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FINANCIAL ANALYSIS
TABLE OF CONTENTS
Overview of financial statements...................................................................................................................... 3
Business analysis............................................................................................................................................ 3
Stakeholders .............................................................................................................................................. 3
Financial Statement analysis ......................................................................................................................... 4
Credit analysis............................................................................................................................................ 4
Equity analysis ........................................................................................................................................... 5
Different types of analysis ............................................................................................................................. 5
Business environment analysis.................................................................................................................. 5
Accounting analysis ................................................................................................................................... 9
Financial analysis ..................................................................................................................................... 10
Basis of financial analysis............................................................................................................................. 10
Financial statement preparation ............................................................................................................. 11
Tools for financial analysis....................................................................................................................... 13
Efficient market hypothesis ......................................................................................................................... 17
Implications ............................................................................................................................................. 17
Financial reporting and analysis ...................................................................................................................... 18
The reporting environment ......................................................................................................................... 18
Factors affecting the reporting environment .......................................................................................... 18
Nature and purpose of financial accounting ............................................................................................... 20
Desirable qualities ................................................................................................................................... 20
Principles of accounting........................................................................................................................... 20
Fair value accounting ................................................................................................................................... 21
Definition of Fair Value accounting ......................................................................................................... 21
Implication for analysis............................................................................................................................ 22
Accrual accounting ...................................................................................................................................... 23
The concept of accruals ........................................................................................................................... 24
Accrual adjustment.................................................................................................................................. 24
Relevance and limitations of accrual accounting .................................................................................... 25
The concept of income ................................................................................................................................ 25
Economic income .................................................................................................................................... 26
Accounting income .................................................................................................................................. 26
Accrual vs. Economic income .................................................................................................................. 26
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Accounting analysis ..................................................................................................................................... 27

Need for accounting analysis................................................................................................................... 27
Process of accounting analysis ................................................................................................................ 29
Analysing investing activities ........................................................................................................................... 30
Assets classification ..................................................................................................................................... 30
Current Assets ............................................................................................................................................. 30
Cash and cash equivalents....................................................................................................................... 30
Receivables .............................................................................................................................................. 31
Prepaid expenses..................................................................................................................................... 32
Inventories ................................................................................................................................................... 32
Inventory accounting and valuation ........................................................................................................ 33
Analysing inventories............................................................................................................................... 33
Long-lived assets.......................................................................................................................................... 36
Accounting for long term assets .............................................................................................................. 36
Capitalizing vs. Expensing ........................................................................................................................ 37
Plant assets and natural resources.............................................................................................................. 38
Valuation.................................................................................................................................................. 38
Depreciation ............................................................................................................................................ 38
Analysing Impairments ............................................................................................................................ 41
Intangible assets .......................................................................................................................................... 42
Accounting for intangibles ....................................................................................................................... 42
Asset Revaluations under IFRS .................................................................................................................... 43
Accounting Treatment ............................................................................................................................. 43
Analysis implications ............................................................................................................................... 44
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OVERVIEW OF FINANCIAL STATEMENTS

BUSINESS ANALYSIS

While business analysis is the

process of evaluating a
company’s economic prospects
and risks, financial statement
analysis is the application of
analytical tools and techniques to
derive estimates and inferences
useful in business analysis.

Conclusions derived from

financial statement and business
analysis are used to make
business decisions, which extend from equity to debt valuation to earnings predictions and so on.

STAKEHOLDERS
Stakeholders are the key group who uses the financial statement because it provides them with information about the
firm’s ability to:

1. ability and opportunities to create profit

2. risks

There exist different categories of stakeholders, each one with specific interests; however, sometimes one can belong to
more than a category at a time (e.g.: a manager who is also a shareholder).Analysts can distinguish them into internal
and external by means of their position within the firm:

1. external stakeholders do not have access to financial information on a day to day basis, as they do not manage
the business and, thus must wait for the annual financial analysis;

2. internal stakeholders are the managers and directors of a company, who, because of their position, already have
all the information and do not need to wait for the annual financial analysis of the business.

E XTERNAL STAKEHOLDERS
External stakeholders’ categories are:

1. Investors, also known as shareholders or stockholders, whose main interest are profit and the avoidance of
losses, as they are the risk-bearer of the company

2. Creditors, such as banks or financial institutions and suppliers. As they are owed money from the business,
they are interested in its ability to create value, as it is the only way they can retrieve their money.

They can be divided in trade and non-trade creditors.

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3. Managers and directors, who bear the responsibility of the company’s success, which is linked to their career
and salaries.

4. External agents, such as analysts and auditors;

their role is to interpret the company’s ability to
create value in the interest of other categories,
however, with different aims:

Auditors assess the transparency and accuracy of the

financial statement, not its results, while analysts
aim at evaluating profitability and solvency of a
company. if an auditor gives a negative opinion of a
company’s financial statement the analyst’s work
becomes useless

5. Authorities such as the Government are

interested in company’s financial analysis (and
profit) for tax-purposes and because of the economical and social impact the company has on the
environment

6. Employees and Unions whose job, salaries and careers depend on the company’s ability to make profit and
create value

7. Competitors are indeed interested in the company’s ability to make profit, either to exploit its loss of
costumers, or to study its success factors.

FINANCIAL STATEMENT ANALYSIS

Financial statement analysis can be of different types, and each type has a
different focus based on who its user is.

CREDIT ANALYSIS
Credit Analysis is particularly useful for creditors and it is based on their
needs (i.e. the asymmetric risk creditors bear), thus focusing on liquidity
and solvency; these two are facets of the same coin, in the sense in which
they both relate to the company’s creditworthiness.

L IQUIDITY
Liquidity is the ability to pay short-term debts; it depends on current cashflow, which means

1. collection of receivables
2. make up of current assets and their liquidity.
These aspects must be consistent meaning that:

Liquidity + Receipts ≥ Payments

S OLVENCY
Solvency is the ability to pay long-term debts, which depends on:

• profitability, as a company can pay credits in the long run only if it creates value.
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• capital structure which is the consistency.

EQUITY ANALYSIS
Shareholders are interested in the company’s ability to create profit and intrinsic value, which is the company’s (or its
stock) value disregarding actual market value.

Even if a company is not able to pay dividends, its intrinsic value represents the price for which shareholders can sell
the company or their own shares, thus make profit.

When carrying out an analysis for shareholders analysts usually follow different steps;

1. We start to analyse the company’s competitive environment and business strategy – which must be consistent
with the environment, in order to enable the company to compete in the market –.

2. We follow by starting an accounting analysis, as a good bookkeeping process is the prerequisite for a true
financial statement

3. Given the accounting analysis, analysts analyse the annual financial statement, which explain the company’s
ability to create value

4. Finally, analysts estimate the company’s intrinsic value, which represents the price for which the company can
be sold; in fact, even if dividends have not been payed, whenever a company has created value, a shareholder
might choose to sell its equity.

DIFFERENT TYPES OF ANALYSIS

Charting is an analysis which aims to determine the company’s intrinsic value by studying historical share prices and
internal data; however, it is not regarded as accurate, as it does not consider the external data.

Fundamental analysis is the same as charting, however it also considers the business strategy and the competitive
environment in which the firm founds itself.

Prospective analysis adds even more to fundamental analysis, by shifting

its focus from the past to the future of the company to determine its
intrinsic value.

V ALUATION MODEL
A company’s intrinsic value is estimated through a valuation model;
inputs to this model are the forecast of future payoffs and the cost of
capital. These can be found by evaluating the company’s prospects and
its financial statements.

In turn, quality if this analysis depends on the reliability and economic

content of the financial statement, which requires an accounting analysis.

BUSINESS ENVIRONMENT ANALYSIS

The business environment analysis seeks to identify and assess a company’s economic and industry circumstances,
whereas the strategy analysis seeks to assess the company’s strengths and weaknesses along its opportunities and risks.

It consists of two parts: industry analysis and strategy analysis.

I NDUSTRY ANALYSIS
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Industry analysis is usually carried out by means of the Porter framework, which identifies different players in the
industry and classifies their interactions.

Examples of such players are: suppliers, consumers or competitors

S OURCES OF COMPETITION
We particularly focus on Porter’s three sources of competition and their causes.

1. Rivalry among existing firms, there exist 5 possible causes:

a. Excess capacity and exit barriers

We speak of capacity when analysts refer to the number of products/services that a company can
produce/deliver over a set period. If the level of production is higher than demand, then the firm
risks either of not selling it or to be forced to lower the price in order to recover the costs of
production, thus exacerbating competition.

Furthermore, if there also exist significant exit barriers (e.g. Very specialized assets or regulations
that make exit costly) this problem is even more evident.

b. Degree of differentiation and switching costs

The extent to which a company can avoid competition depends also to the extent to which it can
differentiate its products/services, as the more they are unique the more they can be chosen by
costumers to which needs they best adapt.

On the other hand, if personalization is not feasible, a viable alternative to lower competition for
similar products is that of price competition

c. Industry growth rate

In a quick-paced industry existing firms can easily attract customers; thus, they have no need to
try and steal each other’s costumers

d. Concentration

Depends on the number of firms and their relative sizes: the higher number of firms with
charging high switching costs as to discourage costumers to change their provider.
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e. Scale and learning economics.

This point is, however directly linked with the firm’s production volume; suppose there is an
initial fixed cost: the more goods are produced the more this cost is spread among them, thus
making the cost of production lower.

Company A Company B

Variable Costs 200 800

Fixed Costs 800 200

Total 1000 1000

Even though both firms have the same total costs, as their cost structure is different (because of the
variation of fixed to variable costs) Company A has a better scale economy.

On the same reasoning, learning economics occurs whenever employee acquire skills and becomes
more efficient.

2. Threat of new entrants

a. First mover advantage:

Early entrants in an industry may deter future entrants if there are first mover advantages.

E.g. first movers might be able to set industry standards or enter exclusive arrangements with
suppliers of cheap raw materials.

If there are learning economies, early firms will have an absolute cost advantage over new
entrants. First mover advantages are also likely to be large whether there are significant switching
costs for customers once they start using existing products

b. Access to channels of distribution and relationships

Since there exist limited capacity in existing distribution channels and high costs of developing
new channels can act as powerful barriers to entry. E.g. First mover obtained all the channel of
distribution or made exclusive arrangements with suppliers

Existing relationships between firms and customers in an industry also make it difficult for new
firms to enter an industry, thus lowering competition.

c. Legal barriers

There are many industries in which legal barriers limit entry.

E.g. Patents and copyright in research intensive industries, licensing regulations about taxi
services, medical services, etc.

3. Threat of substitute products:

a. Price sensitivity.

Buyers are more price sensitive when the product is undifferentiated Cost ($)
and there are few switching costs. The sensitivity of buyers to price
Input A 70
also depends:
Input B 20
i. on the importance of the product to their own cost structure
Input C 1
ii. on the importance of the product to the buyers’ own product
quality. Final 100
product
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This same reasoning applies to the company, regarding their own cost structure:

The firm’s price sensitivity is not really affected by a change in Input C, as it represents only 1% of the
total costs and, probably, not even a great quality is needed. Sensitivity increases when higher levels of
quality are needed.

b. Relative bargaining power in input and output markets

Even if buyers are price sensitive, they may not be able to achieve low prices unless they have a strong
bargaining position. Relative bargaining power in a transaction depends, ultimately, on the cost to each
part of not doing business with the other part.

E.g. The buyers bargaining power is determined by the number of buyers relative to the number of
suppliers, volume of purchases by a single buyer, number of alternative products available to the buyer,
etc.

Conversely, suppliers are powerful when there are only a few companies and few substitutes available to
their customers.

The lower these three risks are, the higher a chance a firm in this industry has for profit.

