Financial reporting Contents: Definition and aims of accounting: o Accounting (general definition) is the information system that measures business activities, processes that information into reports and communicates the results to decision makers providing useful information for: To manage businesses, helping in designing business plan and how to finance the company. To evaluate businesses, both managers and investors need accounting information to evaluate if the company is able to reach its goals or if it’s a profitable investment (in comparison to other investments) o Financial accounting provides information mostly to external users. It is regulated. Its primary objective is to provide information useful for making investment and lending decisions. It is focus on the external transaction o Management accounting provides mostly confidential information for internal decision makers (for example top executives). It is not regulated and typically more detailed than financial accounting. It is focus on the internal transaction We are focus on financial statement analysis: methods and tools o The key product of financial accounting is the set of financial statements or financial reports: those documents told us how well a business entity is performing in terms of profits and losses and where it stands in financial terms The most basic concept in accounting is the entity concept, which is an organization that stands apart as a separate economic unit. From an accounting point of view, we need to sharply separate each entity in order not to confuse its affairs with those of other entities. When we prepare a set of financial statements, we do it with reference to a specific entity, which can be an individual company (individual financial statements) or a group of companies (consolidated financial statements). o The main dimensions of financial statement analysis include those documents: Balance Sheet (or Statement of financial position) Income Statement (or Profit & Loss, or Statement of operations, or Statement of Income or Statement of Comprehensive Income) Statement of shareholders’ equity gave us information on the change of ownership which had occurred over the time period Statement of Cash Flows gave us an insight of the cash generation
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Financial reporting
Contents:
Definition and aims of accounting:o Accounting (general definition) is the information system that measures business activities, processes
that information into reports and communicates the results to decision makers providing useful informa-tion for:
To manage businesses, helping in designing business plan and how to finance the company. To evaluate businesses, both managers and investors need accounting information to evaluate if
the company is able to reach its goals or if it’s a profitable investment (in comparison to other investments)
o Financial accounting provides information mostly to external users. It is regulated. Its primary objective is to provide information useful for making investment and lending decisions. It is focus on the external transaction
o Management accounting provides mostly confidential information for internal decision makers (for ex-ample top executives). It is not regulated and typically more detailed than financial accounting. It is focus on the internal transaction
We are focus on financial statement analysis: methods and toolso The key product of financial accounting is the set of financial statements or financial reports: those docu-
ments told us how well a business entity is performing in terms of profits and losses and where it stands in financial terms
The most basic concept in accounting is the entity concept, which is an organization that stands apart as a separate economic unit. From an accounting point of view, we need to sharply sepa-rate each entity in order not to confuse its affairs with those of other entities.
When we prepare a set of financial statements, we do it with reference to a specific entity, which can be an individual company (individual financial statements) or a group of companies (consoli-dated financial statements).
o The main dimensions of financial statement analysis include those documents: Balance Sheet (or Statement of financial position) Income Statement (or Profit & Loss, or Statement of operations, or Statement of Income or
Statement of Comprehensive Income) Statement of shareholders’ equity gave us information on the change of ownership which had
occurred over the time period Statement of Cash Flows gave us an insight of the cash generation Notes to the accounts provides useful insight such as accounting policies, asset and liabilities
measure criteria, explanation and detailed on items variation,… Management discussion and analysis is a summary of the management opinion and comments
of historical performance and future expectation An Audit report testified the quality of the information contain in the reports Listed companies are required to prepare and publish financial statements every quarter and for
the whole year, while private companies typically prepare financial statements annually.o Income Statement and Balance Sheet formats
The Balance sheet report is divided in three major categories: Asset are the economic resources of a business that are expected to be of benefit in the
future and whose value can be reliably measured Liabilities are “outsider claims”, that is economic obligations (debts) payable to out-
siders (creditors) (example: a loan) Shareholders’ (or Owners’) Equity represents the net wealth belonging to the owners
who invested money in the firm The IS reports the revenue and the expense divided in main categories
When we talk about different “formats” of financial statements, we mean different ways to ar-range the items according to different formats. It helps the user to calculate intermediate/partial results or ratios which are particularly meaningful to understand the performance and the soundness of the company
Preparing financial statement formats is sometimes called “reformulation of financial statements”. There is no rule regulating how to prepare financial statement formats. If you look at different handbooks on financial statement analysis, you find different for-mats, using different labels or, even worse, using the same label with a different mean-ing. What is important is CONSISTENCY in the definitions used and a clear understanding of what is behind each of them
Once the Balance sheet and IS have been rearrange according to these formats, different kinds of analysis can be carried out.
A horizontal analysis consists of the study of percentage changes in comparative finan-cial statements of the same company. In other words, the amount of each category of items is compared with the same category in financial statements of previous account-ing periods in order to get the main trend. This kind of analysis is also called “trend analysis”.
A vertical analysis consists of the study of the relationship (in percentage) of each cate-gory of items to a specified base. In the balance sheet this base is usually the value of total assets. In the income statement this is the value of total sales revenue. This kind of analysis is also called “common size analysis”.
Typologies of reclassification for Balance sheet are: Liquidity to stress apart the due date of the items this definition is based on the IAS 1:
o An asset shall be classified as current when it satisfies any of the following cri-teria:
It is expected to be realized in, or is intended for sale or consumption in, the entity’s normal operating cycle;
It is held primarily for the purpose of being traded; It is expected to be realized within twelve months after the reporting
period It is cash or a cash equivalent (unless it is restricted from being ex-
changed or used to settle a liability for at least twelve months after the reporting period).
All other assets shall be classified as non‐current.o A liability shall be classified as current when it satisfies any of the following cri-
teria: It is expected to be settled in the normal operating cycle; It is held primarily for the purpose of being traded; It is due to be settled within twelve months after the reporting period The entity does not have an unconditional right to defer settlement of
the liability for at least twelve months after the reporting period Operating vs. financial asset
IS formats are: Single step income statements may arrange revenues and expenses in two different
sections (right and left or one above the other). it arrives at N Income in one single step For financial statement analysis, we need a different format in order to better under-
stand which are the main determinants of net income/loss, hence a multiple step in-come statement is prepared in effort to highlight important relationships between rev-enues and expenses
o COG which is computed differently between industrial and merchandise indus-tries
o General and administrative expenseo Gross margin is the first step and give a sense of profitabilityo Selling expenses o Ebit is one of the most important pieces of information. It shows if and how
profitable is the typical activity of the company, apart from the way such activ-ity is financed. It tends to be stable in time, if no change in the strategy of the company takes place
o GICO gives the profitability taking apart extraordinary itemso In order to calculate taxes related to the different areas of the income state-
ment, the analysts usually apply an average rate or the company’s “marginal tax rate”.
o Note: The difference between total tax expense (from the official income state-ment) and the taxes related to extraordinary and financial items are subtracted from the operating income.
According to IAS 1 all items of income and expense recognized in a period must be set up
o In a single statement of comprehensive income, oro In two statements: a separate income statement and a statement of compre-
hensive income beginning with profit or loss and displaying components of other comprehensive income.
Total comprehensive income is the change in equity during a period resulting from transactions and other events, other than those changes resulting from transactions with owners in their capacity as owners.
Other comprehensive income comprises items of income and ex-pense that affect equity but are not recognized in profit or loss as re-quired or permitted by other IFRSs (e.g. changes in revaluation sur-plus, gains or losses from translation of financial statements, gains or losses on some re‐measurements to fair value)
o An entity shall also present an analysis of expenses using a classification based on either the nature of expenses or their function within the entity, whichever provides information that is reliable and more relevant.
The first form ( nature of expense method). Expenses are aggregated according to their nature and are not reallocated among various func-tions within the entity.
