Financial Accounting Theory Test One

Probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.

Probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.

HORIZONTAL COMPETITION
Rivalry among Existing Firms
Threat of New Entrants
Threat of Substitutes
VERTICAL COMPETITION
Buyer Power
Supplier Power

Often the first order of competition.
Industries are characterized by:
-Concentrated rivalry.
-Diffuse rivalry.
Greater the industry concentration, the lower the competition between existing rivals and thus the more profitable the firms will be.

How easily can new firms enter a market?
Are there entry barriers?
Do the existing rivals have distinct competitive advantages making it difficult for other firms to enter and compete?
-If so, firms in the industry will likely generate higher profits than if new entrants can enter the market easily.

How easily can customers switch to substitute products or services?
How likely are they to switch?
With close substitutes, competition increases and profitability decreases.
Unique products with few substitutes, enhance profitability.

Relates to the relative number of buyers and sellers in the industry and the leverage buyers have with respect to price.
Relates to buyers’ price sensitivity and the elasticity of demand.
Are the buyers price takers or price setters?

Relates to leverage in negotiating input prices from suppliers.
If an industry has a large number of potential buyers of inputs that are produced by relatively few suppliers, the suppliers will have greater power in setting prices and generating profits.

1-Identify Economic Characteristics and Competitive Dynamics in the Industry
2-Identify Company Strategies
3- Assess the Quality of the Financial Statements
4- Analyze Profitability and Risk
5-Project Future Financial Statements
6-Value the Firm

Economic characteristics and competitive dynamics influences the strategies firms will employ.
Does the industry include a large number of firms selling similar products or small competitors with unique products. Is technological change important? Are sales growing rapidly or slowly?

Framework for Strategy Analysis
Nature of product or service, specific or broad?
Integration within value chain, backward or forward integration?
Geographical diversification
Industry diversification

Product differentiation strategy
Unique products
Achieving relatively high profit margins
Low-cost leadership strategy
Non-differentiated products
Accepting a lower profit margin in return for a higher sales volume and market share

Integration in Value Chain
Manufacturing: Is the firm conducting all manufacturing operations itself or outsourcing all manufacturing or outsourcing the manufacturing of components but conducting the assembly operation in-house?
Distribution: Is the firm maintaining control over the distribution function or outsourcing it?

Is the firm targeting its products to its domestic market or integrating horizontally across many countries?

Is the firm operating in a single industry or diversifying across multiple industries?

Assets = Liabilities + Shareholders’ Equity
Assets portion of the balance sheet reports the effects of a firm’s operating decisions and investing decisions.
Liabilities and shareholders’ equity portion of the balance sheet reports obligations that arise from a firm’s operating decisions and financing decisions.

Income Statement
Balance Sheet
Statement of Cash Flows
Statement of Shareholders’ Equity
-First three statements are required; most companies include all four.

A firm can recognize as assets only those resources:
for which it has the rights to future economic benefits as a result of a past transaction or event.
for which the firm can predict and measure, the future benefits with a reasonable degree of precision and reliability.
Categorized into Current Assets, Investments, Property, Plant, and Equipment and Intangibles.

Reflect managers’ expectations of future sacrifices of resources to satisfy existing obligations.
Categorized into:
Current liabilities : includes obligations a firm expects to settle within one year.
Noncurrent liabilities: includes long-term debt obligations, other liabilities, and deferred income taxes.

Provides information about the profitability of a firm for a period of time.
Under accrual basis of accounting, revenue when is recognized when:
It has completed all (or substantially all) of the revenue-generating process by delivering products or services to customers.
It is reasonably certain it has satisfied a liability or generated an asset that it can measure reliably.

Firms residual interest or claim.
It includes:
Amounts initially contributed by shareholders for an interest in a firm.
Cumulative net income in excess of dividends declared.
Shareholders’ equity effects of the recognition.
Treasury stock.

Assesses a firm’s past ability to generate free cash flows and for predicting future free cash flows.
Categories:
Operating
Investing
Financing
Transactions not directly involving cash are disclosed either in a supplementary schedule or in a note to the statement of cash flows.

Tools:
Common-size financial statements
Percentage change financial statements
Financial Statement Ratios
Profitability: EPS, ROCE etc.
Risk: Current Ratio, Debt to Equity Ratio etc.

Forecasts are the inputs into valuation models and the quality of the decisions rests on the reliability of the forecasts.
Forecasted financial statements rely on assumptions the analyst makes about the future.
Amounts from the forecasted financial statements serve as the basis for the valuation models.

Approaches:
Dividends
Earnings
Cash flows
Market
-First three methods will give same value.

Strategic Risks
Operating Risks
Financial Risks
Information Risks

Environment Risks
Organization Risks
-Corporate Objective and Strategies
-Leadership
-Management
-Corporate Governance
-Investor/Creditor relations
-Human Resources

-Workforce
-Suppliers
-Physical PLant
-Protection
-Products and Services
-Customers
-Regulatory Compliance

-Capital/Financing
-Investing
-Regulatory Compliance

-Information Systems
-Strategic Information
-Operating Information
-Financial Information

Enhancement of assets or settlements of obligations suring the period as a result of manufacturing goods and services and selling the same that represent the major central and ongoing activities of the entity

Outflows or other using up of assets or incurrences of liabilities (or a combination of both) during a period from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity's ongoing major or central operations.

Increases in equity (net assets) from peripheral or incidental transactions of an entity except those that result from revenues or investments by owners.

Not from the central ongoing activities of the company, peripheral, not owner transactions

Decreases in equity (net assets) from peripheral or incidental transactions of an entity except those that result from expenses and distributions by owners.