Despite Porter’s Framework popularity, the model has one important limitation: it does not consider that there aren’t
clear boundaries for industries and, to have an actual forecast, a clear definition is the basic need.

S TRATEGY ANALYSIS
As a good strategy is the prerequisite to obtain competitive advantage and a higher, more sustainable, profitability.
Business Strategy Analysis is the evaluation of both a company’s business decisions and its success at establishing a
competitive advantage; this includes assessing a company’s expected strategic responses to its business environment
and the impact of these responses on its future success and growth. Strategy analysis requires scrutiny of company’s
competitive strategy for its product mix and cost structure.

C OMPETITIVE ADVANTAGE
When aiming at creating competitive advantage, there exist two opposite methods: cost leadership or differentiation.

COST LEADERSHIP
Whenever a firm chooses to base its strategy on cost leadership, what it’ doing is:

1. Producing at the lowest cost (i.e.: no differentiation and lower quality)

2. Setting the lowest price

3. Choosing the cheapest materials and channels of distribution

4. Focusing on efficiency and economies of scale.

DIFFERENTIATION
On the other hand, whenever a firm chooses to focus on differentiation, it is:

1. Aiming at producing at the highest quality level in order to satisfy the costumers’ specific needs.

2. Flexible

3. Invest in marketing, research and development and customer relationship

4. Focuses on having the best channel of distribution.

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ACHIEVING COMPETITIVE ADVANTAGe

Obviously, there is a middle ground as
well as the possibility for a firm to dif-
ferentiate the strategy given different
targets.

Obviously, the choice of strategy is an

important first step for a firm, but it does
not automatically lead to the achieve-
ment of competitive advantage.

To achieve competitive advantage, the

firm must have the capabilities needed
to implement and sustain the chosen
strategy.

Main factors to evaluate include:

1. Unique core competencies.

It is important that the resources supporting the core competencies cannot easily be acquired by competitors or
substituted for by other resources.

2. A system of activities that fits with the strategy and potentially reinforce each other.

3. Strategic positioning.
Firms must identify a specific segment of an industry and focus on it (e.g. a particular group of services varie-
ties; the needs of a particular customer group; particular access and distribution channels).

At the same time, focusing on protecting these points from the competitors, in order to maintain the advantage.

ACCOUNTING ANALYSIS
Accounting analysis consists in the process to evaluate and correct accounting data gathered from financial statements
for them to better reflect the reality; as financial statement ore financial analysis primary source, the latter’s quality and
depends on the financial statement’s reliability.

As external stakeholder does not have access to the bookkeeping process, what they can do is check for the auditor’s
opinion.

C OMPARABILITY
We need financial statements to be comparable over time and firms; to gain such comparability, statements need to be
constant over time.
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It is thanks to comparability that analysts are able to understand if a firm’s profit are good: a 5% profit increase in a de-
creasing industry is outstanding, however, if competitors’ profits have risen by 10% not so much; same goes for time
comparisons, if a 5% profit increase after years of non-growth had happened, it would be a great result, if however, past
profits were skyrocketing, the company might be losing profit.

ACCOUNTING RISK
At the same time, it is possible that analysts encounter the different distortion problems which may arise in accounting,
such as:

1. Managerial estimations, which can be honest errors or omissions;

2. Earnings management by directors and managers to manipulate or window-dress statements

3. Accounting standards, which affect the business representation, and the subsequent business analysis, can
cause a distortion as OICs are more prudent and thus less updated, while IFRs and GAAPs are less reliable, but
more updated.

The uncertainty caused by these distortions in financial analysis is known as accounting risk and the goal of accounting
analysis is to reduce it and improve the economic content of the financial statement.

FINANCIAL ANALYSIS
The use of financial statements to analyse a company’s financial position

and performance and to assess future financial performance is considered a financial analysis. FA’s most difficult part is
probably the prospective analysis, whose scope is to understand the company’s ability to be profitable in the future and
to sustain it even if external and internal conditions might change.

1. Profitability analysis–Evaluates return of investments, i.e. company’s sources and levels of profits. It also in-
volves identifying and measuring the impact of various profitability drivers.

2. Risk analysis – Evaluates riskiness and creditworthiness of a company; the solvency and liquidity of a com-
pany along with its earnings variability. Because risk particularly concerns with creditors, risk analysis is often
discussed in the context of credit analysis. But it is also important to equity analysis, both to evaluate the relia-
bility and sustainability of company performance and to estimate a company’s cost of capital.

3. Analysis of cash flows–Evaluates how a company is obtaining and deploying its funds.

V ALUATION
The next step lays of the previous three, as prospective analysis is the forecasting of future payoffs – typically earnings,
cash flows or both – and the output is a set of expected future payoffs used to estimate the company value.

Valuation is the process of converting forecasts of future payoffs into an estimate of company value. To determine a
company value, an analyst must select a valuation model (e.g. some models are grounded on expected earnings and
some others are grounded on expected cash flows) and must also estimate the company’s cost of capital.

BASIS OF FINANCIAL ANALYSIS

Financial statements and related disclosures inform analysts about the full
measure activities of a company which are:
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1. planning activities refer to purposes and strategies adopted by the

company, given data from industry and business analysis; this plan is
summarised in a business plan. The business plan, however, is only
available to internal stakeholders; external stakeholders must refer to
the letter to shareholders and the management discussion and
analysis.

2. financing activities refer to methods that a company uses to raise

money to pay for their needs such as: raw materials for production,
implementing marketing activities and research and development. There are two main sources of external
financing: one is equity investors, the second is creditors; the composition of financing activities depends on
conditions existing in financial markets. Decisions on issues such as:

a. the amount of financing necessary sources

b. timing of repayment

c. structure of financing agreements

determine a company organizational structure and affect its growth as well as influence its exposure to risk and
the power of outsiders in business decisions.

Return is the equity investors share of a company earnings in the form of either earnings distribution or
earnings reinvestment; when analysts speak of earnings distribution they speak of the payment of dividends to
shareholders; distributed earnings – or investment or earnings – retention refers to earnings retained within the
company for using them in business. This is also called internal financing.

The earnings retention ratio reflects the proportion of earning retained and is defined as one less the dividend
pay-out ratio.

Equity financing can happen by means of cash or any asset or service contributed to a company in exchange
for equity share, however, the main benefit of public offerings of shares is the potential to raise substantial
funds for business activities

Creditor Financing is different from equity financing in that an agreement or contract is usually established; it
requires repairment of the loan with interest at specific dates. Risk for creditors is the possibility of a business
will default in repaying its loans and interest, in this situation creditors might not receive their money due and
bankruptcy order legal remedies could ensue, such remedies impose costs on creditors.

3. investing activities refer to a company's acquisition of investments for purposes of selling products and providing
services or to invest excess cash. If they are done in order to conduct the company's business operations, they are
called operating assets; if their aim is to invest excess cash in securities, such as other companies’ equity stocks,
they are known as financial assets. Investing decisions involve several factors such as:

a. type of investment necessary

b. amount required

c. acquisition timing

d. asset location

e. contractual agreement.

4. operating activities represent the carrying out of the business given planning, financing and investing activities;
they are a company’s primary source of earnings and must reflect the company's success in buying from input
markets as selling in output markets.

FINANCIAL STATEMENT PREPARATION

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At the end of a period financial statements are prepared to represent financing and investing activities at a point in time
and to summarise operating activities for the previous period; since financial statements reflect the business activities,
they become the information sources of business analysis

S OURCES OF INFORMATION
1. For qualitative information analysts and auditors refer to
a. external sources such as press releases financial press or website

b. internal sources such as

i. the vision or mission statement

ii. the chairperson's letter

iii. the management discussion and analysis which highlights any favourable or unfavourable trends
and identifies significant Events and uncertainties that affect the company's liquidity capital
resources and results of operations.

iv. the management report aims to reinforce senior management’s responsibilities for the company's
financial internal control system and shared roles of management directors and the auditor in
preparing financial statements

v. the auditor’s report rough which is an opinion on whether the company’s financial statements are
prepared in conformity with generally accepted accounting principles.

vi. The explanatory notes which are mean of communicating additional information regarding items
included or excluded from the body of the statements such as the accounting principles and
methods employed detailed disclosures regarding the individual financial statement items
commitments and contingencies business combinations transactions with related parties stock
option plans legal proceedings and significant customers

vii. Supplementary Information include information on business segments data experts, sales
marketable securities valuation accounts short term borrowings and quarterly financial data

viii. the proxy statement contains information accessory for shareholders in voting matters for which
the proxy is solicited a proxy isn't mean whereby a shoulder authorises another person to act for
him or her at the meeting of shareholders

2. On the other hand, for quantitative information sources are the annual financial statements as well as greater
information from outside such as economic indicators or industry statistics.

Annual financial statements are: the balance sheet, the income statement, the statement of changes in shareholders
equity and the statement of cash flows

T HE B ALANCE SHEET
The balance sheet reports on financing and investing activities at a specific point of time, usually the last day of the
reporting period; it shows the fundamental accounting equation which is:

𝐴𝑠𝑠𝑒𝑡𝑠 = 𝐸𝑞𝑢𝑖𝑡𝑦 + 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

we distinguish the liabilities and assets as current on noncurrent and their difference is called the working capital.

Current assets are expected to be converted into cash or used in operation within one year or the operating cycle
whichever is longer; On the other end current liabilities are obligations the company is expected to settle within one
year or the operating cycle whichever is longer.

T HE INCOME STATEMENT
The income statement measures our company’s economic performance over a period of time, usually one year, which
can or cannot correspond to the solar year; it is a financial representation of the operating activities of a company during
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this period. Typically, the bottom line is net income which purports to measure the amounts that the company earned
during the period which means the difference between revenues and expenses

I NTERMEDIATE MEASURES OF INCOME

Income statement often includes several other intermediate measures of income such as:

 the income from continuing operations, that represents the earnings from continuing operation before of
the provision for income taxes

𝑅𝑒𝑠𝑢𝑙𝑡𝑠 𝑓𝑟𝑜𝑚 𝑐𝑜𝑛𝑡𝑜𝑛𝑢𝑖𝑛𝑔 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑜𝑛𝑠 = 𝑟𝑒𝑣𝑒𝑛𝑢𝑒𝑠 − 𝑒𝑥𝑝𝑒𝑛𝑠𝑒𝑠

Before income taxes and except for discontinuing operations.

 operating earnings, which does not have a fixed definition, but refers to the difference between sales
revenues and all operating responses

𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑟𝑒𝑠𝑢𝑙𝑡𝑠 = 𝑠𝑎𝑙𝑒𝑠 𝑟𝑒𝑣𝑒𝑛𝑢𝑒𝑠 − 𝑎𝑙𝑙 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑒𝑥𝑝𝑒𝑛𝑠𝑒𝑠

 gross profit or gross margin is the difference between sales and cost of goods sold.

𝐺𝑟𝑜𝑠𝑠 𝑚𝑎𝑟𝑔𝑖𝑛 = 𝑛𝑒𝑡 𝑠𝑎𝑙𝑒𝑠 − 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑 𝑠𝑜𝑙𝑑

The income statement is consistent with accrual basis of accounting principles, which means that: revenues are
recognised when the company sells good or provide this services regardless or when cash is received; while expenses
accrues when they can be matched with revenues; amortization expenses accrue consistently with their monetization
plan and the useful life of an asset; losses accrue when they emerge.

Consistently with the prudence principle the traditional part of the income statement does not include unrealised
expenses and revenues: these components are shown within the other comprehensive income section and within the
comprehensive income statement.

S TATEMENT OF CASHFLOW
The statement of cash flows has to deal with the fact that earnings do not typically equal net cash flows because
revenues are not immediately cast and expenses are not immediately paid. The statement of cash flows reports on cash
inflows and cash outflows.

