Accounting

Income statement + CF = period; balance sheet = point in time.

Net income (income statement) → flows into retained earnings (balance sheet) → starting point of the indirect CF calculation.

```
Assets = Equity + Liabilities
```

It must hold at every point in time. If your balance sheet doesn't balance, you have an error in the model.

Every dollar on the asset side must be funded — either by owners (equity) or by third parties (debt, payables, provisions).

Check: total assets − total liabilities and equity = exactly 0, every period. The most common junior mistake.

Shows economic performance over a period (quarter / fiscal year).

Revenue when earned (not when cash arrives), expenses when economically incurred.

```
Revenue
→ Gross profit (after COGS)
→ EBITDA (after personnel/other)
→ EBIT (after D&A)
→ EBT (after interest)
→ Net income (after taxes)
```

The income statement is not the same as cash flow. A company can be profitable and still die of illiquidity (typical for growth companies with high working-capital needs).

• Operating CF (OCF): cash from operations
• Investing CF (ICF): capex, acquisitions, asset sales
• Financing CF (CFF): debt, dividends, share buybacks

```
Sum of the 3 sections + beginning cash = ending cash
```

The cash flow statement is the bridge between the accrual income statement and cash reality — and the most important statement for IB. Valuation and debt capacity are based on cash, not net income.

The standard answer every junior has to master — the 60-second version:

'The income statement shows profitability over a period — revenue minus expenses gives net income.

The balance sheet shows what the company owns at a point in time and how it is financed — assets = equity + liabilities.

The cash flow statement shows cash movements over a period in three sections: operating, investing, financing.

Linkage: net income from the income statement is the starting point of the cash flow statement (indirect method) and, after dividends, flows into retained earnings on the balance sheet. The change in cash at the bottom of the cash flow statement goes into the cash line on the balance sheet.'

Two permitted formats under IFRS (IAS 1) and local GAAP:

• Nature-of-expense method — expenses grouped by nature (raw materials, personnel, depreciation, other). Dominant among smaller local-GAAP filers because it sits closer to the bookkeeping logic.
• Cost-of-sales method — expenses grouped by function (COGS, SG&A, R&D, D&A separate or embedded). The international standard; almost all public companies (SAP, Siemens, Bayer) report cost-of-sales. IB practice: for a multiples comparison and a DCF you need the cost-of-sales format — if the target only provides nature-of-expense, a manual restatement is required (typically allocating personnel costs to COGS/SG&A/R&D).

Gross margin is only readable under the cost-of-sales method.

• Non-current assets (long-term): property, plant & equipment (PP&E), intangible assets, goodwill, financial assets.
• Current assets (short-term): inventory, trade receivables (AR), other receivables, cash.

• Equity: share capital, additional paid-in capital, retained earnings, OCI.
• Non-current liabilities: bonds, bank loans, pension provisions, deferred taxes.
• Current liabilities: trade payables, other provisions, short-term bank debt.

The three statements are connected through three hard-wired linkages — every serious 3-statement model build stands or falls with them.

• Income statement → balance sheet: net income flows through retained earnings into equity.
• Income statement → cash flow statement: net income is the starting point of the indirect OCF method; non-cash items (D&A, stock-based comp, impairments) are added back.
• Cash flow statement → balance sheet: closing cash sets the balance-sheet cash position; each CF section drives a different balance-sheet line.

Classic question — D&A rises by 10 at a 30% tax rate works out as follows:

The change in assets (−10 + 3 = −7) equals the change in equity (retained earnings −7) — the balance sheet balances.

• Income statement: no effect — capex is capitalized, not expensed.
• Balance sheet:

Asset swap — total assets unchanged.

• Cash flow:

The change in assets (−20 + 6 = −14) equals the change in equity (retained earnings −14) — the balance sheet balances.

Net income flows through retained earnings into equity. The roll-forward formula:

```
Retained earnings(t) = Retained earnings(t−1) + Net income(t)
− Dividends(t) − Share buybacks(t, from RE) ± OCI(t)
```

Net income does NOT go directly into cash. Cash moves exclusively through the cash flow statement — depending on working-capital changes, capex, debt drawdowns, and the like. A company can report net income of 100 and generate cash of 0 or negative if AR and inventory rise by 100+.

cumulative net income minus cumulative dividends since inception. Fed by realized income-statement results. Other comprehensive income (OCI): value changes that under IFRS are booked directly in equity without running through the income statement. Typical OCI items:

• Pension remeasurements (actuarial gains/losses, IAS 19).
• Cash-flow-hedge value changes (effective portion).
• FX translation differences from subsidiaries.
• FVOCI value changes on certain financial instruments.

No effect — dividends are not an expense but an equity transaction. Cash flow statement: financing cash flow −50, Δ cash −50 (under US GAAP dividends paid must be financing; IFRS permits operating or financing, financing is the norm). Balance sheet: cash −50 (assets), retained earnings −50 (equity). The balance sheet balances. Important in an IB context: the cash paid out reduces the company's equity value (the share goes ex-dividend), which matters for DCF and SOTP timing. For mature dividend payers (e.g. utilities, insurers, banks, consumer staples), dividend policy is a primary valuation driver via the DDM.

A dividend becomes a liability only when it is declared (approved by the board or, where required, by shareholders at the AGM). Dividends proposed or declared after the balance-sheet date are NOT a liability at period end — disclosure only under both IFRS (IAS 10) and US GAAP.

Recognition when economically incurred — revenue when the good or service is delivered, expense when the resource is consumed.

Recognition on the actual movement of money — when the cash lands in or leaves the account.

Items that reduce net income without a cash effect — hence added back in the OCF reconciliation:

• Depreciation & amortization (D&A) — the largest item.
• Stock-based compensation (SBC) — IFRS 2 stock options, RSUs.
• Impairments — goodwill, PP&E, intangibles.
• Change in deferred taxes (DTA/DTL).
• Equity-method income (share of investees' NI — cash only comes via dividends).
• Fair-value changes on financial instruments (unrealized G/L).
• Unwinding of the discount on long-term provisions (pensions, onerous contracts).
• Losses on asset sales (against the cash proceeds in investing).

Working-capital changes are booked in the OCF section (indirect method) as reconciliation items between net income and OCF.

An increase in WC ties up cash → OCF falls. A decrease in WC frees up cash → OCF rises. Concrete signs: Δ receivables (AR) ↑ → OCF ↓ (revenue was booked but no cash collected). Δ inventory ↑ → OCF ↓ (cash tied up in stock). Δ payables (AP) ↑ → OCF ↑ (you owe suppliers more, conserving cash).

An inventory write-down of 50 at a 30% tax rate, treated as a non-cash impairment (the write-down typically lands in COGS or 'other operating expenses'):

The change in assets (−50 + 15 = −35) equals the change in equity (retained earnings −35).

SBC is an expense (typically in personnel or SG&A) — personnel expense +30, EBIT −30, taxes −9, net income −21. Cash flow statement: net income −21, but SBC is non-cash → add-back +30 in OCF → Δ OCF +9 (tax shield). Balance sheet: equity +30 (additional paid-in capital from share-based compensation) and retained earnings −21 → equity net +9. Cash +9. Assets +9, equity & liabilities +9 → balances.

Key point: SBC is non-cash but an economically real expense — you are handing out equity stakes. IB practice and buyside analysts almost always add SBC back out of 'adjusted EBITDA' (especially in tech: Microsoft, Salesforce). At large-cap tech names (SAP), SBC runs to roughly $1–2bn per year.

