Archive for the 'Adjusting Reported Financial Statements' Category

The Income Statement: Operating versus Non-Operating Components

On the income statement, accounting standards encourage separate treatment of operating and non-operating items. Operating items are those relating to the day-to-day management of the enterprise: sales, cost of sales, selling, general and administrative expense, research and development costs, etc. Often the net of these items is presented as a subtotal, operating income.

Non-operating items include investing and financing activities, which are reported separately from operating income (unless pertaining to a financial services firm, for which such items are operational.) Non operating items include the interest, dividends and profits on investments made in the securities of other companies; interest expense; etc.

Some investments in other companies are made for strategic reasons, such as access to raw materials. In these cases, investors and analysts may wish to classify the investments as operating.

While taxes are a normal operating expense, they are also affected by non-operating items. Often, analysts will adjust operating profit by the tax rate to arrive at NOPAT (net operating profit after tax.)

Posted on 2nd May 2008
Under: Adjusting Reported Financial Statements, Financial Statement Analysis, Fundamental Analysis, Investing in Stocks | No Comments »

Cash Flow Return on Investment (CFROI)

Cash Flow Return on Investment (CFROI) is an internal rate of return (IRR) type metric measuring the return expected to be generated by a firm’s existing assets throughout their useful lives. CFROI can be calculated in five steps:

  • compute the average life of assets by dividing gross assets by depreciation expense
  • compute gross cash flow by adjusting net income for non-cash charges, financing expenses, operating lease payments and equity reserve accounts
  • compute the gross investment as gross plant and equipment adjusted for reserves, capitalized expenses, restructuring charges, amortization and the present value of operating leases
  • compute the value of any assets that will not depreciate (which will represent the future value)
  • solve for IRR (or CFROI)

Posted on 31st December 2007
Under: Accounting, Adjusting Reported Financial Statements, Valuation | No Comments »

Adjusting Net Income to Reflect Economic Pension Expense

Pension accounting rules permit certain expense items to be smoothed into income. However, the required disclosures allow investors to adjust the income statement to reflect the true underlying economic cost related to pension plans. The economic cost should equal any change in the plan liability other than benefits paid or employer contributions.

Consider the following pension disclosures from KLA-Tencor’s 10K.

KLAC pension disclosures

The pension obligation increases by 4,175, and benefits paid of $1,519 should be added back to that amount to determine the underlying economic change in obligation. 4,175 + 1,519 = 5,694.

The fair value of assets rose by $1,255. The contributions and benefit payments were a net $789 which should be deducted from this. Notice that in this case the benefits paid figure differs between the asset side and the liability side. It is possible some benefits were paid as a lump sum settlement. At any rate, the net change in assets was 1,255 – 789 = 466.

The net change in the economic liability, then, was 5,694 – 466 = 5,228. Contrast that with the reported pension expense.

klacpensionexpense.jpg

The economic change in the value of the pension was $5,228, but the income statement showed an expense of just $2,280. An investor might want to adjust the income statement by adding $2,948 to pension expense, reducing operating income by the same amount. The effect on net income would be smaller due to the tax effects.

For KLA-Tencor, reported operating income was 589,868 in 2007. After this adjustment it would have been$586,920 – approximately half a percent lower. Earnings per share for the year would have been at least a penny lower.

Posted on 21st November 2007
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Interest and Dividends: Differences Between US GAAP and International Accounting Standards

IAS and US GAAP both require a statement of cash flows divided into operating, investing and financing sections. The two standards differ in the classification of certain items, particularly interest and dividend payments. The differences are summarized in the table below.

  IAS Classification US GAAP Classification
Interest received Operating or investing Operating
Interest paid Operating or financing Operating
Dividends received Operating or investing Operating
Dividends paid Operating or financing Financing

Posted on 12th November 2007
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Using Revenue and the Balance Sheet to Derive Cash Collected From Customers

The “top line” revenue number is of particular significance in financial statement analysis. For one thing, overstating the revenue line will generally have a direct impact on profits. A relatively easy way to assess the earnings quality of revenue is to convert it into cash collections from customers, as would be done when creating a direct-method statement of cash flows.

Under normal circumstances, revenue and cash collections from customers should follow a similar pattern. By analyzing the ratio of revenue to cash collection over time, investors may be able to detect changes in the quality of sales. The conversion itself is fairly simple: Cash collections from customers = Revenue – the change in accounts receivable + any change in deferred revenue.

It is useful to check the footnotes to the financial statements, as deferred revenue and certain receivables are frequently lumped into “other” liabilities and assets, respectively. It would also be prudent to adjust receivables for any changes in the amount of securitized, or “factored” receivables.

Posted on 2nd November 2007
Under: Accounting, Adjusting Reported Financial Statements, Financial Statement Analysis, Fundamental Analysis, Investing in Stocks, Ratio Analysis | No Comments »

Reclassifying Pension Related Cash Flows for Analysis Purposes

On the statement of cash flows, all contributions to a pension fund are treated as operating cash flows. Such contributions are typically constrained by minimum requirements set by law and maximum levels above which the contributions are no longer tax deductible. Contributions will not typically match the changes in the actual obligation.