Under IAS, also government bonds must be considered as cash, given that they possess two characteristics, which are:

1. they are short term, which means that their due date is lower than three months

2. they are low risk, for example German bonds as opposed to the Brazilian ones.

Cash flow analysis is primarily used as a tool to evaluate the sources and uses of funds it provides insights into how a
company is obtaining its financing and deploying its resources. it is grounded on the preparation and interpretation of
the statement of cash flows and he is also used in cash flow forecasting and as a part of liquidity analysis.

S TATEMENT OF CHANGES IN SHAREHOLDERS ’ EQUITY

The statement of changes in shareholders equity is composed of the statements of retained earnings, comprehensive
income and changes in capital accounts; it is a measure of the ultimate bottom line, that is all changes to shareholders
equity excluding transactions involving exchanges with shareholders.

All the financial statements are linked by design, which means the period of time statements – such as the income
statement of cash flows and a statement of shareholders equity – explain the point in time balance sheet. This concept is
known as the articulation of financial statements.

TOOLS FOR FINANCIAL ANALYSIS

When conducting a financial analysis, analysts can use a variety of tools in conduct a variety of analysis such as
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 horizontal analysis, also known as the comparative financial statement analysis

 the vertical analysis, that’s known as the common size financial statement analysis

 ratio analysis

 cash flow analysis and

 valuation.

C OMPARATIVE ANALYSIS
Comparative analysis reviews consecutive balance sheets, income statements or statements of cash flow from period to
period regarding a specific company, allowing us to appreciate the evolution of performance and situation of a
company: basically, analysts are interested in trends; analysts can study them by means of year to year analysis or an
index analysis.

Y EAR TO YEAR CHANGE ANALYSIS

The year to year change analysis compares financial statements over relatively short time periods – two to three years –
and is usually performed with analysis of year to year changes in individual accounts, which means that a base year is
chosen as a starting point and then, analysts compute the change of single accounts of the financial statements over
time. Even more than absolute values, analysts are interested in the relative ones, by means of percentages.

This procedure, however, possesses some limitations:

1. whenever negative amounts appears in the base and a positive amount in the next period – or vice versa –
analysts cannot compute a meaningful percentage change;

2. when there is no amount for the base-year, no percentage change is computable

3. when the base year amount is particularly small, analysts can compute the percentage change, but the number
must be interpreted with caution.

I NDEX NUMBER CHANGE ANALYSIS

If longer periods need to be analysed, analysts use the index number change analysis, in which they choose a base
year for all item with a preselected index number usually set to 100. Because the base-period is a frame of reference for
all comparisons, it is best to choose a normal year regarding business conditions.

C OMMON SIZE ANALYSIS

Common size analysis’ purpose is the valuation of the internal makeup of financial statements and the valuation of
financial statements accounts across companies; its output is a proportionate size of assets liability equity revenues and
expenses. In other words, it shows what proportion of a group or sub-group is made up of a particular account.

For example, in analysing a balance sheet it is common to express total assets or liabilities plus equity as 100%;
accounts within these groups are expressed as a percentage of their respective total. Following the same reasoning, in an
income statement analysis, sales are often set as 100% with the remaining income statement accounts expressed as a
percentage of sales.

Common size statements are also useful for intercompany comparison, because financial statements of different
companies are recast in common-size format, thus they can be meaningfully compared.

This analysis can highlight differences in account makeup and distribution between companies, but reasons for such
differences should be explored and understood.

One key limitation, however, is the failure to reflect relative sizes of the companies under analysis.

To meaningfully interpret common size analysis, a further examination of both demands for the accounts under the
analysis and the basis for their computation is required.

R ATIO ANALYSIS
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The purpose of ratio analysis is to evaluate the relationship between two or more economically important items; it is
often misunderstood, as it must be considered a starting point for further analysis rather than an end one as it is most
useful to identify areas requiring further investigation and, in general, when future oriented.

I NTERPRETATION OF RATIO ANALYSIS

Its output is a mathematical expression of the relationship between the analysed items; however, caution must be used
when applying this analysis, since it is important that a prior accounting analysis has been taken out. Interpretation is
the key of this type of analysis.

We must be aware of the effects that affect a company’s ratio beyond internal operating activities, such as: economic
events, industry factors, management policies and accounting methods; in general, when interpreting ratios, analysts
must consider that they are not relevant in isolation and must be compared to prior ratios, predetermined standards and
ratios of competitors.

I LLUSTRATION OF RATIO ANALYSIS

Ratio analysis is most important when applied to three important areas of financial statement analysis

1. credit or risk analysis, in which analysts use two main types of ratios:

liquidity ratios to evaluate the ability to meet short term obligation

i. current ratio which measures current assets available to satisfy current liabilities

ii. acid test ratio which uses only the most liquid caravan antacids cash short term investments
an account receivables

iii. the collection period for receivables

iv. the days to sell inventory

capital structure and solvency ratios do evaluate the ability to meet long term obligations

i. Total debt to equity ratio

ii. long term debt to equity ratio

iii. the times interest earned ratio

2. profitability analysis

a. return on investments to assess financial rewards to the suppliers of equity and debt financing

b. operating performance to evaluate profit margins from operating activities

c. asset utilization in order to assess the effectiveness and intensity of an asset in generating sales

3. valuation ratios to estimate the intrinsic value of a company

V ALUATION MODELS
Valuation refers to techniques used in estimating the intrinsic value of a company or its stock; it is based on present
value theory, which states that the value of a debt or equity security is equal to the sum of all expected future payoffs
from the security, discounted to the present at an appropriate discount rate.

D EBT – OR BOND – VALUATION

 16

With that, or bond valuation, analysts determine the expected or desired yield based on factors such as current
interest rates, expected inflation, and risk of default.

E QUITY VALUATION
With equity valuation the investor has no claim on predetermined payoffs, instead, the equity investors looks for two
main uncertain pay offs: dividend statement and capital appreciation.

DIVIDEND DISCOUNT MODEL

The main limitation of the dividends discount model is that this practical valuation technique must compute value using
finite forecast horizon. However, forecasting dividends is very difficult in such a setting because dividend payments are
discretionary and different companies adopt different payment policies, therefore, actual dividend pay-outs are not
indicative of company value except in a very long run.

FREE CASHFLOW DISCOUNT MODEL

When analysts talk of free cash flow to equity model, analysts can define it for equity investors or the entire firm.

If analysts are speaking for the entire firm:

 FCF equals operating cash flow less investments in operating assets;

 17

 Vt represents the value of the entire firm;

 K is the weighted average of cost of capital, that includes both the cost of the end of equity.

RESIDUAL INCOME MODEL

Doing an equity valuation, analysts can also computer residual income model, this method defines equity value at
time tea as the sum of the current book value and the present value of all future expected residual income.

While both of the last models overcome some problems of using dividends, these are defined in terms of an infinite
horizon, to drive value using a finite horizon analysts must replace the present value of future difference rounded at a
particular future date by an estimate of continuing value, which is also called terminal value.

EFFICIENT MARKET HYPOTHESIS

The efficient market hypothesis deals with the reaction of market prices to financial and other information. Whether the
stock market is highly efficient, the current stock price is highly reactive to financial and other information and thus it
represents a good estimate of a company's value.

There exist three different efficient market hypotheses

1. in the first one analysts have a weak form of EMH hello in which prices reflect only the information
contained in the historical price movements

2. the semi-strong form, in which prices reflect only all publicly available sources of information.

3. the strong form states that prices reflect all information including the inside one

IMPLICATIONS
The implications are different: firstly, EMH assumes the existence of competent and well-informed analysts, but if all
information is instantly reflected in prices, attempts to reap consistent rewards through financial statement analysis are
futile. This extreme position represents a paradox: on one hand, financial statement analysts are assumed capable of
keeping market sufficient, yet the same analysts are assumed as unable to earn excess returns from their efforts.
Secondly, if analysts presume their effort is regarded as futile, the efficiency of the market ceases; for these reasons, it is
more reasonable to think that EMH is built on aggregate, rather than individual, investor behaviour. Focusing on
aggregate behaviour highlights average performance and ignores or masks individual performance based on ability,
common sense and ingenuity, as well as superior individual timing in acting on information.

Furthermore, EMH’s alleged implication regarding the futility of financial statement analysis fails to recognise an
essential difference between information in its proper interpretation. That is, even if all information available at a given
point in time is incorporated in price, this price does not necessarily reflect value: market efficiency depends not only
on availability of information but also in its correct interpretation. A competent analysis of information entering the
marketplace requires a sound analytical knowledge base.
 18

FINANCIAL REPORTING AND ANALYSIS

THE REPORTING ENVIRONMENT
The reporting environment is composed of all the forces which influence the Financial Analysis process and its main
output are the statutory financial reports; such reports can be divided into three categories:

 Financial statements:

Strictly speaking, the annual financial statement is not a statutory document; its equivalent – at least in
the US – is the Form-10K, which public companies must file annually with SEC. However,
information in this form is rarely timely, for this reason companies are also required the Form-10Q
quarterly to provide more time-relevant information.

 Earnings announcement:

Between the end of the reporting period and the publication of statements there is usually a time-lag of
one to six weeks; in order to account for this delay, companies publish earnings announcements
before. Such announcement is a summary of key information regarding the company’s performance
and position; it has been observed that much of the market reaction regarding stock prices happens on
the day earnings are announced, rather than when the financial statements are published.

 Other statutory reports:

Such as the proxy statement and the prospectus.

FACTORS AFFECTING THE REPORTING ENVIRONMENT

On the other hand, the main influencing factors are: accounting standards; Managers; enforcing and control mechanism.

A CCOUNTING STANDARDS
Accounting Standards are a set of rules and guidelines of financial accounting; they are established by different bodies –
so called standard setters – for each Country, such as the IASB for IAS/IFRS or the FASB for US GAAPs. These rules
determine measurement and recognition policies, such as how assets are measured, when liabilities are incurred, and so
on.

As for US GAAPs, the FASB is composed of seven members who represent the various interest groups, such as
investors, managers, accountants and analysts.

S TANDARD SETTING PROCESS

Standard setting is a political process, which often results in a compromise between the conflicting interests at stake
and, thus, fails to require the most relevant information.

The IASB, on the other hand, is a private sector body representing interests of accountants and other relevant parties
from other Countries; IFRS tend to be principle based, thus providing guidelines rather than “cookbooks” for
accounting standards.

M ANAGERS
Managers bear the primary responsibility for fair and accurate financial reporting, as they have the ultimate control over
the integrity of the financial records and accounting systems; recognizing this feature, CEOs are legally required to
certify accuracy and veracity of financial statements.

M ANAGERIAL DISCRETION
Managerial discretion is needed within the context of financial statements and the bookkeeping process for two reasons:

1. Accounting standard often require managers to choose between alternatives;

2. Accounting numbers often need an estimation to be defined.

 19

From a managerial viewpoint, the most important aspect of a new accounting standard is its cost; thus, a manager
typically opposes standards that:

1. Decreases reported earnings;

2. Increases earnings volatility;

3. Discloses competitive information.

M ONITORING AND ENFORCING MECHANISMS

Reliability and integrity of financial disclosure are ensured by monitoring and enforcement mechanisms; such
mechanisms include:

1. Audit opinion, produced by external auditors, which is based on the audit report and can be:

a. Clean, the company is fairly represented

b. Qualified, the company is fairly represented, with some exceptions

c. A disclaim in expressing any opinion.

In Italy, all limited liability companies (except for some particularly small ones) must publish an audited
annual report, when the representation of the business is heavily distorted, auditors express an adverse opinion.

2. Corporate governance: since financial statements need to be approved by the company’s BoD, most firms
appoint an audit committee, which is entrusted with:

a. overseeing the accounting process

b. overseeing the internal control mechanism

c. oversee internal and external audits.