The second form ( function of expense or ‘cost of sales’ method) clas-sifies expenses according to their function as part of cost of sales or, for example, the costs of distribution or administrative activities. At a minimum, an entity discloses its cost of sales under this method sepa-rately from other expenses
The choice between the function of expense method and the nature of expense method depends on historical and industry factors and the nature of the entity. Both methods provide an indication of those costs that might vary, directly or indirectly, with the level of sales or production of the entity. Because each method of presentation has merit for different types of entities, IAS 1 requires management to se-lect the most relevant and reliable presentation. However, because information on the nature of expenses is useful in predicting future cash flows, additional disclosure is required when the function of ex-pense classification is used
o An entity shall not present any items of income and expense as extraordinary items, either on the face of the income statement or in the notes.
o Rule and principle: aims and scope Since financial accounting is primarily aimed at providing information to outsiders, it is necessary
to set some rules: In order to limit the incentive for the companies to “manipulate” their results and to
provide unreliable information on their performance. Also, to make the financial statements more understandable and comparable for out-
sider users. Rules are established through different sources, the most important of which are the following:
Law is more important in the civil law country, in developed country it usually define the general principle
Professional accounting standards, which in turn can be issued: at a national or interna-tional level
The two most important principle are the IAS/IFRS in UE (international level) and the US GAAP (in 2010 they’ll be one standard for those two economic area):
o The first one is used by all listed UE company since 2005 (consolidated) and for single company since 2006
o The US GAAP by the US company or international company listed in US. It is stated by both SEC and FASB
o Complementary to those standard there exist the national standard valid for all the local business (not listed)
The basic financial accounting principles, Such principles concern:
o The format of financial statements (how to classify the different items in the public financial reports)
o The recording process o The valuation of the financial statement items, hence it implies estimation, and
wherever estimation exists the risk for “manipulation” increases. Principles mainly affecting the recording process are the revenue principle, the match-
ing principle (expenses must be matched against the revenues they contribute to earned) the prevalence of substance over form, while the cost principle, the conser-vatism and the consistency principle mainly relate to the valuation of assets and liabili-ties.
It is clear that the management has room for flexibility, hence it is important to assess the quality of earnings
Some deepening in fair value is deserved:o Quoted market prices in an active market provide the most reliable measure-
ment of the fair value of any asset.o If no active market exists for an asset, its fair value reflects the amount that the
entity would have paid for the asset, at the acquisition date, in an arm’s length transaction between knowledgeable and willing parties, based on the best in-formation available. In determining this amount, an entity considers the out-come of recent transactions for similar assets.
o Ratio analysis allows to analyst to assess the performance and the soundness of the firm, according to the dimensions: Growth, Solvency, Liquidity and Profitability & efficiency
Ratios are relationships between relevant sub‐totals or aggregates of values taken from balance sheet or income statement
Liquidity is the company’s ability to meet its liabilities in the short term, also known as “short term solvency”. The ratios commonly used are:
Current Ratio gives a more precise idea (also in relative terms) of the short term ability to pay liabilities. It should not be lower than one, but the normal level can change from industry to industry. Normally, a ratio above 2 is considered good, but should not be ap-plied mechanically
o (Short-t assets/Short-t Liabilities) Acid Ratio takes into consideration only the most liquid assets, in order to give an idea
of the company’s ability to meet its short term liabilities if they came due immediately. Note that also prepaid expenses, if any, would be excluded from the calculation of short‐term assets. On average, an acid test of 1 is considered acceptable
o (Short-t assets – Inventory – Pre-paid expenses)/Short-t Liabilities Cash flow liquidity ratio considers, in the numerator, assets that are truly liquid and
CFO (from the cash‐flow statement), which represents the cash generated from the firm’s operations
o (Cash +Short-t investments +Cash flow from operations)/Short-t liabilities Days working capital cycle
o Days receivable or Average collection period (in days) Accounts receivable/(sales/365)
o Days payable or Average payment period (in days) Accounts payable/(Pur-chases /365)
o Days inventory or Average inventory period Inventory/(Cost of goods sold/365)
o Net trade cycle (or cash cycle) helps the analyst understand why cash flow generation has improved or deteriorated by analyzing the key balance sheet accounts that affect CF from operations.
Days inventory + Days receivable - Days payable Solvency indicates the business’ ability to pay long‐term debt. The main ratio used to evaluate
solvency is the following: Debt ratio states the proportion of a company’s assets that is financed with debt. The
lower the ratio, the lower the business’ future obligations. Creditors view a high debt ratio as a strong evidence risk.
There are several variants the traditional one (total liabilities/total Asset), the debt to equity ratio (total liabilities/total equity), the financial debt to equity ratio (Financial Liabilities/Shareholders’ equity)
Some study show that a standard index up to 0.67 is generally considered acceptable (2 for the debt to equity), however a comparison with the industry average is the best way to evaluate it.
Another solvency ratio is the so‐called “coverage ratio”. Creditors prefer this to be higher than 1. (Owners’ Equity/Fixed operating assets)
Analysts should check if all the obligations of the company are included in the liabilities. There are others ratio which aim to measure the capability to repay interest expense,
those ratio are:o Times interest earned (interest cover) Ebit/Interest expenseo Cash interest coverage (CFO +Interest paid)/ Interest paid
Growth analysis aims at giving an idea of how much or how fast the company is growing in size. In general, growth ratios focus either on the size of the activity or on the investment of the shareholders. The following ratios can be calculated
Growth rate in sales Growth rate in total asset Growth of shareholder’s equity
Profitability (and efficiency) is one of the most important dimensions in financial statement anal-ysis. A company is supposed to produce enough profit for its owners and for the remuneration of people. Apart from the ratios arising from the common size analysis, there are some specific ra-tios to analyze profitability
ROE is a measure of total profitability for owners. It should be compared to alternative investment opportunities, similar to the company as regards the level of risk
o It can be decomposed in EBIT/TA * TA/OE * NI/EBIT, hence it is function of the leverage, ROA and the weight of non operating function, however the relation isn’t linear, any change in leverage will affect ROA as well
o Another formula is [ROA(2) + (ROA(2)- fin. Charges/Tot liabilities)* Debt to eq-uity ratio]*NI/GICO
ROA is an indicator of the profitability of the activity of the company independently from the way it is financed and from extraordinary gains and losses (except in the last formula used). This should be compared to the industry average and main competitors
o It has several variants for the numerator: EBIT, “EBIT + financial revenues” and “Net income + Net of taxes interest expense”
o A better measure is ROICo It can be decomposed EBIT/Sales * Sales/TA, hence it is function of ROS (how
profitable are sales) and asset turnover (which measures the production effi-ciency, how many units per assets)
o The typical tools used to analyze financial statements are: Balance Sheet and Income Statement formats, ratio analysis and cash flow analysis
These analyst are based comparison with reference to time and different entities (industrial aver-age and key competitors)
It is also crucial understanding the underlining Business activities, which are mirrored in the fi-nancial statements, so a good understanding of the latter is based on a deep understanding of the typical transactions performed by the company.
This has a direct impact on the way we analyze financial statements. For example, some transactions are classified as “operating” in some companies and as “financial” in oth-ers, just because the two companies perform a different combination of activities.
When a company is diversified, i.e. performs different activities, we should analyze (if possible) the different activities separately (see session on segment reporting).
