FAQ to be consulted when you encounter issues with interpreting, analyzing, or processing specific accounting items, you can refer to this article.

ACCRUALS

Accruals are used to recognize revenue and costs in the period they relate to, even if they are booked in a different period. Essentially, accruing means transferring revenue or costs from the profit and loss (P&L) statement to the balance sheet.

• Prepaid costs: These are costs for goods or services to be received later. For example, if a rental charge for a 12-month period is paid in advance on October 1st, three-quarters of this charge would be recorded as prepaid costs on the asset side of the balance sheet as of December 31st.
• Deferred income: This is income recorded before the corresponding goods or services are delivered. For example, a cable company that receives annual subscription payments on October 1st would record three-quarters of these payments as deferred income on the liabilities side of its balance sheet as of December 31st.

Additionally, there are accrued income and costs, which function similarly to deferred income and prepaid costs but in reverse. For instance, a company may accrue R&D costs, considering them as an intangible asset to be amortized or depreciated rather than appearing immediately in the P&L.

CASH ASSETS

Cash assets are short-term investments made using a company’s excess cash. To be considered cash equivalents in accounting, these investments must be very liquid, short-term, easily convertible into cash for a known amount, and have negligible risk of value change. In practice, several criteria are applied, especially for UCITS, such as benchmark index, liquidity frequency, exit penalties, volatility, and counterparty risk. The stricter classification of investments as cash equivalents arose after the 2007-2008 liquidity crisis, when some investors found that so-called cash investments were actually risky and not liquid during the crisis. Classifying assets as cash or long-term investments is crucial for assessing a company’s liquidity. Economically, an analyst will determine whether an asset contributes to operating earnings and should be integrated into capital employed or if it is a financial investment (short or long term). Financial investments are then deducted from net debt.

CONSTRUCTION CONTRACTS

For long-term projects like building dams or ships, companies use the percentage of completion method. This means recognizing sales and profits proportionate to the work completed at the end of each financial year. US rules also allow the completed contract method, where revenue is recognized only upon project completion. Construction projects in progress are part of the operating working capital. The percentage of completion method results in steadier profits over several years, while the completed
contract method can seem more cautious. Analysts should watch for changes in accounting methods for construction contracts, as such changes, though not permitted under IFRS, might be used to artificially improve reported net income.

CONVERTIBLE BONDS AND LOANS

Convertible bonds can be converted into shares of the issuing company at the holder’s request. If not converted, they are repaid in cash at maturity. Under IFRS, convertible bonds are split between debt and equity, treated as compound financial instruments consisting of a straight bond and a call option. The present value of the coupons and repayment amount, discounted at the firm’s borrowing rate, is recorded as debt. The remaining value is recorded as equity. Each year, interest is accounted for as with a standard bond, with part as the actual payment and the rest as a notional amount. When evaluating convertible bonds, consider the conversion conditions. If the share price is above the conversion price, treat the bonds as equity, reversing related interest expense net of tax to increase net income and increasing the number of shares by those to be issued upon conversion. If the share price is below the conversion price, treat the bonds as conventional bonds and classify them as borrowings.

DEFERRED TAX ASSETS AND LIABILITIES

Deferred taxation arises from differences between the taxable and book values of assets and liabilities, leading to deferred tax assets or liabilities. These differences occur when revenue and expenses are recognized in different periods for accounting and tax purposes.

Deferred tax liabilities are created when assets are valued higher on the balance sheet than their tax base or when certain costs are immediately tax-deductible but recognized in accounts over several years. On the other hand, deferred tax assets arise from provisions deductible only when the associated risk materializes or from tax losses that can offset future taxable income. Contingent tax liabilities represent potential taxes that the company may have to pay if it makes certain decisions, like distributing reserves on which tax hasn’t been paid. In consolidated accounts, companies must recognize all deferred tax liabilities. Deferred tax assets from tax losses are recognized when it is likely they will be used to reduce future taxes. Deferred tax is not recognized on non-deductible goodwill depreciation or taxes payable on distributions, as these are taken directly to shareholders’ equity.