In addition, companies could also issue internal audits.

3. As for the US, the SEC is entrusted with the power of enforcing accounting standards by means of checking
the statutory reports and bringing actions against companies which commit violations of accounting standards.

4. The threat of litigation is another important deterrent against violations of accounting standards.

A LTERNATIVE INFORMATION SOURCES

Other than statutory reports, there exist other important alternative sources of information for an analyst’ forecasts
and recommendations:

1. Economic, Industry and Company News, which impact current and future financial condition and
performance; however, their effect varies across industries and companies given the perceived risk.

2. Voluntary Disclosure by managers aims at:

a. Decreasing legal liability

b. Expectation adjustments: managers have incentives in disclosing information if they believe that
market’s expectations are sufficiently different from their own.

c. Signalling where managers are said to disclose positive information in order to increase the
company’s stock price.

d. Intent to manage market expectations

3. Information intermediaries, which is an industry devoted to collecting, processing, interpreting and

disseminating information about the financial prospect of companies. Such industry includes analysts,
advisers, debt raters, forecasters and buy and sell side analysts (analysts specialized in advising internal
users, such as investment companies, and outside users, the general public, respectively).
 20

Thus, they are not directly linked with making investment and credit decisions, but rather providing useful
information for decision makers. They are generally viewed as performing at least one of four functions:

a. Information gathering

b. Information interpretation

c. Prospective analysis

d. Recommendations.

NATURE AND PURPOSE OF FINANCIAL ACCOUNTING

It is possible to evaluate strengths and weaknesses of accounting and its relevance to effective analysis and decision
making given the desirable qualities of information, principles and conventions underlying financial accounting.

DESIRABLE QUALITIES
The desirable qualities of accounting are:

1. Relevance, that is the capacity of an information to affect a business decision. Given the limited space the
bookkeeping process allows, accountants need to perform a selection of information to include; such selection
is done by using the criterion of relevance (a synonym also for materiality). However, two issues arise:

a. For who does the disclosed information be material? It is common practice to consider external
stakeholders as the users of relevant information

b. Who is entrusted with the responsibility to decide what is relevant? Managers, who are, however,
obliged to disclose their analysis in the Notes to the Annual Financial Statements.

2. The reliability of a financial statement is defined as:

An annual financial statement that represents a true and fair view of a company.

In order to explain such a definition, analysts refer to the collateral characteristics of:

a. Verifiability, which means that the information represented is confirmable.

b. Representational faithfulness, which means that the represented information represents reality

c. Neutrality, which means that the information depicted is truthful and unbiased

3. Finally, analysts speak of comparability and consistency, which are prerequisites of the previous two
qualities. In fact, comparability ensures that the information if measured in a similar manner across companies,
while consistency is concerned with the fact that the same method is used over time similar transaction.

L IMITATIONS OF ACCOUNTING INFORMATION

At the same time, analysts and financial users must be aware of the limitations of accounting information, namely:

1. Timeliness, as the disclosure is periodic and not on a real-time basis

2. Frequency, strictly related to the previous point, when are this information disclosed? Obviously, a higher
frequency ensures also a better timeliness, however, information is typically disclosed quarterly, semi-annually
or annually.

3. Forward looking, alternative information sources use much forward-looking information, whereas, financial
statements contain limited forecasts; in addition, historical cost-based accounting (and conservatism) yields a
recognition lag.

PRINCIPLES OF ACCOUNTING
As form important principles of accounting, analysts recognize four of them:

1. Historical cost and fair value, which are two opposed views on how to measure and record income;
 21

a. Historical cost is also known as transaction-based accounting, as it states that assets must be recorded
at their purchase price. Its main advantage is that value is fair and objective. Information disclosed if
more reliable, but less relevant, since it isn’t timeliness.

b. Fair value accounting estimates the current economic value of an asset, thus information disclosed is
more relevant, even if less reliable, since it is subject to managerial discretion.

2. Accrual accounting, which states that revenues must be recognized when earned, while expenses only when
incurred; it is arguably the most important, but also controversial feature of modern accounting.

3. Materiality identifies a threshold on when information impacts accounting decision making. According to
FASB it is defined as:

The magnitude of an omission or misstatement of accounting information that, in

the light of surrounding circumstances, makes it possible that the judgement of a
reasonable person relying on the information would be changed or influenced by
the omission or misstatement.

4. Conservatism, which deals with the choice on what type of information must be disclosed, usually the least
optimistic regarding uncertain events and transactions; it reduces reliability and relevance of disclosed
information, since it understates both net assets and net income. Furthermore, it delays the recognition of good
news, while immediately recognizing a bad one.

There are two types of conservatism:

a. Unconditional conservatism, which is applied across the board in a consistent manner, so that assets
values are perpetually understated

b. Conditional conservatism, refers to the adage:

Recognize all losses immediately but recognize gains only after they are realized.

FAIR VALUE ACCOUNTING

Fair value accounting is an alternative for historical cost where assets and liabilities are values at the fair value, which
typically is the market price, at the measurement date, i.e. approximately the date of financial statements. Such price is
regulated by IFRS 135.

Since FV is based on a hypothetical transaction, it is more volatile and subjective than historical cost; for this reason,
under IFRS and SFASs, FVA is currently used to record the value of financial assets, such as marketable securities,
whereas it is not accepted under Italian GAAP.

DEFINITION OF FAIR VALUE ACCOUNTING

Under IFRS and SFASs Fair Value is defined as:

Fair value is the price that would be received from selling an asset or that would be
paid to transfer a liability in an orderly transaction between market free participants
on the measurement date – SFAS 157, IFRS 13

Where:

 The price is considered an exit price, i.e. The price to sell the asset, not to buy it – known as the entry price.

 The measurement is market-based, which means analysts do not consider the net realizable value adopted by
inventories in IAS 2.

 We only consider orderly transaction, which means they happened under usual circumstances on an active
market.
 22

 As for liabilities, analysts consider their fair value as the price to be paid to transfer them to another subject.

H IERARCHY OF INPUTS
Furthermore, there exists a so-called hierarchy of inputs to evaluate an asset/liability at fair price, which is composed of
three levels.

L EVEL 1 INPUTS
Whenever possible, level 1 inputs are
mandatory, these inputs represent the
quoted price in an active market for the as-
sets.

L EVEL 2 INPUTS
If such prices are not available, it is possi-
ble to adjust based on the other two levels
of inputs in an orderly manner – i.e. In a
down-top approach.

Particularly, level two inputs are composed of:

1. Quoted prices from active markets for similar, but not identical assets or liabilities;

2. Quoted prices for identical assets or liabilities from inactive markets.

L EVEL 3 INPUTS
Finally, level 3 inputs are made up of unobservable inputs, which roughly translates into an estimate of the expected
income present value.

V ALUATION TECHNIQUE
Given the availability of input data, a valuation technique must be chosen and, unless a change in circumstances allows
for a more accurate determination of values, must be used consistently. Such valuation techniques are:

1. Market approach, where prices from actual market transactions are used, whether direct or not – it corresponds
to level 1 or 2 of inputs.

2. Income approach, where analysts measure Fair Value as a discounted future cashflow or earning expecta-
tions to the current period – corresponds to level 3 inputs

3. Cost approach, analysts use it to determine the current replacement cost of an asset, given its residual service
capacity. Thus, analysts define it as the current cost to a market participant to acquire or construct a substi-
tute asset that generates comparable utility after adjusting for technological improvements, natural wear and
tear and economic obsolescence – it can be used for all levels of inputs.

IMPLICATION FOR ANALYSIS

A DVANTAGES AND DISADVANTAGES
FVA, as all other accounting methods, is characterized by advantages and disadvantages, which are:

1. Advantages:

a. Reflection of current information: in contrast with historical cost, FVA always updates information to
the measurement date, thus enhancing its relevance to financial statement users.

b. Consistent measurement criteria: it is the only conceptually consistent measurement criteria, as op-
posed to the current financial accounting, which is based on a mix-mash criterion.
 23

c. Comparability; because of the consistency FVA improves comparability across firms.

d. No conservative bias, in favour of neutrality

e. More useful for equity analysis in contrast with the traditional financial accounting, which focuses
mainly on credit analysis.

2. Disadvantages

a. Lower objectivity, since FVA is based on managerial discretion in the choice of inputs, it is less relia-
ble than financial accounting;

b. Susceptibility to manipulation, particularly by means of level 3 inputs

c. Lack of conservatism, which constitutes two amin disadvantages:

i. It does not offset the optimistic bias of managers, as conservative accounting does;

ii. It is less relevant to credit analysis, since creditors prefer statements that highlight downside
risk.

d. Excess income volatility, because of the proportion of income which is composed of assets and liabili-
ties that would be valued under fair value accounting.

H ISTORICAL COST ACCOUNTING VS . FAIR VALUE ACCOUNTING

One particularly interesting feature of fair value accounting is its definition of income, contrasting the traditional defini-
tion given by historical cost accounting; in order to fully understand it, however, analysts need to start from the dif-
ferences between these two methods.

Historical Cost accounting Fair Value accounting

Transaction Valuation is based on past transac- Valuation is based on hypothetical

tions and does not necessarily reflect transactions happening under the
vs. the current conditions of the market market’s current circumstances

current valuation

Cost Cost is primarily defined as the cost Cost is based on the market valua-
incurred by the business. tion.
vs.

Market based approach

Alternative income approaches Income is determined by matching Income is net change in assets and li-
revenues and expenses; its aim is to abilities’ fair value and approximates
reflect the company’s current profit- the company’s economic income.
ability.

ACCRUAL ACCOUNTING
According to the Statement of Financial accounting concepts No. 1:

Information about an enterprise earnings based on accrual accounting,

generally provides a better indication of enterprises’ present and continu-
ing ability to generate cashflows than the information limited to the finan-
cial aspect of cash receipts and payments.
 24

THE CONCEPT OF ACCRUALS

The conceptual superiority of accrual accounting arises because the income statement redacted under this
method provides more relevant information regarding the company’s present and future ability to generate
cash. This is achieved considering the methods’ aim, which is to inform users about the consequences of
business activities for a company’s future cashflow as soon as possible and with a certain level of cer-
tainty; such objective is pursued by recognizing revenues when earned and expenses when incurred, re-
gardless of whether cashflows were contemporary or not.

ACCRUAL ADJUSTMENT
The so-called accrual adjustments, however, rise the problem of subjectivity within this method, since, at
the end of each reporting period, ongoing operations must be split between the past reporting period and
the following one by means of estimation.

A CCRUALS AND CASHFLOWS

Strictly speaking, accruals are the sum of accounting adjustments that make net income different from net cashflow;
because of double entry, these adjustments affect the balance sheet by increasing or decreasing an assets’ or liabilities’
account by an equal amount, which yields the following identity:

Net income = Operating cashflow + accruals

However, over the life of a company, accrual and cashflow income become equivalent: it is in the short
term that adjustments need to be made; namely:

1. Adjustments to solve timing problems, which refer to cashflows that do not occur contemporane-
ously with business activities yielding the cashflows;

2. Adjustments to solve the matching problem, which is given by cash inflows and outflows gener-
ated by a business activity which, however, are not matched in time.

C ASHFLOWS WITHIN AN INDUSTRY

It is important to recognize that there are different types of cashflows within a firm; namely:

1. Operating cashflow, which refers to cash originated by the company’s ongoing activities;

2. Free cashflow to the firm reflects the added effect of investment a divestment in operating assets,
which appeals analysts as it represents cash that is free to be paid both to equity and debt holders;

3. Free cashflow to equity, adds changes in the firms’ debt levels to free cashflow to the firm, and,
thereby, yields the cashflow that are available to equity holders;

4. Net cashflow, which represents the bottom line, is the net change in the cash account balances, in-
cluding cash-equivalents.

