Course Content
INTRODUCTION TO FINANCIAL STATEMENT ANALYSIS
This topic covers the LOS (Learning Outcome Statements) 19 as covered by the CFA institute. According to this statement, after going through this reading, a student shall be able to: a. Describe the role of financial reporting and financial statement analysis. b. Describe the role of key financial statements, i.e. i. Statement of financial position, ii. Statement of comprehensive income, iii. Statement of changes in equity, and iv. Statement of cash flows. c. Describe the importance of financial statement notes and supplementary information. This includes: i. Disclosures of accounting policies, ii. Methods, and iii. Estimates used in financial reporting. d. Describe the: i. Objectives of audit of financial statements, ii. the types of audit reports, and iii. the importance of effective internal controls. e. Identify and describe information sources that analysts use in financial statement analysis besides annual financial statements and supplementary information; f. Describe the steps in the financial statement analysis framework.
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FINANCIAL REPORTING STANDARDS
This part of the study session 6 is covered under the LOS (Learning Outcome Statement) 20, as covered by the CFA institute. After going through this chapter, a student shall be able to: a. describe the objective of financial statements and the importance of financial reporting standards in security analysis and valuation; b. describe roles and desirable attributes of financial reporting standard-setting bodies and regulatory authorities in establishing and enforcing reporting standards, and describe the role of the International Organization of Securities Commissions; c. describe the International Accounting Standards Board’s conceptual framework, including the objective and qualitative characteristics of financial statements, required reporting elements, and constraints and assumptions in preparing financial statements; d. describe general requirements for financial statements under International Financial Reporting Standards (IFRS); e. describe implications for the financial analysis of differing financial reporting systems and the importance of monitoring developments in financial reporting standards; analyze company disclosures of significant accounting policies. There are revisions and amendments that keep happening to the existing financial reporting standards o n a regular basis. It is thus advisable to the students to keep updating themselves regarding such changes to maintain a decent understanding regarding the financial reporting framework towards a better analysis.
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UNDERSTANDING INCOME STATEMENTS
This part of the study session 7 is covered under the LOS (Learning Outcome Statement) 21, as covered by the CFA institute. After going through this chapter, a student shall be able to: a. describe the components of the income statement and alternative presentation formats of that statement; b. describe general principles of revenue recognition and accrual accounting, specific revenue recognition applications (including accounting for long-term contracts, installment sales, barter transactions, gross and net reporting of revenue), and implications of revenue recognition principles for financial analysis; c. calculate revenue given information that might influence the choice of revenue recognition method; d. describe general principles of expense recognition, specific expense recognition applications, and implications of expense recognition choices for financial analysis; e. describe the financial reporting treatment and analysis of non-recurring items (including discontinued operations, extraordinary items, unusual or infrequent items) and changes in accounting standards; f. distinguish between the operating and non-operating components of the income statement; g. describe how earnings per share are calculated and calculate and interpret a company’s earnings per share (both basic and diluted earnings per share) for both simple and complex capital structures; h. distinguish between dilutive and anti-dilutive securities, and describe the implications of each for the earnings per share calculation; i. convert income statements to common-size income statements; j. evaluate a company’s financial performance using common-size income statements and financial ratios based on the income statement; k. describe, calculate, and interpret comprehensive income; l. describe other comprehensive income, and identify major types of items included in it.
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UNDERSTANDING BALANCE SHEETS
This part of the study session 7 is covered under the Reading 22, as covered by the CFA institute. After going through this chapter, a student shall be able to: a. describe the elements of the balance sheet: assets, liabilities, and equity; b. describe uses and limitations of the balance sheet in financial analysis; c. describe alternative formats of balance sheet presentation; d. distinguish between current and non-current assets, and current and non-current liabilities; e. describe different types of assets and liabilities and the measurement bases of each; f. describe the components of shareholders’ equity; g. convert balance sheets to common-size balance sheets and interpret common-size balance sheets; h. calculate and interpret liquidity and solvency ratios.
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UNDERSTANDING CASH FLOW STATEMENTS
This part of the study session 7 is covered under the Reading 23, as covered by the CFA institute. After going through this chapter, a student shall be able to: a. compare cash flows from operating, investing, and financing activities and classify cash flow items as relating to one of those three categories given a description of the items; b. describe how non-cash investing and financing activities are reported; c. contrast cash flow statements prepared under International Financial Reporting Standards (IFRS) and US generally accepted accounting principles (US GAAP); d. distinguish between the direct and indirect methods of presenting cash from operating activities and describe arguments in favor of each method; e. describe how the cash flow statement is linked to the income statement and the balance sheet; f. describe the steps in the preparation of direct and indirect cash flow statements, including how cash flows can be computed using income statement and balance sheet data; g. convert cash flows from the indirect to direct method; h. analyze and interpret both reported and common-size cash flow statements; i. calculate and interpret free cash flow to the firm, free cash flow to equity, and performance and coverage cash flow ratios.
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FINANCIAL ANALYSIS TECHNIQUES
This part of the study session 7 is covered under the Reading 24, as covered by the CFA institute. After going through this chapter, a student shall be able to: a. describe tools and techniques used in financial analysis, including their uses and limitations; b. classify, calculate, and interpret activity, liquidity, solvency, profitability, and valuation ratios; c. describe relationships among ratios and evaluate a company using ratio analysis; d. demonstrate the application of DuPont analysis of return on equity, and calculate and interpret effects of changes in its components; e. calculate and interpret ratios used in equity analysis and credit analysis; f. explain the requirements for segment reporting, and calculate and interpret segment ratios; g. describe how ratio analysis and other techniques can be used to model and forecast earnings.
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INVENTORIES
