Theories of Capital Structure

Capital structure theories explore how firms choose between different sources of financing, particularly the mix of debt and equity. These theories help understand the impact of capital structure decisions on a company’s value, cost of capital, and financial risk. The main capital structure theories are:

1. Net Income (NI) Theory

• Proposed by: David Durand
• Concept: The theory suggests that an increase in debt in the capital structure decreases the overall cost of capital (due to the tax deductibility of interest), leading to an increase in the firm's value.
• Key Point: Higher debt proportion results in a lower weighted average cost of capital (WACC), thus increasing the firm's value.

2. Net Operating Income (NOI) Theory

• Proposed by: David Durand
• Concept: The theory assumes that the cost of equity increases as debt increases, leaving the overall cost of capital unchanged. As a result, capital structure decisions do not affect the value of the firm.
• Key Point: Capital structure is irrelevant to the firm’s valuation; only operating income matters.

3. Traditional Theory

• Concept: This theory is a compromise between the NI and NOI theories. It argues that there is an optimal capital structure where the WACC is minimized, and the firm's value is maximized. Beyond this point, increasing debt will raise the cost of equity significantly, leading to an increase in WACC.
• Key Point: The firm should use some debt, but too much debt will eventually increase the firm's risk and cost of capital.

4. Modigliani and Miller (M&M) Theory

• Developed by: Franco Modigliani and Merton Miller (1958)
• Concept:
• Proposition I (Without Taxes): In a world with no taxes, the value of a firm is independent of its capital structure. The firm’s value is determined by its earning power and the risk of its underlying assets.
• Proposition II (With Taxes): When taxes are considered, the use of debt creates a tax shield (since interest is tax-deductible), which increases the value of the firm. Hence, in the presence of corporate taxes, the firm should finance entirely through debt to maximize its value.
• Key Point: Debt increases firm value because of tax benefits, but other factors like bankruptcy costs should be considered.

5. Pecking Order Theory

• Proposed by: Stewart Myers and Nicholas Majluf (1984)
• Concept: Firms prefer internal financing (retained earnings) over external financing. If external financing is necessary, firms prefer to issue debt over equity. This preference is due to information asymmetry, as issuing equity can signal to investors that managers believe the firm is overvalued.
• Key Point: Firms follow a financing hierarchy: internal funds → debt → equity.

6. Trade-Off Theory

• Concept: This theory acknowledges the tax advantages of debt (interest tax shield) but also considers the costs of financial distress and bankruptcy. Firms aim to balance these costs and benefits to find an optimal capital structure.
• Key Point: There is a trade-off between the tax benefits of debt and the potential bankruptcy costs.

7. Agency Theory

• Developed by: Jensen and Meckling (1976)
• Concept: This theory focuses on conflicts of interest between managers (agents) and shareholders (principals). High levels of debt can reduce agency problems by limiting the free cash flow available for managers to misuse. However, excessive debt can also lead to risk-shifting behavior, where managers take on high-risk projects at the expense of debt holders.
• Key Point: Capital structure choices are influenced by the need to mitigate agency conflicts.

8. Market Timing Theory

• Concept: This theory suggests that firms time their financing decisions based on market conditions. Firms issue equity when stock prices are high (overvalued) and issue debt when interest rates are low.
• Key Point: Firms adjust their capital structure to take advantage of favorable market conditions.

9. Signaling Theory

• Concept: According to this theory, capital structure decisions send signals to the market. Issuing debt can be a positive signal that the firm is confident in its ability to generate cash flows to service the debt, while issuing equity may signal that the firm's stock is overvalued.
• Key Point: The choice between debt and equity conveys information to investors.

Summary of Key Theories:

Each of these theories provides a different perspective on how firms make decisions about their capital structure and the trade-offs involved.

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IFRS 1, "First-time Adoption of International Financial Reporting Standards,"

IFRS 1, "First-time Adoption of International Financial Reporting Standards," provides guidelines for entities that are adopting IFRS for the first time. Its main objective is to ensure that an entity's first IFRS financial statements contain high-quality information that:

1. Is transparent for users and comparable over all periods presented;
2. Provides a suitable starting point for accounting in accordance with IFRS;
3. Can be generated at a cost that does not exceed the benefits.