A CCRUAL PROCESS
The accrual process is based on the revenues recognition and expenses matching principle, which means:

1. That revenues are recognized when both earned and realized (or when they are considered realiza-
ble);

a. A revenue is considered realized when cash is acquired;

b. It is considered realizable when the company receives an asset convertible to cash when a
product or service is delivered
 25

2. Expenses need to be matched with a corresponding revenue, for example: products cost are recog-
nized when a product is sold, and its amount is transferred to COGS, while the remaining costs in-
curred are considered period costs.
Some period costs, however, cannot be matched with an expense, i.e. administrative costs, and are
thus recognized when incurred.

SHORT- AND LONG-TERM ACCRUALS

Whenever analysts consider accruals analysts need to take into account whether they are short or long term; short
term accruals or working capital accruals arise in the short term and refer to differences between income and cash flow,
they are primarily due to inventories and credit transaction; long term accruals arise from the capitalization process, that
is: the deference of cost incurred in the current period, whose benefits are expected in the future ones.

Accrual accounting has a conceptual superiority over cashflow one, given the higher relevance in measuring a com-
pany’s present and future cash-generating ability; in particular:

Short term accruals better reflect an income number that better reflects profitability

Long term accruals pose a problem for free cash flow, since the latter is computed by subtracting long
term assets from operating cashflows, which means that FCF tends to be negative until a business matures,
however, in late maturity and decline a company divests its assets, generating positive investing cash-
flows. This means that FCF sends a reverse message about a company’s prospects.

For this reason, the capitalization process improves income’s relevance by both reducing its volatility and
matching costs of long-term investments to its benefits.

RELEVANCE AND LIMITATIONS OF ACCRUAL ACCOUNTING

From an analysis standpoint, then analysts must take into consideration differences between accrual and
cashflow accounting:

Accrual Accounting Cashflow Accounting

Income More relevant in measuring a Less relevant in the context of

company’s financial condition current income
and performance as well as in
valuation

Reliability Are more subject to distortions, Even if they are more volatile
because of the alternative ac- than net income, they are more
counting methods (i.e. LIFO vs. difficult to manipulate.
FIFO etc.) and of earnings man-
agement.

Thus, taking these factors into consideration, analysts can compute a company’s value by using both
methods.

THE CONCEPT OF INCOME

Income, also referred to as earnings of profit, summarizes the net effect of business’s operations over a period of time; it
serves as both a measure of change in stockholders’ wealth and as an estimate of a business’s current profitability.
Given the different criteria used to estimate income, analysts can differentiate accounting, or reported, income and
economic income.

The accounting concept of income is based on accrual accounting, while economic income is concerned with the
change in equity-holders’ wealth.
 26

ECONOMIC INCOME
Economic income is made-up of current cashflows plus the present value of estimated future cashflows, including both
realized and unrealized gains. It is most useful in estimating the exact return for shareholders over a period, but is, how-
ever, less reliable in terms of future earnings potential, at is based on the socio-economical environment, which is vola-
tile by definition.

The two components of economic income are permanent and operating income.

P ERMANENT INCOME
Permanent income, also called sustainable or recurring income, represents the stable average income, given the current
state of its business conditions; thus, it is said to reflect a long-term perspective. Even if it is said to be more stable than
accounting income, it is highly influenced by globalization, a factor that adds a layer of instability and volatility to the
environment.

It is directly proportional to the economic value of the business, that, for a going concern, is expressed as:

𝑃𝑒𝑟𝑚𝑎𝑛𝑡𝑒𝑛𝑡 𝑖𝑛𝑐𝑜𝑚𝑒
𝐶𝑜𝑟𝑝𝑜𝑟𝑎𝑡𝑒 𝑣𝑎𝑙𝑢𝑒 =
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 (𝑊𝐴𝐶𝐶)

O PERATING INCOME
Alternatively, analysts also speak of operating income, which is income arising from operating activities – it is only
considered in the international context, and in Italy is only an accessory –. Other than recurring, operating components,
it may occasionally include some non-recurring components, such as restructuring charges.

Financially, it is commonly defined as EBIT (Earnings Before Interest and Taxes), even if sometimes also NOPAT is
shown, which is Net Operating Income at the net of taxes computed on it.

ACCOUNTING INCOME
The accounting income, on the other hand, corresponds to the reported income computed based on the concept of ac-
crual accounting; its main purpose is income measurement, but it is known that this process suffers from measurement
problems, thus a major task of financial analysis is to adjust accounting income to ensure is better reflects the economic
reality.

It is useful to see accounting income as made up of three components:

Accounting income reflects the effects of a transaction, but does not consider

Permanent component, which is expected to persist indefinitely, and is defined as:

1$𝑜𝑓 𝑐𝑜𝑚𝑝𝑎𝑛𝑦 𝑣𝑎𝑙𝑢𝑒

, 𝑤ℎ𝑒𝑟𝑒 𝑟 = 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑐𝑎𝑝𝑖𝑡𝑎𝑙
𝑟

Transitory component are one-time events that have a dollar-for dollar effect on a company’s value.

Value-irrelevant components have no economic value but are rather accounting distortions.

ACCRUAL VS. ECONOMIC INCOME

Conceptually, accrual accounting converts cashflow to a measure of income, however, accounting income doesn’t pur-
port to measure neither economic nor permanent income but is rather based on a set of rules which have evolved over
time, to cater to several, often conflicting, objectives. Some reasons for these differences are:

1. There is a difference between the concepts between permanent and economic income, however, accounting
standards are inconsistent in defining the measure of income, as both are reports in different part of the finan-
cial statements
 27

2. Historical Cost determines divergences between accounting and economic income, since current cost is not
reflected and unrealized gains/losses are not recognized.

3. Accounting income reflects the effects of a transaction, but does not consider the economic effects unaccompa-
nied by a transaction

4. Conservatism delays income increasing event’s recognition, while immediately recognizing decreasing event

5. Earnings management are typical of accounting income and have little to do with economic reality, however it
is such behaviour that increases accounting income’s ability to recognize economic reality.

A DJUSTMENTS TO INCOME
Furthermore, from analysis standpoint, analysts need to take into account that economic, permanent and operating
income differ in both nature and purpose and, thus, adjustments need to be made; namely:

1. When dealing with permanent income, analysts need to first determine the permanent component of the cur-
rent’s period accounting income and, subsequently identify and exclude – or smooth – transitory components.
Such adjusted earnings are referred to as core earnings, and are useful for:

a. Determine the company’s profit to equity ratio

b. For valuation techniques such as earnings’ multiples

c. To forecast earnings or cashflows with a meaningful starting point

d. Helping to derive assumptions used in forecasting

However, an analyst must be aware that core earnings are not always a reliable estimate for permanent income
because:

a. Although core earnings exclude clearly identifiable transitory components, there is no guarantee that
the components included are necessarily permanent in nature

b. An analyst must consider long term changes to the company’s business conditions that are not re-
flected in the non-recurring earnings’ component

2. To adjust accounting income for economic income, analysts include both recurring and non-recurring com-
ponents; however, analysts need to realize that these adjustments are not faithful representations of eco-
nomic income, since analysts cannot determine the change in value of fixed assets which are recorded at
historical cost.

3. When determining operating earnings, analysts often start off with core earnings, from which they exclude
non-operating income components, such as interest expense; however, operating earnings include all revenue
and expenses that pertain to a company’s operating business, regardless of their recurrence

ACCOUNTING ANALYSIS
Accounting analysis is the process of evaluating the extent to which a company’s accounting numbers reflect economic
reality; it involves a number of different tasks, such as evaluating a company’s accounting risks and earnings quality,
and estimating earnings power. In short, accounting analysis is the process an analyst uses to identify and assess ac-
counting distortions in a company’s financial statements.

NEED FOR ACCOUNTING ANALYSIS

The need for accounting analysis arises for two reasons:

1. To correct for accrual accounting’s distortions, so that information better reflect the economic reality;
 28

2. To adjust accounting information for the need of the particular user who is performing the analysis.

A CCOUNTING DISTORTIONS
Accounting distortions are deviations of reported information from the underlying business reality; they are particularly
present in accrual accounting by means of its nature: in fact, this process is based on the idea of managerial estimation
and, thus, more vulnerable to manipulation or distortion. analysts recognize four types of distortions in particular:

Accounting standards distortions are attributed to:

1. the political process of standard setting: since different users are affected by the accounting standards, they
often lobby in order to protect their conflicting interests, thus resulting in standards that fall short of requiring
the most relevant information;

2. some accounting principles cause distortions, the most notable examples are:

a. historical cost principle – as it reduces relevance of the balance sheet;

b. transaction basis of accounting is inconsistent with goodwill: purchased goodwill is recorded as an

asset, but internally produced one is not

c. double entry implies that the balance sheet articulates with the income statement, meaning that many
transaction affect both statements, when accounting rules often better one at the expense of another –
think FIFO vs. LIFO.

3. Conservatism is a third source of distortion, as it leads to a pessimistic bias, that is problematic for equity anal-
ysis.

4. Estimation errors, which are, as before-said, inherent of accrual accounting;

5. Reliability vs. relevance: analysts attribute this distortion to the excessive emphasis given to the reliability
principle, often at the expense of relevance of accounting information

6. Earning management is defined as the purposeful intervention by management in the earnings determination
process, usually to satisfy selfish objectives” (Schipper, 1989). It often involves window-dressing of financial
statements in either the cosmetic form – with no cashflow consequences – or a real one – with cashflow conse-
quences; analysts furthermore distinguish earnings management by means of visible and invisible form,
where the former is achieved by changing accounting standards and the latter by changing estimates and poli-
cies. Strategies adopted include:

a. Increasing income, by adjusting accruals to increase reported income; this process can be sustained
for several years and then subsequently reversed with a onetime change, which, in turn, can be per-
ceived as less relevant on grounds of its reporting, which is done below the line.

b. Big bath strategy involves taking as many write-offs as possible over one period – usually, a markedly
poor performance one, or one with unusual events – to relieve other period of expenses, or in conjunc-
tion with an increasing income strategy;

c. Income smoothing, where managers increase or decrease income in order to reduce its volatility.

Motivations to undergo such a process vary, but can be mainly classified as:

a. Contracting incentives, given by the contractual form under which managers are hired: often times,
compensation includes bonuses on earnings; such bonuses are computed over earnings showed by
accounting numbers and have a lower and upper bound: in order to receive such bonus, managers can
be inclined to smooth income, so that it lays between the two bounds.
 29

b. The potential effect over stock prices in order to beat market expectations, thus gaining some personal
benefits – option or stock offerings, to avoid lay-offs in case of mergers, etc.

c. Other incentives include impact on labour demand, management changes or societal view.

The mechanics by which earnings management can occur are various, but the most important are, namely:

a. Income shifting, which is achieved by moving income from one period to another, by means of accel-
erating or delaying recognition of revenues or expenses.

b. Classificatory earnings management, which is achieved by classifying some expenses or revenues in

certain parts of the income statement to affect analysis inferences regarding the recurring nature of
such items.

PROCESS OF ACCOUNTING ANALYSIS

The process of accounting analysis involves several interrelated processes and tasks; however, analysts mainly take
two into account.

E VALUATION OF EARNINGS
Evaluation of earnings quality is defined by many analysts as the extent of conservatism adopted by the company; alter-
natively, it is defined in terms of accounting distortion; such an evaluation is performed given the following steps:

1. Identification and assessment of key accounting policies: are the policies reasonable or aggressive? What is
their impact on reported numbers?

2. Evaluation of the extension of accounting flexibility, generally speaking, the higher the flexibility, the lower
the earnings quality; however, it must be taken into account that some industries have higher volatility than
others, and thus require higher flexibility;

3. Determination of the reporting strategies: are they aggressive? Does the company have a clean audit report?
Does the management have a reputation for integrity?