Identical net income can lead to a massively different cash effect. Compare a cash sale vs. a sale on credit (30% taxes in each case):

Asset deal or PPA logic — the buyer capitalizes the target's net assets at fair value, and the difference to the purchase price is goodwill (here: 200 purchase price − 80 net assets = 120).

no effect — the acquisition is a pure balance-sheet transaction.

The change in assets +100 (−100 + 120 + 80) equals the change in equity & liabilities +100 (debt +100, equity unchanged).

A goodwill impairment is usually NOT tax-deductible (tax goodwill and book goodwill differ). Assumption here: not deductible.

The change in assets −100 equals the change in equity −100 — the balance sheet balances with no cash movement.

In a cleanly built 3-statement model, the balance sheet is the last statement built, and cash is the plug.

The income statement is forecast-driven (top line × margins). The cash flow statement is derived from the income statement plus WC assumptions plus capex. The closing-cash figure (opening cash + ΔCash from the cash flow statement) is then carried into the balance sheet. All other balance-sheet items — PP&E, AR, AP, debt, and equity — are forecast separately. If assets and liabilities & equity don't match at the end, there is a model error.

The cash flow statement breaks down into three sections:

• CFO / OCF: cash from operations. Start: net income (indirect method), adjusted for non-cash items and working-capital changes.
• CFI / ICF: cash from investing — capex, M&A, asset sales, securities purchases/sales. Typically negative at growing companies.
• CFF: cash from financing — debt raises/repayments, dividends, equity issuance, buybacks.

```
Sum of 3 sections + beginning cash = ending cash → balance sheet
```

OCF is the most important section — operating cash generation drives valuation and debt capacity.

Always indirect. Links the income statement and balance sheet cleanly in mathematical terms.

Senior asks 'which method?' → 'Indirect, the standard in IB modeling'.

```
EBIT × (1−t) + D&A − Capex − ΔNWC
```
Cash for ALL capital providers (equity + debt). The standard for a DCF (enterprise value).

```
OCF − Capex + Net Borrowing
```
For equity holders only. The standard for a DDM, equity DCF, and LBO cash-sweep logic.

• DCF context: 'FCF' = FCFF
• LBO context: 'FCF' = FCFE

FCF/sales >8% = solid; >15% = strong.

net income (starting point) + D&A (non-cash add-back) + stock-based compensation + impairments / write-downs + Δ deferred taxes (DTA reduction / DTL increase as an add-back) + losses / − gains on asset sales (against the cash proceeds in investing) + equity-method loss / − equity-method income ± other non-cash items (e.g. the unwinding of the discount on a pension provision) − Δ AR (AR ↑ → OCF ↓) − Δ inventory (inventory ↑ → OCF ↓) + Δ AP (AP ↑ → OCF ↑) ± Δ other WC items = OCF.

operating inventory purchases (that's OCF via Δ inventory) — a classic junior mistake.

interest payments are a mandatory part of OCF. Rationale: interest is an operating expense and runs through net income. IFRS (IAS 7): optional — interest payments may be shown in OCF OR in financing cash flow. Interest / dividends received are likewise optional (OCF or investing). Impact on IB practice: when comparing comps of US companies vs. IFRS reporters (e.g. Microsoft vs. SAP), OCF can differ structurally — if an IFRS reporter like SAP moves interest paid into financing, its OCF is higher, all else equal, than a US GAAP reporter's, which must show interest paid in OCF (interest received is likewise mandatorily OCF under US GAAP). Adjustment in the model: for clean comps, standardize OCF to 'IFRS, interest in financing' or 'GAAP, interest in OCF'.

Unlevered FCF (FCFF / FCF to firm): cash for ALL capital providers (equity + debt).

EBIT × (1−t) + D&A − Capex − Δ NWC. NO interest effect, NO debt repayment.

the standard DCF valuation of enterprise value, discounted at WACC. Levered FCF (FCFE / FCF to equity): cash ONLY for equity holders, after all debt obligations.

OCF − Capex + Net Borrowing (= raises − repayments). Application:

• Equity DCF / DDM for banks/insurers (where WACC is poorly defined).
• LBO models for cash sweep / debt repayment.
• Dividend-capacity analysis.

95% of IB DCFs use FCFF; FCFE stays for special cases.

The cash bridge is the mathematical link of the cash movement across a period.

```
Opening cash + OCF + ICF + CFF + FX effect = closing cash
```

This bridge has to tie in every 3-statement model — otherwise the balance sheet doesn't balance. 'Restricted cash' (guarantees, escrows) is usually NOT included in this bridge, but is a separate balance-sheet line.

FX effects in the cash flow statement arise when a group consolidates subsidiaries in a foreign currency. Standard under both IFRS (IAS 7) and US GAAP (ASC 830/230): the FX effect is shown as a separate reconciling line at the end ('effect of exchange rate changes on cash').

Cash at a foreign-currency subsidiary is translated at the current period-end rate — the difference from the prior-year period-end rate is the FX effect on cash (cash flows during the year are translated at actual or average rates).

FCF conversion measures how much of book profit actually converts into cash.

```
FCF conversion = FCF / EBITDA (or FCF / net income)
```

SBC is a non-cash expense → an add-back in OCF under the indirect method.

Δ in an asset item (other than cash) hits OCF with the opposite sign. Δ in a liability item (current liabilities) hits it with the same sign. Concretely: AR ↑ by X → −X in OCF (you booked revenue but collected no cash). Inventory ↑ by X → −X (cash tied up in stock). Prepaid expenses ↑ by X → −X (cash already out, expense not yet in the income statement).

AP ↑ by X → +X (you owe more, conserving cash). Accrued expenses ↑ by X → +X (expense booked, not yet paid). Deferred revenue ↑ by X → +X (cash received, revenue not yet booked). Modeling trap: the NWC definition varies — some models include tax payables or dividend payables, some don't. IB standard: model only 'operating working capital' — i.e. AR, inventory, AP, other operating receivables/payables. Cash, debt, and dividends out.

Restructuring charges typically contain both components — separating them cleanly is quality-of-earnings standard:

• Non-cash portion: asset impairments (plant closures with PP&E write-downs), goodwill impairment, intangibles write-offs — added back to OCF like other non-cash items.
• Cash portion: severance payments, lease-termination fees, decommissioning costs — booked into OCF via Δ restructuring provision (a balance-sheet line).

If a restructuring expense of $100 is booked in the income statement, of which $60 is non-cash and $40 a future cash outflow, it all runs through net income:

• Add-back: $100 (the entire restructuring expense).
• Δ provision: +$40 (building the provision).
• In the cash-payment year: Δ provision −$40 (release), no income-statement effect.

Standard red flags that DD teams check systematically:

• OCF grows slower than net income over several years — signals decaying earnings quality (e.g. an AR build-up to manipulate revenue).
• High working-capital volatility with no seasonality explanation — possible period-end balance-sheet optimization.
• Capex < maintenance-capex threshold (rule of thumb: < 80% of D&A at industrials) — short-term cash optimization at the expense of the asset base.
• A growing share of 'other operating activities' in OCF — a catch-all line, often opaque non-cash items.
• Aggressive capitalization of R&D or software costs — shifts expense from the income statement into capex, an artificial boost to EBITDA and OCF.
• Reverse factoring (supplier-financing programs) — can inflate AP artificially and inflate OCF without being immediately disclosed as debt.