The analysis of IAS/IFRS (or US GAAP) compliant financial statementso Accounting for fixed assets (cost and revaluation model)
Fixed asset are recorded mainly using the cost principle, for whom the transaction should be recorded at its historical cost. This methodology ensure reliability and objectiveness, however IAS allows also to measure fixed asset at the fair value
Since fixed asset has a long life, it is necessary to properly allocate value to each period (match -ing principle), the tool used is depreciation: It depends on:
Cost is the sum of all the costs incurred to bring the asset to its intended us. The typical items included in the cost are: purchase price, applicable taxes, purchase commission, legal fees, transportation charges, insurance while the asset is in transit and installation costs as well as cost for testing the asset before it is used
Estimated useful life (is an estimate of how long the assets will be useful. This can be expressed in years, units of output or other measures)
Estimated residual value (is to be estimated as the amount the company would receive currently for the asset if it were of the age and in the conditions expected at the end of its useful life)
Depreciation can be computed in different way, this choice will affect the earrings Straight line method (the referred unit is number of years)
Units of production method (units production) Accelerated depreciation method
As a general principle, IAS 36 states that an asset should be impaired if its carrying amount (that is its net book value) is lower than its recoverable amount, hence besides depreciation valua-tion methodology require the implementation of impairment test (conservatism principle)
When significant improvements are carried out on a fixed asset, the related costs are recorded as an increase in the historical cost (and therefore the book value) of the asset. This kind of im-provements are typically classified as “extraordinary maintenance”. Ordinary maintenance can-not be “capitalized”
o Accounting and valuation for property, plant and equipment (PPE) are regulated by IAS 16. PPE are tangi-ble assets that are held by an enterprise for use in the production or supply of goods or services, for rental to others, or for administrative purposes; and they are expected to be used during more than one period. The principal issues in accounting for property, plant and equipment are:
The timing of recognition of the assets; which happens whenever it is probable that future eco-nomic benefits associated with the item will flow to the entity; and The cost of the item can be measured reliably
The recognition of the carrying amount. An asset shall be measured at its cost, which includes purchase price, import duties and non‐refundable. purchase taxes (after deducting trade dis-counts and rebates), any costs directly attributable to bringing the asset to the location and con-dition necessary for it to be capable of operating in the manner intended by management and the initial estimate of the costs of dismantling and removing the item and restoring the site on which it is located (accounted as provisions).
The cost of a self‐constructed asset is determined using the same principles as for an acquired asset
When payment for an item of property, plant and equipment is deferred beyond normal credit terms, its cost is the cash price equivalent; the difference between this amount and the total payments is recognized as interest expense over the period of credit un-less it is capitalized.
An item of PPE may be acquired in exchange or part exchange for a nonmonetary asset or assets. The cost of such an item is measured at fair value or, if this is not possible, at the carrying amount of the asset given up.
The capitalization of borrowing costs is regulated by IAS 23, which states that borrow-ing costs shall be capitalized when they refer to a qualifying asset, that is an asset that necessarily takes a substantial period of time to get ready for its intended use or sale.
o Such procedure does not apply to borrowing costs directly attributable to the acquisition, construction or production of: (a) a qualifying asset measured at fair value; or (b) inventories that are manufactured, or otherwise produced, in large quantities on a repetitive basis, in those case the borrowing costs shall be recognized as an expense in the period when they are incurred
To the extent that funds are borrowed specifically for qualifying asset, this amount shall be determined as the actual borrowing costs incurred during the period less any invest-ment income on the temporary investment of those borrowings. The amount of bor-rowing costs eligible for capitalization shall be determined by applying a capitalization rate to the expenditures on that asset. The capitalization rate shall be the weighted av-erage of the borrowing costs applicable to the borrowings of the entity that are out-standing during the period, other than borrowings made specifically for the purpose of obtaining a qualifying asset
o The capitalization of those cost should began as soon as expenditures for the asset are being incurred; borrowing costs are being incurred; and activities that are necessary to prepare the asset for its intended use or sale are in progress.
o Capitalization of borrowing costs shall be suspended during extended periods in which active development is interrupted and when substantially all the activ-ities necessary to prepare the qualifying asset for its are complete
The measurement after recognition: An entity shall choose either the cost model or the revalua-tion model as its accounting policy and shall apply that policy to an entire class of property, plant and equipment
Cost model, that is the depreciation. Note that any change in the depreciation path or residual value estimate must be accounted for a change in the accounting estimate
Revaluation model should be used whenever the fair value of an item of PPE can be measured reliably. Revaluations shall be made with regularity to ensure that the carry-ing amount does not differ materially from that which would be determined using fair value at the balance sheet date. (only IAS allows this method)
o If there is no market‐based evidence of fair value because of the specialized nature of the item an entity may need to estimate fair value using an income or a depreciated replacement cost approach
o When an item is revalued, any accumulated depreciation at the date of the revaluation is treated in one of the following ways:
restated proportionately with the change in the gross carrying amount of the asset so that the carrying amount of the asset after revaluation equals its revalued amount. This method is often used when an asset is revalued by means of applying an index to its depreciated replace-ment cost.
eliminated against the gross carrying amount of the asset and the net amount restated to the revalued amount of the asset. This method is often used for buildings.
o If an item is revalued, the entire class of PPE to which that asset belongs shall be revalued
o If an asset’s carrying amount is increased as a result of a revaluation, the in-crease shall be credited directly to equity under the heading of revaluation sur-plus. However, the increase shall be recognized in profit or loss to the extent that it reverses a revaluation decrease of the same asset previously recognized in profit or loss.
o If an asset’s carrying amount is decreased as a result of a revaluation, the de-crease shall be recognized in profit or loss. However, the decrease shall be deb-ited directly to equity under the heading of revaluation surplus to the extent of any credit balance existing in the revaluation surplus in respect of that asset
o The revaluation surplus included in equity in respect of an item of PPE may be transferred directly to retained earnings when the asset is derecognized. This may involve transferring the whole of the surplus when the asset is retired or disposed of. However, some of the surplus may be transferred as the asset is used by an entity. In such a case, the amount of the surplus transferred would be the difference between depreciation based on the revalued carrying amount of the asset and depreciation based on the asset’s original cost.
Any impairment need during the PPE lifeo Accounting for inventory
According to the cost principle, the cost of any asset (including inventory) is the sum of all the costs incurred to bring the asset to its intended use
For merchandise inventory, the intended use is readiness for sale. Therefore, its cost does not include advertising cost, sales commissions and so on. Typical items included in the merchandise inventory cost (which is called “purchase cost” for merchandise) are:
Purchase price (net of allowances and returns), Customs duties, Shipping or other trans-portation cost (so called “freight‐in”) and Insurance cost
For finished products, the historical cost includes production costs Since the cost per unit of inventory may change over time it is crucial to properly assign the right
cost to each item. The methodologies used are: Specific units cost FIFO LIFO, which can’t be used any more And weighted average cost
The valuation of inventory, like all the other assets, is based on a number of principles. As stated before, among these there are:
The consistency principle: and the accounting conservatism: “anticipate no gains but provide for all probable loss”.
According to the accounting conservatism principle, inventory must be reported in the financial statement at whichever is lower: its historical cost or its net realizable value.
o For merchandise, the “net realizable value” is defined as the expected selling price minus direct selling costs (like sale commissions or transportation).
o For other kinds of inventory, more estimation is required.o Accounting for receivables and equivalent
Those items must be updated in their value at the end of each period to account whenever is probable that there is the risk not to collect all the procedure, the tool used is the uncollectible accounts and recorded as an expense
According to IAS 37 a provision shall be recognized when: An entity has an obligation as a result of a past event; It is probable that an outflow of resources embodying economic benefits will be re-
quired to settle the obligation Reliable estimate can be made of the amount of the obligation
The amount recognized as a provision shall be the best estimate of the expenditure required to settle the present obligation at the balance sheet date.
The estimation shall be based on all the information available. When possible, the estimation is based on the past experience of the company. The PV of the liability must be estimated if it is going to be settled in the long-t
o Accounting for leasing is regulate by IAS 17 A lease is an agreement whereby the lessor conveys to the lessee in return for a payment or se-
ries of payments the right to use an asset for an agreed period of time. There are two main kinds of leasing,
Finance lease is a lease that transfers substantially all the risks and rewards incidental to ownership of an asset. Title may or may not eventually be transferred
Operating lease is a lease other than a finance lease Those categories are defined on the base of substance of the transaction and not on the basis of
the contract stipulated. The classification is based on the extent to which risks and rewards of a leased asset lie with the lessor or the lessee.
