Ac330 Financial Accounting Notes

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. beg end "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. beg 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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