(07 36334) Financial Statement Analysis and

Business Valuation

Lecture 3

Current assets

Week 3

Dr. Chun Yu Mak

Assistant Professor in Accounting & Finance
 Learning objectives
◼ Concept of current assets
◼ Inventories valuation & analysis
◼ Receivables, bad debts, securitization
◼ Investment securities
◼ Derivatives

Learning outcomes
After this lecture, you must know:
⚫ What are current assets?
⚫ Inventory valuation & analysis
⚫ Receivable valuation, securitisation & analysis
⚫ Accounting for debt & equity securities & analysis
⚫ Accounting for derivatives & the related analysis
Purposes of investigating current assets;

(1) Liquidity concern;

(2) We can examine the accruals accounts – future inflow of
operating cash flows – forecast future operating cash inflow;
(3) For us to do equity valuation;

(4) Earnings management opportunities that would be utilised

by managers.
 Concepts

Financing activities, are the transactions with claimants, via raising

cash for business in exchange for equity and debts claims and
returning cash to claimants.

Investing activities, are the cash raised from financing activities

and generated in operations to acquire assets to be employed in
operations. These assets may be physical assets, like inventories,
plant, and equipment, or knowledge and intellectual assets, like
technology and know-how – operating assets.

Operating activities, utilize the assets in which the firm has

invested to produce and sell products. Operating activities combine
assets with labour and materials to produce products and services,
sell them to customers, and collect cash from customers. If
successful, the operations generate enough cash to reinvest in
assets or return to claimants.
 Current assets
◼ Resources or claims to resources that are readily convertible to
cash, usually within 1 financial year or operating cycle, which
ever is longer.
◼ i.e. inventories/stocks, account receivables, investment
securities, derivatives, cash & cash equivalents.

Inventories
⚫ IAS 2 paragraph 6, Inventories are assets:
a) held for sale in the ordinary course of business;
b) in the process of production for such sale; or
c) in the form of materials or supplies to be consumed in the
production process or in the rendering of services.
⚫ i.e. raw materials & consumables; work-in-process; finished
goods & goods for resale; payments on account; goods held out
on consignment; but excluding those waiting for return to
suppliers (UK CA 1985 Sch. 4, FRS 5).
 Valuation of inventories
◼ The unit cost (UK CA 1985 & SSAP 9, US GAAP, IAS 2 para. 11)
= [costs of acquiring + costs of conversion & preparing for sale
+ costs incurred on the inventories up to the date they are
ready for use or sale (i.e. purchase tax, freight, storage,
insurance while in transit or storage) + interest on capital
borrowed to finance production costs (CA 1985 Sch 4, para 26)]
/ No. of units acquired.
◼ Lower of cost or net realisable value
◼ The matching principle
◼ Cost of good sold
= Opening inventories + Purchased – Closing inventories
◼ Problem: how to determine unit costs of inventories on hand?
 Inventory cost flows

◼ Specification cost identification method

--Each item of inventory and its cost need to be identified & retained
until sold.

◼ First-In, First-out (FIFO) (Subramanyan & Wild (2014): 44% US firms use it.)
--Values of closing inventories is close to replacement costs, physical
flow of stock is observed.
--it does not matches the more current unit cost with the current
revenues, overstates/understates profits—inflation/deflation.

◼ Average cost (20% US firms use it.)

--Unit cost = Total value/Total No. of Inventories (Opening +
Purchased)
 Inventory analysis

4. The danger of rising inventories

(Example 10.2, HSG pp.75-77)
--Rising closing inventories V.S. Rising turnover
Negative signals:
--Earnings management—profit & stock / turnover increase
--Unexpected sales decrease
Positive signals:
--For merchandising, managers expected increase in sales in
next year.
--For manufacturing, increases in raw materials or work-in-
process inventories—persist increasing in sales and earnings.
Example: Seasonal effects for fashion, electronic products etc.
 Receivables
◼ Receivables are amounts due from others that arise from the sale of
goods or services, or the loaning of money.
➢ Accounts receivables (or called Trade receivables)—arising from
credit sales.

➢ Notes receivables—formal written promises of indebtedness due from

others (i.e. amounts receivable under finance leases & loan notes).

➢ Others receivables (i.e. sales of fixed assets, investments, corp. tax

recoverable, deferred taxation, prepayments, etc.)
➢ Receivables are valued at net realisable value—total amount of
receivables less an allowance for bad debts (UK CA 1985, US GAAP)

❑ Provision for bad debts: is set up based on experience, customer

fortunes, economy/industry expectations & collection policies.

❑ Accumulated provision for bad debts—subtracted from debtors on B/S.

