CFA level 2 study notebook2 2015 1

explainhow accounting for stockgrantsand stock options affects financial statements,and the importance ofcompanies’assumptionsinvaluingthese grantsand options,page116 Thetopicalcoveragec

CFA SCHWESER

2015

EXAM PREP

Financial Reporting and Analysis and Corporate Finance

BOOK 2 - FINANCIAL REPORTING AND

Readingsand LearningOutcomeStatements 3

StudySession5—Financial Reporting and Analysis:

StudySession6-Financial Reporting andAnalysis:IntercorporateInvestments,

Post-Employment and Share-Based Compensation, and Multinational Operations 68

StudySession7 — FinancialReporting and Analysis: Earnings QualityIssues

Self-Test-Financial Reporting and Analysis .213

StudySession8 -CorporateFinance 221

StudySession9-CorporateFinance:Financing and ControlIssues 314

Self-Test-CorporateFinance .394

SCHWESERNOTES™2015CFALEVEL II BOOK 2: FINANCIAL REPORTINGAND ANALYSIS AND CORPORATE FINANCE

©2014Kaplan,Inc.Allrightsreserved

Publishedin2014by Kaplan,Inc

Printedinthe UnitedStatesofAmerica

PPN:3200-5543

If this book does not have the hologram with the Kaplan Schweser logo on the back cover, it was

distributed without permission of Kaplan Schweser, a Division of Kaplan, Inc., and is in direct violation

of global copyright laws Your assistance in pursuing potential violators of this law is greatly appreciated.

Required CFA Institute disclaimer: “CFA Institute does not endorse, promote, or warrant the accuracy

or quality of the products or services offered by Kaplan Schweser.CFA®and Chartered Financial

Certain materials contained within this text are the copyrighted property of CFA Institute.

following is the copyright disclosure for these materials: “Copyright, 2014, CFA Institute Reproduced and republished from 2015 Learning Outcome Statements, Level I, II, and III questions fromCFA®

Program Materials, CFA Institute Standards of Professional Conduct, and CFA Institute’s Global

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Disclaimer: The Schweser Notes should be used in conjunction with the original readings as set forth

by CFA Institute in their 2015 CFA Level II Study Guide The information contained in these Notes

covers topics contained in the readings referenced by CFA Institute and is believed to be accurate.

However, their accuracy cannot be guaranteed nor is any warranty conveyed as to your ultimate exam

success The authors of the referenced readings have not endorsed or sponsored these Notes.

The

READINGS AND

READINGS

Thefollowingmaterialis areviewofthe FinancialReporting andAnalysis,and Corporate

16.Long-livedAssets:ImplicationsforFinancial Statements andRatios

20.Evaluating QualityofFinancial Reports

21.Integration of FinancialStatementAnalysisTechniques

STUDY SESSION 9

ReadingAssignmentsCorporateFinance,CFA ProgramCurriculum,Volume3,LevelII

LEARNINGOUTCOME STATEMENTS (LOS)

topicreview;however, the order may have beenchangedinorderto get abetterfitwith the

flow ofthereview

Thetopicalcoveragecorrespondswith thefollowingCFAInstituteassigned reading:

The candidate should be ableto:

a. calculate andexplainhowinflation and deflation of inventorycostsaffectthe financialstatementsandratiosof companies thatusedifferent inventoryvaluationmethods,(page10)

b explainLIFO

statementsandratios,(page15)

c convert acompany’sreportedfinancialstatementsfromLIFOtoFIFOfor

d describe theimplicationsofvaluinginventoryat netrealisable value for financial

statementsandratios,(page23)

e. analyze andcomparethe financialstatementsandratiosof companies,including

those thatusedifferent inventory valuationmethods,(page25)

f explainissuesthatanalystsshould consider when examiningacompany’s

inventory disclosures and othersourcesofinformation,(page27)

ThetopicalcoveragecorrespondswiththefollowingCFAInstituteassigned reading:

16.Long-livedAssets:ImplicationsforFinancialStatementsandRatios

The candidate should beableto:

a. explain and evaluate how capitalisingversusexpensingcostsin theperiodin

whichtheyareincurred affects financialstatementsandratios,(page34)

b explainandevaluate how the differentdepreciationmethods forproperty,plant,

and equipment affect financialstatementsandratios,(page41)

c. explainand evaluate how impairment and revaluation ofproperty,plant,andequipment, andintangibleassetsaffect financialstatementsandratios,(page46)

d analyze and interpret financialstatementdisclosuresregarding long-livedassets.

(page49)

reserveandLIFOliquidationand theireffectsonfinancial

e. explainand evaluate howleasingrather thanpurchasingassetsaffects financial

statementsandratios,(page51)

f explainand evaluate how finance leases and operating leases affect financial

statementsandratiosfromthe perspectives of both the lessor and the lessee

(page51)

Thetopicalcoveragecorrespondswith thefollowingCFAInstituteassigned reading:

17.IntercorporateInvestments

Thecandidate shouldbe ableto:

a. describe the classification,measurement,and disclosure under International

Financial Reporting Standards(IFRS)for1) investments infinancialassets,

5)specialpurposeand variableinterestentities,(page68)

b distinguishbetweenIFRSandUS GAAP intheclassification,measurement,

and disclosureofinvestmentsin financialassets, investmentsinassociates,

jointventures,business combinations, andspecialpurposeand variableinterest

entities,(page68)

c. analyze how different methods usedto accountfor intercorporateinvestments

affect financialstatementsandratios,(page91)

Thetopicalcoveragecorrespondswith thefollowingCFAInstituteassigned reading:

18.EmployeeCompensation:Post-Employmentand Share-Based

Thecandidate should be ableto:

a. describe thetypesofpost-employmentbenefitplansandimplicationsfor

financialreports,(page103)

b explainandcalculatemeasuresofadefined benefit pensionobligation(i.e.,

presentvalue of the defined benefitobligationandprojectedbenefitobligation)

andnetpensionliability(or asset),(page104)

c. describe thecomponentsofacompany’sdefined benefit pensioncosts.

(page108)

d explainand calculate the effect ofadefined benefitplan’sassumptionsonthe

defined benefitobligationandperiodicpensioncost,(page111)

e. explainand calculate howadjustingforitemsof pension and otherpost¬

employmentbenefitsthatarereportedinthenotes tothe financialstatements

affects financialstatementsandratios,(page113)

f interpret pensionplannotedisclosuresincludingcash flow related information

(page114)

g explainissuesassociatedwithaccountingforshare-based compensation

(page115)

h explainhow accounting for stockgrantsand stock options affects financial

statements,and the importance ofcompanies’assumptionsinvaluingthese

grantsand options,(page116)

Thetopicalcoveragecorrespondswith thefollowingCFAInstituteassigned reading:

19 MultinationalOperations

Thecandidate should be ableto:

a. distinguishamongpresentation (reporting)currency,functionalcurrency,and

localcurrency,(page126)

b describeforeigncurrency transactionexposure,includingaccounting for anddisclosures aboutforeigncurrency transactiongains andlosses,(page127)

c. analyze howchangesinexchangeratesaffectthetranslated sales of the subsidiaryandparentcompany,(page128)

affectstheparentcompany’sbalance sheet andincomestatement,and determinewhich methodisappropriate invariousscenarios,(page128)

e. calculate the translation effects and evaluate the translation ofasubsidiary’s

balance sheet andincomestatementintotheparentcompany’spresentation

currency,(page134)

f analyze how thecurrent ratemethod and thetemporalmethod affect financial

statementsandratios,(page142)

g analyzehow alternative translation methods for subsidiaries operating in

hyperinflationaryeconomiesaffect financialstatementsandratios,(page146)

h describe how multinational operations affectacompany’seffectivetax rate.