This part of the study session 8 is covered under Reading 25, as covered by the CFA Institute. The candidate should be able to: a distinguish between costs included in inventories and costs recognised as expenses in the period in which they are incurred; b describe different inventory valuation methods (cost formulas); c calculate and compare cost of sales, gross profit, and ending inventory using different inventory valuation methods and using perpetual and periodic inventory systems; d calculate and explain how inflation and deflation of inventory costs affect the financial statements and ratios of companies that use different inventory valuation methods; e explain LIFO reserve and LIFO liquidation and their effects on financial statements and ratios; f convert a company’s reported financial statements from LIFO to FIFO for purposes of comparison; g describe the measurement of inventory at the lower of cost and net realisable value; h describe implications of valuing inventory at net realisable value for financial statements and ratios; i describe the financial statement presentation of and disclosures relating to inventories; j explain issues that analysts should consider when examining a company’s inventory disclosures and other sources of information; k calculate and compare ratios of companies, including companies that use different inventory methods; l analyze and compare the financial statements of companies, including companies that use different inventory methods.
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LONG-LIVED ASSETS
This part the study session 8 is covered under Reading 26, as covered by the CFA Institute. After reading this chapter a candidate should be able to: a. distinguish between costs that are capitalised and costs that are expensed in the period in which they are incurred; b. compare the financial reporting of the following types of intangible assets: purchased, internally developed, acquired in a business combination; c. explain and evaluate how capitalising versus expensing costs in the period in which they are incurred affects financial statements and ratios; d. describe the different depreciation methods for property, plant, and equipment and calculate depreciation expense; e. describe how the choice of depreciation method and assumptions concerning useful life and residual value affect depreciation expense, financial statements, and ratios; f. describe the different amortisation methods for intangible assets with finite lives and calculate amortisation expense; g. describe how the choice of amortisation method and assumptions concerning useful life and residual value affect amortisation expense, financial statements, and ratios; h. describe the revaluation model; i. explain the impairment of property, plant, and equipment and intangible assets; j. explain the derecognition of property, plant, and equipment and intangible assets; k. explain and evaluate how impairment, revaluation, and derecognition of property, plant, and equipment and intangible assets affect financial statements and ratios; l. describe the financial statement presentation of and disclosures relating to property, plant, and equipment and intangible assets; m. analyze and interpret financial statement disclosures regarding property, plant, and equipment and intangible assets; n. compare the financial reporting of investment property with that of property, plant, and equipment.
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INCOME TAXES
This part of the study session 8 is covered under Reading 28, as covered by the CFA Institute. After reading this chapter a candidate should be able to: a. describe the differences between accounting profit and taxable income, and define key terms, including deferred tax assets, deferred tax liabilities, valuation allowance, taxes payable, and income tax expense; b. explain how deferred tax liabilities and assets are created and the factors that determine how a company’s deferred tax liabilities and assets should be treated for the purposes of financial analysis; c. calculate the tax base of a company’s assets and liabilities; d. calculate income tax expense, income taxes payable, deferred tax assets, and deferred tax liabilities, and calculate and interpret the adjustment to the financial statements related to a change in the income tax rate; e. evaluate the impact of tax rate changes on a company’s financial statements and ratios; f. distinguish between temporary and permanent differences in pre-tax accounting income and taxable income; g. describe the valuation allowance for deferred tax assets—when it is required and what impact it has on financial statements; h. compare a company’s deferred tax items; i. analyze disclosures relating to deferred tax items and the effective tax rate reconciliation, and explain how information included in these disclosures affects a company’s financial statements and financial ratios; j. identify the key provisions of and differences between income tax accounting under International Financial Reporting Standards (IFRS) and the US generally accepted accounting principles (GAAP).
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NON-CURRENT (LONG-TERM) LIABILITIES
This part of the study session 8 is covered under Reading 28, as covered by the CFA Institute. After reading this chapter a candidate should be able to: a. determine the initial recognition, initial measurement, and subsequent measurement of bonds; b. describe the effective interest method and calculate interest expense, amortization of bond discounts/premiums, and interest payments; c. explain the derecognition of debt; d. describe the role of debt covenants in protecting creditors; e. describe the financial statement presentation of and disclosures relating to debt; f. explain motivations for leasing assets instead of purchasing them; g. explain the financial reporting of leases from a lessee’s perspective; h. explain the financial reporting of leases from a lessor’s perspective; i. compare the presentation and disclosure of defined contribution and defined benefit pension plans; j. calculate and interpret leverage and coverage ratios.
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FINANCIAL REPORTING QUALITY
This part of the study session 9 is covered under Reading 29, as covered by the CFA Institute. After reading this chapter a candidate should be able to: a. distinguish between financial reporting quality and quality of reported results (including quality of earnings, cash flow, and balance sheet items); b. describe a spectrum for assessing financial reporting quality; c. distinguish between conservative and aggressive accounting; d. describe motivations that might cause management to issue financial reports that are not high quality; e. describe conditions that are conducive to issuing low-quality, or even fraudulent, financial reports; f. describe mechanisms that discipline financial reporting quality and the potential limitations of those mechanisms; g. describe presentation choices, including non-GAAP measures, that could be used to influence an analyst’s opinion; h. describe accounting methods (choices and estimates) that could be used to manage earnings, cash flow, and balance sheet items; i. describe accounting warning signs and methods for detecting manipulation of information in financial reports.
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APPLICATIONS OF FINANCIAL STATEMENT ANALYSIS
This part of the study session 9 is covered under Reading 30, as covered by the CFA Institute. After reading this chapter a candidate should be able to: a. evaluate a company’s past financial performance and explain how a company’s strategy is reflected in past financial performance; b. forecast a company’s future net income and cash flow; c. describe the role of financial statement analysis in assessing the credit quality of a potential debt investment; d. describe the use of financial statement analysis in screening for potential equity investments; e. explain appropriate analyst adjustments to a company’s financial statements to facilitate comparison with another company.
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Financial Reporting and Analysis
About Lesson