DILUTION PROFIT AND LOSSES

When a parent company does not fully participate in a capital increase by its subsidiary, the parent records a dilution profit if the increase is above the subsidiary’s book value. Conversely, a valuation below the book value results in a dilution loss.

For example, if a parent company pays 200 for a 50% stake in a subsidiary with equity of 100, and the subsidiary then raises capital by 80, valuing it at 400, the parent’s shareholding dilutes to 41.67%. The parent’s equity share increases from 50 (50% of 100) to 75 (41.67% of 180), resulting in a gain of 25. This profit of 25 corresponds exactly to the profit that the parent company would have made by selling an interest of 50% − 41.67% = 8.33% based on a valuation of 400 and a cost price of 100 for 100%,
since 25 = 8.33% × (400 − 100). Dilution gains and losses create accounting profits without cash inflows and are non-recurring. They should be excluded from assessments of a company’s regular earnings.

FINANCIAL HEDGING INSTRUMENTS

Hedging aims to mitigate financial risks linked to variations in exchange rates, interest rates, and raw material prices, arising from commercial operations (like foreign currency receivables) or financial operations (like variable-rate debt) through the use of derivatives such as options, futures, and swaps. Under IFRS, accounting for these hedging instruments is complex, requiring them to be recorded on the balance sheet at fair value, with changes in value booked as income or expense. However, if the hedge is perfectly aligned with the underlying risk, hedge accounting can be applied, otherwise, changes in value will appear on the income statement. For instance, with fair value hedges, both the hedged item and the hedging instrument should have their value changes reflected in the income statement to avoid inconsistencies. In cash flow hedges, such as a chocolate producer hedging cocoa prices with a forward purchase, IFRS allows recording changes in the hedging instrument’s value in equity until the actual transaction occurs, preventing illogical losses or gains. Financial managers should ensure that hedging is not speculative, categorizing operations as commercial or financial. Changes in the value of instruments hedging operating receivables or debts should be included in EBIT and working capital, while those hedging financial investments or debts should be linked to net debt on the balance sheet and reflected in the income statement.

INTANGIBLE FIXED ASSETS

Intangible assets, ranging from start-up costs to brand values, play a significant role in a company’s balance sheet, warranting close attention due to their accounting treatment’s latitude. Under IFRS, intangible assets are recognized only if future economic benefits are probable and their costs can be reliably measured. Internally generated goodwill and certain other costs are expensed, while development costs are capitalized under specific conditions. Financial analysts should monitor increases in intangible assets closely to detect potential attempts to obscure losses. Brands and market share acquired from third parties are crucial but often undervalued assets, especially in industries like consumer goods and luxury items. While some analysts may disregard their financial value, brands contribute significantly to a company’s valuation. Therefore, our approach suggests considering their value when evaluating a company. Ultimately, the treatment of intangible assets reflects a company’s financial and accounting policies, influencing its tax expenses and overall financial health.

INVENTORIES

Inventory encompasses materials used in a company’s operations, such as raw materials, finished goods, and work in progress. Their valuation varies by item, with raw materials valued at acquisition cost and finished products at production cost, considering both direct and indirect production expenses. Costs should be calculated based on normal activity levels to avoid deferring losses and inflating profits. Some costs, like financial charges, are typically excluded from inventory valuation, though interim interest payments may be included under specific conditions. Any changes in inventory valuation methods should be disclosed for accurate period-to-period comparisons. Inventories represent deferred costs affecting future profits, with their accumulation accelerating profit realization and their reduction
decreasing net income. Valuation methods do not directly affect a company’s cash position but significantly influence equity. During inflation, inventories may carry unrealized gains, while price declines can lead to real losses. Adopting a replacement cost basis can accurately reflect gains and losses each year, especially in slow-moving inventory sectors, thus avoiding crises by accurately reflecting asset values and avoiding loss deferrals.