Not from the central ongoing activities of the company, peripheral, not owner transactions

Demand
Supply
Manufacturing
Marketing
Investing & Financing

Are customers highly price-sensitive or relatively insensitive?
Is demand growing rapidly or is the industry relatively mature?
Does demand move with the economic cycle or is it insensitive to it?
Does demand vary with the seasons or is it relatively stable throughout the year?

Are suppliers offering similar or unique products?
Are there high barriers to entry?
Are there high barriers to exit, such as environment cleanup costs?

Is the manufacturing process capital-intensive or labor-intensive or a combination of the two?
Is the manufacturing process complex with low tolerance for error or relatively simple with ranges of products that are of acceptable quality?

Is the product promoted to other businesses or marketed directly to consumers?
Does steady demand pull products through distribution channels, or must firms continually create demand?

Are the assets of firms in the industry relatively short-term or long term?
Is there relatively little risk or high risk in the assets of firms in the industry?
Is the industry relatively profitable and mature generating enough cash flows or growing rapidly and in need of external financing?

One of the most frequently used measures of profitability.
The only financial ratio that GAAP requires firms to disclose on the face of the income statement.
Covered explicitly by the opinion of the independent auditor.
Types of EPS:
Basic EPS (Simple Capital Structure)
Diluted EPS (Complex Capital Structure)

For the firms do not have:
Outstanding convertible bonds or convertible preferred stock that can be exchanged for shares of common stock.
Options or warrants that holders can use to acquire common stock.

(Net Income - Preferred Stock Dividends) divided by (Weighted Average Number of Common Shares Outstanding)

For the firms that have Convertible securities and/or stock options or warrants outstanding.
Presents two EPS amounts: Basic EPS & Diluted EPS
Diluted EPS reflects the dilution potential of convertible securities, options, and warrants

(Net Income - Preferred Stock Dividends) + (Adjustments for Dilutive Securities) Divided by (Weighted Average Number of Common Shares Outstanding) + (Weighted Average Number of Shares Issuable from Dilutive Securities)

It does not consider the amount of assets or capital required to generate a particular level of earnings.
Two firms with the same earnings and EPS are not necessarily equally profitable.
The number of shares of common stock outstanding serves as a poor measure of the amount of capital in use.
Despite the above criticisms of EPS as a measure of profitability, it remains one of the focal points of announcements and is frequently used valuing firms.

Simple way of creating greater comparability across firms and for same firm through time.
Most frequently utilized in:
Income statement: by expressing all line items scaled by revenues.
Balance sheet: by expressing all line items scaled by total assets.
Common scaling enables figures across firms and across time to be more comparable.

1- Management, possessing authority, commits to a plan of sale
2- LLA group can be sold immediately in its present condition
3- An active program to locate buyers has commenced
4- Sales of the asset is probable within one year
5- Sales price is reasonable
6- It is unlikely the sales plan will be withdrawn or significantly modifies

-Sold immediately in its present condition
-Sale probable within one year

Subjects the asset to terms that are usual and customary for sale of the assets of this type.
-Example: Condition met at the date a firm commits to a plan to sell a building (transfer will take place after a reasonable time necessary to vacate the building).
-Example: Condition not met when entity commits to a plan to sell a building when the transfer is contingent on the seller constructing and occupying a building at some distant date.

Exceptions to sale within a year are permitted.
-Deferral must be driven by events and circumstances that are beyond the sellers control and that were previously considered to be unlikely

Exit Price, the amount for which a firm could sell an asset or pay to settle or transfer a liability;

In an orderly transaction between market participants;

At the measurement date.

Has an impairment occurred?

Measure the loss.

1- The way the asset is used
2- Its physical condition
3- Changes in the business climate or legal factors
4- Accumulation of costs to construct an asset exceeds the amount originally expected
5- Present likelihood (more likely than not) that LLA will be disposed of significantly before the end of it's previously estimated life.

1- Fundamental Qualitative Characteristics
2- Enhancing Qualitative Characteristics
3- The Cost Constraint

a) Relevance
-Predictive Value
-Confirming Value
-Materiality
b) Faithful Representation
-Completeness
-Neutrality
-Freedom from Error
c) Steps to Apply the Fundamental Qualitative Characteristics

a) Comparability
b) Verifiability
c) Timeliness
d)Understandability

Based on inputs that are readily available via prices for identical assets or liabilities in actively traded markets such as securities exchanges.

Include quoted prices for similar assets or liabilities in active or inactive markets, other observable information such as yield curves and price indexes, and other observable data such as market-based correlation estimates.

Firms's own assumptions about the fair value of an asset or a liability, such as using various data about future cash flows and discount rates to estimate present value.

Acquisition Cost
-Amount paid initially to acquire the asset.
-Includes all costs required to prepare the asset for its intended use.
-Excludes costs to operate the asset
Examples: Land, intangibles with indefinite lives, goodwill, prepayments.

-Service potential is consumed gradually or immediately.
-The asset is reduced and an expense is increased.
Examples: Buildings, equipment and other depreciable assets, intangibles with limited lives.

-Monetary asset or liability.
-Present value computation uses appropriate interest rates .
Examples: Investments in bonds held to maturity, long-term receivables and payables, noncurrent unearned revenue, current receivables and payables.

-FASB – Exit Price; IASB – Exit or Entry Price
-Obtaining the right price – Different Sources of Fair value estimates (3-Tier Hierarchy) described in SFAS No.157 and IFRS No.7
Examples:
Investments in marketable equity and debt securities
Financial instruments and derivative instruments

Includes following items (net of taxes)
-Unrealized changes in the market value of marketable securities, hedged financial instruments and derivatives.
-Foreign currency translation adjustments.
-Changes in pension and other post-employment benefit assets and liabilities.