Here are some key points of IFRS 1:

1. First-time Adoption

An entity is considered a first-time adopter if, for the first time, it makes an explicit and unreserved statement in its financial statements that it complies with IFRS. This could be either the first set of financial statements or an interim financial report.

2. Opening IFRS Balance Sheet

The first-time adopter is required to prepare an opening IFRS balance sheet at the date of transition to IFRS. This balance sheet is the starting point for its accounting under IFRS.

3. Mandatory Exceptions

Certain exceptions must be adhered to when applying IFRS for the first time. These exceptions cover areas such as:

• Derecognition of financial assets and liabilities: Certain financial assets and liabilities that were derecognized under previous GAAP before the date of transition should not be recognized under IFRS.
• Hedge accounting: Hedge accounting can only be applied prospectively from the date of transition unless all hedge accounting criteria are met at that date.
• Estimates: An entity’s estimates under IFRS at the date of transition to IFRS must be consistent with estimates made for the same date under previous GAAP.

4. Voluntary Exemptions

IFRS 1 permits certain exemptions to ease the transition to IFRS. Some of these exemptions include:

• Business Combinations: The option to not apply IFRS 3 retrospectively to past business combinations.
• Share-based Payment Transactions: An exemption for share-based payment transactions that were granted before November 7, 2002, or vested before the date of transition to IFRS.
• Cumulative Translation Differences: An exemption that allows resetting of cumulative translation differences to zero.
• Deemed Cost: An option to measure items of property, plant, and equipment, investment property, or intangible assets at fair value as deemed cost on the date of transition.

5. Disclosures

IFRS 1 requires comprehensive disclosures to explain how the transition from previous GAAP to IFRS affected the entity’s reported financial position, financial performance, and cash flows. These disclosures include:

• Reconciliations of equity reported under previous GAAP to equity under IFRS.
• Reconciliations of total comprehensive income under previous GAAP to total comprehensive income under IFRS.
• Explanation of material adjustments made to the cash flow statement.

6. Reconciliations

An entity must provide reconciliations that show the impact of the transition on its reported financial statements. This includes:

• A reconciliation of its equity reported under previous GAAP to its equity under IFRS.
• A reconciliation of its total comprehensive income reported under previous GAAP to its total comprehensive income under IFRS.

Overall, IFRS 1 aims to facilitate a smooth transition to IFRS by providing clear guidelines and practical relief in certain areas, ensuring that entities can adopt IFRS in a cost-effective manner while providing reliable and comparable financial information.

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Finance Act 2024

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Financial Distress analysis Bankruptcy Forecasting

Financial distress analysis involves evaluating a company's financial condition to determine if it is at risk of being unable to meet its obligations. This analysis helps identify early warning signs of potential financial difficulties, allowing stakeholders to take corrective measures. Here are the key components and methods used in financial distress analysis:

1. Financial Ratios

Several financial ratios can indicate potential financial distress:

• Liquidity Ratios: Low liquidity ratios (e.g., Current Ratio, Quick Ratio) suggest that the company might struggle to meet short-term obligations.
• Solvency Ratios: High leverage ratios (e.g., Debt to Equity Ratio, Debt to Assets Ratio) indicate high debt levels, which can lead to financial distress if earnings are insufficient to cover interest payments.
• Profitability Ratios: Declining profitability ratios (e.g., Net Profit Margin, Return on Assets) can signal deteriorating financial health.
• Efficiency Ratios: Inefficiencies in asset management (e.g., low Asset Turnover Ratio, high Inventory Turnover Ratio) may indicate operational problems that can contribute to financial distress.

2. Altman Z-Score

The Altman Z-Score is a widely used model for predicting the probability of a company entering bankruptcy. It combines several financial ratios into a single score. The formula varies for manufacturing and non-manufacturing firms, but a common version is:

$Z = 1.2 \times \text{(Working Capital / Total Assets)} + 1.4 \times \text{(Retained Earnings / Total Assets)} + 3.3 \times \text{(EBIT / Total Assets)} + 0.6 \times \text{(Market Value of Equity / Total Liabilities)} + 1.0 \times \text{(Sales / Total Assets)}$

Scores above 3.0 suggest a low risk of bankruptcy, while scores below 1.8 indicate a high risk.