Accounting bodies across the world, including SEC in the US, has from time to time set the roadmap and deadlines for the convergence from GAAP towards IFRS; but these were rarely met.

In Europe, as per the direction of the European Union (EU), each of its member countries must individually adopt the IFRS, starting from 2005.

As far as most of the Asian countries are concerned they have accepted to adopt the IFRS, either directly or by converging their standards in line with the international standards and remaining compliant with local regulations and requirements. Around 120 countries have either adopted IFRS fully or issued directives and set deadlines for the same.

The convergence of these standards used by the countries worldwide with IFRS aims to achieve harmony with IFRS. The term convergence can be considered to mean: ‘to design and maintain national accounting standards in a way that financial statements prepared in accordance with a country’s accounting standards are in line with the IFRS’. IAS 1 requires the financial statements of entities to comply with all the requirements of IFRS. This, however, doesn’t mean that the IFRS should be adopted word to word. The local standard setters in any country can add certain disclosure requirements or remove some requirement that does not create compliance with their local accounting standards. Thus convergence with IFRS means adoption of IFRS with exception wherever necessary. IFRS is currently being used in more than 100 countries and it may be expected that all the major countries will adopt the same to some extent, at least, in near future.

The convergence of these standards and financial reporting is an important process that can be expected to add to the free flow of investments globally and tries to achieve important benefits for all capital market stakeholders. It improves the comparability of investments on a standard scale globally for the investors and thus helping in lowering their risk of errors of judgment. It eliminates the costly requirements of reinstatement of financial statements by facilitating reporting for companies with operations worldwide. It also helps in promoting greater transparency in the market, which helps all market participants, i.e. buyers, sellers, and regulators. It helps in reducing the operational challenges for accounting firms by providing unified reporting standards and helps to focus their value and expertise around other core objectives of the entity. It creates an opportunity for those involved in standard-setting and others towards improving the reporting model.

