prices and stable or growing inventories, LIFO is the most informative
accounting method for income statement purposes, in that it provides a better measure of current
income and future profitability.

LIFO reserve = Inventory using FIFO – Inventory using LIFO

Inventory using FIFO = Inventory using LIFO + LIFO reserves



R&D Expensing




Note that in this case investments = acquisitions/capitalization

R&D Capitalization
Think of the useful life when calculating the amortization.

ILO 3 – 5 Financial Key Ratios

WSF p 112-114 – “Ratio analysis: Cautionary notes”:

Benchmarks: Ratio computations and comparisons are influenced by the lack of or inappropriate use of
benchmarks.

Economic assumptions: Proportionality assumption ignores the existence of fixed costs. When there are
fixed costs, changes in costs (and thus profits) are not proportional to changes in sales.

Timing and Window dressing: Fiscal year-end numbers may not correspond to normal operations. As a
result, especially for seasonal businesses, ratios may not correspond to normal operational relationships.
The timing issue leads to the problem of window dressing, i.e. the manipulation of numbers to show the
firm at a more favorable light.

Negative numbers: ex. (-10 000) / (-100 000)= 10% ! A positive number. Without the use of a good
computer program, or correct use of the numbers given, you can get incorrect ratios.

Accounting methods: choice of accounting method and estimates can greatly affect the financial
statement.

Profitability: (1)financial performance of the business (2) efficiency in value creation.

Financial position: (1) financial strength of the business (2) sufficient risk buffer to cope with the
business risk.

Liquidity: (1) payment capacity of the business (2) ability to meet claims.

Activity: Analysis of the relationship between (1) the level of operations and (2) the capital needed for
operations. (1) and (2) refer to sales and COGS in most cases. COGS: production plus purchases. A way to
measure activity is capital turnover, a ratio that is industry specific.

The DuPont chart (Y-axis: profit margin, X-axis: capital turnover): the graph will be ROCE. Position in the
chart indicates industry, strategy (Porter) and performance.

Cash Cycle:
                                                       Accounts
                                           Finished
                                           goods       receivable
                               Work in
                               progress
      Raw materials

      Accounts payable



Time from raw material to finished good: inventory time.



Current vs. deferred tax: a legal entity does not need to report deferred taxes.

Three general explanations why the present value of a pension obligation may change during a year:
The PV of pension obligations will increase as services are performed by the employee during the current
year (current service cost). The PV of pension obligations will also increase due to future payments of
pensions coming one year closer to settlement (interest cost). The PV of pension obligations will
decrease when payments of pensions are made during the year.

Effects on CAPEX Ratio of capitalizing instead of expensing R&D: If an expenditure is capitalised instead
of expensed, cash flows from operations (the numerator of the capex ratio) will increase (the expense is
no longer withdrawn), but cash flows from investing in tangible and intangible fixed assets (the
denominator of the capex ratio) will become more negative (the capitalised amount is treated as an
investment). The more specific effects depend on the level of the capex ratio.

Untaxed reserves: If you have purchased a machine with a long useful life, in the Swedish context, tax
legislation allows for greater depreciation amounts compared to IFRS. This will lead to a difference
between the carrying value in the consolidated accounts and the value according to the Swedish taxation
rules (see lecture notes).

Loss carry-forwards: These losses are possible to net against future profits in the legal entities that
reported the losses. Therefore these “loss carry-forwards” are valuable to the group, provided that it is
likely that the legal entities who reported the losses will earn profits in the future. The tax rate times the
loss carry forward represents a deferred tax asset. In the legal entity this difference will be referred to as
“untaxed reserves”. In the consolidated accounts, the difference represents a so called taxable
temporary difference, which leads to the recognition of a deferred tax liability. The tax rate times the
taxable temporary difference (the untaxed reserve in this case) represents a deferred tax liability.

IAS 2: Inventories shall be measured at the lower of cost and net realisable value. FIFO or weighted
average cost formula should be used.
ILO 6 - Corporate valuation

Residual income valuation (RIV):
                  T
                        (ROE t  e )  Bv t 1 VT  Bv T
V0  Bv 0       
                 t 1       (1  e ) t
                                               
                                                 (1  e ) T

Present Value of Expected Dividends (PVED):
        T     p surv ,t  E0 ( DIVt surv (t ))       p surv ,T  E0 (VT surv (T ))
V0                                             
       t 1               (1   E ) t                       (1   E ) T

r*E = (rE + pfail)/(1 – pfail) =

g*ss = (g + pfail)/ (1 - pfail) = ROE*SS(1-pr*SS) = growth in future dividends conditioned on survival

g = g*ss(1-pfail)+(-100%)pfail

* In every model: always adjust for the month the dividends are payed out



Growth in owner’s Equity: ROE – growth in Dividends



Why high SD does not automatically lead to higher expected returns: A higher standard deviation does
not automatically leads to a higher expected return. Imagine two stocks with the same expected return
and the same standard deviation but a correlation that is less than unity. Any portfolio of these two
stocks will have the same expected return but a lower standard deviation. In other words, the difference
between the portfolio standard deviation and the stocks’ standard deviation has not lead to higher
expected return. Apparently, not all risks are priced.



The variance of a portfolio approaches the average of the covariances within the portfolio when the
number of stocks goes to infinity. If the correlation equals one there is no diversification whatsoever.
Also remember that the correlation increase whenever there is a crisis.

SD(RMkt )  [Cov(Ri , R j )]1 / 2  [Corr (Ri , R j )SD(Ri )SD(R j )]1 / 2

                        1                             1
SD( RP )  [n            2
                            Var( Ri )  n  (n  1)  2 Cov( Ri , R j )]1 / 2
                        n                            n



SDp = n*(1/n2)*VAR( ri ) + 2*n*(n-1)*(1/n2)*COV(ri,rj)

								
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