 Analysis of receivables
(1) Consideration changes in the allowance accounts
• computed relative to sales, receivables, or industry and market
conditions.
(2) Collection Risk
• Comparing competitors’ receivables as a percent of sales with that of
investigated firm
• Examining customer concentration
• Investigating the age pattern of receivables
Debt turnover=Credit sales/Trade debtors~15%-20%
Debt collection period=Trade debtors/Credit sales x 52~6 to 7 weeks
• Determining portion of receivables that is a renewal of prior
receivables
• Analyzing adequacy of allowances for discounts, returns,
other credits, provision for bad debts

(3) Authenticity of Receivables

• Review credit policy for changes
• Return policies for changes
(4) Securitisation of receivables
• Securitization/factoring is when a company sells all or a portion of
its receivables to a third party—factor house/Special Purpose
Entity (SPE), in order to get the provision of finance for working
capital.

• Operation illustration:
• Receivables can be sold with or without recourse to a seller
(recourse refers to guarantee of collectibility).

• Sale of a receivable with recourse does not effectively transfer

risk of ownership (UK FRS 5), the receivable must be presented as
an asset and a compensating liability on the BS.

• Example
 Example1: Capital One - Securitization
1) Receivables
with recourse
2) Receivables Security interest
without recourse in receivables Bond Market
SPE
Sponsoring Company

cash cash
cash

debtors
Effects of securitisation with/without recourse on the balance sheet
This treatment Adjustments
is alright if it for the with
is without recourse
recourse. contract.
Assets Before After Adjusted
Cash $ 50 $ 450 $ 450
Receivables 400 0 400
Other current assets 150 150 150
Total current assets 600 600 1,000
Noncurrent assets 900 900 900
Total assets $ 1,500 $ 1,500 $ 1,900
Liabilities
Current liabilities $ 400 $ 400 $ 800
Noncurrent liabilites 500 500 500
Equity 600 600 600

Total liabilities and equity $ 1,500 $ 1,500 $ 1,900

Key ratios
Current ratio 1.50 1.50 1.25
Total Debt to Equity 1.50 1.50 2.17
 Investment securities

 They are also called “marketable securities”:

➢ Debt securities: Government/corporate debt obligations
➢ Equity securities: Corporate shares that is readily marketable
➢ Valuation:
➢ UK CA 1985 allows for revaluating and current cost accounting -
Lower of cost and net realisable value.
➢ IFRS 9 Financial Instruments and IFRS 13 Fair Value
Measurement for valuation of financial assets and financial
liabilities based on fair value, since 1 January 2018.
➢ Methods of valuation and reasons must disclosed in notes to the
accounts.
 Classification

Investment Securities

Debt Securities Equity Securities

No Influence (below 20%
Trading holding)
- Trading
- Available-for-Sale

Held-to-Maturity Significant Influence

(between 20% and
50% holding)

Controlling Interest (above

Available-for-Sale 50% holding)
 Accounting for debt securities

Accounting

Balance Sheet Income Statement

Category Description Unrealized Other

Gains/Losses

Trading Securities Fair Value Recognize in net Recognize realized

acquired mainly income gains/losses and
for short-term or interest income in
trading gains net income
(usually less than
three months)

Available-for-Sale Securities neither Fair Value Not recognized in Recognize realized

held for trading net income, but gains/losses and
nor held-to- recognized in interest income in
maturity comprehensive net income
income

Held-to-Maturity Securities Amortized Not recognized in Recognize realized

acquired with both Cost either net income gains/losses and
the intent and or comprehensive interest income in
ability to hold to income net income
maturity
 Accounting for transfers between debt security classes

Transfer Accounting

Effect on Asset Value in Effect on Income Statement

From To Balance Sheet

Trading Available-for-Sale No effect Unrealized gain or loss on

date of transfer included in
net income

Available-for-Sale Trading No effect Unrealized gain or loss on

date of transfer included in
net income

Available-for-Sale Held-to-Maturity No effect at transfer; Unrealized gain or loss on

however, asset reported date of transfer included in
at (amortized) cost comprehensive income
instead of fair value at
future dates

Held-to-Maturity Available-for-Sale Asset reported at fair Unrealized gain or loss on

value instead of date of transfer included in
(amortized) cost comprehensive income
 Classification & accounting for equity securities

Category No Influence Significant Influence Controlling

Interest
Available-for-Sale Trading

Ownership Less than 20% Less than 20% Between 20% and 50% About 50%

Purpose Long- or Short-term Degree of business control Full business

intermediate-term investment or control
investment trading

Valuation Basis Fair value Fair value Equity method Consolidation

Balance Sheet Fair value Fair value Acquisition cost adjusted Consolidated
Asset Value for proportionate share of balance sheet
investee’s retained
earnings and appropriate
amortization

Income Statement: In comprehensive In income Not recognized Not recognized

Unrealized Gains income

Income Statement: Recognize Recognize Recognize proportionate Consolidated

Other Income dividends and dividends and share of investee’s net income
Effects realized gains and realized gains income less appropriate statement
losses in income and losses in amortization in income
income
 Analysis investment securities
 Three objectives:
(i) To separate operating from investing /financing performance
(ii) To evaluate investment performance & risk
(iii) To analysis accounting distortions due to accounting rules
&/or earnings management involving investment securities
➢ Possible accounting distortions:
(a) Opportunities for gains trading
(b) Liabilities recognised at cost
(c) Inconsistent definition of equity securities
(d) Classification based on intent
 Derivatives
◼ Market risks: changes commodity prices, interest rate & foreign currency
exchange rate.