4. Identification of red flags, such as:

a. Poor financial performance;

b. Reported earnings consistently higher than cashflows;

c. Auditor resignation

d. Etc.

A DJUSTMENT OF FINANCIAL STATEMENTS

Adjustment of financial statements is another key task, especially the income statement and the balance sheet. Some
common adjustments include:

1. Capitalization of long-term operating leases;

2. Adjustments for one-time changes – such as impairment;

3. Recognition of economic funded status of pensions or other post-retirement benefits;

4. Removal of the effect of selected deferred income tax liabilities and assets from the balance sheet.
 30

ANALYSING INVESTING ACTIVITIES

ASSETS CLASSIFICATION
Assets are classified as:

1. Current assets – or short-term assets – are resources or claims to resources that are expected to be sold, col-
lected or used within one year or the operating cycle – whichever is longer. Examples of current assets are:

a. Cash and cash equivalents

b. Accounts receivables

c. Inventories

d. Prepaid expenses

2. Noncurrent assets – or long-term assets – are resources or claims to resources that are expected to yield bene-
fits extending beyond one year or the operating cycle, whichever is longer, such as:

a. Fixed assets – Property, Plant and Equipment

b. Intangible assets

c. Deferred charges

3. Financial assets consist mainly of marketable securities and other investments in nonoperating assets

4. Operating assets constitute most of the company’s assets; they are usually valued at cost and are expected to
yield returns in excess of the weighted average cost of capital.

CURRENT ASSETS
Current assets include cash and other assets that are expected to be converted into cash within an operating cycle; an
operating cycle is defined as the amount of t time from commitment of cash for purchase until the collection of cash
resulting from the sale of a product happens.

Cash represents the staring and the end point of this cycle, which is used to classify assets and liabilities as current or
noncurrent; the difference between current assets and current liabilities represents the working capital, which is a dou-
ble-edged sword prom the company’s perspective, as working capital is needed to effectively operate, yet it need to be
financed, usually entailing other operating costs for the company – i.e. credit losses on receivables, logistic expenses for
inventories, etc.

CASH AND CASH EQUIVALENTS

C ASH
Cash is the most liquid asset and includes currency available and funds on deposit in bank accounts, checking accounts
and some savings accounts.

C ASH EQUIVALENTS
Cash equivalents are highly liquid short-term investments, given that they are:

1. Readily convertible into a known cash amount

2. Close to maturity date – usually three months – and not sensitive to interest rates changes

G OVERNMENT BONDS AS CASH EQUIVALENTS

 31

IFRS recognize some government bonds as cash equivalents, given that they are short term bonds and are issued by a safe
and strong country – i.e. German bonds as opposed to Brazilian ones.

L IQUIDITY
When analysts speak of cash and cash equivalents, analysts speak of liquidity; that is: the amount of cash and cash
equivalents that a company either has at hand or that it can raise in a short period of time.

It provides flexibility to take advantage of changing market conditions and to react to strategic actions by competitors, as
well as the ability to pay obligations as they mature.

In general, a higher liquidity is required by companies in dynamic industries.

A NALYSIS OF CASH AND CASH EQUIVALENTS

Companies risk a reduction in liquidity when the market of short-terms investments declines, thus cash and cash equiva-
lents are sometimes required to be maintained as compensating balances to support existing borrowing arrangements or
as collateral for indebtedness – this procedure is known as covenant of a debt.

RECEIVABLES
Receivables are amount due from others that arise from the sale of good or services, or form advances to other compa-
nies; they are classified as:

1. Accounts receivables, which refer to general promises of indebtedness due from customers;

2. Notes receivables, refer to specific, formal, written promises of indebtedness due from others

3. Tax refunds are sometimes also classified as receivables.

V ALUATION OF RECEIVABLES
Experience shows that company usually do not collect all of their receivables, thus, an estimation must be done. This
means that receivables are reported at their net realizable value – total amount of receivables minus an allowance for
uncollectible accounts.

Uncollectible accounts are, thus, written off against the allowance and the expected loss is included in current operating
expenses; such allowance is estimated by managers given their experience, customer fortunes, industry expectation, and
collection policies.

A NALYSING RECEIVABLES
While a qualified opinion by an independent auditor might lend assurance to the validity of receivables, the analysis
must be aware of:

1. Error in judgement of their ultimate collection;

2. Changes in the allowance computed relative to sales receivables or industry and market conditions.

The reason is that, ultimately, assessment of earnings quality is ultimately affected by analysis of receivables and their
collectability.

C OLLECTION RISK
In addition to a mathematical, formulaic approach in calculating the provision of bad debts, analysts must review the
allowance for uncollectibles given their knowledge of the industry conditions; while full information to assess collec-
tion risk is not included in financial statements, other sources exist, such as:

1. Competitors’ receivables, particularly as a percentage of sales – how does the company compare to its compet-
itors? Does it have higher relative receivables?;
 32

2. Examination of customers’ concentrations risk – are all receivables concentrated in one or few customers?;

3. Computation and investigation of trends in receivables – how many receivables are overdue? For how long
have they been? How does the company position relative to industry averages?

4. Determination of the portion of renewed receivables of prior accounts/notes receivable

A UTHENTICITY OF RECEIVABLES
The description of receivables in financial statements or notes to financial statements is usually insufficient to provide
reliable clues as to whether receivables are genuine, due and enforceable; one factor that affects authenticity is, for ex-
ample, the right of merchandise return. Thus, an analyst must review credit policies and changes, as these types of re-
ceivables usually entail more collection risk.

S ECURITIZATION OF RECEIVABLES
Securitization – or factoring – of receivables happens when a company sells a portion of its receivables to a third party;
the procedure usually happens by means of bonds, where the collection of receivables provides the source of yield of
the issued bonds. Such sale can happen with or without recourse where, by recourse analysts intend a guarantee of
collectability.

1. If a receivable is sold with recourse, the risk of ownership is not transferred to the buyer, thus they must con-
tinue to be recorded as both an asset – a receivable – and a liability – the compensating amount for the bond
which has been sold.

2. Receivables sold without recourse transfer the risk of ownership to the buyer and, thus, can remove the receiv-
able from the balance sheet.

PREPAID EXPENSES
Prepaid expenses are advance payments for services or good not yet received and that extend beyond the current period,
such as rent, insurance, utilities.

Whenever analysts consider prepaid expenses analysts must:

1. Identify the reason behind the expense;

2. Classify the expense.

E.g. rent for two years is paid in November, when analysts are preparing the annual financial statement in
December, analysts register the amount of rent that covered the month of November as an expense in the
income statement, the amount covering rent for the next year in the balance sheet as a current prepaid expense
under assets – this amount of rent is used in the operating cycle – and the exceeding amount as noncurrent pre-
paid expense under assets in the balance sheet – this amount of rent is used in the following operating cycle,
thus its benefits are noncurrent.

A NALYSIS OF PREPAID EXPENSES

Whenever analysts are analysing prepaid expenses two main issues can arise:

1. Sometimes, for convenience, noncurrent prepaids are included among current prepaid expenses, however, if
their magnitude is large they warrant scrutiny

2. Any substantial change in prepaid expenses warrants scrutiny.

INVENTORIES
Inventories are goods held for sale – outputs of the manufacturing process –, or goods bought in order to be transformed
into outputs. They can be:
 33

1. Expensed, which means they are treated like period costs and reported when their expense is incurred, given
they either

a. Have generated revenues

b. Have caused administrative expenses (which cannot be matched against a specific revenue)

2. Capitalized, which means inventories are treated as product costs and, thus, treated as an asset and charged
against future period revenues benefitting from their sale

I NVENTORY COSTING METHODS

The costing methods are used in order to allocate cost of goods available for sale –beginning inventory plus net pur-
chases – between cost of goods sold – in the income statement as an income deduction – or ending inventory – in the
balance sheet as a current asset.

The flow of cost in inventories can be explained by the inventory equation which states:

𝐸𝑛𝑑𝑖𝑛𝑔 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑖𝑒𝑠 = 𝑏𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑖𝑒𝑠 + 𝑛𝑒𝑡 𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠 − 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑 𝑠𝑜𝑙𝑑

INVENTORY ACCOUNTING AND VALUATION

Costing methods need to be adopted homogenously for inventory classes, which, in turn, need to be identified; further-
more, such methods need to be consistent for each class over time.

P ERIODIC AND CONTINUOUS ACCOUNTING FOR INVENTORIES

Companies can decide whether to update accounting for inventories in a periodic form – i.e. at the end of each reporting
period – or in a continuous one. Under the former procedure, a dedicated bookkeeping process is established and subse-
quently updated in a continuous way – i.e. whenever there is a change in inventories –; such method is more convenient
for larger companies, that tend to have larger inventories with a higher amount of transactions.

I NVENTORY COST FLOWS

FIFO
This method supposes that the first units purchased are the first to be sold.

LIFO
Under LIFO the last unit purchased are the first to be sold

However, this method is not allowed in many countries primarily because it can delay or reduce tax payments.

A VERAGE COST
This method assumes that the units are sold without regard to the purchase order, so that both COGS and ending inven-
tories are computed as a simple weighted average.

ANALYSING INVENTORIES
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I NVENTORY COSTING EFFECTS ON FINANCIAL STATEMENTS

I NCOME STATEMENT ( PROFIT )
Give the different costing method of choice, gross profits can be affected over a period; particularly, in period of rising
prices, FIFO inventories produce higher gross profits, because cost inventories are matched against revenues at the cur-
rent price. This phenomenon is often referred to as FIFO phantom profits.

FIFO PHANTOM PROFITS: ECONOMIC PROFIT VS. HOLDING GAIN

The so-called phantom profits are actually the sum of two components: the economic profit and the holding gain, which
are defined as:

𝐸𝑐𝑜𝑛𝑜𝑚𝑖𝑐 𝑝𝑟𝑜𝑓𝑖𝑡 = 𝑢𝑛𝑖𝑡𝑠 𝑠𝑜𝑙𝑑 ∗ (𝑠𝑎𝑙𝑒 𝑝𝑟𝑖𝑐𝑒𝑠 − 𝑟𝑒𝑝𝑙𝑎𝑐𝑒𝑚𝑒𝑛𝑡 𝑐𝑜𝑠𝑡)

Where analysts approximate the replacement cost to the cost of the most recent purchased inventories

𝐻𝑜𝑙𝑑𝑖𝑛𝑔 𝑔𝑎𝑖𝑛 = 𝑜𝑓 𝑢𝑛𝑖𝑡𝑠 𝑠𝑜𝑙𝑑 ∗ (𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑟𝑒𝑝𝑙𝑎𝑐𝑒𝑚𝑒𝑛𝑡 𝑐𝑜𝑠𝑡𝑠 − 𝑜𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝑎𝑐𝑞𝑢𝑖𝑠𝑖𝑡𝑖𝑜𝑛 𝑐𝑜𝑠𝑡𝑠)

Where holding gains are a function of the inventory turnover and the rate of inflation

B ALANCE SHEET
In period of rising prices, LIFO reports prices at a significantly lower level than replacement costs

C ASHFLOWS
The increase in gross profit under FIFO also results in higher pre-tax income and, consequently, higher tax liability,
which results in a cash-squeeze as they pay higher taxes and must replace inventories at higher costs than the originally
purchased one; avoidance of such cash squeeze constitutes the primary reason for LIFO adoption.

LIFO CONFORMITY RULE AND LIFO RESERVE

The IRS, however, requires that companies using LIFO for tax purposes use it also for financial reporting; this require-
ment is known as the LFIO conformity rule.