Interest directly attributable to a qualifying asset (e.g. a construction project taking > 12 months to build) MUST be capitalized — it does NOT run through the income statement as interest expense, but is capitalized into PP&E and depreciated over the useful life. Cash-flow-statement effect:

• The cash out for the interest payment runs through investing as part of capex (instead of through OCF/financing as an interest payment) — OCF is reported higher accordingly.
• Reported interest expense in the income statement is lower than the actual interest burden. Impact on valuation adjustments: (a) EBIT/EBITDA is reported higher (interest sits outside the income statement). (b) Coverage ratios (EBIT/interest) are artificially overstated. (c) Capex is reported higher, so FCF is lower. Adjustment in the model: back capitalized interest out of PP&E, or at least show it in a sensitivity.

The OCF structure differs structurally between classic industrials and SaaS business models:

```
NWC = current operating assets − current operating liabilities
= (AR + Inventory + Prepaid) − (AP + Accrued + Deferred Revenue)
```

• Cash (except a minimal operating cash balance)
• Short- and long-term debt
• Tax items (separate)
• Dividends payable

NWC captures the cash tied up in day-to-day operations. When a company grows, AR and inventory rise faster than AP — so every growth phase needs additional NWC, which ties up cash and weighs on FCF.

NWC/sales runs at 5–25% depending on the industry.

```
CCC = DSO + DIO − DPO
```

DSO 60, DIO 90, DPO 45 → CCC = 105 days.

cutting the CCC is a classic PE lever — 30 days at a $500m-sales middle-market company frees up ~$40m of cash.

a days-based method per component, driven by the relevant P&L line.

• AR: % of revenue or DSO days — forecast: AR (t) = DSO × Sales (t) / 365.
• Inventory: % of COGS or DIO days — Inventory (t) = DIO × COGS (t) / 365.
• AP: % of COGS or DPO days — AP (t) = DPO × COGS (t) / 365.
• Other items typically as a % of sales or OpEx. Step by step: (a) calculate historical DSO/DIO/DPO from the last 3 years. (b) identify the trend (rising / falling / stable). (c) forecast assumption — the standard is a 3-year average as steady state, with an improvement plan if applicable. (d) flow Δ NWC per forecast year through the cash flow statement.

industry-specific NWC profiles (NWC / sales ratio) vary considerably by business model:

seasonal businesses show large intra-year NWC swings that are hidden in year-end snapshots. Examples:

• Toys (Mattel, Lego): a Q4 sales peak means an AR peak in December/January, then a cash inflow in February — year-end AR overstates the steady state by 30–50%.
• Construction / heating equipment (HVAC manufacturers): a Q3–Q4 delivery peak, low activity in Q1 — year-end inventory above average.
• Agricultural machinery / seeds: a Q1–Q2 spring season — year-end inventory is a seasonal build.
• Travel / hotels: advances drive deferred revenue seasonally. Modeling approach: (a) a 12-month rolling average instead of a year-end snapshot. (b) quarterly modeling for liquidity / covenant stress. (c) in DD: 24 monthly data points as a plausibility check.

locked-up cash (or 'trapped cash') = cash that exists economically but is not available for group financing. Typical reasons:

• Cash at foreign subsidiaries whose repatriation triggers withholding tax or capital controls (e.g. China, Russia — relevant for multinationals with subsidiaries there).
• Restricted cash for guarantees, escrows, project bonds.
• Cash in joint ventures requiring minority-partner approval.
• Pension-plan assets (segregated for beneficiaries). Difference from NWC: locked-up cash is not operating working capital but a financing restriction. IB consequence: (a) in the EV-to-equity bridge, locked-up cash is typically NOT netted as 'cash' against debt — it is shown separately as 'restricted cash'. (b) DCF: the NWC forecast is unchanged, but reflect it in the net debt adjustment.

the SPA contains a 'locked-box' or 'closing accounts' mechanism. Locked-box: the working-capital position at the reference date (e.g. December 31 before closing) is 'locked' — the buyer bears the risk / upside between the reference date and closing. Closing accounts: NWC at closing is actually calculated, compared with the reference NWC, and the difference becomes a purchase-price adjustment. Reference NWC = a 12-month average ('normalized NWC') — typically the negotiation hot spot.

the buyer (a middle-market company) extends its payment terms to suppliers from 30 → 90 days. A bank is inserted in between: the bank pays the supplier immediately (at a discount), and the buyer pays the bank at 90 days. Effects:

• Supplier: gets cash faster (positive, but at a discount).
• Buyer: AP ↑, DPO ↑ → NWC falls → OCF rises.
• Bank: earns a margin on the discount. Accounting issue: reverse-factoring liabilities are often carried as 'trade payables' (an operating liability) even though economically they are bank debt.

window-dressing indicators — typical in audit DD:

• Q4 AR significantly lower than the Q1–Q3 average — an indicator of aggressive collections before year-end or an AR sale (factoring) only in Q4.
• Q4 DPO significantly higher than the average — supplier payments deliberately pushed past year-end.
• Q4 inventory lower than seasonally expected — deliveries accelerated into Q4.
• Jumps in 'other current liabilities' specifically in Q4 — catch-all bookings.
• Reverse factoring activated specifically at year-end.

if you simply extrapolate NWC as a % of sales, NWC grows linearly with revenue — which understates the fact that fast-growing firms often tie up proportionally more NWC (DSO rises as the customer base diversifies). Methodical approach:

• Model NWC components separately — DSO, DIO, DPO individually, not as a bulk % of sales.
• Customer-mix effect: when growth comes from large customers, DSO typically rises to 75–90 days (large customers pay more slowly).
• Geographic mix: growth in emerging markets raises DSO and inventory because of longer logistics routes.
• Mix adjustment: at 30% growth, stress DSO by 5–10 days vs. steady state.

negative NWC = AR + inventory < AP + deferred revenue. It means customers / suppliers finance the working capital — you pay suppliers later than customers pay you. Consequences:

• Growth FREES cash instead of tying it up — an excellent business model.
• Reduces capital requirements, raises ROIC dramatically. Business models with structural negative NWC: (a) SaaS / subscription (Salesforce, Adobe): customers pay annually/quarterly in advance, deferred revenue builds up. (b) discount retail (Aldi, Lidl): customers pay immediately, suppliers 60–90 days later. (c) insurance: premiums come up front, claims over years. (d) online marketplaces (Amazon): cash on delivery or before shipping, marketplace commissions later. (e) travel / booking (Booking.com): deposits up front, spending at the trip date.

as part of the group, the divested business often had NO AR/AP/inventory systems of its own — everything was consolidated. In a carve-out, NWC has to be re-allocated. Standard issues:

• Shared-service AR / AP: group treasury holds central receivables / payables that need to be attributed to a division — allocation logic is required.
• Intercompany items: the carve-out business has receivables / payables against remaining group sister companies — at closing these are converted into 'third-party receivables' with new payment terms (a TSA).
• Setup inventory: the carve-out needs a new stand-alone warehousing structure, often with build-up costs of 5–15% of the stand-alone inventory.
• Customer onboarding: customer contracts have to be migrated — a temporary DSO extension of 15–30 days is typical.

advances are a cash inflow without revenue recognition — typical in machinery, plant engineering, and made-to-order manufacturing.

Under IFRS 15 this liability item is a 'contract liability' (similar to deferred revenue, but for long-term projects). On project acceptance or at a milestone, the advance becomes revenue and the liability unwinds.

reported NWC and operating NWC are not the same concept — valuation almost always calls for operating NWC.