(page149)

i explainhowchangesinthecomponentsofsales affect earningssustainability

(page150)

j analyzehowcurrencyfluctuationspotentiallyaffect financial results, givena

company’scountriesof operation,(page151)

STUDY SESSION 7

The topicalcoveragecorrespondswith thefollowingCFA Instituteassigned reading:

20 EvaluatingQuality of Financial ReportsThecandidate should be ableto:

a. demonstrate theuseofaconceptualframework for assessing thequalityofa

company’sfinancialreports,(page165)

b explain potential problemsthat affect thequalityof financialreports,(page166)

c. describehowtoevaluate thequalityofacompany’s financialreports,(page169)

d evaluate thequalityofacompany’sfinancialreports,(page169)

e. describe theconceptofsustainable (persistent) earnings, (page172)

f describe indicators of earningsquality, (page172)

g explainmeanreversioninearnings and how the accrualscomponentof earningsaffectsthespeedofmean reversion,(page174)

h evaluate the earningsqualityofacompany,(page174)

i describe indicators of cash flowquality, (page177)

j evaluate the cash flowqualityofacompany,(page177)

k describe indicators of balance sheet quality, (page178)

1 evaluate the balance sheetqualityofacompany,(page178)

m. describesourcesof information aboutrisk,(page179)

Thetopicalcoveragecorrespondswith thefollowingCFA Instituteassigned reading:

21.Integration of FinancialStatementAnalysisTechniques

The candidate should be ableto:

a. demonstrate theuseofaframework fortheanalysisof financialstatements,

givenaparticular problem,question,orpurpose(e.g., valuingequity basedon

comparables,critiquingacredit rating,obtainingacomprehensive pictureoffinancialleverage, evaluatingthe perspectives given inmanagement’sdiscussion

of financialresults),(page191)

b identifyfinancial reporting choices and biases that affect thequalityand

comparabilityofcompanies’financialstatements,andexplainhow such biases

mayaffect financialdecisions,(page192)

c. evaluate thequalityofacompany’sfinancial data,and recommend appropriate

adjustmentstoimprovequalityand comparabilitywith similarcompanies,

including adjustmentsfor differencesinaccounting standards, methods, and

assumptions,(page206)

d evaluate howagivenchangeinaccounting standards, methods,orassumptions

affects financialstatementsandratios,(page207)

e. analyze and interprethow balance sheet modifications,earnings normalization,

and cash flowstatementrelated modifications affectacompany’sfinancial

statements,financialratios,and overall financialcondition,(page200)

STUDY SESSION 8

Thetopicalcoveragecorrespondswith thefollowingCFA Instituteassigned reading:

22. Capital Budgeting

The candidate should be ableto:

a. calculate theyearlycash flows of expansion andreplacementcapitalprojects,

and evaluate how the choice ofdepreciationmethod affects those cash flows

(page224)

b explainhow inflation affectscapital budgeting analysis, (page231)

c. evaluatecapitalprojects and determine theoptimal capitalprojectinsituations

of1)mutuallyexclusive projects withunequallives,using either the least

commonmultipleoflivesapproachortheequivalentannual annuityapproach,

and2) capitalrationing,(page232)

d explainhow sensitivityanalysis,scenarioanalysis, andMonteCarlosimulation

canbeusedto assessthestand-alone risk ofacapitalproject,(page237)

e. explainand calculate the discountrate,basedonmarket risk methods,to usein

valuingacapitalproject,(page240)

f describetypesofreal options and evaluateacapitalproject using realoptions

(page241)

g describecommoncapital budgeting pitfalls, (page244)

h calculate and interpret accountingincomeandeconomic incomeinthecontext

ofcapital budgeting, (page245)

i distinguishamongtheeconomicprofit,residualincome,and claims valuation

models forcapital budgetingand evaluateacapitalproject using each

(page249)

Thetopicalcoveragecorrespondswith thefollowingCFAInstituteassigned reading:

23 CapitalStructure

Thecandidate should be ableto:

a. explaintheModigliani—Miller propositionsregarding capitalstructure,including

the effects ofleverage,taxes,financial distress,agencycosts,and asymmetric

informationon acompany’scostof equity,costofcapital,andoptimal capital

structure,(page269)

structuremayfluctuatearounditstarget,(page277)

c. describe the role of debt ratings incapitalstructurepolicy, (page277)

d explainfactorsananalystshould considerinevaluatingthe effect ofcapital

structurepolicyon valuation,(page278)

e. describe international differencesintheuseof financialleverage,factorsthat

explainthesedifferences,andimplicationsofthese differences forinvestment

analysis,(page279)

Thetopicalcoveragecorrespondswith thefollowingCFA Instituteassigned reading:

24 Dividends and ShareRepurchases: Analysis

Thecandidate should be ableto:

value givenadescriptionofa corporatedividendaction,(page288)

b describetypesof information(signals) that dividendinitiations, increases,

decreases, andomissions may convey,(page289)

c. explainhow clientele effects andagency issues mayaffectacompany’spayout

policy,(page290)

d explainfactorsthat affectdividendpolicy, (page292)

e. calculate and interpret the effectivetax rate on agivencurrency unitof

corporateearnings under doubletaxation,dividend imputation, andsplit-rate

tax systems,(page293)

payoutpolicies,and calculate the dividend under eachpolicy, (page295)

g explainthe choice between paying cash dividends andrepurchasingshares

(page298)

h describe broad trendsincorporatedividendpolicies, (page301)

i calculate and interpret dividendcoverage ratiosbasedon1)netincomeand

2) free cashflow,(page302)

j identifycharacteristics of companies thatmaynotbe abletosustaintheir cash

dividend,(page302)

Thetopicalcoveragecorrespondswith thefollowingCFAInstituteassignedreading:

25 CorporatePerformance, Governance,andBusinessEthicsThecandidate should be ableto:

stakeholder impactanalysis, (page314)

b discussproblemsthatcanariseinprincipal-agentrelationshipsand mechanismsthatmaymitigate suchproblems, (page316)

c. discussrootsofunethical behavior and howmanagersmightensurethat ethical

JusticeTheoriesasapproachestoethical decisionmaking, (page318)

Thetopicalcoveragecorrespondswith thefollowingCFAInstituteassigned reading:

