Financial Accounting - Balance Sheet and Asset Recognition

Balance sheet

1. Two major downward accounting bias for equity

1. Assets are on the balance sheet at cost. Historical cost does not match current value
2. Intangible assets are not on balance sheet unless the company acquired them

1. Economic income = income + OCI
2. Working capital = (current assets- cash) – (current liabilities – debt)
3. Shareholder’s funds = equity + preferred + minority
4. ROCE = EBIT margin * asset turn
5. Different values

1. Realizable value (fair value): selling price
2. Replacement value (current cost): cost to buy the asset now
3. Economic value (value in use): expected future income of the asset
4. Recoverable amount = higher of RV and EV

Asset recognition

1. GAAP: a resource controlled by firm as result of past transaction; future economic benefits probable; value of asset reliably measured
2. Expense v.s capitalize; expense will normally increase gear and decrease return on capital
3. IFRS: research should be expensed; development should be expensed unless it’s (1) complete (2) reliably measured (3) generating future economic benefits
4. GAAP: R&D expensed
5. Purchasing accounting: (1) fair value on balance sheet (2) Difference in goodwill
6. Impairment

1. IFRS: write down to recoverable value (higher of RV and EV). Impairment goes to income statement. Upward revaluation allowed
2. GAAP: carrying value v.s. undiscounted cash flow.

Liability recognition

1. Liabilities are discounted
2. Netting (off-balance sheet finance) : operating lease, securitization, non-consolidation
3. Finance lease (GAAP) : PV of lease payment > 90% of value of asset. Lease term >75% of asset life time.
4. Lessee: recognize asset and liability of PV of payment; depreciate asset (straight line), lease payment split into interest payment and principle payment which reduces the liability amount.
5. Lessor: carry a receivable of net investment in the lease. Rentals allocated to capital and finance income to provide constant return
6. Operating lease does not reduce equity or change ROE
7. Derecognize the liability only when the obligation is discharged
8. Securitization leads to good receivable ratios, net debt, sudden performance improvement

Cash flow and income

1. Startup cost capitalization
2. Interest capitalization – internally developed asset
3. Revenue recognition: effective transfer of risk and reward. % of completion, completed contract, cost recovery
4. Revenue recognition issues: agency/principle, multi-period delivery; channel pushing (BMS); Sales return; Bundle transaction (APPLE)
5. Pro forma: company modifies GAAP in reporting (e.g. impairment of goodwill and intangibles, reorganization costs, EBITDA)
6. Non-GAAP flagging
7. Underlying (excl. exceptional) v.s comprehensive income. We need both
8. Headline earning: GAAP earnings adding back remeasurement (gain/loss on disposal, impairment of goodwill, revaluation)
9. Cash flow also vulnerable to accounting policy
10. Currency: book a currency; exchange difference in OCI; company hedge cash flow to FX
11. Manager: dislike volatility; beat; bonus; share price manipulation
12. Revaluation is costly and should be done annually. It will bring up value of assets to current value which decreases gearing ratio. However, higher carrying value of assets will lead to higher depreciation cost. Also the asymmetric treatment of revaluation under GAAP also discourages companies to do so. The revaluation gain goes to OCI, however, loss to P&L. Revaluation will depress ROCE, ROE and P/B ratio.
13. Investment property: held to earn rental or capital appreciation. Company can elect to recognize the asset at historical cost or fair value. The changes in value reported in P&L
14. Earning management device

1. Revenue recognition: gross/net (GROUPON), bundle transaction (APPLE), accounting for long term contract, recognize unearned revenue (Enron, QMH), channel stuffing (Wholesale to channel)
2. Cost capitalization: interest, maintenance cost, startup cost; IFRS allows development cost to be capitalize for certain industries, for instance, automotive (Peugeot)

1. Earning management signals

1. Balance sheet effect of aggressive accounting

1. Revenue anticipation: receivables
2. Cost postpone: intangibles, tangible assets (capitalized development cost, marketing expense, etc.)

1. Cash flow signals

1. Poor cash conversion: huge gap b/w free cash flow and revenue

1. Balance sheet signal of conservative accounting

1. Delayed revenue recognition: deferred revenue liability
2. Cost anticipation: provision

1. Financial assets

1. Held-to-maturity assets: recognized at cost, impairment test
2. Available-for-sale assets: fair value through OCI
3. Trading assets: fair value through P&L
4. Derivatives: if hedging, fair value through OCI; if not hedging, fair value through P&L

1. Fair value involves a lot of judgment, GAAP 3 level hierarchy

1. Level 1: Quoted price for identical assets
2. Level 2: Estimate based on observable input
3. Level 3: Estimate based on unobservable input

1. Bank regulators working with various iteration of Basel accord set minimum level of bank capital. Regulatory capital/risk weighted assets
2. QMH case

1. Capitalize nearly all expenses: start-up, interest expense, maintenance, etc.
2. Revalue hotels every year and overvalue the assets
3. Internal franchise policy to guarantee revenue for 2 years
4. Sales and operating lease back hotels to flatter net debt position, take disposal profits on cost rather than revalued amount, and take a lease holiday

1. Enron

1. Creation of unconsolidated SPE
2. Long term contract mark to market by sales to SPE
3. Compounded future revenue to an up-front PV (JEDI agreed to pay Enron management fee, 80% was made a requirement payment, taken as revenue)

1. Segment reporting

1. Threshold: segments account for 10% of revenue or asset should be reported
2. Company should report segments accounting for at least 75% of the total
3. Segments should base on internally reported operating segments
4. Measures of revenue, profit and asset are reported; And other profit related measures incl. interest income, depreciation, tax expense are regularly reported to management
5. Geographic information should be provided on revenue and assets in the home country and overseas

1. Balance sheet incompleteness

1. Missing tangibles

1. Operating lease
2. Service contracts

1. Missing intangibles

1. Land rights; Acquired are on balance sheet and others are missing
2. Management competence
3. Brand
4. Reputation for service excellence
5. Intelligence (HR)

1. Valuation

1. No revaluation
2. Accelerated depreciation to depress asset value on balance sheet

1. Comprehensive income: sum of net income and other items that bypass the income statement because they are not recognized

1. Items: revaluation surplus, currency exchange gain/loss, actuarial gain/loss on pension fund, gain/loss on the fair value of assets (AFS)
2. It measures the economic profit the company generates. Without it, the ROCE are not reliable proxies for economic return. Though GAAP tries to smooth earning by allowing companies to park volatilities in OCI, OCI is not always a noise. Over long term, OCI can be systematically negative or positive

1. Joint venture: an agreement where the parties that have joint control over the agreement have right in the asset of the agreement. Equity method. Parties recognize its share of net asset on balance sheet and its share of P&L in income statement
2. Onerous contract: loss making contract in which the cost to fulfill the obligation is greater than the economic profit. Provision should be created