Furthermore, such companies are also required to disclose the amount by which inventory costing would have been re-
ported had they chosen FIFO as a costing method; the LIFO reserve is the difference between these two amounts and is
useful in order to understand the effect on cashflows of the costing method.

O THER ISSUES IN INVENTORY VALUATION

LIFO LIQUIDATION
As aforementioned, costing methods are required to be adopted homogenously and consistently for inventory classes;
thus, in periods of rising prices, a company that has adopted LIFO costing method early on, must continue to do so; this
implies that when inventory quantities are reduces, each cost layer id matched against current – rising – selling prices
resulting in inflated profits. This process is known as LIFO liquidation, a process which analysts must be aware of and
that can also happen reversely – in period of decreasing prices, LIFO liquidation causes a decrease in gross profit.

LIFO TO FIFO ANALYTICAL RESTATEMENT

The LIFO liquidation in periods of rising prices can be computed by analysts by means of the LIFO reserve in three
adjustments:

1. Restate inventories amounts as:

𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑖𝑒𝑠 = 𝑅𝑒𝑝𝑜𝑟𝑡𝑒𝑑 𝐿𝐼𝐹𝑂 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 + 𝐿𝐼𝐹𝑂 𝑟𝑒𝑠𝑒𝑟𝑣𝑒

2. Increase deferred taxes payables by:

𝐿𝐼𝐹𝑂 𝑟𝑒𝑠𝑒𝑟𝑣𝑒 ∗ 𝑇𝑎𝑥 𝑟𝑎𝑡𝑒

 35

3. Restate retained earnings as:

𝑅𝑒𝑡𝑎𝑖𝑛𝑒𝑑 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠 = 𝑟𝑒𝑝𝑜𝑟𝑡𝑒𝑑 𝑟𝑒𝑡𝑎𝑖𝑛𝑖𝑛𝑔 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠 ∗ [𝐿𝐼𝐹𝑂 𝑟𝑒𝑠𝑒𝑟𝑣𝑒 ∗ (1 − 𝑇𝑎𝑥 𝑟𝑎𝑡𝑒)]

Generally speaking, in periods of rising prices, LIFO income is lower than the FIFO one, however, the net effect de-
pends on the combined effect of:

1. Change in ending and beginning inventories

2. Liquidation of LIFO layers

3. Other factors

FIFO TO LIFO ANALYTICAL RESTATEMENT

The adjustment of FIFO to LIFO, unfortunately, is based on an assumption and may, therefore, be prone to error; such
assumption is constituted by the rate of inflation carried by each particular line of inventory, r, which must be computed
separately for apiece and is estimated as:

𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐿𝐼𝐹𝑂 𝑟𝑒𝑠𝑒𝑟𝑣𝑒

𝑟=
𝐹𝐼𝐹𝑂 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑖𝑒𝑠 𝑓𝑟𝑜𝑚 𝑝𝑟𝑒𝑣𝑖𝑜𝑢𝑠 𝑦𝑒𝑎𝑟 𝑒𝑛𝑑

We then consider of the FIFO holding gain on beginning inventory – BIFIFO –; such gain is given by:

𝐻𝑜𝑙𝑑𝑖𝑛𝑔 𝐺𝑎𝑖𝑛 = 𝐵𝐼 ∗𝑟

Which means, in turn, that the Cost Of Goods Sold under LIFO is understated by:

𝐶𝑂𝐺𝑆 = 𝐶𝑂𝐺𝑆 + (𝐵𝐼 ∗ 𝑟)

I NVENTORY COSTING METHODS FOR MANUFACTURING COMPANIES

The cost of inventories for manufacturing consists of three components:

1. Raw materials

2. Labour

3. Overhead – the indirect cost incurred in the manufacturing process, such as depreciation of equipment, super-
visory wages and utilities

O VERHEAD COSTS ESTIMATION

While the first and the second can be easily estimated, overhead costs are more difficult to identify and, often, are the
largest component between them; thus it highly depends on the assumption used.

Usually, it is allocated over all units produced; for this reason, instead of being expensed, it is capitalized, since it is
included in cost of the inventories and remains on the balance sheet until it can be matched against the revenue pro-
duced by the sale of the goods and, subsequently, moved to the income statement.

INCREASE OR DECREASE IN INVENTORIES EFFECTS ON OVERHEAD COSTS

If there is an increase in production – i.e. inventories – overhead costs remain in the balance sheet as a consequence of
the higher ending inventory, thus, inflating profitability. However, if inventory quantities decrease, the income state-
ment is burdened both by the current and previous overhead costs.

L OWER OF COST OR MARKET

The generally accepted principle of inventory valuation is the lower of cost or market, which implies that if inventories
decline in market value below its cost for any reason, then the account must be written down to match this loss. Such
 36

write down is effectively charged against revenues in the period in which the loss occurs, however, since writeups are
prohibited, inventory is conservatively valued.

Analysis of inventories must take into account this rule, as it tends to understate inventories regardless of the cost
method used and, consequently, depress the current ratio.

M ARKET
It is defined as current replacement cost through either purchase or reproduction. However, it must not be higher than
net realizable value nor than net realizable value reduced by a normal profit margin.

C OST
Is defined as the acquisition cost of inventory and is computed using LIFO, FIFO or average cost.

LONG-LIVED ASSETS
Long-lived assets are resources that are used to generate revenues or reduce cost in the Assets
long run; they can be:

1. Tangible fixed assets, such as PPE;

Long-lived assets Current assets
2. Intangible assets, such as patents, trademarks, copyrights, and
goodwill;

3. Deferred charges, such as development expendi-

tures. Even if they are usually considered as current Non-current assets Deferred charges
assets, because their benefits can either:
 Tangible
a. Be reaped after a long amount of time;
 Intangible
b. It is uncertain whether they can be matched
against revenues.

E.g. Research and Development expense: it might never generate revenue, thus it is registered when incurred.

However, deferred charges cannot be considered as current assets nor as non-current assets, thus analysts
classify them as long-lived assets together with tangible and intangible non-current assets.

ACCOUNTING FOR LONG TERM ASSETS

C APITALIZATION , ALLOCATION AND IMPAIRMENT
The process of long-term assets accounting involves three distinct activities: capitalization, allocation and impairment.

1. Capitalization is the process of deferring a cost that is incurred in the current period and which benefits are ex-
pected to extend to one or more future periods.

2. Allocation is the process of periodically expensing a deferred cost

a. For tangible assets analysts speak of depreciation

b. For intangible assets analysts speak amortization

c. For natural resources analysts speak of depletion.

3. Impairment is the process of writing down the book value of an asset, when its expected future cashflows are
no longer sufficient to recover the remaining cost reported on the balance sheet.

C APITALIZATION
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In order to be capitalized, an asset must have some prerequisites that need to be met contemporaneously:

1. Its cost must arise from a past transaction or event;

2. Its future benefits must be identifiable and reasonably probable;

3. It must allow the owner restrictive control over future benefits

e.g. training expenses cannot be capitalized, since the employee receiving it might choose to quit the
job or work for competitors, thus, point 3 is not met.

A LLOCATION
Allocation is the periodic assignment of asset cost to expense over its expected future life; its amount is determined by:

1. Useful life

2. Salvage value

3. Allocation method

Unfortunately, each of these factors relays on estimation.

I MPAIRMENT
While allocation does account for the loss of value of an asset, it only takes into consideration a decrease given by us-
age; if an asset loses value for other reasons – such as an extraordinary event – the write down of its value is classified
as an impairment.

Impairment of an asset consists in the process of writing down the value of such
asset when its expected – undiscounted – cashflow is less than its carrying value.

However, such process causes two distortions:

1. Conservative bias distortion, under GAAPs, where the process cannot be reversed. However under IFRSs,
which system promotes fair value accounting, reversal is accepted by means of IAS 16, and in OIC the cost
model of accounting is followed, thus an asset must be written up at cost when losses are cancelled --- even if
the writeup cannot exceed cost.

2. Large transitory effects from recognizing asset impairments distort net income.

CAPITALIZING VS. E XPENSING

Capitalizing Expensing
Income 1. Postpones the recognition Yields a more volatile income be-
of expenses → higher in- cause of the nature of capital ex-
come in the acquisition pe- penditure: it is a “lumpy” one, while
riod, but lower in the sub- its benefits are steadily earned over
sequent ones time.
2. Yields a smoother income
series
ROI Since income is less volatile, also ROI Expensing assets yields a lower in-
also tends to be more stable, as vestment base, making income
both the denominator – investment more volatile – numerator of ROI –
base – and the numerator – ROI – → in turn, the even smaller denomi-
are affected nator causes the ratios to become
more volatile and less useful.
 38

Solvency Better reflection of the company Worse reflection of the company,

given an understatement of equity
when there are productive assets
Operating Cashflows Investing cashflows Operating cashflows

PLANT ASSETS AND NATURAL RESOURCES

P LANT ASSETS
Property, plant and equipment – or PPE or Plant Assets – are non-current, tangible assets actively used in operation –
such as manufacturing, merchandising or service processes – to generate revenues and cashflows over more than one
period; their expected future life can be reasonably estimated and are not acquired for sale in the ordinary course of
business.

N ATURAL RESOURCES
Natural resources, also called wasting assets, are rights to extract or consume natural resources.

VALUATION
V ALUATION OF PLANT ASSETS
When evaluating PPE, the historical cost principle is applied; this means that the expense incurred is recorded as the
price plus all the extra costs incurred in order to prepare the asset for its intended use.

V ALUATION ANALYSIS OF PLANT ASSETS

Valuation typically emphasizes the objectivity of historical cost, the conservatism principle and accounting for the
money invested; however analysts must also be aware of its limitations, which are:

1. Failure to reflect market value on the balance sheet

2. Loss of relevance when assessing replacement values

3. Incomparability across companies

4. Incomparability between purchases

On contrast, whenever Fair Value valuation is accepted – only by IFRSs – we:

1. Overcome historical cost’s limitations, but

2. Values are highly subjective and volatile.

V ALUATION OF NATURAL RESOURCES

Natural resources are reports at their historical cost plus the cost of discovery, exploration and development; such costs
are typically allocated over estimated units of reserves.

DEPRECIATION
Depreciation is the process of allocating the cost of a plant asset to expense in the accounting periods benefiting from its
use; although added back in the statement of cashflows as a noncash expense, depreciation does not provide funds for
the replacement of an asset.

Balance sheet Income statement

Cost allocation
Acquisition cost Expense

(unused) (used)

Its calculation is based on two factors:

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1. Salvage Value

2. Acquisition cost

R ATE OF DEPRECIATION
The rate of depreciation is given, in turn, by the assets’ useful life and the allocation method chosen by managers.

U SEFUL LIFE ON AN ASSET

The useful life on an asset is an estimate that varies greatly given:

1. Physical deterioration

2. Obsolescence

a. Ordinary obsolescence

b. Extraordinary obsolescence, given by radical technological changes

A LLOCATION METHOD
Once the useful life of an asset has been determined, the periodic depreciation expense – that is, how the overall cost is
divided over the useful life – depends on the allocation method.

STRAIGHT LINE
Straight line depreciation method allocates the cost of an asset to its useful life on the basis of equal periodic changes,
so that:

𝐶𝑜𝑠𝑡 − 𝑠𝑎𝑙𝑣𝑎𝑔𝑒 𝑣𝑎𝑙𝑢𝑒

𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑒𝑥𝑝𝑒𝑛𝑠𝑒 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟 =
𝑈𝑠𝑒𝑓𝑢𝑙 𝑙𝑖𝑓𝑒 𝑖𝑛 𝑝𝑒𝑟𝑖𝑜𝑑𝑠

The rationale is that physical deterioration occurs uniformously over time. However, this method presents three key
limitations:

1. in the case of non-fixed structures, which value is influenced also by their obsolescence, analysts cannot
compute obsolescence itself uniformously

2. in later years, when assets are more likely less efficient, they require higher maintenance, thus higher costs

3. there is a distortion of the rate of return, as this computation yields an increasing return over time, which, in
most business, does not reflect economic reality.