Excluded from operating NWC (they belong elsewhere):

• Cash and short-term bank debt — in net debt.
• Short-term tax receivables and payables — separately as tax items.
• Dividends payable — an equity transaction.

Machine 100, 10-year useful life → capex 100 (balance sheet), D&A 10/yr (income statement).

Model capex separately from opex (capex via % of sales or absolute, opex via margin structure).

Capex intensity = capex/sales. Industrials 5-10%, tech 2-5%, telco/utilities 15-25%.

• Straight-line (standard under local GAAP + IFRS): same annual rate
• Declining-balance (local GAAP, for tax optimization)
• Units-of-production (rare)

D&A shown together — both non-cash, treated the same in the cash flow statement.

D&A/sales: industrials 4-8%, tech 1-3%, capital-intensive 10-20%.

investments that preserve the existing asset base — replacing worn-out machinery, renovations, software updates. Keeps the business at steady state, generates NO organic growth. Growth capex: investments that expand capacity / reach — new plants, new lines, new geographies. Drives future growth. Rules of thumb for estimation:

• Maintenance capex ≈ D&A (long-run steady state — replacement matches depreciation). At steady-state operators (middle-market industrials), maintenance capex is 80–110% of D&A.
• Growth capex = total capex − maintenance capex.
• At young / growing companies: capex >> D&A → most of it is growth. At mature companies: capex ≈ D&A → mostly maintenance. Valuation implication: a DCF forecast should set long-term capex ≈ D&A (steady state), otherwise it implicitly assumes growth capex in perpetuity — which systematically overstates the valuation.

Standard forecast mechanics in every 3-statement model.

```
Ending Net PP&E = Beginning Net PP&E
+ Capex (cash investment from CFI)
− D&A (from income statement, non-cash)
− Net book value of disposals
+ Net PP&E of acquired targets
− Impairment charges
```

This bridge must match balance-sheet PP&E exactly. If it doesn't tie out: often double-counted capex or a forgotten asset-disposal book value.

R&D is split into two phases. Research phase: expensed IMMEDIATELY (no option). Development phase: MUST be capitalized when 6 criteria are met (technical feasibility, intent to sell, availability of resources, etc.). Capitalized software is amortized over its useful life (typically 3–5 years). Local GAAP: capitalizing internally generated intangibles is PERMITTED (an option introduced by a 2010 local GAAP reform), but the research phase EXPLICITLY is not. In practice: many middle-market companies do NOT capitalize (the conservative local-GAAP approach), whereas IFRS reporters must.

Consequence for the comps comparison: SAP (IFRS, capitalizes) shows higher EBITDA than a comparable local-GAAP reporter that expenses R&D in full. Adjustment in DD: for an apples-to-apples comp, reclassify R&D into capex or vice versa.

The accounting useful life (IFRS / local GAAP) is the estimated economic useful life — meant to reflect economic reality. The tax useful life (statutory depreciation tables) is prescribed in standardized form by the tax authority, often shorter than the economic life.

Tax D&A differs from book D&A — the temporary difference creates a deferred tax (a DTL, because tax D&A is usually faster).

The capex / D&A ratio is a standard indicator of the investment cycle:

Impairment test on 'triggering events' — market changes, technological disruption, margin decline, etc. Test: if carrying amount > recoverable amount (= the higher of fair value − disposal costs and value in use), then impair down to the recoverable amount. Reversal POSSIBLE if value recovers (except goodwill). Local GAAP: a write-down for a permanent impairment of fixed assets. A mandatory write-up when the reasons for the impairment cease — stricter than IFRS.

Standard approach in buy-side DD when the sell-side gives no breakdown:

• Long-term D&A average: maintenance capex ≈ D&A over the last 5 years. The cleanest approach for steady-state industrials.
• PP&E replacement estimate: gross PP&E / average useful life × inflation factor.

Under IAS 16.43, PP&E assets made up of significant components with different useful lives must be depreciated separately (component depreciation).

Software-heavy firms (SaaS, tech industrials) often capitalize significant R&D / software costs under IFRS. Effect: income-statement EBITDA is higher (expense is shifted into capex), but cash FCF is unchanged. Valuation distortion:

• EV/EBITDA multiples will look lower (higher EBITDA in the denominator) → the multiple comparison to comps with different capitalization practices is distorted.
• Reported D&A (amortization of capitalized software) is higher → the EBIT vs. EBITDA spread is artificially large. Adjustment approaches: (a) 'capitalized R&D adjustment': move capitalized R&D / software back into opex → adjusted EBITDA is lower, comparable to R&D-expensing comps. (b) Cross-check with FCF multiples: with FCF (= EBITDA − capex) the distortion is smaller, because capex includes the capitalized R&D. Real-world: SAP capitalizes ~$1.5bn of software costs per year — adjusted EBITDA for comps with US SaaS firms (which expense more) is typically 5–10% lower than reported.

Cyclical industrials (steel, chemicals, auto suppliers) show huge capex swings over the economic cycle — in boom years capacity expansions are caught up on, in downturn years capex is cut to a minimum.

• Extrapolating capex from 1 'normal' base year — either a boom year (overstated) or a recession year (understated); valuation distorted by 15–30%.
• Forecasting D&A on a straight line with no capex lag — in capex boom years D&A is too low, in later years too high.

• Mid-cycle capex: a 7–10-year average as the steady state.
• Normalize capex / sales to a 7–10-yr average — typically 4–8% at cyclical middle-market companies.
• Capex phasing in the DCF: years 1–2 reflect the current cycle, years 3+ converge to mid-cycle.
• Terminal capex = terminal D&A for steady-state conditions.

the acquisition / production cost of all tangible assets, accumulated since capitalization. Grows continuously with capex, falls only on disposals. Accumulated depreciation: cumulative depreciation over the assets' lives. Net PP&E (also 'carrying value' / 'book value'): gross PP&E − accumulated depreciation. This is the balance-sheet line item. Valuation relevance:

• Net PP&E in the balance sheet and 3-statement model — standard.
• Gross PP&E is useful for 'asset aging': net PP&E / gross PP&E shows how 'young' the asset base is. A ratio of 0.7+ → young asset base, little catch-up capex needed. A ratio < 0.3 → old asset base, deferred-maintenance risk.
• Replacement-cost estimate: gross PP&E × inflation factor since capitalization.

terminal-year capex = terminal-year D&A.

In steady state, growth and the asset base stay constant — replacement capex matches depreciation exactly.

The terminal year ≠ a mid-forecast year. In forecast years 1–5, capex can be > D&A (a growth phase building up PP&E) or < D&A (a consolidation phase reducing assets). But in the terminal year the two must converge — otherwise it implies perpetual asset build-up or shrinkage. Common junior mistakes:

• Extrapolating capex / sales flat from mid-forecast into the terminal → capex > D&A → unrealistic.
• Holding D&A flat while capex rises → balance-sheet PP&E diverges. Clean mechanics: (a) capex (terminal) = D&A (terminal). (b) D&A (terminal) consistent with net PP&E (terminal) and the long-term average useful life. (c) PP&E growth in the terminal equals sales growth (= long-term g, typically 1.5–2.5%).

They arise from temporary differences between the book value (local GAAP/IFRS) and the tax-base value. They reverse in the future → so you recognize the tax effect today.

Book value < tax base, or a loss carryforward → future tax savings.