26.CorporateGovernance

Thecandidate should be ableto:

a. describeobjectivesandcoreattributes ofaneffectivecorporategovernance

system,and evaluate whetheracompany’scorporategovernancehas those

attributes,(page325)

b comparemajor businessforms,and describe the conflicts ofinterestassociated

witheach,(page326)

c. explainconflictsthatarisein agencyrelationships, including manager-share¬

holder conflicts and director-shareholderconflicts,(page327)

d describeresponsibilitiesofthe board of directors, andexplainqualificationsand

corecompetencies thataninvestmentanalystshould look forintheboard of

directors,(page329)

e. explaineffectivecorporategovernancepracticeasitrelatestothe board of

directors,and evaluatestrengthsand weaknesses ofacompany’scorporate

f describe elements ofacompany’sstatementofcorporategovernancepoliciesthat

g describe environmental, social, andgovernanceriskexposures,(page332)

h explainthevaluationimplicationsofcorporategovernance,(page334)

Thetopicalcoveragecorrespondswith thefollowingCFA Instituteassigned reading:

11.Mergers andAcquisitions

The candidate should beableto:

a. classifymergerand acquisition(M&A) activitiesbasedonforms of integration

and relatedness of businessactivities,(page344)

b explaincommonmotivationsbehindM&A activity,(page345)

c. explain bootstrappingof earningspershare(EPS)and calculateacompany’s

postmergerEPS.(page348)

d explain,basedonindustry lifecycles,the relation betweenmerger motivations

andtypesofmergers,(page350)

e contrastmerger transactioncharacteristics by form ofacquisition,methodof

payment,and attitude oftarget management,(page351)

f distinguishamongpre-offerandpost-offertakeover defense mechanisms

(page354)

g calculate and interpret the Herfindahl-Hirschman Index, and evaluate the

likelihood ofanantitrustchallengeforagiven businesscombination,(page357)

disadvantagesofeach,(page371)

i calculate free cash flows fora targetcompany,andestimatethecompany’s

comparabletransactionanalyses, (page364)

k evaluateatakeover bid, and calculate the estimated post-acquisition value of

anacquirer and the gains accruedtothetargetshareholdersversusthe acquirer

shareholders,(page372)

1 explainhow price andpaymentmethod affect the distribution of risks and

benefitsin M&Atransactions,(page376)

m. describe characteristics ofM&Atransactionsthatcreate value,(page377)

n. distinguishamongequitycarve-outs,spin-offs, split-offs,andliquidation

(page377)

o. explaincommon reasonsfor restructuring,(page378)

learning outcome statements set forth by CFA Institute This topic is also covered in:

EXAM FOCUS

This topicreviewdiscusses the analysis of inventory given the differentcostflowmethods:FIFO, LIFO,andweightedaveragecost.Youmustunderstand how eachmethod affects the firm’sliquidity, profitability,activity, andsolvencyratios.Also, beabletomake the appropriate financialstatementadjustmentsforLIFO firms, LIFO

liquidations, andinventorywrite-downs

INVENTORYACCOUNTING

The choice of inventorycostflowmethod(knownasthecostflow assumption under

sheet, andmanyfinancialratios.Additionally,thecostflowmethodcanaffectthe firm’s

RecallfromLevelIthatcostofgoods sold(COGS) isrelatedtothebeginningbalance

ofinventory,purchases,andtheendingbalance ofinventory

COGS=beginninginventory+purchases—endinginventory

endinginventory=beginninginventory+purchases—COGS

particularvaluation methodincreasesthe value ofendinginventory, the COGS would

belower under that method

LOS 15.a:Calculateandexplainhow inflation and deflation of inventory

costsaffectthe financialstatementsandratiosof companies thatusedifferentinventory valuationmethods.

CFA®ProgramCurriculum,Volume2,page8

If thecostof inventoryremainsconstant overtime,determiningthe firm’sCOGSand

endinginventoryissimple.TocomputeCOGS,simply multiplythenumber ofunits

soldby thecostper unit.Similarly,to computeendinginventory, multiply the number

However, it islikelythat,overtime,thecostofpurchasingorproducinginventorywill

change.Asaresult, firmsmustselecta costflowmethodtoallocate the inventorycost to

UnderIFRS,thepermissible methodsare:

• Specificidentification

• Weightedaveragecost.

Thesame costflowmethodsarealso allowed underU.S GAAP However, U.S GAAP

also permits theuseofthe last-in,first-out(LIFO)method.LIFO isnotallowedunder

IFRS

Professor’sNote:With theexpectedconvergenceofU.S GAAPandIFRSlater

thisdecade, LIFOwillnolongerbepermittedin theUnitedStates

Specific Identification Method

Under the specific identificationmethod,eachunitsoldismatchedwith the unit’s

actualcost.Specificidentificationisappropriate when inventoryitemsare not

interchangeableandiscommonlyusedbyfirmswithasmall number ofcostlyandeasily

distinguishableitems,suchas jewelryand automobiles.Specificidentificationisalso

appropriate forspecialordersorprojects outsideafirm’snormalcourseofbusiness

FIFOMethod

Under theFIFOmethod, the firstitempurchasedisthe firstitemsold Theadvantage

ofFIFOisthatendinginventoryisvalued basedonthemost recentpurchases, arguably

the best approximation ofcurrent cost.Conversely,FIFO COGS isbasedonthe earliest

purchasecosts.Inaninflationaryenvironment,COGSwillbe understatedcomparedto

current costand,as aresult, earningswillbe overstated

LIFOMethod

Under theLIFOmethod,theitempurchasedmostrecentlyisassumedtobe the first

itemsold.Inaninflationaryenvironment,LIFO COGSwillbehigherthanFIFO

whichincreasethe operating cash flow UnderLIFO,endinginventoryonthe balance

sheetisvalued using the earliestcosts.Therefore, inaninflationaryenvironment, LIFO

endinginventoryisless thancurrent cost.

Asdiscussedpreviously,LIFO ispermittedunderU.S GAAPbutisnotallowed under

conformitybetween financial reporting andtaxreporting standardsisrequired

Theincometaxadvantagesof using LIFOexplainitspopularityamong U.S.firms.

earningsaregenerallylower thanFIFOearnings This resultsinthepeculiarsituation

where lowerreportedearningsareassociated withhighercashflowfromoperations

Weightedaveragecostisasimpleandobjectivemethod Theaveragecostper unitofinventoryiscomputedby dividing the totalcostofgoods available for sale (beginninginventory+purchases) bythe total quantity available for sale TocomputeCOGS,the

endinginventory, theaveragecostper unit ismultipliedby the number ofunitsthat

remain

Duringinflationaryordeflationaryperiods,theweightedaveragecostmethodwillproduceaninventory value between thoseproducedbyFIFOandLIFO

Figure1 :InventoryCostFlow Comparison

Consistsof Consistsof

FIFO (U.S.andIFRS)

Theitemsfirst

purchasedarethe first

to be sold.

