Appunti Financial Statement Analysis

Main Assets Evaluation Principles

We zoomed into the financial statements: the framework is the annual report and now we look at the numbers. When we look at the numbers we have these evaluation principles, so criteria, methods that are used to determine the value of Assets, Liabilities, and therefore the Equity.

1. The fundamental rules in assets evaluation
• Accounting Standards represent a set of concepts and techniques that are used to identify, measure and communicate financial information about an economic unit to various users.
• In particular, IFRSs are designed as a common global language for business affairs, so that company accounts are understandable and comparable across international boundaries.
• Nevertheless, managers can exercise the so-called accounting discretion, that is the ability to make a judgment, a choice or a responsible decision, which ultimately impacts on the Financial Statements presentation.
• Therefore, it is important to be aware of which are

Some of the main valuation issues that companies face during their day-by-day operations.

Financial Statement Analysis and Managerial Accounting UCSC | Martina Marazzi

General principles applicable to the asset evaluation distinguish between:

• Monetary assets, carry a fixed value in terms of currency units. They are stated as a fixed value in monetary terms even when macroeconomic factors such as inflation decrease the purchasing power of the currency.
• Cash
• Bank deposits
• Trade receivables
• Other receivables meant for settlement through cash
• Investments in debt capital markets instruments
• Non-monetary assets, conversely speaking, non-monetary assets are those that do not have a value determinable in exact money terms. The value assets that are non-monetary change or fluctuate a lot over time and whose cash convertibility is limited. Therefore, these assets are not that liquid. Examples include property, plant & equipment, intangible assets.

1. asset.
   • Investments in preference shares shall be treated as monetary assets if there is a clause in the contract, by virtue of which, the redemption of preference shares has to be undertaken by the issuing entity after a certain time in the future. Otherwise, investments in preference shares will be treated as assets that are non-monetary.
2. Accounts receivable and allowance for bad debts
   • Accounts receivable are the amounts owed to a company by customers as a result of delivering goods or services and extending credit in the ordinary course of business and they are also known as trade receivables or simply receivables. They are valued at their net realizable value (what is used to value accounts receivable is the value for the sale that have not been collected yet, so revenues that have not been collected yet).
   • Uncollectible accounts (bad debts) are receivables determined to be uncollectible because debtors are unable or unwilling to pay their debts. They need to be deducted

From accounts receivable gross. There are two basic ways to record uncollectible:

• Specific write-off method: the receivables not paid are written off when they are recognized as uncollectible (example, in case of bankruptcy)
• Allowance method: it estimates the portion of accounts receivable that are expected not to be collected

The specific write-off method assumes that all sales are fully collectible until proved otherwise (gross value equals the net realizable value of accounts receivable).

When an account is identified as uncollectible, that account is removed from the books and an expense is recorded and this method, which is used by companies that rarely experience bad debts, is called allowance method.

The allowance method estimates the amount of uncollectible accounts to be matched to the related revenues and it allows to recognize bad debts during the proper period, before

Specific uncollectible accounts are identified in a subsequent period, thus improving the matching of revenues and expenses.

The allowance method has two basic elements:

• An estimate of the amounts that will ultimately be uncollectible
• A contra account, Allowance for Uncollectible Accounts, which contains the estimate and is deducted from Accounts Receivable

The allowance method is based on historical experience and the assumption that the current year is similar to prior years.

The allowance is quantified directly as a percentage of ending account receivable (sometimes differentiated based on the age of the overdue) or indirectly as a percentage of credit sales.

Inventory evaluation and cost of goods sold:

• Inventories are measured at the lower of cost and net realisable value, which is the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale.
• The cost of inventories

includes all costs of purchase, costs of conversion (direct labour and production overhead) and other costs incurred in bringing the inventories to their present location and condition – Under the IFRS the cost of inventories is assigned by:

• Specific identification of cost for items of inventory that are not ordinarily interchangeable
• The first-in, first-out or weighted average cost formula for items that are ordinarily interchangeable (generally large quantities of individually insignificant items)

When inventories are sold, the carrying amount of those inventories is recognised as an expense in the period in which the related revenue is recognised

The amount of any write-down of inventories to net realisable value and all losses of inventories are recognised as an expense in the period the write-down or loss occurs

4- Fixed assets (tangible and intangible), depreciation and amortization

There are two main categories of fixed assets:

• Tangible fixed assets,

including PPE (property, plants and equipment), land, etc. – everything that is long lived, which means that ... and that it will generate cash flow beyond the current accounting period

• Intangible assets, which have no physical form (like trademarks, patents, copyrights, ….)

7 Financial Statement Analysis and Managerial Accounting UCSC | Martina Marazzi

– According to the cost principle, acquired fixed assets should be recorded at their actual cost, also called historical cost

– Remember that the cost of any asset, including fixed assets, is the sum of all the costs incurred to bring the asset to its intended use

– For fixed assets, therefore, the typical items included in the cost are:

• Purchase price
• Applicable taxes
• Purchase commission
• Legal fees
• Transportation charges
• Insurance while the asset is in transit
• Installation costs
• Cost for testing the asset before it is used, etc.

– At the end of the

Accounting period, firm record an expense related to the fact that during the same period they have used fixed assets, so they contributed to the revenue earned.

- Depreciation is the process of allocating the cost of a fixed asset over the years of its useful life, that is over the years that the asset was used

- Depreciation is an expense and a decrease in the asset value

- If, at the end of a given accounting period, the net book value of a fixed asset is higher than the recoverable value of the asset, firms are required to "impair" the asset, which means to record for an extraordinary loss of value (expense)

- Remember that the cost is always the highest value at which an asset can be evaluated. This means that we cannot record a value higher than the cost we paid to acquire the asset (unless the revaluation model is used)

- Amortization: intangible assets are rights or claims to expected benefits that tend to be contractual in nature rather than physical

In nature, examples of intangible assets are patents, copyrights, and franchises. The accounting for intangibles is much like that of tangible assets.

• Acquisition costs of intangibles may be: the cost of purchase, the fair value in a contribution in kind, the capitalized cost in case of capitalization of operating expenses.
• Intangibles are amortized using the straight-line method.
• Firms measure the depreciation based on:
  • Depreciable cost
  • Estimated useful life
• Depreciable cost in most cases corresponds to the total cost of the asset (see before). When it is expected that some money from the sale of the asset at the end of its useful life will be gained, the depreciable cost equals the historical cost - (minus) the residual value.
• The estimated useful life is an estimate of how long the assets will be useful: this can be expressed in years, units of output or other measures.
• There are different methods to allocate the depreciable value to the periods of the asset's.

useful life. The most common in practice are:

• Straight-line method
• Units-of-production method
• Declining balance method (accelerated depreciation)

5- Take home– Non-monetary and monetary assets have different evaluation criteria: costbased and fair value based 8Financial Statement Analysis and Managerial Accounting UCSC | Martina Marazzi

• Accounts receivables are valued at their net realizable value
• Inventories are evaluated at the lower of cost (FIFO; LIFO; weighted average,specific identification) or market price
• Fixed assets (tangible and intangible) are evaluated, respectively, at theirdepreciated or amortized cost

INTRODUCTION TO CONSOLIDATION

1. Intercorporate investment and consolidation