LEASES

Operating leases involve using fixed assets under a rental system, while finance leases allow purchasing the asset at the contract’s end for a predetermined, usually low, amount. These leases present two complex issues for financial analysts:

• Firstly, they finance assets without necessarily appearing on the balance sheet, potentially representing a significant portion of a company’s assets
• Secondly, they signify a commitment, with equipment leasing sometimes resembling debt based on the termination period, and real estate leasing not always treated as debt due to termination clauses, though lease utility often leads to fulfilling the contract’s duration, akin to repaying a loan

Leases are categorized as either finance or operating. A finance lease transfers substantially all risks and rewards of ownership, often indicated by specific contractual terms and the asset’s economic life. Under IFRS, finance leases are capitalized, recorded under fixed assets with corresponding financial debt, and lease payments partly treated as debt repayment and financial expense. Operating leases, on the other hand, are expensed as rents. Sale and leaseback transactions involve deferring any capital gains on disposal over the lease term for finance leases or recognizing them immediately for operating leases. Financial analysts should be cautious of companies with significant operating leases, as they increase fixed costs on income statements and elevate breakeven points.

PREFERENCES SHARES

Preference shares combine features of both shares and bonds, offering fixed dividends, redemption prices, and dates similar to bonds. In the event of liquidation, preference shareholders are prioritized over common shareholders in receiving proceeds. They may also have additional earning participation or cumulative features, ensuring overdue dividends are paid before common shareholders receive any. However, preference shares typically lack voting rights. They are known as Actions de Préférence in France, Vorzugsaktien in Germany, Azioni Risparmio in Italy, and Preferred Stock in the US. Regarding accounting, under IFRS, preference shares are classified as either equity or financial debt based on a “substance over form” analysis. If they mandate redemption by the issuer, include a put option for the holder, or offer fixed dividends regardless of company earnings, they are considered financial debt. Conversely, under US GAAP, preference shares are treated as equity. For financial analysts, categorizing preference shares is straightforward: if they meet criteria for equity, such as returns linked solely to company earnings, no repayment commitments, and last-ranking claims in liquidation, they are treated as equity. Otherwise, they are classified as financial debt.

PROVISIONS

Provisions anticipate future costs, reducing net income when established rather than when expenses are incurred. They are later reversed when the corresponding costs are realized, offsetting the impact on the income statement. This makes provisions essentially forward-looking cost anticipations. Restructuring provisions involve front-loading charges to cover restructuring activities like site closures and layoffs, with future costs gradually written back to smooth earnings. To be accounted for, these costs must represent a confirmed obligation resulting from decisions made by relevant authorities and communicated to affected parties. Financial analysts often debate whether to categorize these charges as operating or non-operating items. Given today’s dynamic business environment, restructuring charges are usually considered structural and deducted from operating profit. Provisions for decommissioning or site restoration address long-term environmental commitments, such as plant decommissioning or site restoration. These are typically booked as the net present value of future commitments. Analysts should treat these provisions as net debt.

STOCK OPTIONS

Stock options, often granted to top executives, allow them to buy or subscribe to company shares at a fixed price. Under IFRS, fully vested options are expensed immediately, while those with a vesting period spread their value over time. Valuing them often uses option-pricing models, adjusting for cancellations and exercise conditions. While they can dilute shareholder value, they don’t directly affect company financials until exercised. Treating them as accounting charges seems illogical. For valuation, deducting their value from capital employed or using a fully diluted approach are common methods.

TANGIBLE ASSETS

Tangible assets, including property, equipment, and industrial tools, are essential for a company’s operations. They are initially recorded at acquisition cost and depreciated over time, except for land. While IFRS allows for revaluation at fair value, this option is rarely used due to complexity. Certain assets, like head offices or urban properties, may appreciate significantly, while others hold minimal value outside of operations. Financial analysts may find historical cost presentation uninformative. Borrowing costs related to asset acquisition can be included under IFRS if future economic benefits are likely. Accounting policies regarding fixed assets can impact net income and solvency. Capitalizing charges as assets boosts net income initially but increases depreciation charges in later periods.