The itemslast

average costofallitems

average costofallitems

Weightedaverage cost

(U.S.andIFRS)

Example:Inventorycostflowmethods

Usethe inventory datainthefollowing figuretocalculate thecostofgoodssold and

endinginventory under theFIFO, LIFO,andweightedaveragecostmethods

Inventory Data

Costofgoodsavailable

UnitssoldduringJanuary

FIFOcostofgoodssold Value thesevenunitssoldattheunitcostofthe firstunits

purchased.Startwith the earliestunitspurchasedand work down,asillustratedinthe

following figure

Frombeginninginventory

Fromfirstpurchase

Fromsecondpurchase

FIFOcostofgoodssold

Endinginventory

LIFOcostofgoodssold Value thesevenunitssoldattheunitcostof the lastunits

purchased.Start with themostrecentlypurchasedunitsand workup,asillustratedin

thefollowing figure

Fromsecondpurchase

Fromfirstpurchase

LIFOcostofgoodssold

Endinginventory

Averageunitcost

Weightedaveragecostofgoodssold 7units@$3.80 per unit=

Notethat prices and inventory levelswererisingovertheperiodand thatpurchases

duringtheperiodwerethesamefor allcostflowmethods

Duringinflationaryperiodsand stableorincreasing inventoryquantities, LIFO COGS

ishigherthanFIFO COGS.Thisisbecause the lastunitspurchasedhaveahighercost

than the firstunitspurchased.UnderLIFO,themorecostlylastunitspurchasedarethefirstunitssold(to COGS).Ofcourse,higherCOGSwillresultinlowernetincome

Using similarlogic,we can seethatLIFOendinginventoryislower thanFIFOending

inventory.UnderLIFO,endinginventoryisvalued using older, lowercosts.

Duringdeflationaryperiodsand stableorincreasing inventoryquantities, thecostfloweffects of usingLIFOandFIFOwill bereversed;thatis, LIFO COGSwill be lower and

LIFOendinginventory will behigher.This makessensebecause themost recentlower

costpurchasesaresold firstunderLIFO,and theunits inendinginventoryareassumed

tobe the earliestpurchaseswithhighercosts.

Figure2:Inventory Valuation andCOGSUnder DifferentEconomic Environments

(Assuming StableorRisingInventory)

Economic

Inaperiodicsystem,inventory values andCOGSaredeterminedatthe end of theaccountingperiod.Inaperpetualsystem,inventoryvalues andCOGSareupdatedcontinuously

Inthecaseof FIFOand specificidentification,endinginventoryvalues andCOGS

arethesamewhetheraperiodicorperpetualsystemisused.Conversely,therecanbe

significantdifferencesininventory values andCOGSwhen usingweightedaveragecost

and LIFO basedonthesystemused

Ratios

costflowmethodcanhaveasignificantimpactonprofitability, liquidity,activity,andsolvency.Inthenextsection,wewilldiscuss theadjustmentsnecessarytocomparefirmswith differentcostflowmethods

financialstatementsandratios

reserveandLIFOliquidationand their effectson

CFA®ProgramCurriculum, Volume2,page12

LIFOReserve

When pricesarechanging,LIFOandFIFOcanresultinsignificantdifferencesin

endinginventoriesandCOGS,therebymakingitdifficulttomakecomparisonsacross

different firms.Aspreviouslydiscussed, therearealso valuationproblemswithLIFO

analyticaland comparisonpurposes, it is necessaryto convertthe LIFO valuestoFIFO

values

Professor’sNote:Analysts don’t typicallyconvertfromweightedaveragecost to

FIFObecause thenecessarydetailis notusuallydisclosed

todisclose the LIFOreserveinthe footnotes The LIFOreserveisthe difference between

LIFOinventory andFIFOinventory:

LIFOreserve =FIFOinventory-LIFOinventory

Therefore:

FIFOinventory=LIFOinventory+LIFOreserve

Figure3illustrates thataddingtheLIFOreserve totheLIFOinventory yieldsFIFO

inventory Remember, FIFOisalways preferredfromabalancesheet perspectivesince

FIFOinventoryisbasedon most recent costs.

Figure3: LIFO Reserve

FIFO

INVENTORY Invent.LIFO

LIFO Reserve

+

OncetheLIFOinventoryisconvertedtoFIFOinventory, theaccountingequation

adjuststockholders’ equity by theLIFOreserve, netoftax.Theincometaxadjustment

taxeswouldhave beenhigher.So, uponconversion toFIFO,weincludethetaxes.

Forexample,saythe LIFOreserveis $150,and thetax rateis40% Toconvertthe

balance sheettoFIFO, increaseinventorybythe$150 LIFOreserve,decrease cashby

$60($150LIFOreserve x40%taxrate),andincreasestockholders’ equity(retained

earnings) by$90[$150 reserve x (1 -40%taxrate)].Thiswillbringthe accountingequation backintobalance Theneteffect oftheadjustmentsisanincrease inassetsandshareholders’ equity of$90,whichisequaltothe LIFOreserve, netoftax.

Professor’sNote:Afirm’s effectivetax rateislikelytovaryfromyeartoyear

Asaresult,itmay be necessaryto computetheincometaxadjustmentusinga

combinationofrates. Thisconceptisillustratedinacomprehensive example

laterinthissection

Forcomparisonpurposes, it isalsonecessaryto converttheLIFOfirm’s COGStoFIFO

COGS.ThedifferencebetweenLIFOCOGSandFIFOCOGSisequaltothechange

intheLIFOreservefor theperiod.So,to convertCOGSfromLIFOtoFIFO,simply

subtract thechangein theLIFOreserve:

FIFO COGS=LIFOCOGS-(endingLIFOreserve -beginningLIFOreserve)

Assuming inflation, FIFO COGSislower than LIFOCOGS,sosubtractingthechange

intheLIFOreserve(thedifferencein COGSunder thetwomethods)fromLIFOCOGSmakesintuitivesense.When pricesarefalling,westill subtract thechangeintheLIFOreserve to convertfrom LIFO COGStoFIFOCOGS Inthiscase,however,the

changeinthe LIFOreserveisnegative andsubtractingitwillresultinhigherCOGS

This again makessense.When pricesarefalling,FIFO COGSare greaterthanLIFOCOGS

Professor’sNote:Ideally,wewouldpreferto convertfromFIFO COGSto

LIFO COGSforanalyticalpurposes.LIFO COGSisabetter representation

Example: Converting endinginventory and COGSfromLIFOtoFIFO

Sipowitz Company, whichusesLIFO,reported end-of-yearinventory balances of$500

in20X5 and$700 in 20X6.TheLIFOreserve was$200for 20X5 and$300for20X6

COGSduring20X6was$3,000.Convert20X6endinginventory and COGSto a

Let’stakealookat a morecomprehensive example.

Example:Convertingfrom LIFOtoFIFO

Viper Corp.isahigh-performancebicycle manufacturer.Viper’sbalancesheets for 20X5

statement werepreparedusingLIFO.Calculatethecurrent ratio,inventoryturnover,long¬

termdebt-to-equityratio,grossprofit margin,netprofit margin, andreturn on assetsratio

for20X6forbothLIFOandFIFOinventorycostflowmethods

ViperBalanceSheet

(PreparedusingLIFO)

ViperIncome Statement

(PreparedusingLIFO)Revenue

Costofgoodssold

210

$60

20X5

effectivetax rate was 20%.