If the company pays more into the plan than the change in benefit obligation, it will reduce the net liability of the fund. Conversely, contributing less than the change in benefit obligation will increase the net liability. For analysis purposes, changes in liability may be better treated on an equal basis with changes in other liabilities – namely as financing cash flows.

To do so, the investor would need to examine the pension disclosures and determine the difference between the change in the funded status and the actual contributions made to the plan. This difference would then be treated as a cash inflow or outflow from financing activities. This can be useful to gauge the sustainable level of cash from operating activity as well.

Posted on 21st October 2007
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Accounting for Property, Plant and Equipment: Differences Between US GAAP and International Accounting Standards

Under IAS 16, as under US GAAP, property plant and equipment are initially recorded on the balance sheet at cost, and systematically charged to expense as depreciation. Unlike GAAP, IAS permits upward revaluation (to the fair value as of the revaluation date) of property, plant and equipment.

Typically, when assets are revalued downward the charge flows through the income statement. In the case of upward revaluation, however, the change typically bypasses the income statement and is made directly to equity. The exception to these general rules is when the revaluation reverses a previous revaluation. In such cases, the reporting mimics that of the original revaluation. So downward reversals go straight to equity, while upward reversals are reported in the P&L.

Posted on 12th October 2007
Under: Accounting, Adjusting Reported Financial Statements, Financial Statement Analysis, Fundamental Analysis, International Investing, Investing in Stocks | No Comments »

Bill and Hold Sales

In a document titled “Report Pursuant to Section 704 of the Sarbanes-Oxley Act of 2002,” the U.S. Securities and Exchange Commission noted that:

Improper accounting for bill-and-hold transactions usually involves the recording of revenue from a sale, even though the customer has not taken title of the product and assumed the risks and rewards of ownership of the products specified in the customer’s purchase order or sales agreement. In a typical bill-and-hold transaction, the seller does not ship the product or ships it to a delivery site other than the customer’s site. These transactions may be recognized legitimately under GAAP when special criteria are met, including being done pursuant to the buyer’s request.

By booking revenue before the customer has accepted delivery of the goods or services in question, a company recognizes revenue earlier than it otherwise would. To the extent that investors expect the company to earn a certain level of revenue in a period, or to the extent that salespeople are compensated based on target sales levels, this accounting practice is considered aggressive.

Ways to identify potentially aggressive revenue recognition include monitoring the relationships between sales and accounts receivable, and sales and deferred revenue or income. Significant variations in these ratios may be a signal that the company’s revenue recognition practices may be changing over time.

Posted on 2nd October 2007
Under: Accounting, Adjusting Reported Financial Statements, Analyzing Press Releases, Fundamental Analysis, Investing in Stocks, Ratio Analysis | No Comments »

Using Pension Disclosures to Understand the Underlying Economic Position

Subsequent to passage of SFAS 158, companies adhering to U.S. GAAP are required to show the net funded status of their pension plans directly on the balance sheet. If fund assets exceed the projected benefit obligation the company will list a net asset. Otherwise, the net amount will be reflected as a liability. Under International Accounting Standards, the net asset or liability might not be reflected on the balance sheet due to permissible smoothing mechanisms.

Although SFAS 158 moves toward full accountability for pensions, the treatment still differs from that of other assets and liabilities. For example, a company borrowing $1 million to buy equipment would record both the asset and the liability, not merely the net amount. Investors can use the pension disclosures to adjust the balance sheet such that it reflects the underlying economic position of the pension plan.

To do so, any net liability or asset would be removed and the plan assets would be added as a separate asset, while the projected benefit obligation would be added to liabilities. A further adjustment would be to treat the actual return on plan assets as a component of income, and the interest on the obligation as an expense.

Posted on 21st September 2007
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Accounting for Foreign Currency Transactions

When companies using different currencies transact business, at least one of the companies will have to translate a foreign currency into its home currency. For sales made in cash, this can be done at the time of sale.

When the sale is made on credit, the company will have to record an account receivable or account payable until the account is settled. During the interim, the relative values of the currencies could change. The accounting treatment for such changes is governed by International Accounting Standard (IAS) 21 and U.S. Financial Accounting Standard (FAS) 52. The treatment is the same under either method.

  • At the time of sale, the sale is recorded at the current exchange rate and an equivalent value asset or liability is created.
  • If balance sheets are prepared prior to collection, the asset or liability must be restated to the then-current exchange rate value. The change is recognized as an unrealized exchange rate gain/loss on the income statement.
  • When the account is collected, the asset or liability is removed and any previously unrecognized gain/loss is recognized on the income statement.

Since the asset and liability are always presented at fair value and changes flow through the income statement, there is seldom need to adjust the financial statements to examine the effect.

Posted on 19th September 2007
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