• Example: loss carryforward 100 × 30% = DTA 30

Book value > tax base (e.g. faster tax depreciation) → future tax burden.

• Example: asset 100 (book) vs. 80 (tax) → 20 × 30% = DTL 6

Other long-term assets/liabilities. ΔDTA/DTL flows through the effective tax rate into the income statement.

The legal tax rate set by the country / jurisdiction. It varies widely — roughly 21–30% across major developed markets (a ~25–30% marginal corporate rate is common, and combined national-plus-local rates differ by location). Effective tax rate: taxes actually paid / EBT per the income statement — can differ significantly. ETR = income-statement taxes / pre-tax income. Reasons for the divergence:

• Tax-exempt income (equity-method / investment income, some capital gains).
• Non-deductible expenses (goodwill impairment, some fines, partly deductible meals/entertainment).
• Mix of foreign subsidiaries with different tax rates.
• Tax credits (R&D incentives, investment credits).
• Changes in the DTA recoverability test.
• Loss carryforward utilization. In IB modeling: use the ETR from the last 3 years as a forecast base; where there are large one-off effects, use a 'normalized ETR'.

Tax depreciation is usually faster than book depreciation — shorter tax useful lives and declining-balance methods are allowed, while book depreciation runs straight-line over the longer useful life.

The tax base of the asset falls faster than the book value, so a temporary difference builds up, which is recognized as a DTL.

A net operating loss (NOL) — a tax loss carryforward — arises when a company reports a tax loss that can be offset against future taxable income. This gives rise to a potential DTA of NOL × tax rate.

• IFRS (IAS 12): the DTA is recognized only to the extent that it is 'probable' that sufficient future taxable profits will be available to use it.
• US GAAP (ASC 740): the DTA is recognized in full, then reduced by a valuation allowance if it is 'more likely than not' (>50%) that some or all of it will not be realized.

Recoverability is assessed from the management forecast (3–5 years), reversing taxable temporary differences, tax-planning strategies and historical profitability. A history of recent losses is strong negative evidence under both frameworks.

DTAs are tax assets on the balance sheet and represent future cash-tax savings. Their treatment in the EV-to-equity bridge is debated and context-dependent — three standard approaches:

• Treat the DTA as a cash equivalent: net it against net debt — the DTA reduces net debt just like cash. Clean for recoverable, usable NOLs.
• Leave the DTA in equity: the valuation ignores the DTA and treats it as an equity item. Conservative.
• DTA present-value method: forecast the expected tax savings over time and discount to present value — the cleanest approach, but time-consuming.

The income-statement tax is the sum of the current tax and the change in deferred tax. The actual cash tax is only the current tax — the change in deferred tax is non-cash and must be neutralized in the OCF reconciliation.

Standard models often show 'Δ deferred taxes' as a single line — cash taxes typically differ from income-statement taxes by 0–5%.

Change-of-ownership rules limit the use of loss carryforwards after a shareholder change — critical in any M&A deal with a loss-making target. The approach differs by jurisdiction:

• US (IRC §382): an 'ownership change' is a >50 percentage-point increase in ownership by 5% shareholders over a 3-year testing period. The NOLs are not forfeited, but annual use is capped at the equity value of the loss company × the IRS long-term tax-exempt rate. Net unrealized built-in gains can increase the cap; if the business is not continued for 2 years, the limitation can fall to zero.
• UK (Part 14 CTA 2010): carried-forward trading losses can be disallowed where a change in ownership coincides with a major change in the nature or conduct of the trade within a set window around the change.
• Germany (§8c KStG), as a forfeiture-style example: a transfer of >50% to one acquirer within 5 years forfeits the losses in full, subject to exceptions for built-in gains (hidden reserves), intragroup transfers and an elective continuity regime (§8d) if the business is unchanged and no 'harmful event' occurs.

When acquiring a loss-making target, a tax DD workstream tests how much of the NOL survives closing and how fast it can be used. The sell-side often argues optimistically (losses preservable), the buy-side is typically more conservative. For large NOLs the gap can be a material share of equity value.

A clean 'tax layer' in a DCF goes beyond a simple ETR. Two core formulas:

```
P&L tax = EBT × statutory tax rate ± permanent differences
Cash tax = (EBT + permanent differences − Δ temporary differences)
× statutory tax rate
```

• PP&E component: ΔDTL from the depreciation difference (tax depreciation vs. book depreciation). Shrinks to 0 with stable capex.
• NOL utilization: the DTA shrinks as it is used up.
• Pension DTA: arises from the difference in the DBO discount rate between the financial-reporting books and the tax books.
• Goodwill: in many jurisdictions not tax-deductible, so it produces no DTL effects.

Two kinds of difference between book value and the tax base that are accounted for very differently.

• Temporary difference: a difference between book value and tax base that reverses at some point. Creates a DTA or DTL.
• Permanent difference: a difference between income-statement expense/income and its tax treatment that never reverses. Creates NO deferred tax, but rather an ETR deviation from the statutory rate.

IAS 12 and ASC 740 (and local GAAP equivalents) allow a DTA from loss carryforwards to be recognized only when realization is 'probable' (IFRS) / 'more likely than not' (US GAAP); local GAAP typically sets a similarly high evidentiary bar.

• Historical profitability: With 3+ years of consistent taxable profits, the DTA can be fully recognized.
• Forecast-based: If the management forecast for the next 3–5 years shows sufficient profits, the DTA can be recognized up to the usable losses.
• Distressed situation: An operating loss pattern or an ongoing restructuring — the DTA cannot be recognized, or is reduced by a valuation allowance.

In an asset deal (unlike a share deal) the buyer acquires individual assets directly — not the company's shares. For tax purposes this steps up the asset bases to the purchase price (fair value at acquisition).

The buyer can depreciate/amortize the step-up for tax — typically over 15 years for goodwill and 5–15 years for other intangibles. This creates an additional tax shield that does not exist in a share deal (there the target's tax bases carry over unchanged).

When the statutory tax rate changes, existing DTAs and DTLs must be remeasured at the new rate — the effect hits the income statement in the year of the change.

```
DTA / DTL = temporary difference × tax rate
```

In a rate cut, both existing DTAs and DTLs fall proportionally. The income-statement effect is the net Δ across all positions.

```
Goodwill = Purchase price − Fair value of net assets acquired
```

Arises solely through M&A — never built up internally ('purchased goodwill').

The buyer pays more than the sum of the individual assets because of synergies, brand, customers, market position, and know-how.

Acquisition 200, fair value of net assets 120, identifiable intangibles 30 → goodwill = 50.

• IFRS 3 / IAS 36: NO scheduled amortization, impairment test only
• Local GAAP: scheduled amortization over 5-15 years

In deals like Bayer-Monsanto and Linde-Praxair, 50-70% of the purchase price is goodwill — sensitive to impairment risk.

Non-monetary, identifiable assets without physical substance (IAS 38).

• Customer relationships: 5-15 years, often from PPA
• Technology / patents: 5-20 years
• Trademarks / brands: indefinite (Coca-Cola) or 5-25 years
• Software: 3-7 years
• Licenses, rights: contract term
• Order backlog: 1-3 years (PPA only)

Intangibles have a definable useful life; goodwill is indefinite.

Intangibles → amortized. Goodwill and indefinite-life assets → impairment test only (IFRS).

PPA negotiation: the more you allocate to identifiable intangibles vs. goodwill → higher D&A → lower EBIT.

