Financial Statement Analysis
What you must know
The reporting framework (balance sheet, income statement, cash flow statement, statement of changes in equity, notes), IFRS versus US GAAP differences, revenue recognition, inventory cost-flow methods, long-lived assets and depreciation, impairment, leases, income taxes, pensions, the indirect-method cash flow statement, and ratio analysis including DuPont decomposition.
Traps
(1) LIFO is permitted only under US GAAP; with rising prices it produces lower inventory, higher cost of goods sold, lower taxable income and therefore higher operating cash flow. (2) LIFO liquidation inflates reported profit. (3) Capitalising rather than expensing raises early net income and operating cash flow but lowers asset turnover and later profitability. (4) A deferred tax liability typically arises when tax depreciation runs ahead of book depreciation. (5) Under IFRS development costs may be capitalised if criteria are met; US GAAP generally expenses research and development. (6) In the indirect method, add back non-cash charges and subtract increases in working capital assets.
Worked example
A firm using LIFO reports inventory of $400 and a LIFO reserve of $150 that rose by $30 this year. Converted to FIFO, inventory becomes $550 and cost of goods sold falls by $30, raising pre-tax income by $30 and net income by 30 x (1 - tax rate). Rule of thumb: FIFO conversion adds the full reserve to inventory and the change in the reserve to profit.