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Ac330 Financial Accounting Notes

Accounting Notes > Financial Accounting, Analysis and Valuation Notes

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AC330 Financial Accounting, Analysis and Valuation

Table of content
AC330 Financial Accounting, Analysis and Valuation

1 Consolidated Balanced Sheet ................................................................................................... 3
"Clean surplus" accounting ............................................................................................................. 3
"Dirty surplus" accounting .............................................................................................................. 3
Revaluation of non-current assets ................................................................................................... 3
Accounting for inventory ................................................................................................................. 3

Purchase (acquisition) accounting method ............................................................................. 5
Steps in consolidation ....................................................................................................................... 5
Analysis of S's equity with NCI ....................................................................................................... 6
Consolidated retained profits in the consolidated balance sheet - alternative check ................ 7
Consolidated statement of changes in equity ................................................................................. 7

Sunder (1975) ............................................................................................................................ 8
Aim/purpose ...................................................................................................................................... 8
Background/theory ........................................................................................................................... 8
Key findings - relationship between accounting changes to LIFO and stock price changes ..... 8

Prakash and Sinha (2013) ........................................................................................................ 9
Relevant past paper .......................................................................................................................... 9
Purpose .............................................................................................................................................. 9
Assumptions/backgrounds ............................................................................................................... 9
Key findings ....................................................................................................................................... 9
Systematic "mismatch" in firms' revenue recognition practices .................................................................... 9 whether analysts fully incorporate information about ∆DRC in sales and earning forecasts .................... 10
Impacts on the market - abnormal returns ................................................................................................... 10

Lent Term Content .................................................................................................................. 11
Balance sheet - Profitability analysis ............................................................................................ 11
Reformulated Balance Sheet .......................................................................................................... 11
Reformulated income statement .................................................................................................... 11
Indicators frequently used by analysts ......................................................................................... 11
Reformated cash flow statement ................................................................................................... 12 Ratio analysis .................................................................................................................................. 12
Operating ROA ............................................................................................................................................ 12

Cash flow analysis ........................................................................................................................... 12
Stock-and-flow equations ............................................................................................................... 12
Summary on standard practice for intangibles ........................................................................... 12 Consolidated Balanced Sheet
"Clean surplus" accounting
Shareholders' Equity + NI - dividends ± net capital contributions = Shareholders' Equity

• Under clean surplus accounting the changes in the statement of financial position are entirely reflected in the statement of total comprehensive income and the transactions with the owners shown in the statement of changes in equity.

• This is an important element for the articulation of accounts and the interpretation of financial statements. It also becomes a crucial element when using financial statements for company valuation.

• The "clean surplus" is calculated by not including transactions with shareholders (such as dividends, share repurchases or share offerings) when calculating returns; whereas standard accounting for financial statements requires that the change in book value equal earnings minus dividends (net of capital changes).

• The concept of a change in wealth being equal to net income is intuitive

• The relevance of clean surplus accounting is diminished by the observation that many of the ratios used in Financial Analysis are based on net income, not comprehensive income.

• This may be justified - e.g. if land is revalued at irregular intervals and its value is somewhat volatile, then the revaluation gains could distort financial ratios.
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"Dirty surplus" accounting
CI = NI ± OCI
Shareholders' Equity + NI ± OCI ± net capital contributions = Shareholders' Equity

• This implies that losses on certain assets (e.g. certain financial instruments) might go straight to equity, without being recorded in the statement of comprehensive income.

• You might regard this as a misrepresentation.
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end

Statement of comprehensive income
(either combined with income statement or separate)
Profit for the year (from the I/S)
Other comprehensive income (OCI):
- Revaluation gains
- Exchange differences (overseas subsidiaries)
Total comprehensive income
OCI includes

• Gains on property revaluation (revaluation reserve)

• Exchange differences (translating foreign operations)

• Gains/losses on cash flow hedges

• Actuarial gains/losses (pension plans)

• Income tax relating to these items
Net capital contributions include:

• New share issues

• Repurchases of shares

• Payments of dividends
Revaluation of non-current assets
Gain (loss) on disposal of revalued asset = Sale proceeds - Carrying amount (based on last valuation)
Accounting for inventory
Cost of sales = opening Inventory + purchases - closing inventory
Inventory needs to be measured at cost

• adjusted back from markup price - Normal selling price / (1+markup%)
Adjustments from
Opening inventory 1 Purchases:
Payments to suppliers
Unpaid suppliers' invoices
Purchases
Closing Inventory:
At cost
Impairment
Net realisable value
Cost
Adjustment
Closing inventory
Cost of sales

2 3 2+3

Adjusted back from mark-up price
Normal selling price / (1+markup%) Purchase (acquisition) accounting method
When the parent (i.e., holding) company (P) acquires control over the subsidiary (S):

• The investment in S is recorded in P's balance sheet at fair value

• On consolidation, if P has acquired less than a 100% of S, the fair values of S's assets and liabilities are recognized in full and the Non-Controlling Interest (NCI) is credited under equity

• Any difference between the investment in S and the fair values of S's net assets acquired is recognized as goodwill
The notion of elimination:

• On P's consolidated balance sheet, the investment in S is eliminated against S's equity acquired with the difference reflecting goodwill