3. Cash Flow Analysis

Evaluating cash flow statements is crucial as cash flow problems often precede financial distress. Key indicators include:

• Negative Operating Cash Flow: Indicates that the company is not generating sufficient cash from its core operations.
• High Capital Expenditures Relative to Cash Flow: Suggests that the company might be over-investing or not generating enough cash to support its investments.
• Poor Free Cash Flow: Low or negative free cash flow (Operating Cash Flow - Capital Expenditures) can signal financial distress.

4. Trend Analysis

Analyzing trends over multiple periods can help identify patterns indicating financial distress. Key trends to monitor include:

• Declining Revenues: Persistent drops in revenue may signal declining demand or competitive issues.
• Increasing Costs: Rising costs without corresponding revenue increases can erode profitability.
• Deteriorating Margins: Shrinking profit margins can indicate operational inefficiencies or pricing pressures.

5. Qualitative Factors

In addition to quantitative analysis, qualitative factors can provide insights into potential financial distress:

• Management Quality: Poor management decisions and lack of strategic direction can lead to financial problems.
• Industry Conditions: Adverse industry trends, such as declining demand or increased competition, can negatively impact financial health.
• Regulatory Changes: New regulations or legal issues can impose additional costs or restrictions on the company's operations.

6. Debt Covenants and Obligations

Reviewing the company's debt covenants and obligations is essential. Violations of debt covenants can trigger penalties or force the company into bankruptcy. Key areas to assess include:

• Interest Coverage Ratios: The ability to cover interest payments from earnings.
• Debt Repayment Schedules: Upcoming debt maturities and the company’s ability to refinance or repay them.
• Covenant Compliance: Adherence to financial covenants set by lenders.

Example of Financial Distress Analysis

Assume we have financial data for a company, ABC Corp:

• Current Assets: $200 million
• Current Liabilities: $250 million
• Total Assets: $500 million
• Total Liabilities: $400 million
• Retained Earnings: $50 million
• EBIT: $30 million
• Market Value of Equity: $100 million
• Sales: $600 million

Let's calculate the Altman Z-Score for ABC Corp:

$Z = 1.2 \times (200 / 500) + 1.4 \times (50 / 500) + 3.3 \times (30 / 500) + 0.6 \times (100 / 400) + 1.0 \times (600 / 500)$ $Z = 1.2 \times 0.4 + 1.4 \times 0.1 + 3.3 \times 0.06 + 0.6 \times 0.25 + 1.0 \times 1.2$ $Z = 0.48 + 0.14 + 0.198 + 0.15 + 1.2$ $Z = 2.168$

A Z-Score of 2.168 indicates that ABC Corp is in the "grey zone," suggesting a moderate risk of financial distress.

Conclusion

Financial distress analysis is a comprehensive approach combining quantitative and qualitative methods to assess a company's financial health and predict potential bankruptcy or insolvency risks. By monitoring financial ratios, cash flows, trends, and qualitative factors, stakeholders can identify early warning signs and take corrective actions to mitigate risks.

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Complete ratio analysis of a company with example.

To perform a complete ratio analysis for a company, you'll need its financial statements, including the income statement, balance sheet, and cash flow statement. Below is an outline of the key financial ratios categorized into different areas of analysis:

1. Liquidity Ratios

These ratios measure the company's ability to meet short-term obligations.

• Current Ratio = Current Assets / Current Liabilities
• Quick Ratio = (Current Assets - Inventories) / Current Liabilities
• Cash Ratio = Cash and Cash Equivalents / Current Liabilities

2. Solvency Ratios

These ratios assess the company's ability to meet long-term obligations.

• Debt to Equity Ratio = Total Debt / Total Equity
• Interest Coverage Ratio = EBIT / Interest Expense
• Debt to Assets Ratio = Total Debt / Total Assets

3. Profitability Ratios

These ratios evaluate the company's ability to generate profit relative to its revenue, assets, and equity.