Convergence is a long-term process; it may take years of improvements and amendments to reach the goal of a single set of standards. In the near future, there may be a mix of standards and two sets of standard setters. Some of the standards may be expected to be prepared together and issued jointly, and others may be prepared and issued independently within the framework of convergence.

1.         Why is Convergence Necessary?

In the present era of globalization and liberalization, the world has become an economic village. It has become extremely important to have a unified globally accepted financial reporting system. A lot of multinational companies are moving out of the confinement of their geographical boundaries to establish their business on a global map. The entities in emerging economies, in order to fulfill their capital needs, are increasingly accessing global markets by getting their securities listed on the foreign stock exchanges. Capital markets are, thus, becoming integrated and consistent with this worldwide trend. More and more companies are also being listed on overseas stock exchanges. A sound financial reporting structure is absolutely necessary for the economic well-being and effective functioning of capital markets.

The users of financial statements may get confused by the different treatments prescribed by different accounting standards for the same type of underlying financial transaction. This confusion also creates inefficiency in the capital market and complexity in the assessment of the financial statements and thus, calls for a single set of high-quality financial reporting standards. Good financial reporting standards will help in fortifying the faith the stakeholders would place in the financial reports of the business entities. Thus, the requirement of a single set of globally accepted accounting standards has inspired many countries to seek convergence of their local accounting standards with IFRSs.

2.         Global Status of Convergence

IFRS are already used (either completely or in parts) in many countries across American, Europe, and Asia; such as countries in the EU, India, China, Pakistan, Hong Kong, Singapore, etc. The status across various countries of IFRS is as follows:

Countries adopted IFRS FRA CFA Level 1 Study Notes

Brazil: Brazil has adopted IFRS for the reporting purpose in the case of publically listed companies along with CPCs (new Brazilian GAAP), since 2010. However for the companies other than the listed companies also the IFRSs are applicable, but the emphasis is more on the CPCs.

Mexico: In Mexico, the IFRSs as published by the IASB are applicable to all the companies whose shares are traded on the stock exchanges i.e. the publically traded companies. However, there is an exception for the financial institutions and the insurance companies; who are required to follow the Mexican Financial Reporting Standards. Also in Mexico, the IFRSs are not permissible for SMEs.

Canada: In Canada, the IFRSs issued by IASB as included in Part I of the CICA handbook are applicable for interim and annual financial statements of all the listed companies. However, for the US-listed issuers, the US GAAP continues to be applicable.

United States of America: In the US currently IFRSs are not applicable and permitted to any corporation. The currently applicable framework is GAAP.

US has always shown willingness to converge to the IFRS. It also had issued the guidelines and set deadlines for the part convergence; even though they were eventually missed. Right now, there is a lack of clear direction as to whether there is any likelihood of adoption of IFRS any time soon in the future.

Argentina: In Argentina, the IFRS as issued by the IASB for consolidated financial statements are applicable to all companies except the financial institutions and the insurance companies; since 2012. Here, for SMEs also the relative version of IFRSs is applicable.

The countries that are members of the European Union, such as the United Kingdom, Austria, Belgium, Greece, Germany, Sweden, etc. are required to adopt the version of IFRS as adopted by the European Union. The EU has a formulated various committees and groups (such as IASB, EGRAG, SARG, ARC, etc.) that issue directives and helps in the implementation of IFRS in the member countries.

India: In India, the IFRSs are planned to be adopted in a phased manner starting Apr. 2016, starting with the listed companies. In India, NACAS issues the IndAS, which are nothing but converged form of IFRS, which are planned to be implemented.

China: In China, the IFRSs are not applicable directly. They follow the Chinese Accounting Standards (CASs), which are nothing but converged form of IFRSs but easily understandable to Chinese readers.

Japan: In Japan, the IFRSs are neither applicable nor permitted on a standalone basis. However, there are companies that meet certain requirements (“specified companies”) that are permitted to use the IFRS for their consolidated financial statement; since March 2010. Additionally, in Japan, Japan’s Modified International Standards (JMIS) based on IFRS were introduced in 2015.

Saudi Arabia: In Saudi Arabia, the banks and financial institutions as regulated by the Saudi Arabian Monetary Agency are required to follow IFRSs. Others are not allowed to follow IFRS.

Singapore: In Singapore, the IFRSs are permitted only if either, company is listed on any other stock exchange outside Singapore that requires IFRS; or an exemption is granted by the authority. Other companies are required to follow Singapore Financial Reporting Standards.

United Arab Emirates: In UAE, all the entities except those in Dubai International Financial Centre and other free zones are required to follow the IFRSs as formulated by the IASB.