Risks include the possibilities of losses from idle capacity or technological obsolescence, loss in the value and of variations in return because of changing economic conditions.
Rewards may be represented by the expectation of profitable operation over the asset’s economic life and of gain from appreciation in value or realization of a residual value
A leasing contract is defined as financial for IAS whenever: (a) the lease transfers ownership of the asset to the lessee by the end of the lease term;
(b) the lessee has the option to purchase the asset at a price that is expected to be suffi-ciently lower than the fair value at the date the option becomes exercisable for it to be reasonably certain, at the inception of the lease, that the option will be exercised;
(c) the lease term is for the major part of the economic life of the asset even if title is not transferred;
(d) at the inception of the lease the present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset; and
(e) the leased assets are of such a specialized nature that only the lessee can use them without major modifications
(a) if the lessee can cancel the lease, the lessor’s losses associated with the cancellation are borne by the lessee;
(b) gains or losses from the fluctuation in the fair value of the residual accrue to the lessee (for example, in the form of a rent rebate equaling most of the sales proceeds at the end of the lease); and
(c) the lessee has the ability to continue the lease for a secondary period at a rent that is substantially lower than market rent
US GAPP are different: 1. Ownership transferred at the end of the lease term; 2. A bar-gain purchase option exists; 3. Lease term equal to or greater than 75% of the asset’s life 4. Present value of minimum lease payments at least 90% of the fair value of the as-set
The accounting for the financial leasing is different only for Italian GAAP, there exist only the op-erating one with disclosure in the note:
At the commencement of the lease term (i.e. the date from which the lessee is entitled to exercise its right to use the leased asset), lessees shall recognize finance leases as as-sets and liabilities in their balance sheets at amounts equal to the fair value of the leased property or, if lower, the present value of the minimum lease payments, each deter-mined at the inception of the lease (i.e. the start of the leasing contract).
The discount rate to be used in calculating the present value of the minimum lease pay-ments is the interest rate implicit in the lease, if this is practicable to determine; if not, the lessee’s incremental borrowing rate shall be used.
o Minimum lease payments are the payments over the lease term that the lessee is or can be required to make. If the lessee has an option to purchase the asset at a price that is expected to be sufficiently lower than fair value at the date the option becomes exercisable (with reasonable certain), at the inception of the lease, the minimum lease payments comprise the minimum payments payable over the lease term to the expected date of exercise of this purchase option and the payment required to exercise it
o The interest rate implicit in the lease is the discount rate that, at the inception of the lease, causes the aggregate present value of (a) the minimum lease pay-ments and (b) the unguaranteed residual value to be equal to the sum of (i) the fair value of the leased asset and (ii) any initial direct costs of the lessor.
o The lessee’s incremental borrowing rate of interest is the rate of interest the lessee would have to pay on a similar lease or, if that is not determinable, the rate that, at the inception of the lease, the lessee would incur to borrow over a similar term, and with a similar security, the funds necessary to purchase it
Any initial direct costs of the lessee are added to the amount recognized A finance lease gives rise to depreciation expense for depreciable assets as well as fi-
nance expense for each accounting period. The depreciation policy for depreciable leased assets shall be consistent with that for depreciable assets that are owned.
o If there is no reasonable certainty that the lessee will obtain ownership by the end of the lease term, the asset shall be fully depreciated over the shorter of the lease term and its useful life.
o To determine whether a leased asset has become impaired, an entity applies IAS 36 ‐ Impairment of Assets.
Accounting for operating lease Lease payments under an operating lease shall be recognized as an expense on a
straight‐line basis over the lease term unless another systematic basis is more represen-tative of the time pattern of the user’s benefit, hence Operating lease is more similar to a normal rent.
Sale and lease‐back transactions involves the sale of an asset and the leasing back of the same asset. The lease payment and the sale price are usually interdependent because they are negoti-ated as a package. The accounting treatment of a sale and leaseback transaction depends upon the type of lease
If a sale and leaseback transaction results in a finance lease, any excess of sales pro-ceeds over the carrying amount shall not be immediately recognized as income by a seller‐lessee. Instead, it shall be deferred and amortized over the lease term.
If a sale and leaseback transaction results in an operating lease, any profit or loss shall be normally recognized immediately in the income statement.
o Accounting for intangible assets are defined by IAS 38 as “an intangible asset is a nonmonetary asset without physical substance”, hence it must be;
Identifiable, so it must be is separable, i.e. is capable of being separated or divided from the en-tity and sold, transferred, licensed, rented or exchanged, either individually or together with a related contract, asset or liability and it should arise from contractual or other legal rights, re-gardless of whether those rights are transferable or separable from the entity or from other rights and obligations
Internally generated goodwill shall not be recognized as an asset, because it is not an identifiable resource. Examples are expenditure incurred to generate future economic benefits, but it does not result in the creation of an intangible asset that meets the recognition criteria.
However An intangible asset arising from development phase (hence all assets arise in the research phase are excluded) shall be recognized if, and only if, an entity can demonstrate all of the following:
o a) technical feasibility of completing the intangible asset so that it will be avail-able for use or sale;
o b) intention to complete, use or sell the intangible asset;o c) ability to use or sell the intangible asset;o d) determination of probable future economic benefits;o e) availability of adequate technical, financial and other resources to complete
the development and to use or sell the intangible asset;o f) ability to measure reliably the expenditure attributable to the intangible as-
set during its development Controlled by the company with law or other instruments, in a way that the produced benefit
are retained by the company The future benefit must be probable, the realizations of those benefits must be estimate by the
best management estimation The cost can be reliably estimate: An intangible asset shall be measured initially at cost, consist-
ing in Its purchase price and Any directly attributable expenditure on preparing the asset for its intended use.
If an intangible asset is acquired in a business combination (i.e. an M&A), the cost of that intangible asset is based on its fair value at the date of acquisition. The fair value of an intangible asset reflects market expectations about the probability that the future economic benefits embodied in the asset will flow to the entity. Therefore, the probabil-ity recognition criterion is always considered to be satisfied for intangible assets ac-quired in business combinations
In a business combination, goodwill is initially measured as the difference between the cost borne to buy the company and the aggregate fair values of the identifiable assets and liabilities of the acquired business
If their is no active market, its fair value shall be estimated on the basis of the best in-formation available. In determining this amount, an entity considers the outcome of re-cent transactions for similar assets. or applying multiples reflecting current market transactions or to the royalty stream that could be obtained from licensing the intangi-ble asset to another party in an arm’s length transaction (as in the ‘relief from royalty’ approach); or discounting estimated future net cash flows from the asset
The cost of an internally generated intangible asset comprises all directly attributable costs necessary to create, produce, and prepare the asset to be capable of operating in the manner intended by management. For borrowing costs, the same rules stated for tangible assets apply.