• Gross Profit Margin = (Revenue - Cost of Goods Sold) / Revenue
• Operating Profit Margin = Operating Income / Revenue
• Net Profit Margin = Net Income / Revenue
• Return on Assets (ROA) = Net Income / Total Assets
• Return on Equity (ROE) = Net Income / Shareholder's Equity
• Return on Investment (ROI) = Net Income / Invested Capital

4. Efficiency Ratios

These ratios measure how well the company utilizes its assets and liabilities.

• Asset Turnover Ratio = Revenue / Total Assets
• Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory
• Receivables Turnover Ratio = Revenue / Average Accounts Receivable
• Payables Turnover Ratio = Cost of Goods Sold / Average Accounts Payable

5. Market Ratios

These ratios provide insights into the company's stock market performance.

• Earnings Per Share (EPS) = Net Income / Average Outstanding Shares
• Price to Earnings (P/E) Ratio = Market Price per Share / Earnings per Share
• Price to Book (P/B) Ratio = Market Price per Share / Book Value per Share
• Dividend Yield = Annual Dividends per Share / Market Price per Share
• Dividend Payout Ratio = Dividends / Net Income

6. Cash Flow Ratios

These ratios evaluate the company's ability to generate cash to meet obligations.

• Operating Cash Flow Ratio = Operating Cash Flow / Current Liabilities
• Free Cash Flow = Operating Cash Flow - Capital Expenditures

Example Analysis

Let's take a hypothetical company, XYZ Corp, and perform a ratio analysis using the above categories. Assume the following financial data (in millions):

Income Statement (Year 2023)

• Revenue: $1,000
• Cost of Goods Sold: $600
• Operating Income: $200
• Net Income: $150
• Interest Expense: $10

Balance Sheet (Year-end 2023)

• Current Assets: $400
• Cash and Cash Equivalents: $100
• Inventories: $150
• Total Assets: $800
• Current Liabilities: $250
• Total Debt: $300
• Shareholder's Equity: $500

Cash Flow Statement (Year 2023)

• Operating Cash Flow: $180
• Capital Expenditures: $50

Market Data

• Average Outstanding Shares: 10 million
• Market Price per Share: $50
• Annual Dividends per Share: $2

Now, let's calculate some key ratios:

Liquidity Ratios

• Current Ratio = $400 / $250 = 1.6
• Quick Ratio = ($400 - $150) / $250 = 1.0
• Cash Ratio = $100 / $250 = 0.4

Solvency Ratios

• Debt to Equity Ratio = $300 / $500 = 0.6
• Interest Coverage Ratio = $200 / $10 = 20
• Debt to Assets Ratio = $300 / $800 = 0.375

Profitability Ratios

• Gross Profit Margin = ($1,000 - $600) / $1,000 = 0.4 or 40%
• Operating Profit Margin = $200 / $1,000 = 0.2 or 20%
• Net Profit Margin = $150 / $1,000 = 0.15 or 15%
• Return on Assets (ROA) = $150 / $800 = 0.1875 or 18.75%
• Return on Equity (ROE) = $150 / $500 = 0.3 or 30%
• Return on Investment (ROI) = $150 / $300 = 0.5 or 50%

Efficiency Ratios

• Asset Turnover Ratio = $1,000 / $800 = 1.25
• Inventory Turnover Ratio = $600 / (($150 + $150) / 2) = 4
• Receivables Turnover Ratio = $1,000 / (Assume Average Accounts Receivable $100) = 10
• Payables Turnover Ratio = $600 / (Assume Average Accounts Payable $50) = 12

Market Ratios

• Earnings Per Share (EPS) = $150 / 10 = $15
• Price to Earnings (P/E) Ratio = $50 / $15 = 3.33
• Price to Book (P/B) Ratio = $50 / ($500 / 10) = 1
• Dividend Yield = $2 / $50 = 0.04 or 4%
• Dividend Payout Ratio = (10 million * $2) / $150 = 0.1333 or 13.33%

Cash Flow Ratios

• Operating Cash Flow Ratio = $180 / $250 = 0.72
• Free Cash Flow = $180 - $50 = $130

This analysis provides a comprehensive overview of XYZ Corp's financial health, performance, and market position.