For every business combination (M&A), IFRS 3 requires the purchase price to be allocated across the target's identifiable assets and liabilities, each measured at fair value. Steps:

• Calculate total consideration: cash + equity component + contingent consideration + assumed liabilities.
• Measure net assets at fair value: PP&E to market, inventory at selling price less remaining costs to complete, customer relationships via DCF, technology via the relief-from-royalty method.
• Goodwill = total consideration − net assets (FV) — the premium over the identifiable net assets.

Goodwill is allocated to a cash-generating unit (CGU) — the smallest identifiable group of assets that generates independent cash flows — and tested there. Test logic:

• AT LEAST annually, plus on any 'triggering event' (margin deterioration, market change).
• Recoverable amount of the CGU = max of (a) fair value − cost of disposal and (b) value in use (= the CGU's DCF).
• If the carrying amount of the CGU (including goodwill) exceeds the recoverable amount, an impairment is due.
• Impairment order: first against goodwill, then pro rata against the other assets.
• A goodwill impairment can NEVER be reversed.

A CGU (cash-generating unit) is the smallest identifiable group of assets that generates cash flows largely independent of other assets. Defined under IAS 36 — critical for goodwill allocation and impairment tests.

Practical definition, typically at one of these levels:

• A business area or segment — e.g. Bayer's Pharma, Crop Science, Consumer Health.
• A subsidiary with separate cash-flow generation.
• A region, if run independently.
• A product line, if sold or marketed separately.

Is a goodwill impairment tax-deductible? In most jurisdictions, usually NOT. Tax goodwill generally exists only where the tax basis was stepped up (an asset deal, or in the US a §338(h)(10)/§338(g) election), and it is then amortized on a fixed schedule — e.g. 15 years under US §197 — independent of book (IFRS or US GAAP) impairment tests. In a share deal there is typically no tax goodwill at all.

Brand-value measurement in a PPA — typical methods:

• Relief-from-royalty (standard): how much royalty would a non-owner have to pay each year to use the brand? Formula: royalty rate × branded sales × (1 − t), discounted.
• Income approach: a forward forecast of the cash flows attributable to the brand.
• Comparable transactions: comparable brand acquisitions (rarely enough data points available).

Customer relationships (CR) and order backlog are both customer-related intangibles, but they are defined and valued differently:

A bargain purchase (negative goodwill / a 'lucky buy'): an acquisition at a price BELOW the fair value of the net assets acquired. Rare — typical in distressed M&A, forced sales, or an incomplete auction. IFRS 3 treatment:

• Reassessment test: auditors / valuers must check that all acquired net assets were measured correctly at fair value and that all liabilities were captured.
• If, after reassessment, there is still negative goodwill → recognize it IMMEDIATELY as income in the P&L ('gain from a bargain purchase').

NOT as a negative balance-sheet item.

A goodwill impairment is non-cash and often not tax-deductible — but it is a very real loss of equity value with far-reaching consequences:

• Net debt / EBITDA covenant: a goodwill impairment is EBITDA-neutral (non-cash, though typically sitting in OPEX), so there is NO direct covenant effect. The underlying operating deterioration that triggers the impairment usually also hits EBITDA — so indirect covenant pressure arises.
• Equity-ratio covenant: a goodwill impairment reduces equity directly. For companies heavy in goodwill, a covenant breach can result.

The standard PPA layer in any acquisition model — the key components and their forecast effect:

IPR&D (in-process R&D) is the target's research and development projects that are not yet complete at the acquisition date but already have value. Under IFRS 3 they are capitalized as identifiable intangible assets at fair value (typically via multi-period excess earnings or a cost approach).

the expected discounted cash flow after successful completion × the probability of success.

is a past goodwill impairment a one-time event or a symptom of structural problems? Indicators of 'one-time':

• A specific trigger — a pandemic lockdown, a regulatory shock (the glyphosate litigation at Bayer-Monsanto), an unexpected market disruption.
• Operating performance stays stable or recovers after the impairment date.
• The CGU remains profitable on a run-rate basis.
• Management has implemented clear, documented restructuring measures. Indicators of 'structural': (a) repeated impairments over 3+ years — see ProSiebenSat.1 (TV-advertising disruption from streaming) or Deutsche Bank's asset-management arm. (b) Structurally declining margins / EBITDA erosion before and after the impairment. (c) A 'goodwill yo-yo' across several of the group's CGUs. (d) The goodwill / EBITDA ratio grows despite the impairment because EBITDA is falling. (e) Industry-wide disruption (print, brick-and-mortar retail). DD implication: for a 'structural' pattern → adjust the valuation with (a) a lower multiple, (b) a more conservative forecast, (c) a higher equity discount.

the buyer already holds a stake in the target and buys additional shares (e.g. from 25% to 60%). IFRS 3 treatment — three steps:

• Measure the pre-existing stake at fair value as of the closing date: the existing 25% stake is remeasured to current market value → the difference between the prior carrying amount (equity method or available-for-sale) and current fair value is a gain / loss in the P&L.
• The acquired shares (35%) at the purchase price.
• Total consideration = fair value of the pre-existing stake + purchase price of the new shares.

The PPA is based on 100% of fair value, then goodwill is calculated. Consequence for reported earnings: a step acquisition can create massive one-time effects.

When you sell a CGU or part of a CGU, the associated goodwill must be disposed of with it — critical for the reported gain / loss on sale.

• If the unit sold was its own CGU, all of the associated goodwill goes with it.
• If only part of a CGU is sold, goodwill is allocated based on 'relative fair values' (the portion sold vs. the portion retained).

```
Gain / loss on disposal = sale proceeds − net-asset carrying value (incl. allocated goodwill)
```

• If goodwill is not allocated, the reported gain is artificially overstated.
• The remaining goodwill in the parent CGU must be retested for recoverability.

• Both standards gross up the balance sheet, so the balance-sheet total and lease liabilities are broadly comparable.
• The P&L is not: for the same leases, IFRS 16 EBITDA and OCF are higher than under ASC 842, because US operating leases still run through operating expense.

When comping an IFRS reporter against a US GAAP reporter, put both on the same basis: either deduct lease depreciation and interest from IFRS EBITDA (pre-IFRS 16 / 'EBITDA after leases'), or add back operating-lease cost to US EBITDA and include operating-lease liabilities in net debt. This is the classic cross-border comps trap.

An asset recognized by the lessee under IFRS 16 — the right to use the leased asset.

• Initial: lease liability + prepayments +/- adjustments
• Subsequent: depreciated over the lease term and shown in D&A

A liability on the balance sheet.

• Initial: PV of all lease payments, discounted at the incremental borrowing rate
• Subsequent: principal repayment reduces the liability; the interest component hits the income statement

Initial entry: RoU 432, lease liability 432.

Year 1 effects:

• D&A: 86 (straight-line over 5 years)
• Interest: 22 (5% x 432)
• Principal repayment: 78

For IFRS 16 adjustments in comps, show RoU assets and lease liabilities separately: include the lease liability in net debt and show the EBITDA effect versus reported.

Under old IAS 17 operating-lease accounting, the full lease cost was booked as rent expense in operating expenses, reducing EBITDA. Under IFRS 16 the lease is split:

• D&A on the RoU asset goes into D&A — it reduces EBIT, not EBITDA.
• Interest on the lease liability goes into interest expense — it reduces EBT, not EBITDA.

operating leases also go on the balance sheet (RoU asset + lease liability), but the lease cost stays a single straight-line operating expense — so US EBITDA is unchanged. Only ASC 842 finance leases get the D&A + interest split. Same leases, same economics: IFRS 16 EBITDA is higher than US GAAP EBITDA.