Answer:

Thecurrentratio(current assets /currentliabilities)underLIFO is$630/$325 =1.9

Toconvert toFIFO,the20X6 LIFOreserveof$100 isaddedto current assets

(inventory) andincometaxes ontheLIFOreserveof$21aresubtracted from cash

Theincome taxes onthe 20X6 LIFOreserve arecalculatedat ablendedrate asfollows:

=2.2.Thecurrentratio ishigher underFIFOasendinginventorynowapproximates

current cost.

©2014Kaplan,Inc.

The inventoryturnoverratio (COGS/averageinventory) underLIFOis $3,000/

Toconvert toFIFOCOGS, it is necessarytosubtract thechangeintheLIFOreserve

beginningreserve =$10

ToconvertLIFO averageinventoryto FIFO,theaverage LIFOreserveisaddedto

Alternatively,we cancalculateaverage FIFOinventorybyaveraging thebeginning

andendingFIFOinventory:($290beginningLIFOinventory+$90beginningLIFO

reserve +$310endingLIFOinventory+$100endingLIFO reserve)/2 =$395

Thus, underFIFO,inventoryturnoveris($3,000 - 10changeinLIFOreserve)/

($300 + $95average LIFOreserve) =7.6 Inventoryturnoverislower underFIFOdue

tohigheraverageinventory in the denominator and lowerCOGSin thenumerator

(assuminginflation)

Long-termdebt-to-equityratio

Thelong-term debt-to-equityratio(long-termdebt / stockholders’ equity) under

Toconvert toFIFO,the 20X6LIFOreserve, netoftax,isaddedtostockholders’

equity Theadjustmenttostockholders’ equityis necessarytomakethe accounting

equation balance The20X6LIFOreserveof$100wasaddedtoinventory and

stockholders’ equity

Thus, underFIFO,long-term debt-to-equityis $715 /($1,030 +$79ending

LIFOreserve, netoftax)=0.6447.Long-termdebt-to-equityislower underFIFO

(assuminginflation)becausestockholders’equityishigher,since itreflects the effects

ofbringingtheLIFOreserve ontothe balance sheet

25.0%

Toconvert toFIFO grossprofitmargin, the$10changeintheLIFOreserveis

subtracted fromLIFO COGS.Thus,underFIFO, grossprofitmarginis($1,000 +

$10changein LIFO reserve)/$4,000=25.3% Grossprofitmarginishigherunder

FIFObecause COGSislower under FIFO

NetprofitmarginThenetprofitmargin(net income/revenue)underLIFO is $210 / $4,000=5.3%.

Toconvert toFIFOnetprofitmargin, subtract the$10changein theLIFOreserve

fromLIFOCOGSto getFIFO COGSandincrease incometaxes$3 ($10 increase

inreserve x30%taxrate).Theincrease in incometaxesisthe result ofapplyingthe20X6tax rate totheincrease intaxableprofit(lower COGS)

less under FIFO (assuminginflation)

Professor’sNote: Wedidnotrecognize theentiretaxeffect ofthe 20X6LIFO

reserveinthe 20X6incomestatement. ThechangefromLIFOtoFIFO is

handledretrospectively.Inotherwords,hadwebeen usingFIFO allalong,

theresulting highertaxeswould have already been recognizedinthe previousyears’incomestatements.

Toconvert toFIFOreturn on assets,LIFOnet income isincreasedbythechangein

the LIFOreserve, netoftax. Thus, FIFOnetincome isequalto$210+$10change

inreserve -$3taxes =$217

ToconvertLIFO averageassets,add thebeginningandendingLIFOreserves,

tax, tototalassets.Thus, FIFOaverageassetsisequalto ($2,07020X6assets +$79

20X6reserve, netoftax +$1,94020X5assets +$7220X5reserve, netoftax)12=

$2,081.

netof

Thus,the FIFOreturn on assetsis $217/$2,081=10.4%.Inthisexample,the firm

isslightlylessprofitableunderFIFObecause theincreasein FIFOnetincome ismore

than offset by theincreaseinFIFOaverageassets.Thisisnotalways thecase.

Recall that theLIFOreserveisequaltothe difference betweenLIFOinventory and

FIFOinventory TheLIFOreservewillincreasewhen pricesarerising and inventoryquantitiesarestableorincreasing If the firmisliquidatingitsinventory,orif pricesare

falling,the LIFOreservewilldecline

profitmargins andhigherincometaxes.Note,however,that thehigher profitis

artificial (phantom) becauseit isnotsustainable Thefirmcannotliquidateitsinventory

indefinitelybecauseitwilleventuallyrun outofgoodstosell.Youcanthink ofaLIFO

liquidationasfinallyrecognizing previouslyunrecognizedinventory gainsintheincome

statement.

Obviously,firmscandeliberatelyincreaseearningsby simply liquidatingthe older, lower

costinventory andnotreplacingthe inventory.However,LIFOliquidationscanalso

result from strikes,recessions,ordecliningdemand fromcustomers.

TheanalystshouldadjustCOGS for thedeclineinthe LIFOreservecausedbyadecline

ininventory.FirmsmustdiscloseaLIFOliquidationinthe financialstatementfootnotes

tofacilitatetheadjustment

Example:LIFOliquidation

Atthebeginningof20X8,Big 4ManufacturingCompany had560unitsof inventory

produced.Compute the artificial(phantom) profitthat resulted from theliquidation

pretaxprofitwashigherby$860.Thehigher profitisunsustainable because Big 4will

eventuallyrun outof inventory

LOS 15.c:Convertacompany’s reportedfinancialstatementsfromLIFOto

FIFOforpurposesof comparison

CFA®ProgramCurriculum,Volume2,page12

adjustmentsfor comparativepurposes Inaddition,analystsmayneedtomakeadjustmentsinadvance ofananticipatedchangeininventory method.Forexample,if

U.S.firmsadoptIFRSasexpected,LIFOinventory accounting willdisappear

Theadjustmentsfor comparativepurposesaregenerallymaderetrospectively.This

meansthe prioryearfinancialstatements are recastbasedonthenew costflow method

Thecumulative effect of thechangeisreportedas anadjustmenttothebeginning

retained earnings of the earliestyearpresented

Forexample,returningto ourearlierLIFOadjustmentexample,theanalystwouldrecast

Figure 4: Viper Balance Sheet

(AdjustedfromLIFOto FIFO)Assets

409 252

i

Subtract taxes on LIFO reserveof$21 and $18for20X6 and 20X5,respectively

3AddLIFO reserve (netoftax)of$79and$72for 20X6and20X5,respectively

reserve

(Adjustedfrom LIFOto FIFO)

$1,010

650360

5031093Net income

217

$60

4 Subtract $10changein reservefor20X6.

5Add$3 taxes onchangein the reserve for 20X6.

The effectsof the adjustments confirmourunderstandingof the differencesinLIFO

balance sheet.Higherinventory resultsinhighercurrent assetsandhighertotalassets.