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TRP Circular _ NBR _ Bangladesh

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IAS 7, "Statement of Cash Flows,"

 IAS 7, "Statement of Cash Flows," is one of the International Financial Reporting Standards (IFRS) established by the International Accounting Standards Board (IASB). This standard requires entities to present a statement of cash flows as an integral part of their financial statements. The primary objective of IAS 7 is to provide information about the historical changes in cash and cash equivalents of an entity by classifying cash flows during the period into operating, investing, and financing activities.

Key Components of IAS 7:

1. Definitions:
• Cash: Comprises cash on hand and demand deposits.
• Cash equivalents: Short-term, highly liquid investments that are readily convertible to known amounts of cash and are subject to an insignificant risk of changes in value.
2. Cash Flow Classifications:
• Operating Activities: These are the principal revenue-producing activities of the entity and other activities that are not investing or financing activities. Examples include receipts from sales of goods and services, payments to suppliers and employees, and other expenses.
• Investing Activities: Activities related to the acquisition and disposal of long-term assets and other investments not included in cash equivalents. Examples include purchases and sales of property, plant, and equipment, and proceeds from the sale of investments.
• Financing Activities: Activities that result in changes in the size and composition of the equity capital and borrowings of the entity. Examples include proceeds from issuing shares, borrowings, repayments of borrowings, and dividends paid.
3. Presentation of Cash Flows:
• Entities must report cash flows from operating activities using either the direct method (disclosing major classes of gross cash receipts and payments) or the indirect method (adjusting net profit or loss for the effects of non-cash transactions, changes in working capital, and other items).
• Cash flows from investing and financing activities are reported separately.
4. Reporting Cash Flows on a Net Basis:
• Certain cash flows may be reported on a net basis, such as cash receipts and payments on behalf of customers when the cash flows reflect the activities of the customer rather than those of the entity.
5. Foreign Currency Cash Flows:
• Cash flows arising from transactions in a foreign currency must be recorded in the entity's functional currency using the exchange rate at the date of the cash flow.
6. Interest and Dividends:
• Cash flows from interest and dividends received and paid should each be disclosed separately and classified consistently from period to period. These can be classified as operating, investing, or financing activities depending on their nature and how they are managed within the entity.
7. Income Taxes:
• Cash flows arising from income taxes should be separately disclosed and classified as cash flows from operating activities unless they can be specifically identified with financing and investing activities.
8. Non-Cash Transactions:
• Investing and financing transactions that do not require the use of cash or cash equivalents should be excluded from the statement of cash flows but must be disclosed elsewhere in the financial statements.

Importance of IAS 7:

• Decision-Making: Provides valuable information to investors, creditors, and other stakeholders about the entity's ability to generate cash and cash equivalents, and the entity’s needs to utilize those cash flows.
• Performance Evaluation: Assists in evaluating the changes in net assets of an entity, its financial structure (including its liquidity and solvency), and its ability to affect the amounts and timing of cash flows in order to adapt to changing circumstances and opportunities.
• Comparability: Enhances the comparability of reporting entities' performance and cash flow situations, which is crucial for analysis and decision-making by stakeholders.

Overall, IAS 7 helps in enhancing the transparency and comparability of financial statements by providing a clear picture of an entity’s cash inflows and outflows.

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IAS 2 - Inventories

IAS 2, "Inventories," is an International Financial Reporting Standard (IFRS) issued by the International Accounting Standards Board (IASB). It provides guidance on accounting for inventories and is applicable to all entities except those specifically excluded, such as financial instruments and biological assets related to agricultural activity. 

Here's an explanation of the key aspects of IAS 2:

Scope

IAS 2 applies to all inventories, which include assets:

• Held for sale in the ordinary course of business (finished goods).
• In the process of production for such sale (work in progress).
• In the form of materials or supplies to be consumed in the production process or in the rendering of services (raw materials).

Measurement

Inventories should be measured at the lower of cost and net realizable value (NRV).

Cost of Inventories

The cost of inventories includes:

• Costs of Purchase: Purchase price, import duties, transportation, handling, and other costs directly attributable to the acquisition.
• Costs of Conversion: Costs directly related to production, such as direct labor and a systematic allocation of fixed and variable production overheads.
• Other Costs: Costs incurred in bringing the inventories to their present location and condition.