ACCELERATED
Accelerated methods of depreciation allocate the cost of an asset to its useful life in a decreasing manner; such charges
should compensate for:

1. increasing repair and maintenance costs

2. decreasing revenues and operating efficiency

3. higher uncertainty of revenues in later years, due to assets’ obsolescence.

However, since the depreciation expense cannot fall under the salvage value, if this rule is violated with the accelerated
depreciation method, analysts adopt from that moment in time the straight-line depreciation.

D ECLINING B ALANCE METHOD

Applies a constant rate to the declining carrying value of the asset, which is approximated to a multiple of the straight-
line rate, often the double.
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1. We compute the straight-line depreciation rate

2. We multiply it by a quantity, typically 2, to obtain the declining balance rate

(𝐷𝑜𝑢𝑏𝑙𝑒)𝑑𝑒𝑐𝑙𝑖𝑛𝑖𝑛𝑔 𝑏𝑎𝑙𝑎𝑛𝑐𝑒 𝑟𝑎𝑡𝑒 = 2 ∗ 𝑠𝑡𝑟𝑎𝑖𝑔ℎ𝑡 𝑙𝑖𝑛𝑒 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒

3. We compute the depreciation expense that, however, ignores salvage value by means of the beginning period
book value

𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑒𝑥𝑝𝑒𝑛𝑠𝑒 = (𝑑𝑜𝑢𝑏𝑙𝑒)𝑑𝑒𝑐𝑙𝑖𝑛𝑖𝑛𝑔 𝑏𝑎𝑙𝑎𝑛𝑐𝑒 𝑟𝑎𝑡𝑒 ∗ 𝑏𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑝𝑒𝑟𝑖𝑜𝑑 𝑏𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒

S UM OF THE YEARS DIGITS

Applies a decreasing fraction to asset cost, less salvage value; the fraction’s denominator is the sum of the asset’s useful
life in term of years (for a five year useful life the denominator is 1+2+3+4+5=15) and the numerator is the remaining
life ate the beginning of the period (so on year one the fraction would be: = ; on year two: = , etc.)

S PECIAL
Special depreciation methods are found in certain industries where the value of an asset is influenced by its activity lev-
els.

D EPLETION
Depletion is the allocation of the cost of natural resources on the basis of the rate of extraction or production; as depre-
ciation, it is subject to estimation, thus analysts need to be alert.

I MPAIRMENT
When the fair value of an asset falls below its depreciated carrying value on the balance sheet, this values undergoes an
impairment, that is: the asset’s value is written down to the fair value.

Under IFRS, namely IAS 26, such process can be reversed to its original value and, by means of IAS 16, even above
their depreciated historical cost under certain conditions.

A NALYSING DEPRECIATION
Whenever analysing depreciation an analyst aims at assessing:

1. Reasonableness of depreciable base, by means of:

a. Ration of depreciation to total assets

b. Other size-related factors

2. Useful life by reviewing any revisions of useful life and analysing asset age; measures include:

a. Average total life span

𝐺𝑟𝑜𝑠𝑠 𝑝𝑙𝑎𝑛𝑡 𝑎𝑛𝑑 𝑒𝑞𝑢𝑖𝑝𝑚𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑡𝑜𝑡𝑎𝑙 𝑙𝑖𝑓𝑒 𝑠𝑝𝑎𝑛 =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑦𝑒𝑎𝑟 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑒𝑥𝑝𝑒𝑛𝑠𝑒

b. Average age

𝐴𝑐𝑐𝑢𝑚𝑢𝑙𝑎𝑡𝑒𝑑 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑎𝑔𝑒 =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑦𝑒𝑎𝑟 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑒𝑥𝑝𝑒𝑛𝑠𝑒

c. Average remaining life

 41

𝑁𝑒𝑡 𝑝𝑙𝑎𝑛𝑡 𝑎𝑛𝑑 𝑒𝑞𝑢𝑖𝑝𝑚𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑟𝑒𝑚𝑎𝑖𝑛𝑖𝑛𝑔 𝑙𝑖𝑓𝑒 =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑦𝑒𝑎𝑟 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑒𝑥𝑝𝑒𝑛𝑠𝑒

d. Average total life span

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑡𝑜𝑡𝑎𝑙 𝑙𝑖𝑓𝑒 𝑠𝑝𝑎𝑛 = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑎𝑔𝑒 + 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑟𝑒𝑚𝑎𝑖𝑛𝑖𝑛𝑔 𝑙𝑖𝑓𝑒

These measures also reflect on profit margins and financing requirements.

3. Allocation method, the quality of information regarding such methods in annual reports varies greatly, thus it
is difficult to infer much from them without quantitative information on the extent of their use and the assets
that are affected.

Another challenge arises from differences in allocation methods used for tax purposes and financial reporting;
possibilities are:

a. Straight line for both financial reporting and tax purposes

b. Straight line for financial reporting and accelerated for tax reports, which results in deferred tax pay-
ments, yielding cost-free use of funds

c. Use of accelerated method for both purposes, which yields higher depreciation in higher years, that
can be extended over many years for an expanding company.

ANALYSING IMPAIRMENTS
Even if, in the context of natural resources and of plant assets, valuation is done according historical cost, this method is
not particularly relevant in assessing replacement values or in determining future needs for operating assets; further-
more, these valuations are not comparable across different companies’ reports or in assessing alternative uses of funds.

In addition, in periods of changing prices, assets valued at historical costs represent expenditures given different pur-
chasing powers, nevertheless, companies can still write impair such assets even if, such write downs might distort re-
ported results.

R ECOVERABILITY TEST
Under current rules, companies use a recoverability test to define whether an impairment exist; such test consists in an
estimation of net future cashflows from an asset and its eventual disposition; if such undiscounted future cashflows are
lower than the asset’s carrying amount, it is impaired.

A NALYSIS ISSUES
From an impairment analysis three main issues arise:

1. Evaluation of the appropriateness of the amount impaired; it is the most difficult task for an analysts, since
multiple factors must be taken into account:

a. Identification of the assets/class of assets that is being taken down

b. Measurement of the percentage that is being taken down

c. Evaluation of the appropriateness of this impairment, for which footnote information detailing reason-
ing can help, as well as external factors – industry wide downturns, market crashes, etc. – and com-
paration with other companies in the industry write-offs.

2. Evaluation of the appropriateness of the timing of the impairment; regarding this issue, analysts must note
whether write-downs are being delayed, an objective that can be achieved by comparing with other companies
in the industry, and if there is the possibility that a big bath is occurring.
 42

3. Analysis of the effects of the impairment on income.

INTANGIBLE ASSETS
Intangible assets are:

1. Right, privileges, and benefits of ownership or control over noncurrent assets

2. Such assets lack physical substance

3. Their future benefits and their useful life are difficult to determine, if not indefinite

4. Are, mostly, acquired for operational use

5. Inseparable from a company or its segment

6. Experience large valuation changes given competitive circumstances.

P URCHASED AND INTERNALLY GENERATED INTANGIBLES

Whenever intangibles are internally generated – e.g. marketing campaigns, sales training – they cannot be capitalized,
even if future benefits are highly likely; on contrast, purchased intangibles are valuated at historical cost. The rationale
is conservatism, presumably from the increased uncertainty of realizing the benefits of intangibles.

ACCOUNTING FOR INTANGIBLES

Especially for accounting purposes, intangibles are generally divided into identifiable and unidentifiable intangible as-
sets.

I DENTIFIABLE INTANGIBLES
Identifiable intangibles are assets that are separately identified and linked with specific rights/privileges, with a limited
benefit period, such as:

1. Patents

2. Trademarks

3. Copyrights

4. Franchises

Such assets are recorded at cost and amortized over their benefit period; the writing off of the entire cost of such assets
at acquisition is prohibited. Cost includes:

1. Purchase price

2. Legal fees

3. Filing fees

U NIDENTIFIABLE INTANGIBLES
Unidentifiable intangibles are assets that either develop internally or cannot be identified when purchased; their benefit
period is usually unlimited. An example is that of goodwill.

G OODWILL
The makeup of goodwill can vary greatly from company to company: it can be defined as the ability to attract custom-
ers or qualities inherent to the business activities; it implies earning power or better, translates into future excess earn-
ings, where such excess is identified as the level of earnings above normal.
 43

If it is internally generated, it is not accounted for, however, whenever a merger or an acquisition happens, goodwill is
accounted as any excess acquisition cost remaining after the amount paid is allocated over all identifiable assets and
liabilities according to fair market value.

A NALYSING INTANGIBLES
In analysing intangibles, analysts must be prepared to form their own estimates regarding their valuation and pay partic-
ular attention to goodwill, as it does not require amortization and must be written off when the superior earning power
justifying its existence disappears.

In particular, three useful practices are:

1. Review of amortization periods – or, under IAS 38, impairment test evidences – as lower amortization amount
increases reporting earnings, it can be subjects to distortion and any likely bias in this context lowers the im-
pairment losses.

2. Search for unrecorded intangibles and goodwill, which is most likely existing off-balance sheet

3. Examine super earnings as evidence of goodwill

ASSET REVALUATIONS UNDER IFRS

Under IFRS a company can decide to report any class of operating assets under the revaluation model, that is, a proce-
dure which allows company to periodically revalue assets and report them at fair value, even if the revalued amount
exceed the depreciated value of the asset.

ACCOUNTING TREATMENT
There are only two circumstances under which IFRS allow assets to be written up:

1. Through the creation of a revaluation surplus

2. Reversing any prior impairment, as long as the written-up value does not exceed the depreciated historical
cost.

R EVERSAL OF PRIOR IMPAIRMENT

This procedure is regulated by IAS 26 and the reversal is attributed to various reasons:

1. Markets could reverse earlier declines in the value of an asset – a brief decline in the real estate market, with a
subsequent recover

2. Adverse business conditions that impaired the value in use may improve later on

3. A company can find an alternative use for an asset, thus increasing its value-in-use.

Effects of this procedure on financial statements are:

1. The asset subject to the reversal will carry its written-up value on the balance sheet;

2. The reversal will create a gain that will be included in the period’s net income and, therefore, in retained earn-
ings

3. Finally, future period depreciation will be determined as a proportion of the written-up value of the asset and,
therefore, be larger than in periods prior to the reversal.

R EVALUATION MODEL
The writeup of the carrying value of an asset even above the depreciated historical cost, on condition that the revalua-
tion model is adopted for the whole class of assets to which the particular asset belongs.
 44

Under the revaluation model, a company must re-estimate the whole class value at fair value on a periodic base and
continuously adjust their reported value accordingly; these continuous revaluation happens by creation of a revaluation
surplus.

R EVALUATION SURPLUS
The revaluation surplus is the amount by which an asset’s carrying value on the balance sheet exceeds the historical
cost; it constitutes a separate line item in shareholders’ equity. Gains or losses will not be disclosed, but rather included
in the period’s comprehensive income.

Depreciation will be recognized, however, the expense will be divided as follows:

1. Depreciation pertaining to value within the historical cost will be deducted from it;

2. Depreciation pertaining to value over the historical cost will be deducted from the revaluation surplus.

ANALYSIS IMPLICATIONS
The revaluation procedure has significant implication for analysis, which are:

1. When done for legitimate reasons, asset revaluation might actually improve the balance sheet numbers because
of increased relevance.;

2. Income numbers are adversely affected by the large transitory numbers that are introduced by asset revalua-
tion, both up and downwards.

3. Revaluation are often done at management’s discretion;

4. Comparison across time can be affected by assets’ revaluation.

5. Finally, upward assets revaluation are a fertile area for earnings management.