After recognize cost there others measurement, in fact subsequently the initial recognition, such assets shall be measured at cost less any accumulated depreciation or impairment loss
Cost Model. Intangible asset, which has a defined life must follow an amortization plan to respect the matching principle, otherwise none
o The depreciation plan shall be allocated on a systematic basis over its useful life. It shall begin when the asset is available for use and shall reflect the pat-tern in which the asset’s future economic benefits are expected to be con-sumed by the entity
Revaluation Model For the purpose of revaluations under this Standard, fair value shall be determined by reference to an active market.
o The residual value should assume 0, it could be different if there is a third part commitment or an active market (even in the future)
There are some difference with US GAAP and Italian one: Revaluation model is not allowed for both national standard, in Italy all intangible are
subjected to amortization, in US you could capitalize internal intangible if they are com-puter software and website
o Impairment test is regulated by IAS 36. It is applied to tangible, intangible and financial assets other, while it does not apply to inventories, assets arising from construction contracts, deferred tax assets, as-sets arising from employee benefits, or assets classified as held for sale (or included in a disposal group that is classified as held for sale)
Timing of the impairment test There is an impairment loss whenever the carrying amount of an asset exceeds its re-
coverable amount through use or sale.o Recoverable amount is determined for an individual asset, unless the asset
does not generate cash inflows that are largely independent of those from other assets or groups of assets. If this is the case, recoverable amount is deter-mined for the cash‐generating unit (CGU) to which the asset belongs
o The best evidence of an asset’s fair value less costs to sell is a price in a binding sale agreement in an arm’s length transaction, adjusted for incremental costs that would be directly attributable to the disposal of the asset, otherwise we will use the valuation provided by an active market less the costs of disposal.
o If there is no binding sale agreement or active market for an asset, fair value less costs to sell is based on the best information available, hence we will use value in use method
(a) estimating the future cash inflows and outflows to be derived from continuing use of the asset and from its ultimate disposal; and (b) ap-plying the appropriate discount rate to those future cash flows.
The risk of variations in the amount or timing of the future cash‐flows can be reflected either as adjustments to the future cash flows or as adjustments to the discount rate
An entity shall assess at each reporting date whether there is any indication that an as-set may be impaired. If any such indication exists, the entity shall estimate the recover-able amount of the asset.
Irrespective of whether there is any indication of impairment, an entity shall also:o (a) test an intangible asset with an indefinite useful life or an intangible asset
not yet available for use for impairment annually by comparing its carrying amount with its recoverable amount.
o (b) test goodwill acquired in a business combination for impairment annually Indicators of impairment an entity shall consider, as a minimum, the following indications:
(a) during the period, an asset’s market value has declined significantly more than would be expected as a result of the passage of time or normal use.
(b) significant changes with an adverse effect on the entity have taken place during the period, or will take place in the near future, in the technological, market, economic or legal environment in which the entity operates or in the market to which an asset is dedicated.
(c) market interest rates or other market rates of return on investments have increased during the period, and those increases are likely to affect the discount rate used in cal-culating an asset’s value in use and decrease the asset’s recoverable amount materially.
(d) the carrying amount of the net assets of the entity is more than its market capitaliza-tion.
(e) evidence is available of obsolescence or physical damage of an asset. (f) significant changes with an adverse effect on the entity have taken place during the
period, or are expected to take place in the near future, in the extent to which, or man-ner in which, an asset is used or is expected to be used. These changes include the asset becoming idle, plans to discontinue or restructure the operation to which an asset be-longs, plans to dispose of an asset before the previously expected date, and reassessing the useful life of an asset as finite rather than indefinite.
(g) evidence is available from internal reporting that indicates that the economic perfor-mance of an asset is, or will be, worse than expected
If the recoverable amount of an asset is less than its carrying amount, the carrying amount of the asset shall be reduced to its recoverable amount. That reduction is an impairment loss, which shall be recognized immediately in profit or loss, unless the asset is carried at revalued amount according to the revaluation model, in this case any impairment loss of a revalued asset shall be treated as a revaluation decrease in accordance with that other Standard
o Cash generating units/reporting units is the smallest group of assets that includes the asset and gener-ates cash inflows that are largely independent of the cash inflows from other assets or groups of assets.
If there is any indication that an asset may be impaired, recoverable amount shall be estimated for the individual asset. If it is not possible to estimate the recoverable amount of the individual asset, an entity shall determine the recoverable amount of the cash‐generating unit to which the asset belongs (the asset’s cash‐generating unit)
The identification of an asset’s cash‐generating unit involves judgment that depend on various factors including how management monitors the entity’s operations or how management makes decisions about continuing or disposing of the entity’s assets and operations
To define the Cash generating units we need to: Value the unit, using or market value if available assets, otherwise The carrying amount of a cash‐generating unit shall be determined on a basis consis-
tent with the way the recoverable amount of the cash generating unit is determined. It includes the carrying amount of only those assets that can be attributed directly, or allo-cated on a reasonable and consistent basis, to the cash generating unit and will gener-ate the future cash inflows used in determining the cash‐generating unit’s value in use; and does not include the carrying amount of any recognized liability, unless the recover-able amount of the cash‐generating unit cannot be determined without consideration of this liability.
For the purpose of impairment testing, goodwill acquired in a business combination shall, from the acquisition date, be allocated to each of the acquirer’s cash‐generating units, or groups of cash‐generating units, that are expected to benefit from the syner-gies of the combination, irrespective of whether other assets or liabilities of the acquire are assigned to those units or groups of units. Each unit or group of units to which the goodwill is so allocated shall:
o (a) represent the lowest level within the entity at which the goodwill is moni-tored for internal management purposes; and
o (b) not be larger than an operating segment determined in accordance with IFRS 8 Operating Segments
o We will apply the same rule of impairment test, any loss must be first allocate to his goodwill, then if exceed to his assets pro rata
o If an impairment loss has been recognized in prior periods for an asset other than goodwill and it may no longer exist or may have decreased, the entity shall estimate the recoverable amount of that asset, that must not exceed the carrying amount that would have been determined (net of amortization or de-preciation) had no impairment loss been recognized for the asset in prior years
A reversal of an impairment loss for an asset other than goodwill (that cannot be reversed) shall be recognized immediately in profit or loss, unless the asset is carried at revalued amount in accordance with an-other Standard
There are difference among accounting principle: In Italy an impairment is done only if it is per-manent, reversal is not allowed in US and in Italy with some limitation, in Italy there is no spe-cific guidelines on how to test impairment
o Financial instruments are ruled by IAS 39 A financial asset is any asset that is: cash, an equity instrument of another entity, a contractual
right to receive cash or another financial asset from another entity; or to exchange financial as-sets or financial liabilities with another entity under conditions that are potentially favorable to the entity and
Contract that will or may be settled in the entity's own equity instruments and is: A non-derivative for which the entity is or may be obliged to receive a variable number
of the entity's own equity instruments; or A derivative that will or may be settled other than by the exchange of a fixed amount of
cash or another financial asset for a fixed number of the entity's own equity instru-ments. For this purpose the entity's own equity instruments do not include puttable fi-nancial instruments classified as equity instruments in accordance with paragraphs 16A and 16B, instruments that impose on the entity an obligation to deliver to another party
a pro rata share of the net assets of the entity only on liquidation and are classified as equity instruments in accordance with paragraphs 16C and 16D, or instruments that are contracts for the future receipt or delivery of the entity's own equity instruments
Initial recognition: a financial asset or a financial liability on its balance sheet should be recog-nize when, and only when, the entity becomes a party to the contractual provisions of the instru-ment
The asset classification in IFRS 9 are based on Entity’s business model for managing the financial assets and Contractual cash flow characteristics of the financial asset
Financial Assets at Amortized Cost if they met both these conditions:o The asset is held within a business model whose objective is to hold assets in
order to collect contractual cash flows.o The contractual terms of the financial asset give rise on specified dates to cash
flows that are solely payments of principal and interest on the principal amount outstanding
Financial Assets at Fair Value is residual to the first one Measurement in IFRS 9:
Amortized cost approach is based on the effective interest methodo The effective interest method allows to allocate the interest income or interest
expense over the relevant period of the asseto The effective interest rate is the rate that exactly discounts estimated future
cash payments or receipts through the expected life of the financial instrumento See example hand put 10
Fair value method is always the sameo In the case of absence of market the price should be calculated considering The
time value of the money; Credit risk; Prepayment risk; Volatility; and Etc. (ex-ample in hand out 10)
Impairment test on financial asset IAS 39 At each balance sheet date it is necessary to evaluate the assets in order to verify if any
impairment events have occurred If there is any objective evidence, then, it is necessary to apply a specific evaluation,
otherwise a generic one should be applied The difference between the asset's carrying amount and the present value of estimated
future cash flows (if positive) defines the amount of the loss Derecognition of financial asset means to remove an asset from an entity’s balance sheet; events
that leads to derecognition are the collection of a financial asset or transfer of a financial asset IAS 39 defines the requirements to be applied in order to classify a transaction as a
“true sale” (under an accounting point of view not legal) An entity shall derecognize a financial asset when, and only when:
o First requirements are The contractual rights to the cash flows from the financial asset ex-
pire; or An entity transfers the contractual rights to receive the cash flows of
the financial asset; or An entity retains the contractual rights to receive the cash flows of the
financial asset, but assumes a contractual obligation to pay the cash flows to one or more recipients
o Second requirement: When an entity transfers a financial asset, it shall eval-uate the extent to which it retains the risks and rewards of ownership of the financial asset:
if the entity transfers substantially all the risks and rewards of owner-ship of the financial asset, the entity shall derecognize it;
if the entity retains substantially all the risks and rewards of owner-ship of the financial asset, the entity shall continue to recognize the financial asset;
if the entity neither transfers nor retains substantially all the risks and rewards, the entity shall determine whether it has retained control of the financial asset
The entity has to significantly change its exposure to the variability in the present value of the future net cash flows from the financial asset to derecognize the asset
We need to perform a qualitative, meaning understanding the clauses and a quantitative (only if the first is not suffi-cient) analysis
o Third requirement: § 20 (c): if the entity neither transfers nor retains sub-stantially all the risks and rewards of ownership of the financial asset, the en-tity shall determine whether it has retained control of the financial asset. In this case:
if the entity has not retained control, it shall derecognize the financial asset;
if the entity has retained control, it shall continue to recognize the fi-nancial asset to the extent of its continuing involvement in the finan-cial asset
o Since it is really complex it will change, up to now there has been a note from the board which allows company to derecognize when:
The contractual rights to the cash flows from the Asset expire; The entity transfers the Asset and has no continuing involvement in it; The entity transfers the Asset and retains a continuing involvement in
it but the transferee has the practical ability to transfer the Asset for the transferee’s own benefit.