TheadjustmenttoCOGSalso confirmsourunderstanding.FIFO COGS isloweras

comparedto LIFO(assuminginflation)because underFIFO the lowercostunitsare

soldfirst.LowerCOGSresultsinhighernetincome

for financialstatementsandratios

CFA®ProgramCurriculum, Volume2,page23

The inventorycostflowmethod shouldnotbe confused with the inventory valuation

method The valuation methodisusedindeterminingthe carrying valueonthe balance

sheet andintesting inventory for impairment

UnderIFRS,inventoryisreportedonthe balance sheetatthe lowerofcost or net

realizable value.Netrealizable valueisequaltothe estimated sales price less the

estimatedsellingcostsandcompletioncosts.Ifnetrealizable valueislessthanthe

balance sheetcost,the inventoryis“writtendown”to netrealizable value andaloss

isrecognizedintheincomestatement.Ifthereisasubsequentrecoveryinvalue,

the inventorycanbe “writtenup”andagainisrecognizedintheincomestatement.

However,theamountofanysuch gainislimitedtotheamountpreviously recognizedas

aloss.Inotherwords,inventorycannotbereportedonthe balance sheetat an amount

that exceedsoriginalcost.

UnderU.S GAAP,inventoryisreportedonthe balance sheetatthe lowerofcost or

market Marketisusuallyequaltoreplacementcost;however,marketcannotbegreater

thannetrealizable value(NRV) orless than NRVminusanormalprofitmargin If

replacementcostexceedsNRV,then marketis NRV.Ifreplacementcostisless than

LO

c

.2 Professor’sNote:Thinkoflowerofcost ormarket, where “market”cannot

be outsidearangeofvalues Therange isfromnetrealizable valueminusa

normalprofitmarginto netrealizable value.Sothesizeoftherangeisthenormalprofitmargin “Net”meanssalesprice lesssellingandcompletioncosts.

thenew costbasis

Example:Inventory writedownZoom,Inc.sellsdigitalcameras.Per-unitcostinformation pertainingtoZoom’s

$210

Originalcost

Estimatedsellingprice $225

Netrealizable value $203

UnderIFRS, inventoryisreportedonthe balancesheetatthelower ofcost or net

realizable value.Sinceoriginalcostof$210exceedsnetrealizablevalue($225 -$22=

$203),theinventory is writtendowntothenetrealizable valueof$203anda $7loss

($203 netrealizable value— $210originalcost) isreportedintheincomestatement.

UnderU.S GAAP,inventoryisreportedatthe lower ofcost ormarket.Inthiscase,

greaterthanreplacementcost,andnetrealizable valueminusanormalprofitmargin

($203 —$12= $191)isless thanreplacementcost.Sinceoriginalcostexceeds market(replacementcost),the inventoryis writtendownto$197anda$13loss($197

replacementcost - $210originalcost) isreportedintheincome statement.

Example:Inventorywrite-upSuppose thatintheyearafterthe writedownin thepreviousexample,netrealizablevalue andreplacementcostbothincreaseby$10.Whatisthe impact of therecovery

UnderIFRS,Zoomwillwrite upinventoryto$210 per unitand recognizea$7gain

$7.The carrying valuecannotexceedoriginalcost.

UnderU.S GAAP,

write-upisallowed The per-unit carrying value willremainat

no

Recall thatLIFOendinginventoryisbasedonolder,lowercosts(assuminginflation)as

comparedtoFIFO.Sincecostisthe basisofdeterminingwhetheranimpairment has

occurred,LIFOfirmsarelesslikelytorecognize inventory write-downsascomparedto

firms using FIFOorweightedaveragecost.

Analystsmustbeawareof howaninventory write-down,orwrite-up, affectsafirm’s

currentand futureperiods.Thus,comparabilitywith previousperiodsmaybeanissue

Reporting inventory above historicalcostispermittedunderIFRSandU.S GAAPin

likeproducts,suchasagriculturaland forestproducts,mineralores,and precious metals

Under this exception, inventoryisreportedat netrealizable value, and the unrealized

gains and losses fromchangingmarket pricesarerecognizedintheincomestatement.If

an activemarketexistsforthecommodity,thequotedmarketpriceisusedtovaluethe

inventory.Otherwise,recentmarkettransactionsareused

LOS15.e:Analyzeandcomparethe financialstatementsandratiosof

CFA®ProgramCurriculum, Volume2,page23

canbe summarizedinFigure5

The differencesin LIFOandFIFO

Figure5:LIFOandFIFOComparison—Assuming Inflation and StableorIncreasing

Quantities

lower taxes

lower net income (EBTandEAT)

lowerinventory balances

highercash flows(less taxespaidout)

lower netandgrossmargins

higherinventoryturnover

higher debt-to-equity

higherinventory balances

higher workingcapital(CA — CL)

highercurrent ratio

lowerdebt-to-equity

Afirm’s choice of inventorycostflowmethodcanhaveasignificantimpacton

profitability, liquidity, activity, and solvency

LO

c

.2 Professor’sNote:Thepresumptioninthissection isthat pricesarerising and

inventoryquantitiesarestableorincreasing

profitmarginsascomparedtoFIFO

Liquidity

AscomparedtoFIFO, LIFOresultsinalower inventory valueonthe balance sheet

measureofliquidity,isalso lowerunderLIFOthan underFIFO.Workingcapitalis

lower underLIFOaswell,becausecurrent assets arelower

ActivityInventoryturnover(COGS/averageinventory)ishigherfor firmsthatuseLIFO

comparedtofirmsthatuseFIFO.UnderLIFO, COGS isvaluedat more recent,

highercosts(highernumerator),while inventoryisvaluedatolder,lowercosts(lower

hand(365/ inventoryturnover)

Solvency

LIFOresultsinlowertotalassetscomparedtoFIFO, since LIFOinventoryislower

debt-to-equityratioarehigherunderLIFOcomparedtoFIFO

Professor’sNote:Anotherwayofthinkingabout the impactofLIFOon

stockholders’ equityisthat becauseLIFO COGS ishigher,netincome islower

comparedtoFIFOstockholders’ equity

Let’sreturn tothe earlierLIFOadjustment example.Forcomparisonpurposes,the

followingtablesummarizesourfindings.Notethe results of Viper’speergrouphavebeenincluded foranalyticalpurposes

©2014Kaplan,Inc.