Methods to determine the cost of inventories include:

• First-In, First-Out (FIFO)
• Weighted Average Cost

Net Realizable Value (NRV)

NRV is the estimated selling price in the ordinary course of business, less the estimated costs of completion and the estimated costs necessary to make the sale. When the NRV is lower than the cost, the inventory should be written down to NRV.

Recognition as an Expense

When inventories are sold, the carrying amount of those inventories should be recognized as an expense in the period in which the related revenue is recognized. Any write-down to NRV and any loss of inventories should be recognized as an expense when the write-down or loss occurs.

Reversal of Write-Downs

If the NRV of a previously written-down inventory increases, the amount of the write-down can be reversed, limited to the original write-down amount. This reversal is recognized as a reduction in the amount of inventories recognized as an expense in the period the reversal occurs.

Disclosure Requirements

Entities must disclose:

• The accounting policies adopted for inventories.
• The total carrying amount of inventories and their classification.
• The amount of inventories recognized as an expense during the period.
• The amount of any write-down of inventories recognized as an expense.
• The amount of any reversal of any write-down recognized as a reduction in the amount of inventories recognized as an expense.
• The carrying amount of inventories pledged as security for liabilities.

Practical Application

1. Inventory Valuation: Ensuring that inventories are correctly valued using the lower of cost and NRV method helps in accurate financial reporting.
2. Cost Formulas: Choosing the appropriate cost formula (FIFO or weighted average) that best reflects the flow of inventory.
3. Impairment Consideration: Regular assessment of NRV to identify and write down impaired inventories ensures that financial statements reflect the true economic value of the inventories.

By adhering to IAS 2, entities ensure consistency and comparability in financial reporting related to inventories, which is crucial for investors, regulators, and other stakeholders who rely on financial statements for decision-making.

 

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IAS 10 - Events after the reporting period

IAS 10, also known as International Accounting Standard 10, deals with events that occur after the balance sheet date but before the financial statements are authorized for issue. These events are important because they can provide additional information about the financial position of the entity and may require adjustments to the financial statements.

Here's an explanation of key concepts covered under IAS 10:

1. Definition of Events After the Balance Sheet Date:
• These are events that occur between the balance sheet date (the end of the reporting period) and the date when the financial statements are authorized for issue. The balance sheet date is the date as of which the financial position (assets, liabilities, and equity) is measured.
2. Two Types of Events:
• Adjusting Events: These are events that provide further evidence of conditions that existed at the balance sheet date. If an adjusting event occurs, the entity adjusts the amounts recognized in its financial statements to reflect this new information. Adjusting events typically require adjustments to the financial statements and are reflected in the financial statements as if they had occurred at the balance sheet date.
• Non-Adjusting Events: These are events that are indicative of conditions that arose after the balance sheet date and do not affect the amounts recognized in the financial statements. Non-adjusting events may require disclosure in the financial statements to provide users with relevant information about the entity's financial position, performance, and potential risks.
3. Examples of Adjusting Events:
• Settlement of a court case that confirms a liability existed at the balance sheet date.
• Discovery of new information about the value of assets or liabilities that existed at the balance sheet date.
• Bankruptcy of a customer that occurred shortly after the balance sheet date but confirms that a receivable is impaired at the balance sheet date.
4. Examples of Non-Adjusting Events:
• Natural disasters occurring after the balance sheet date.
• Major business combinations or disposals of assets after the balance sheet date.
• Changes in market prices or interest rates after the balance sheet date.
5. Disclosure Requirements:
• IAS 10 requires disclosure of the nature of each significant adjusting and non-adjusting event after the balance sheet date. For adjusting events, entities disclose the impact of those events on the financial statements. For non-adjusting events, entities disclose the nature of the event and an estimate of its financial effect or state that such an estimate cannot be made.
6. Date of Authorization for Issue:
• Financial statements are authorized for issue when they are approved for issue by management and, where applicable, the board of directors. This date determines the cut-off for events to be considered in the financial statements.

In summary, IAS 10 ensures that financial statements provide relevant and reliable information by addressing events that occur between the balance sheet date and the date when financial statements are authorized for issue. It distinguishes between adjusting events that require changes to the financial statements and non-adjusting events that may require disclosure to help users assess the entity's financial position and performance.

 

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