Operating-lease obligations are economically debt-like: fixed future cash obligations. Standard IB approaches:

• IFRS 16 logic (standard for IFRS reporters post-2019): The lease liability is already on the balance sheet and is included directly in net debt:

```
Net debt = bank debt + bonds + lease liability - cash
```

• Capitalized-lease adjustment for pre-IFRS-16 comps: operating-lease expense x 7-8x as the implied lease-debt value, historically a Moody's-style adjustment.

IFRS 16 moves lease cash outflows from operating cash flow into financing cash flow, which is a major issue for cash-flow comparisons.

• Pre-IFRS-16: Lease payments, for example 100 p.a., are fully in OCF as paid rent expense and reduce OCF by the full amount.
• Post-IFRS-16 split:
• Principal repayment of the lease liability goes into financing cash flow.
• The interest component has a classification choice under IFRS: OCF or financing CF. Many companies show interest in OCF.

For lessees, IFRS 16 standardizes the model: almost all leases go on balance sheet as an RoU asset plus a lease liability; operating-lease accounting is gone. For lessors, IFRS 16 keeps the dual model:

• Operating lease (lessor view): The asset stays on the lessor's balance sheet, is depreciated normally, and rental income is recognized as revenue. Standard for landlords and equipment-leasing companies.
• Finance lease (lessor view): The asset is economically transferred to the lessee, and the lessor accounts for it like a sale plus receivable.

Finance-lease classification indicators:

• ownership transfers at the end
• bargain purchase option
• lease term covers most of the useful life, often >75%
• PV of lease payments is close to fair value, often >90%

IFRS 16 allows two exemptions from the RoU asset / lease liability model:

• Short-term leases: remaining lease term <= 12 months. The lessee can choose not to capitalize them; lease payments continue as rent expense. This simplifies administration for short contracts.
• Low-value-asset leases: new asset value around $5,000 or similarly immaterial. The lessee can choose not to capitalize them; typical examples are printers, laptops, and office equipment.

Practice:

• Large companies often do not use the short-term exemption broadly because consistency and compliance are easier.
• The low-value exemption is commonly used because it is a materiality threshold.

IFRS 16 triggered a wave of covenant renegotiations in 2019. Standard effects on key covenants:

operating leases also go on the balance sheet, but lease cost stays in operating expense — EBITDA and interest coverage are unchanged. The only question is whether the operating-lease liability counts as debt, and US credit agreements typically exclude it (finance leases are included). The covenant shock is therefore much smaller for US GAAP borrowers than for IFRS 16 borrowers.

The sold subsidiary often uses group real estate such as headquarters or a plant site. In a carve-out, a new lease has to be set up and IFRS 16 mechanics apply.

• Pre-carve-out: The group owns the real estate as PP&E on its balance sheet; the subsidiary pays an internal charge and does not recognize a lease.
• Carve-out: Buyer and seller negotiate a new 5-15 year lease agreement.
• Seller: Property remains PP&E; the new lease with the subsidiary is an operating lease from the lessor side, producing rental income.
• Buyer / sold subsidiary: The new lease is recognized under IFRS 16 as RoU asset + lease liability, materially changing the stand-alone balance sheet.

Sale-leaseback (SLB) means the owner sells an asset, typically real estate, and immediately leases it back. It is a classic cash-generation transaction and is often used in PE contexts to repay debt after an LBO.

Is it a sale under IFRS 15?

• Has control transferred to the buyer?
• Is there no repurchase option that neutralizes sale accounting?
• Have substantial risks and rewards transferred?

Lease accounting has major valuation implications in lease-heavy sectors. Two canonical examples:

• Primarily real-estate leases for stores and warehouses.
• Lease terms are often 5-10 years, with renewal options and variable rent as a percentage of sales.
• IFRS 16 effect is large: RoU assets and lease liabilities can be 30-50% of total assets, with a visible EBITDA step-up after adoption.
• Valuation practice: use pre-IFRS-16 EBITDA for retail comps and include the lease liability fully in net debt.

Variable lease payments are common in retail and restaurants, especially rent linked to revenue. IFRS 16 treats them differently depending on structure:

• In-substance fixed variable payments (for example, '10% of sales, minimum $100k'): the guaranteed minimum is included in the lease liability and capitalized. The variable amount above the minimum is expensed as incurred.
• Pure variable payments (for example, '8% of sales, no minimum'): not included in the lease liability; expensed when incurred.

• Middle-market companies: often still have DB plans, direct pension promises, pension funds, or support funds.
• Public companies: often hybrid: DB for legacy employees, DC for new hires.

Targets with DB plans can carry significant pension liabilities, often 10-25% of total assets for industrial middle-market companies.

Treat pension underfunding as a net debt adjustment. For DB-heavy industrials, pension underfunding can be $50-500m and should be included as a debt-like item in the EV-to-equity bridge.

The DBO, or defined benefit obligation, is the present value of all future pension obligations, discounted using the discount rate. It is valued actuarially every year.

• Demographic assumptions: mortality table, employee turnover, retirement age.
• Financial assumptions: discount rate, expected salary growth, inflation, pension trend.
• Plan specifics: benefit formula and vesting conditions.

```
Net pension liability = DBO - plan assets
```

If plan assets exist, they offset the DBO. If not, the liability equals the full DBO.

IAS 19 splits pension expense into four components, each shown in a different income-statement or equity category:

Plan assets are assets held in a legally separate pension trust or pension fund and reserved to satisfy pension claims.

• Legally separate from the employer's assets, often through a contractual trust arrangement.
• Usable only for pension obligations.
• Protected from insolvency.

Fair value at the balance-sheet date. Typical allocation:

• Bonds: 40-60%
• Equities: 25-40%
• Real estate: 5-15%
• Alternative investments, such as hedge funds or private equity: 5-15%

Pensions are a standard debt-like item in the EV-to-equity bridge.

```
Tax-effected pension adjustment = (DBO - plan assets) x (1 - tax rate)
Equity value = EV - net debt - tax-effected pension adjustment - other debt-like items
```

Pension provisions are typically tax-deductible when paid in cash. The tax shield reduces the economic burden, so the net pension liability is scaled by (1 - tax rate).

The discount rate is the most sensitive DBO valuation assumption. The DBO is the present value of long-duration obligations, often with a 15-25 year duration. A higher discount rate lowers the present value and therefore lowers the DBO.

A 100 bps increase in the discount rate reduces the DBO by 12-20%, depending on duration.

• The DBO change from a discount-rate move is a remeasurement item and goes to OCI, not the income statement.
• Equity changes accordingly.
• There is no cash effect; it is a balance-sheet movement.
• Future pension expense is lower because service cost and net interest are calculated on the reduced DBO base.

Pensions are often a hot spot in carve-outs because the allocation can be complex. Standard approaches:

• Frozen plan at the seller: The existing DBO stays legally with the seller group, employee claims remain unchanged, and no new benefits accrue. The buyer takes over the employees and creates a new DC plan. This is cleaner for the buyer and often preferred.
• Pension transfer: A portion of the DBO and plan assets transfers to the buyer. Negotiations cover which employee pensions transfer, how plan assets are allocated, and employee / labor-law approvals.
• Hybrid: Active employees transfer to the buyer, while retirees stay with the seller.