If there isn’t derecognition it is the case of a financing, hence I cannot remove the asset from my balance sheet and I have to create a financial liabilities over the transaction and a cash positive movement equal
The analysis of consolidated financial statements arises when one company controls another company (normally by acquiring its shares), but the latter continues to exist as a separate entity and to keep its own assets and liabili-ties. The documents that regulate it are the following:
IAS 27 – Consolidated and separate financial statements, it is to enhance the relevance, reliabil-ity, and comparability of the information contained in those reports, it also specifies the circum-stances in which consolidated financial statements are required, as well as providing guidance on the required accounting for changes in ownership levels, including changes that result in the loss of control of a subsidiary. IAS 27 also includes requirements for disclosure of information to al-low financial-statement users to evaluate the nature of the relationship between the parent en-tity and its subsidiaries
IFRS 3 – Business combinations IAS 31 – Interests in joint‐ventures IAS 28 – Investments in associates
o The concept of control and the consolidation area, from an accounting point of view, this is the case in which we have a “group of companies” and we have to prepare consolidated financial statements.
IAS 27 defines control as “the power to govern the operating and financial policies of an entity so as to obtain benefits from its activities” and it also states that all the subsidiaries must be included in the consolidation
The controlling company is called “parent company” or “holding”, while the controlled one is called“ subsidiary
Control is presumed to exist when the parent owns, directly or indirectly through subsidiaries, more than half of the voting power of an entity unless, in exceptional circumstances, it can be clearly demonstrated that such ownership does not constitute control.
(a) the parent is itself a wholly‐owned subsidiary, or is a partially‐owned subsidiary of another entity and its other owners, including those not otherwise entitled to vote, have been informed about, and do not object to, the parent not presenting consoli-dated financial statements;
(b) the parent’s debt or equity instruments are not traded in a public market; (c) the parent did not file, nor is it in the process of filing, its financial statements with a
securities commission or other regulatory organization for the purpose of issuing any class of instruments in a public market; and
(d) the ultimate or any intermediate parent of the parent produces consolidated finan-cial statements available for public use that comply with International Financial Report-ing Standards
Control also exists whenever: (a) power over more than half of the voting rights by virtue of an agreement with other
investors; (b) power to govern the financial and operating policies of the entity under a statute or
an agreement; (c) power to appoint or remove the majority of the members of the board of directors
or equivalent governing body and control of the entity is by that board or body; or (d) power to cast the majority of votes at meetings of the board of directors or equiva -
lent governing body and control of the entity is by that board or body. The existence and effect of potential voting rights that are currently exercisable or convertible,
including potential voting rights held by another entity, are considered when assessing whether an entity has the power to govern the financial and operating policies of another entity. Potential voting rights are not currently exercisable or convertible when, for example, they cannot be ex-ercised or converted until a future date or until the occurrence of a future event.
In assessing whether potential voting rights contribute to control, the entity examines all facts and circumstances (including the terms of exercise of the potential voting rights and any other contractual arrangements whether considered individually or in combination) that affect poten-tial voting rights, except the intention of management and the financial ability to exercise or con-vert
Most large corporations own controlling interests in other companies. These interests appear in the balance sheet of the parent company among assets, in most cases at cost. Hence, it is need another indicator for the value of the subsidiaries
Consolidation accounting is a method of combining the financial statements of sub-sidiaries with that of the parent company as if the parent and its subsidiaries were a sin-gle entity. In different words, the assets, liabilities, revenues and expenses of each sub-sidiary are added to the parent’s accounts as if the parents had acquired directly the as-sets and liabilities of the subsidiary instead of investing in its shares
Therefore, the consolidation process doesn’t consist only in adding up the individual companies’ financial statements, but also in making them consistent with each other and in eliminating all those items that wouldn’t be there if the activity were actually per-formed by the parent company only (thus avoiding double counting).
o Consolidation methods for subsidiaries is ruled by IFRS 3, and it can be described as follows:o Collect the individual companies’ financial statementso Make them uniform as concerns:
The dates they are referred to (difference among the reporting dates cannot be longer than 3 months)
The accounting policies The reporting currency (if necessary, translation takes place) The formats used
o Add the single items of the “uniform” individual statementso Eliminate “double counting
We can decide to prepare consolidated financial statements right on the date of the ac-quisition or later (typically at the end of each accounting period after the acquisition takes place)
o The first one is the simplest case since no intra‐group transactions have taken place yet, so the only consolidation entry to be made is the elimination of the investment and the subsidiary’ equity. Also, there is no consolidated income statement on the date of the acquisition. Consolidated income statement, ac-tually, shows the consolidated results reached by the holding company and its subsidiaries as a group AFTER the acquisition has taken place. On the date of the acquisition, there is no operation performed by the group yet, so there is no income statement to be prepared.
Procedure for acquisition method According to this method, all the identifiable assets and liabilities of the subsidiary must
be measured at their fair values at the moment of the acquisitions, hence there could be the case to include assets and liabilities which were not previously recognized in the financial statements
Assets and liabilities of the subsidiary must be measured at 100% of their fair value even if the parent company owns less than 100% of the share capital of the former
o The reason behind this requirements it is that the company to acquire those asset should have paid “their fair value”, which can also be different from the book value they have in the subsidiary’s individual financial statements
IAS 12 (Income taxes) states that when the fair value recognized in a business combination (including consolidation) is not recognized for tax purposes (i.e. the fiscal regulation does not consider the adjust-ment to fair values for its purposes), the deferred tax effect shall be recorded.