◼ Hedges/hedging transactions:
Contracts that seek to insulate companies’
assets/liabilities/commitement/net investment from market risks of
changes in fair value or future cash flows.
These contracts are hedging instrument. The companies’
assets/liabilities/commitement/net investment are hedged item. (IAS 39)

◼ Derivatives are financial instruments (future, options & swaps) whose

value is derived from the value of another asset, class of assets, or
economic variable such as a stock, bond, commodity price, interest rate or
currency exchange rate.

◼ Reason of investing derivatives:

➢ Minimizing the market risk
➢ For making profit on trading (such as Shell, Tate & Lyle)
➢ Strong international competition in banking, traditional business of taking
deposits and lending is much less profitable. Therefore, bankers turn to
trading.
 ◼ Forward contract
➢ It is an obligation executed by purchaser and counterparty to trade a
security or asset at a specified future date. The price paid for the
security or asset is either agreed upon at the time the contract is
entered into, or determined at delivery.
❑ It is generally traded over-the-counter: negotiate with a single
counterparty.
❑ It carries a counterpart (or default) risk.
➢ It is not a derivative contract covered by US FASB SFAS 133.

◼ Future contract
➢ It is an agreement between two or more parties to buy/sell a certain
commodity or financial assets at a pre-agreed price and at a specified
future date or during a specified future time period. It has standard
delivery dates, trading units, terms & conditions. (Hull 2003)
❑ It is traded on organized markets.
❑ No default risk, gains & losses are counted every day-margin call.
➢ Now, it is more popular than forward contract.
 Option contract

➢ It is a right, not obligation for a party to buy (call

option) or sell (put option) a specific underlying assets
at a pre-agreed price on the settlement date (European
style, called “Plain vanilla”), or a time chosen by the
holder up to maturity (American style, called
“American option”). It is also called “future option”,
it is an option on a future contract (Hull 2003,
Bouchaud & Potters 2003)

➢ Condition: if the price of assets on that future date is

higher than the contract price.

➢ It is available in organised market or over-the-counter.

 ◼ Interest swap

➢ Interest swap protects a firm from the impact of

fluctuations in interest rates on the interest charge it
has to pay on its floating rate debt.
➢ Two parties exchange future cash flows
➢ Expecting interest rate increase—using fixed-for-floating
interest-rate swap
➢ Expecting interest rate decrease—using floating-for-
fixed interest-rate swap
➢ Example:
 ◼ Accounting treatments of derivatives (US GAAP)

Derivative Balance Sheet Income Statement

Speculative Derivative recorded at fair Unrealized gains and losses included in

value income
Fair value hedge Both derivative and hedged Unrealized gains and losses on both
asset and/or liability derivative and hedged asset and/or liability
recorded at fair value included in income
Cash flow hedge Derivative recorded at fair Unrealized gains and losses on effective
value (offset by accumulated portion of derivative are recorded in other
comprehensive income) comprehensive income until settlement date,
afterwhich transferred to income; unrealized
gains and losses on the ineffective portion of
derivative are included in income
Foreign currency Same as fair value hedge Same as fair value hedge
fair value hedge
Foreign currency Same as cash flow hedge Same as cash flow hedge
cash flow hedge

Foreign currency Derivative (and cumulative Unrealized gains and losses reported in other
hedge of net unrealized gain or loss) comprehensive income as part of translation
investment in recorded at fair value (part adjustment
foreign operation of cumulative translation
adjustment in accumulated
comprehensive income)
 Analysis of derivatives

➢ Identifying the reasons of using derivatives

➢ Risk exposure & effectiveness of hedging strategies
➢ Transaction-specific vs. companywide risk exposure
➢ Classify the transaction as operating income or financing income—
nature of business activities
➢ Companies are required to (i) limit the amount of investment, and
(ii) separating functions of confirming & settlement—improve the
strength of internal audit.
 Example:
Abstract of Marks & Spencer’s annual reports 2021
 Lecture review

◼ Concept of current assets

◼ Inventories valuation & analysis
◼ Receivables, bad debts, securitization
◼ Investment securities
◼ Derivatives
References:
◼ Text book Ch.4, pp.226-242, Ch.5 pp.274-287, 299-320
◼ Holmes, Sugden & Gee, 2005 Interpreting Company Reports & Accounts, 10th Edition,
FT Prentice Hall, Chs. 16, 17, 18, 23

Supplementary:
Alfredson, Leo, Picker, Pacter and Radford, (2009), Applying International Accounting
Standards, Wiley, Chs. 5 and 8.

For the latest version IFRS 7: Financial Instruments: Disclosures, go to the

following website:
http://www.ey.com/global/content.nsf/International/Assurance_-_IFRS_-_Overview

Questions for tutorial classes:

Exercises: 5-1, Problems: 5-1,

Canvas:
All handouts, tutorial class questions and answers, past exam papers can be
downloaded on Canvas.