• P's consolidated balance sheet includes all of S's assets and liabilities

• The consolidated share capital and share premium must always be that of the parent company only
Goodwill captures (subject to annual impairment test)

• Quality of management

• Quality of legal paperwork

• R&D

• Brand value
Steps in consolidation

1. Open a new account in P under asset, investment in S

2. Cash-for-paper

Paper-for-paper

Remove investment in S
from cash

P issues shares worth A to acquire shares of S

1. exchange ratio = shares / shares

2. Each new share issued is worth = A / shares

3. Consideration = new shares issued by P * value of new share
* %acq

4. Share premium = shares * (value of new share - nominal value)
Adjustments in the equity of P

5. Open new account in P: Investment in S = A

6. Share capital of P increases by shares * nominal value (usually 1)

7. Share premium of P increases by shares * (value of new share nominal value) = A - increase in share capital
P

S

P

S

p

P

P

P

3. 4.

Add together two companies' balance sheets
Eliminate P's investment in S by setting it against S's shareholder's equity

Shareholder's equity should only be those of P's

5. Calculate goodwill = price of consideration - fair value of net assets acquired - goodwill impairment,
under asset

Use analysis of S's equity (see note below)
o The individual assets and liabilities of the acquired company have to be revised to their fair value at the acquisition date

Goodwill will be the difference between the revalued net assets and the investment by the parent

6. Effects of increase in fair value of net assets (=TA-TL)
o Revaluation increases
§ Increases group by revaluation * %CI
§ Increases NCI by revaluation * %NCI
o Goodwill decreases

7. goodwill impairment

reduce goodwill (Cr Goodwill)
o Increase expense on I/S (Dr Goodwill impairment)
o Goodwill impairment is deducted after operating profit, since it's not an operating expense

8. Add minority interest = fair value of net assets acquired * %NCI (item c in the analysis of S's equity) 9.

10. 11.

12. 13.

14. 15.

16. 17.

18. Deduct from retained profits

pre-acquisition profits of S (because that's already paid for)
o Post-acquisition profits attributable to NCI
Eliminate inter-company transactions (avoid double-counting)
o Provision for unrealised profit (PURP) = remaining stockmark-up%100 + markup%
o PURP = remaining stock * markup%
o Upstream sale (S sells to P)
§ (Dr) increase COGS by PURP (whole amount)
§ (Cr) Reduce inventory by PURP
§ Reduce consolidated RE by %acq*PURP
§ Reduce NCI by %NCI*PURP
§ (Dr) Reduce sales revenue by inventory at cost * (1+markup%)
§ (Cr) reduce COGS by inventory at cost * (1+markup%),
o Downstream sale (P sells to S)
§ Eliminate against controlling interest
Eliminate inter-company balances

Eliminate trade receivables and payables in both P and S (since they cancel out with each other)
o Record cash in transit under asset (if they don't exactly cancel out)
Consolidated RE = P's retained earnings b/f + profit after tax attributable to P
Consolidated retained earnings - check it's equal to

P's retained earnings c/f + P's proposed but not paid dividends + S's post-acquisition earnings - goodwill impairment -%acq*(PURP+excess depreciation)
Profit after tax is split between equity holders of P and NCI
Adjust for differences in accounting policies to the P's, e.g. excess depreciation

Adjust operating expenses (depreciation)
o Adjust non-current assets

Adjust S's profit after tax when calculating NCI's shares in the CIS
If acquisition happens in the middle of the financial year

Net profit needs to be adjusted for expenses that happen pre/post-acquisition
§ E.g. needs to remove finance cost that only happens post-acquisition

Pre-acquisition profit = net profit * pre-acq-portion +/- things that only occur pre-acq

Post-acquisition profit = net profit * post-acq-portion +/- things that only occur post-acq
Calculating profit attributable to NCI
o NCI% x

(S' profit after tax post-acquisition

Less PURP
o Less Excess Depreciation)
Adjust for dividends (S to P)
o Dividends from pre-acquisition profits (S to P) - As if S is returning assets acquired by P
to P (like cashback!)
§ Dr S's pre-acquisition reserves (split between group and NCI)
§ Cr Consideration = original consideration - dividends*%acq
§ Net effect on goodwill = 0

Dividends from post-acquisition profits (S to P)
§ Dividends paid - Need to be eliminated (restating S's accounts)

• Dr Dividend Income (P)

• Cr Retained earnings (S)
o Dividends proposed
§ Dr Dividend Proposed
§ Cr Retained earnings

Analysis of S's equity with NCI
Total

Group pre-acq

£1 ordinary shares
Revaluation

NCI
post-acq Retained earnings brought forward
Profit for the year
Pre-acq
Post-acq
Fair value of net assets
Consideration paid to acquire x% of S
Goodwill on consolidation
Less goodwill impairment

a b b-a
Goodwill
(goes to FP)

Split equity between group and NCI by percentage
Consolidated retained profits in the consolidated balance sheet - alternative check
Consolidated retained earnings
P's retained earnings brought forward xxx
Consolidated profit to equity holders xxx
Dividends paid by P only
(xxx)

xxx Consolidated statement of changes in equity

C
(goes to FP)

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