For example if an increase in a plant is recorded while applying the ac-quisition method, but it is not recognized by tax regulation, a deferred tax liability shall be recorded in the liabilities side. This liability repre-sents actually an adjustment to the fair value recognized in the asset due to the loss of a “fiscal benefit” that the acquirer would have through depreciation if, instead of buying the shares of the sub-sidiaries, it had bought the asset directly (when assets are bought di-rectly, the fiscal regulation recognizes the whole fair value paid for them).
The deferred tax effect can give rise to both deferred tax liabilities and to deferred tax assets.
IAS 12 states that on goodwill no tax effect must be recognized (in or-der not to increase its value).
o The 100% recognition of assets and liabilities, irrespective of the percentage of ownership in the controlled entity, does not directly apply to goodwill. It can indeed be recorded either only for the part acquired by the parent company or in full:
According to Full goodwill method pertaining to minority interests is recognized in the consolidated Financial Statements. (US GAAP)
According to the modified parent company theory Elimination of the investments and owners’ equity. IFRS 3 states that the elimination
entry related to the investments/O.E. is made always on the basis of the fair values ex-isting on the date of the acquisition
After eliminating investments and subsidiaries’ O.E., and recording for fair values and minority interests, depreciation of updated assets and liabilities must be considered together with the related deferred tax Effect, since such a depreciation has an impact both on the income statement (increase in the expenses, decrease in taxes) and on the balance sheet (decrease in the value of the assets, decrease in deferred tax liabilities
Intra‐group transactions are all those transactions occurred between two companies included in the same consolidation accounts, typically sales and purchases of goods, as-sets or services, financing transactions or dividend distribution. All the accounting ef-fects of such transactions must be eliminated, since they would not be there if the par-ent company had performed the activity of the subsidiaries directly
o Let’s start from the simplest example: one subsidiary sells service to another subsidiary. The seller will record a revenue while the purchaser will record an expense. Both of them must be eliminated when consolidating the accounts since, if they had been one only company, they would not have recorded any revenue or expense.
o Intra‐group revenues and expenses can also be related to a financing transac-tion. For example, if the parent company lends money to a subsidiary, the for-mer will record interest income and the latter will record interest expense. Also in this case the two intra‐group items must be deleted
o Receivables and payables coming from intra‐group transactions, these also must be eliminated
o Things are more complicated when, instead of services, goods (merchandise, finished products, etc.) are exchanged between companies in the same group
Let’s start from the case in which, during the accounting period, one company sells merchandise to another company in the same group and, on the date of consolidation, all these goods have already been sold by the purchaser to customers outside the group. In such a case, what we have to eliminate is only the revenues earned by the seller and the cost of goods sold recorded by the purchaser. By eliminating revenues and expenses for the same amount, we don’t need to con-sider the fiscal impact of the elimination
Let’s consider another case, that is the case in which, on the date of consolidation, the goods sold “intra‐group” are still in the inventory of the purchasing company. In such a case, we eliminate (as usual) all the intra-group revenue. At the same time we have to eliminate the cost of goods sold of the selling company and reduce the inventory of the purchasing company. This elimination affects the consolidated profit/loss and we have to adjust also the related income taxes.
In the case in which, after the intra‐group transaction takes place, one part of the goods have already been sold outside the group and one part is still in inventory, the easiest solution is to consider separately the part already sold outside the group from the part still in inventory, and to apply the rules described in the two previous cases.
o The same logic must be followed when a long‐lived asset is sold/purchased among companies belonging to the same group. This typically affects the value of the asset in the balance sheet and the gain/loss on the sale of the asset in the income statement. Moreover, when the asset is a depreciable one, also the depreciation expense must be adjusted as well as the income taxes
o Whenever a subsidiary pays dividends to the parent company, this transaction must be eliminated. Therefore, we have to decrease the dividend revenues and, at the same time, increase the “retained earnings” which were decreased by the subsidiary when the dividends were given out
o The final step before preparing the consolidated financial statements is to cal-culate and record for the share of profit/loss pertaining to minority interests. The calculation is to be made as follows:
income/loss of the subsidiary ‐ net depreciation expense of the “fair values” ‐/+ net effect of the elimination of intra-group sales/purchases of goods or assets (only for the cases in which the subsidiary is the seller)
In case the full goodwill is recognized, any impairment loss on good-will shall also be considered in the above calculation.
The result of the calculation reported above must be multiplied by the percentage of ownership of the minority
o Consolidation of joint-ventures and associates are defined according to IAS 31, “a joint‐venture is a con-tractual arrangement whereby two or more parties undertake an economic activity which is subject to joint control”
“Joint control is the contractual agreed sharing of control over an economic activity”. The parties are called venturers.
The following characteristics are common to all joint ventures: (a) two or more venturers are bound by a contractual arrangement; and (b) the contractual arrangement establishes joint control, hence the it establishes that
no single venturer is in a position to control the activity unilaterally. This agreement could be evidenced in a number of ways, for example by a contract or minutes of discus-sions between the venturers.
A JV can take several different forms. We focus on the so‐called “Jointly controlled entities” in which ventures where a distinct entity is formed in which each venturer has an interest
Accounting for jointly controlled entities are defined by IAS 31 which allows either proportionate consolidation (preferred method) or equity method (allowed alternative method) to be used for jointly controlled entities
In the proportionate consolidation, only the venturer’s share of assets, liabilities, rev-enues and expenses are included in the consolidated financial statements. As a conse-quence, there is no indication of minority interests (not allowed in US)
o The major difference between the consolidation for subsidiaries and the pro-portionate method is that in the latter all the adjustments are made in propor-tion to the share of ownership of the reporting entity. Hence, all the adjust-ments must be made only for 33% of their value. The venturer can decide to report the share of assets, liabilities, expenses and revenues of the joint ven-ture together with its own (summing them up line by line like we do in normal consolidation) or to show them as separate items.
o Of course the value of the investment must be eliminated in full, since it is al -ready corresponding to the share of ownership of the reporting entity
o All the consolidation adjustments we have already seen with reference to con-solidation accounting for subsidiaries must be carried out also in the propor-tionate method.
The equity method is applied whenever the ownership retain a significant share of con-trol, but not the majority and those investments are not intended to be sold
o Under the equity method, the investment is initially recognized at cost and the carrying amount is increased or decreased to recognize the investor’s share of the profit or loss of the investee after the date of acquisition. This amount is recognized in the investor’s profit or loss
o The equity method is a sort of “synthetic consolidation” in which the balance sheet and income statement items are not consolidated line by line but syn-thetically, by adjusting the value of the investments in the balance sheet of the reporting entity
o Procedure to account for: Distributions received from an investee reduce the carrying amount of
the investment. Adjustments to the carrying amount may also be necessary for
changes in the investor’s proportionate interest in the investee arising from changes in the investee’s equity that have not been recognized in the investee’s profit or loss. Such changes include those arising from the revaluation of property, plant and equipment and from foreign exchange translation differences. The investor’s share of those changes is recognized directly in equity of the investor.
In applying the equity method, we must use many of the procedures applied for the consolidation of subsidiaries.
Rules about the uniformity of financial statements (concerning the date, the accounting policies and the currency) are stated also for the equity method.