The accounting pension liability and the tax deduction usually follow different rules, and the gap has valuation implications.

• IFRS / IAS 19 DBO (US GAAP: ASC 715 PBO): valued using current market discount rates (high-quality corporate bond yields), current salary-growth assumptions and current mortality tables. The balance sheet shows the net deficit (DBO minus plan assets).
• Tax treatment in funded systems (e.g. US, UK): pension cost is generally deductible only when the employer contributes cash to the plan, not when the accounting expense is booked. The accounting deficit therefore has little or no tax base.
• Book-reserve systems (e.g. Germany): plans are often unfunded and a separate tax pension provision is deductible. In Germany it is calculated with a fixed 6% discount rate (§6a EStG), which does not move with market rates, so it can sit far below the IAS 19 DBO.

Underfunding can trigger required cash contributions that pressure liquidity.

• Regulatory funding requirements: Vary by country; some systems are less strict than the US / UK, but pension-protection contributions can depend on underfunding.
• Plan-specific funding clauses: Pension trusts can include minimum-funding agreements.
• M&A triggers: Change-of-control clauses can accelerate funding.
• Ratings pressure: Rating agencies include pension underfunding in adjusted debt, and a downgrade can make refinancing harder.

Plan amendments and curtailments typically occur in restructurings or pension reforms. IAS 19 distinguishes three types with different income-statement treatment:

IFRS 15 is the revenue-recognition standard for contracts with customers. It replaced industry-specific rules with one principle-based model.

Revenue is recognized when control of a good or service transfers to the customer, not simply when an invoice is issued or cash is received.

Identify the contract, identify performance obligations, determine the transaction price, allocate the price, and recognize revenue as obligations are satisfied.

IFRS 15 can shift revenue timing, margins, backlog conversion, deferred revenue, and QoE adjustments. For software, construction, engineering, and project businesses, it is a major DD topic.

1. Identify the contract with the customer.
2. Identify separate performance obligations.
3. Determine the transaction price.
4. Allocate the transaction price to the performance obligations.
5. Recognize revenue when, or as, each performance obligation is satisfied.

The model forces you to separate bundled contracts, estimate variable consideration, and decide whether revenue is recognized over time or at a point in time.

In DD, map the top customer contracts through the five steps. Most revenue-recognition issues come from bundled services, variable rebates, bill-and-hold arrangements, long-term contracts, or aggressive cut-off practices.

Revenue is recognized only when it is earned and realized (or realizable) — typically when delivery or service completion has occurred and the claim is sufficiently certain. This underpinned old IAS 18 / pre-ASC 606 US GAAP (risks-and-rewards transfer) and still drives many local GAAPs (e.g. German HGB, which generally uses completed-contract accounting for long-term projects).

A five-step, control-transfer model. Revenue is recognized when (or as) control of goods or services passes to the customer, and can be recognized over time if the criteria are met.

Realization-based regimes are generally more conservative and focused on certainty. IFRS 15 / ASC 606 follow contract performance: they identify performance obligations, allocate the transaction price and recognize revenue as each obligation is satisfied.

A long-term project might show smoother over-time revenue under IFRS 15 / ASC 606, while a realization-based local GAAP may recognize later or more cautiously depending on the contract.

In local-GAAP-to-IFRS or US GAAP bridges, revenue timing is often one of the largest EBITDA bridge items for project, software and engineering businesses.

Company reports the full customer price as revenue and records supplier cost in COGS. This applies when it is principal.

Company reports only the commission or spread as revenue. This applies when it is agent.

Marketplace sells a product to a customer for $100 and keeps a $15 commission. If agent, revenue is $15. If principal, revenue is $100 and COGS includes the supplier cost.

Gross versus net can massively change revenue scale and margin percentage, while gross profit may be similar. Revenue multiples must be adjusted to the business model.

The parent includes 100% of the subsidiary's assets, liabilities, revenue, expenses, and cash flows in the consolidated financial statements.

When the parent controls the investee. Under IFRS 10, control means power over the investee, exposure to variable returns, and ability to use power to affect those returns.

The non-owned share is shown as non-controlling interest (NCI) in equity and in the income statement.

Full consolidation changes revenue, EBITDA, net debt, and EV-to-equity mechanics. Always check whether multiples are based on consolidated EBITDA and whether NCI needs to be added in the EV bridge.

The investor records the investment as one line on the balance sheet and recognizes its share of the investee's profit or loss in one line below operating profit.

Usually for associates where the investor has significant influence, often presumed at 20-50% ownership, or for joint ventures.

```
Investment carrying value increases by share of net income
Investment carrying value decreases by dividends received
```

Equity-method EBITDA is not included in consolidated EBITDA. For sum-of-the-parts or leverage analysis, use look-through metrics if the associate is material.

The investor does not control the company and does not have significant influence or joint control.

• ownership below 20%
• no board seat
• no veto rights over relevant activities
• no operational involvement
• investment held for financial return

Usually measured under IFRS 9 at fair value through profit or loss or OCI, depending on classification.

Financial investments are usually non-operating assets. In an EV-to-equity bridge, add them to equity value if they are not included in operating EV.

A provision is a liability of uncertain timing or amount. It reflects a present obligation from a past event where an outflow is expected and can be estimated.

• Operating provisions: warranties, bonuses, rebates, returns
• Legal / risk provisions: litigation, environmental, tax disputes
• Structural provisions: restructuring, onerous contracts, asset retirement obligations

Provisions affect EBITDA, working capital, net debt-like items, and QoE. Releases can inflate earnings; under-accruals can hide future cash outflows.

The extent to which reported earnings reflect sustainable, recurring cash-generating performance.

• recurring revenue
• strong cash conversion
• limited one-offs
• conservative accounting
• clean working capital
• low customer / supplier concentration risk

Valuation multiples apply to maintainable earnings, not accounting noise. QoE findings directly affect adjusted EBITDA, purchase price, debt capacity, covenant headroom, and SPA protections.

The income statement shows profitability over a period: revenue minus expenses gives net income.

The balance sheet shows what the company owns and owes at a point in time: assets = liabilities + equity.

The cash flow statement shows cash generated and used over a period, split into operating, investing, and financing cash flow.

Net income starts the indirect cash flow statement and flows into retained earnings. The ending cash balance from the cash flow statement appears on the balance sheet.

Keep it structured and under 60 seconds.

• Net income from the income statement starts the indirect cash flow statement.
• Net income minus dividends flows into retained earnings on the balance sheet.
• D&A is added back in cash flow and reduces PP&E / intangible assets over time.
• Capex reduces cash and increases PP&E.
• Debt issuance / repayment changes cash and debt.
• Ending cash from the cash flow statement becomes cash on the balance sheet.

The balance sheet must balance after every linkage.

Earnings before interest and taxes. It is operating profit after depreciation and amortization.

Earnings before interest, taxes, depreciation, and amortization. It approximates pre-capex operating cash earnings, but it is not cash flow.

D&A.
```
EBITDA = EBIT + D&A
```

EBITDA is common for valuation and leverage because it is less affected by depreciation policies. EBIT is closer to operating profit after asset consumption.

Cash generated by the business after operating needs and capex.

```
EBIT x (1 - tax rate)
+ D&A

• capex
• increase in net working capital

= unlevered FCF
```

Cash flow after interest and debt service.

DCF uses unlevered FCF because enterprise value is capital-structure neutral.