Figure 6:RatioAnalysis

Current ratio

Grossprofitmargin

Liquidity:The after-tax LIFOadjustmentresultedinanincrease inViper’scurrentratio

Theadjustedratioexceeds thepeergroupindicatinggreaterliquidity.Sinceinventoryis

thelargestcomponentofViper’scurrent assets,additional analysisisneeded

Activity:Viper’s adjusted inventoryturnoverdeclinedasexpectedduetothe decreasein

COGSand theincrease in averageinventory.Adjustedinventoryturnoverisless than

inventorydays(365 /inventoryturnover),Viper has 48.0daysof inventoryonhand

while thepeergroup has 37.2daysonhand Too much inventoryiscostlyandcanalso

beanindication of obsolescence

Solvency:Viper’s adjusted long-term debt-to-equityratioof0.6 is inline with thepeer

group

Profitability:Asexpected, Viper’sadjustedgrossprofit andnetprofitmarginratios

increased because COGSislower underFIFO However,theadjustedmarginratiosare

significantlyless than thepeergroup’sratios.Coupledwith loweradjustedinventory

turnover,Viper’slowergrossprofitmarginmaybeanindication that Viperislowering

sales pricesto moveitsinventory Thisisanotherindication thatsomeofViper’s

inventorymaybe obsolete.Aspreviouslydiscussed, obsolete(impaired) inventorymust

be written-down

LOS15.f: Explainissues thatanalystsshouldconsiderwhen examininga

CFA®ProgramCurriculum, Volume2,page 29

Merchandisingfirms,suchaswholesalersandretailers,purchaseinventory thatisready

forsale.Inthiscase,inventoryisreportedinone account onthe balance sheet.On

the other hand,manufacturingfirmsnormallyreportinventory using threeseparate

accounts: rawmaterials,work-in-process,and finishedgoods Analystscan usethese

disclosures,alongwith othersourcesofinformation,suchasManagement’sDiscussion

andAnalysis,as asignalofafirm’s futurerevenuesand earnings

Forexample,anincreaseinrawmaterialsand/orwork-in-processinventorymaybean

indicationofanexpectedincreaseindemand.Higher demand should resultinhigher

revenuesand earnings Conversely,anincreasein finishedgoodsinventory, while

rawmaterials andwork-in-processaredecreasing,maybeanindication ofdecreasing

demand

Analystsshould alsoexaminetherelationshipbetween sales and finishedgoods.Finished

goodsinventory thatisgrowing faster than salesmaybeanindicationofdeclining

demand and,ultimately,excessiveorpotentiallyobsolete inventory Obsolete inventory

willresult in lower earnings in the futureasthe inventoryiswritten-down In addition,

toomuch inventoryiscostlyasthe firmincursstorage costs,insurance,and inventory

taxes.Toomuch inventory alsousescash thatmightbemoreefficientlyused somewhere

else

KEY CONCEPTS

inventoryisbasedonthecostofthemost recentpurchases,thereby approximating

current cost.

inventoryisbasedonthecostofthe earliestitemspurchased.Assuminginflation,

endinginventoryissmaller andCOGSislargercomparedtothosecalculated using

prohibitedunderIFRS

• Weightedaveragecost:COGSand inventory valuesarebetween theirFIFOand

LIFOvalues

• Specific identification: Eachunitsoldismatchedwith the unit’s actualcost.

TheLIFOreserveisthe differencein FIFOendinginventory andLIFOending

inventory.It isusedtoadjusttheLIFOfirm’sendinginventory andCOGSbackto

FIFOfor comparisonpurposes

islowerCOGSandhigher profit.However,theincrease inprofitisnotsustainableonce

thecurrentinventoryisdepleted

ToadjustaLIFO firm’s financialstatements toreflecttheFIFOcostflowmethod:

• Add theLIFOreserve to current assets(ending inventory)

• Subtract theincometaxes ontheLIFOreservefromcurrent assets(cash)

• Add theLIFOreserve, netoftax, toshareholders’ equity

• SubtractthechangeintheLIFOreservefrom COGS

• Add theincometaxes onthechangeintheLIFOreserve toincometaxexpense

LOS 15.d

UnderIFRS, inventoriesarevaluedatthe lower ofcost or netrealizable value Inventory

“write-ups”areallowed,but onlytotheextentthataprevious write-downto net

realizable valuewasrecorded

UnderU.S.GAAP,inventoriesarevaluedatthe lower ofcost ormarket Marketis

usuallyequaltoreplacementcostbutcannotexceednetrealizable valueorbe less than

netrealizable valueminusanormal profit margin.Nosubsequent“write-up”isallowed

LOS 15.e

Assuming inflation and stableorincreasing inventoryquantities:

LIFO results in FIFO results in.

lower taxes

lower net income

lower inventory balanceslowerworking capital

lower netandgrossmargins

higher debt-to-equity

higherinventory balanceshigher working capitallower cash flows (more taxes)

highercurrent ratio lowerinventoryturnover

lowerdebt-to-equity

anexpectedincrease indemand.Conversely,anincrease infinishedgoodsinventory,whilerawmaterials andwork-in-processaredecreasing,maybeanindicationof

12 29

• BeginningLIFOreserve $12,000.

• EndingLIFOreserve $15,000.

• Effectivetax rate40%

4 Kamp,Inc.,sellsspecializedbicycle shoes.Atyear-end, dueto asudden

Theoriginalcostis $43,and thecurrentsellingpriceis $50.Thenormal

profit marginis 10%ofthe selling price, and the sellingcosts are$3perpair

AccordingtoU.S GAAP,which of thefollowingamountsshould each pair of

shoesbereportedonKamp’syear-end balance sheet?

A $42

B $43

C $47

Allelseequal,inperiodsof rising prices and stable inventory levels, which of the

followingstatementsismost accurate?

A FIFOfirmshavehighercash flow from operations than otherwise identical

B Adecreaseinwork-in-process inventory andanincrease infinishedgoodsin

thecurrentperiod

C Inventorygrowththat currently exceeds salesgrowth

6

ANSWERS - CONCEPT CHECKERS

1 B Under LIFO, the last unitspurchasedare the first units sold.

2 A

FIFO net income = LIFO net income +[(endingreserve —beginningreserve) x (1 — tax

rate)] = $125,000 + [(15,000 - 12,000) x 60%] = $126,800

3 C

range The upper bound is net realizable value (NRV), which isequalto theselling

price ($50) lesssellingcosts ($3) for a NRV of $47 The lower bound is NRV ($47)

recorded at cost of $43.

6 A An increase in rawmaterialsinventory may be anindicationof anexpectedincrease in

learning outcome statements set forth by CFA Institute This topic is also covered in:

EXAMFOCUS

profitability, trends,ratios,and cash flow classifications.Youmustunderstand the effects

the effects of thedifferentdepreciationmethods and be abletodetermine ifan assetis

impaired.Finally,you mustthoroughlyunderstand how the classification ofaleaseas

eitheranoperatingorfinancelease affects the balance sheet,incomestatement,and cashflowstatementofboth the lessee and the lessor

CFA®Program Curriculum,Volume2,page 50Whenafirmmakesanexpenditure,itcaneithercapitalizethecost as an asset onthebalance sheetorexpensethecostintheincomestatementintheperiodincurred.Asa

generalrule,anexpenditurethatisexpectedtoprovideafutureeconomicbenefitover

multipleaccountingperiodsiscapitalized;but if the futureeconomicbenefitisunlikely

orhighlyuncertain,theexpenditureisexpensed

Anexpenditurethatiscapitalizedisinitially recordedonthe balance sheetat cost,

presumablyitsfairvalueatacquisition,plusanycostsnecessarytoprepare theasset

foruse.Except for land andintangibleassetswith indefinite lives(suchasacquisition

goodwill),thecostisthenallocatedto theincomestatement overthe life of theasset as

depreciationexpense (fortangibleassets)oramortization expense (forintangibleassets

with finitelives)

Alternatively,ifanexpenditureisexpensed,currentperiodnetincomeisreduced by the

Althoughit maymakenooperationaldifference,the choice betweencapitalizingandexpensing will affectnetincome,shareholders’ equity, totalassets,cash flow fromoperations, cash flow from investing, andnumerousfinancialratios

Net Income

Capitalizinganexpendituredelays the recognition ofexpense intheincomestatement.