Accounting for associate (IAS 28) follow the equity method An associate is an entity over which the investor has significant influence (power to par-
ticipate in the financial and operating policy decisions of the investee) and that is nei-ther a subsidiary nor an interest in a joint venture.
o If an investor holds, directly or indirectly (e.g. through subsidiaries), 20 per cent or more of the voting power, it is presumed that the investor has significant influence, unless it can be clearly demonstrated that this is not the case.
o Conversely, if the investor holds, directly or indirectly, less than 20 per cent of the voting power of the investee, it is presumed that the investor does not have significant influence, unless such influence can be clearly demonstrated.
o Note that a substantial or majority ownership by another investor does not necessarily preclude an investor from having significant influence. It is evi-denced in one or more of the following ways:
representation on the board of directors or equivalent governing body of the investee;
participation in policy‐making processes, including decisions process about dividends or other distributions;
material transactions between the investor and the investee; interchange of managerial personnel; or provision of essential technical information
There exist many difference in this area between accounting Area:
In US the consolidation is applied only for listed company, in Italy this decision is a con-sequence of the legal form of the business
There isn’t any exemption for the consolidation in US, while Italy as well as IAS allows some exception linked to the dimension of the business or for bus- holdings
US GAAP use a bipolar consolidation model. All consolidation decisions are evaluated first under the VIE (variable interest entity) model. When the former absorbs the major-ity of losses, of returns or both. VIEs must be consolidated. The second model looks at the voting interests. There must be the majority ownership of voting shares or by con-tract, however potential voting rights are not considered
In Italy There is control when: a company owns the majority of the voting rights in the shareholders’ meeting; or a company owns enough voting rights to exercise a “control-ling influence” ; or a company has the right to exercise a “controlling influence” by virtue of a contract or the statute; a company controls the majority of voting rights by virtue of an agreement with other shareholders
Regarding the uniformity of the date and accounting policies differently from Italy, IAS and US GAAP allow the consolidation of accounts drawn up at different dates and IAS and do not allow any exception to the rule of uniformity in the accounting policies.
The Italian GAAP allow not to eliminate the intra-group profits and losses when some conditions are met.
o Analysis of consolidated financial statements uses the following main tools: Preliminary analysis is crucial to understand how these statement has been prepared, in fact
Financial statements can change substantially according to some of the choices we make before starting the actual preparation of consolidated
The main issue to be consider are the following:o The kind of group (if integrated in the operating activity or merely financial);o Companies included in the consolidation area;o Consolidation methods: (Proportional recognition of goodwill, Full goodwill or
Proportionate consolidation or Equity method valuation) Preparation of balance sheet and income statement formats. What is important to notice here
is that some intermediate results, like for example operating income, make sense only for groups which are integrated from an operating point of view.
For financial groups which are typically diversified, the analysis should be carried out on the segment data instead of the consolidated ones.
This is the same for balance sheet, if we use the current/non- current classification Ratio analysis make sense only for integrated group
Profitability ratios like ROA or ROIC can calculate for each segment, if we have enough information to do that.
Differently, ROE makes sense also for merely financial groups. However can be analyzed in a particular way in consolidated financial statements:
o NI/ OE =Total consolidated net income/Total consolidated owners’ equityo NI*/ OE*= Parent company’s share of net income/ Par. company’s share of
owners’ equityo NI*/OE* = NI /OE x OE /OE* x NI*/NI
This relationship shows that the profitability of the parent company is function of the profitability of the whole group, the so‐called “owner-ship leverage” and the relationship between the net income of the par-ent company and the net income of the whole group.
The relationship between OE and OE* is called “ownership leverage”. The higher it is, the better is the parent company to attract minority interests to finance the activity of its group
The relationship between NI* and NI shows how “good” the parent company is in collecting the profits of the group relatively to the mi-nority shareholders. It can be lower, equal to or higher than 0.
Also liquidity ratios make sense in any kind of group. There are some typical ratios that are calculated for consolidated financial statements.
Some of these ratios try to depict how much integrated the group is from an operating or a financial point of view.
o The first one aims to tells us how much integrated is the group from an oper-ating point of view. Actually, a high ratio means that we have eliminated a large amount of intra-group sales revenue, and this happens when the group is well integrated. They are calculated as follows:
Aggregate sales‐consolidated sales/ Aggregate saleso Another one tells us how much integrated is the group from a financial point of
view. Actually, a high ratio means that we have eliminated a large amount of financial expense, and this happens when there are a lot of intra-group financ-ing transactions, it is calculated as follows:
Aggr. financial expense‐consolidated financial expense / Aggregate financial expense
We can calculate similar ratios to understand, for example, how much intra‐group financial debt still exists at the end of the consolidation period and so on.
VIT: not always the information provided in the annual report is enough to calculate this kind of ratios. You need the data related to the individual financial statements of the companies included in the consolidation in order to calculate the aggregate amount. Not always such data are reported or collectible otherwise
o As concerns the debt‐to‐equity ratio, for consolidated financial statements it can be calculated in two different ways, according to the kind of relationship the parent company has with minority shareholders:
Total liabilities/ Total consolidated O.E. where total consolidated O.E. is the result of the sum of the
parent company’s share of owners’ equity and minority shareholders’ owners equity, or
Total liabilities + Minority interests/ Parent company’s share of O.E. Actually minority interests are more similar to liabilities than
owners’ equity if minority shareholders are passive outsiders providing funds and expecting a regular dividend flow
Cash‐flow analysis is carried out in the same way we already know for individual financial state-ments. It makes sense if there is a sort of financial integration between the companies of the same group.
The Disclosure about operating segments is useful for diversified group, meaning groups which operate in more than one operating segment. It ruled by IFRS 8
o Such disclosures consists of a breakdown of the group on the basis of the different operating segments. It’s like to split the balance sheet and the IS in more separate segments, as if the different activities were performed by separate entities in the same group. Hence, Preparing segment reporting is like doing the opposite than consolidation
a) That engages in business activities from which it may earn revenues and incur expenses (in-cluding revenues and expenses relating to transactions with thin the same entity),
(b) Whose operating results are regularly reviewed by the entity’s chief operating decision maker to make decisions about resources to be allocated to the segment and assess its performance,
c) For which discrete financial information is available) .
o It is important doing this, because diversified entities operate in segments which are subject to differing rates of profitability, opportunities for growth, future prospects and risks and also because it allows a better analysis of the operating profitability in diversified groups. In such groups, the interpretation of ROA, for example, is not easy since it is the result of different operating activities, so even the interpreta-tion and comparison with other entities is harder
o According to IFRS 8, an entity shall disclose information to enable users of its financial statements to eval-uate the nature and financial effects of the business activities in which it engages and the economic envi-ronments in which it operates.
o The disclosure of segment information is required to listed companies or companies in the process to be listed on a stock market
Two or more operating segments may be aggregated into a single operating segment if aggrega-tion is consistent with the core principle of IFRS 8, so if the segments have similar economic char-acteristics, and similar in each of the following respects
Nature of products or services Nature of the production process The type or class of customer for the products or services The methods used to distribute the products or provide the services If applicable, the nature of the regulatory environment
An entity shall report separately information about an operating segment that meets any of the following quantitative thresholds
(a) Its reported revenue, including both intersegment sales or transfers, is 10 per cent or more of the combined revenue, internal and external, of all operating segments.
(b) The absolute amount of its reported profit or loss is 10 per cent or more of the greater, in absolute amount, of (i) the combined reported profit of all operating seg-ments that did not report a loss and (ii) the combined reported loss of all operating seg -ments that reported a loss.
(c) Its assets are 10 per cent or more of the combined assets of all operating segments. Operating segments that do not meet any of the quantitative thresholds may be considered re-
portable, and separately disclosed, if management believes that information about the segment would be useful to users of the financial statements.
o An entity shall disclose the following information for each reported segment: (a) factors used to identify the entity’s reportable segments, (b) types of products and services from which each reportable segment derives its revenues (c) Information about profit or loss, assets and liabilities for each reportable segment if such an
amount is regularly provided (d) An explanation of the measurements of segment profit or loss, segment assets and segment
liabilities for each reportable segment The revenues from external customers for each product and service, or each group of similar
products and services, unless the necessary information is not available and the cost to develop it would be excessive, in which case that fact shall be disclosed; current ‐ Geographical information about revenues and non a sets, unless the necessary information is not
available and the cost to develop it would be excessive; The extent of its relevance on its major customers. If revenues from transactions with a single
external customer amount to 10% or more of an entity’s revenues, the entity shall disclose that fact, the total amount of revenues from each such customer, and the identity of the segment or segments reporting the revenues
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