Thus,intheperiodthatanexpenditureiscapitalized,the firmwillreporthighernet

incomecomparedtoexpensing.Insubsequent periods,the firmwillreportlowernet

statementthroughthedepreciationoramortization expense.This allocationprocess

reduces thevariabilityofnetincomeby spreadingtheexpenseovertime

Professor’sNote: Forfirmsinanexpansionphase, capitalizing expenditures

mayresultinearningsthatarehigherovermanyperiods comparedto an

expensingfirmbecause theamountofdepreciationfrompreviously capitalized

expendituresisless than theamountofadditionalcoststhatarebeing newly

capitalized

Conversely,ifafirmexpensesanexpenditureinthecurrentperiod,netincome is

reducedbythe after-taxamountoftheexpenditure.Insubsequent periods,noallocation

wascapitalized

Overthe life ofan asset, totalnetincomewillbeidentical.Timing of theexpense

recognitionintheincomestatementistheonlydifference

Shareholders’ Equity

comparedtoexpensing,italso resultsinhigher shareholders’equity(retainedearnings)

Asthecostisallocatedtotheincomestatementinsubsequent periods,netincomewill

be reducedalongwith shareholders’ equity(retainedearnings).Totalassets arehigher

withcapitalization,and liabilitiesareunaffected,sothe accounting equation(A=L+E)

Iftheexpenditureisexpensed,shareholders’ equity(retainedearnings) willreflectthe

Acapitalized expenditureisusuallyreportedin the cash flowstatement as anoutflow

from investingactivities.Ifexpensed,theexpenditureisreportedas anoutflow from

operatingactivities.Thus,capitalizinganexpenditure willresultinhigheroperating cash

flowand lowerinvestingcash flowascomparedtoexpensing Ignoringanypotentialtax

effects1,total cash flow will beexactly thesame.The classification of the cash flowisthe

onlydifference

Recall that whenanexpenditureiscapitalized, depreciationexpense isrecognizedin

subsequent periods.Depreciationisanoncashexpenseand,aside fromanytaxeffects,

doesnotaffect operating cash flow

capitalizing

1

FinancialRatiosCapitalizinganexpenditureresultsinhigherassetsand higher equitycomparedto

expensing Thus, both the debt-to-assetsratioand thedebt-to-equityratioarelower(they havelargerdenominators)withcapitalization

Capitalizinganexpenditure will initiallyresultinhigherreturn on assets(ROA)and

higherreturn onequity(ROE).Thisisthe result ofhighernetincome inthe firstyear

Insubsequentyears,ROAand ROEwillbe lower for thecapitalizingfirmas netincome

isreduced by thedepreciationexpense

Since the expensing firm recognizes theentire expense inthe firstyear, ROAandROE

willbe lowerinthe firstyearandhigherinthesubsequentyears.Afterthe firstyear,

theywould be if the firm hadcapitalizedtheexpenditure Analystsmustbe careful whencomparing firms because expensinganexpendituregives theappearanceofgrowthafterthe firstyear

Whenafirmconstructs an assetforitsown use or,inlimitedcircumstances,for resale,

asset’scost.Theobjectiveofcapitalizinginterestistoaccuratelymeasurethecostof the

assetandtobetter match thecostwith therevenuesgenerated bythe constructedasset.

Thetreatmentofcapitalizinginterest issimilar under U.S.GAAPand IFRS

basedonexisting unrelatedborrowings.Interestcosts ongeneralcorporatedebtinexcess

of projectconstructioncosts areexpensed

Capitalizedinterest isnotreportedintheincomestatement asinterest expense Once

through depreciationexpense (iftheassetisheldforuse),orCOGS (iftheassetisheld

Generally,capitalizedinterest isreportedinthe cash flowstatement as anoutflow frominvestingactivities,whileinterest expense isreportedas anoutflow from operating

activities

Interest CoverageRatio

requiredinterestpayments onitsdebt

Insubsequent periods,thecapitalizedinterest isallocatedtotheincomestatement as

depreciationexpense,notinterest expense.Higherdepreciationexpenseresultsinlower

EBIT Thus,insubsequent periods,thecapitalizedinterestresultsinalowerinterest

coverage ratio (smaller numerator)

Ananalystmaywant to reversethe effect ofcapitalizedinterestandrestatethefinancial

statementsand relatedratios Manyanalysts considerinterestcoverageratiosbasedon

totalinterest expense(includingcapitalizedinterest) as abettermeasureofthe solvency

thisadjustment.When therearedebtcovenants(provisions of theborrowing agreement)

thatspecifyaminimum interest coverage ratio,analysts should beawareofhow theratio

iscalculatedindeterminingwhether thecovenanthasbeen violated(whichcan mean

immediaterepaymentisrequired).Ifthe requirementisthat theinterest coverage ratio

be calculated withcapitalizedinterestincludedin interest expense,the analystmust

adjusttheratioaccordinglytodeterminehow close the firmis toviolatingthedebt

covenant.

Foranalyticalpurposes,the effects ofcapitalizinginterestcanbereversedbymakingthe

followingadjustments:

Theamountofinterestcapitalizedisdisclosedinthe financialstatementfootnotes

• Capitalizedinterest, netofdepreciationrecognizedtodate,shouldberemovedfrom

assetsand shareholders’ equity

• The allocation ofinterestcapitalizedinpreviousyearsshould be removed from

depreciationexpense

investingactivities Foranalysis,itshould be added backtocash flow from investing

the restatedfigures.Theinterest coverage ratioandnetprofitmargin will likely be

lower withoutcapitalization

Let’sworkthroughanextendedexampleofthe financialstatementeffectsofcapitalizing

interest

Example:Effect ofcapitalizinginterest

Soprano Company Balance Sheet

Assets Current assets

Cash Receivables

Liabilities and equity

Current liabilitiesPayables

Short-term debt Currentportionoflong-termdebt

140 160

4555

Total current liabilities $325 $275

Retained earnings Common shareholders’ equity

Soprano CompanyIncome Statement

Taxes

300 100

During20X6,thecompanycapitalized$20ofconstruction interest.Thecapitalized

have decidedto treatthecapitalizedinterestas animmediateexpense

Completethefollowingtable, ignoringany incometaxeffects:

Soprano Company AnswerTemplate

Interest coverage ratio

Cash flow from operations

Cash flow from investing

7.0

5.0%

$220 ($100)

59.8%