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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Introduction
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Role of Financial Statements and Financial Statement Analysis
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Major Financial Statements
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Other Documents
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Other Sources of Information
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Auditor’s Report
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Internal Control
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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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Introduction
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The Objectives of Financial Reporting
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Standard Setting Bodies and Regulatory Authorities
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Convergence of Global Financial Reporting Standards
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International Financial Reporting Standards Framework
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Effective Financial Reporting
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Comparison of IFRS with Alternative Reporting Systems
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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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Introduction
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Income Statement Components
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Presentation Format of Income Statements
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Revenue Recognition
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Expense Recognition
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Non- Recurring / Operating Items
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Earnings Per Share
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Income Statement Analysis
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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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Introduction
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Elements of Balance Sheet
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Uses and Limitations of Balance Sheet
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Alternative Formats of Balance Sheet
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Current Assets/Liabilities vs. Non-Current Assets/Liabilities
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Types of Assets and Liabilities
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Vertical Common Sized Balance Sheet
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Calculation and Interpretation of Solvency and Liquidity 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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Introduction
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Components of Cash Flow Statements
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Reporting of Non-Cash Investing and Financing Activities
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Difference between the Cash Flow Statement Prepared Under IFRS and US GAAP
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Difference between Direct and Indirect Method of Preparing Cash Flow Statement
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Other Relationships in Cash Flow Statement
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Steps in Preparation of Cash Flow Statements
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Conversion of Cash Flow from Indirect to Direct Method
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Analysis and Interpretation of Cash Flow Statement
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Calculation and Interpretation of 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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Introduction
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Tools and Techniques Used in Financial Analysis
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Classifications, Calculation, and Interpretation of Various Ratios
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Du-Pont Analysis
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Equity and Credit Analysis
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Segment Reporting
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Use of Ratio Analysis 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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Introduction
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Product Cost and Period Cost
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Inventory Valuation Method
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Calculation of COGS and Value of Ending Inventory
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Concept of LIFO Reserve and Conversion of LIFO to FIFO / AVCO Method of Valuation
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Measurement of Inventory
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Presentation and Disclosures of Inventory and Related Items
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Issues Involved in Evaluating Inventory
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Impact of Choice of Valuation Methods on the Ratios
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Inventory Analysis
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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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Introduction
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Capitalization of Cost Vs. Expensing
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Intangible Assets
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Impact of Capitalizing vs. Expensing the Assets on Financial Statements and Ratios
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Calculation of Depreciation Expense
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Impact of Choices for Depreciation on Financial Statements and Ratios
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Amortization
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Impact of Choices for Amortization on Financial Statements and Ratios
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Revaluation Model
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Impairment of Assets
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De-recognition of Assets
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Effects of Revaluation, Impairment, and De-Recognition
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Disclosures
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Evaluation of Important Ratios
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Investment Property
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Leasing
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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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Introduction
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Definition of Key Terms
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Creation and Treatment of Deferred Tax Assets / Liabilities
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Tax Base
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Calculation of Tax Expense, Income Tax Payable, Deferred Tax Asset / Liability
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Changes in Tax
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Differences in Temporary and Permanent Differences
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Valuation Allowance
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Current vs. Deferred Tax
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Disclosure Requirements for Deferred Tax Assets / Liabilities
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Key Differences in the Tax Accounting Under IFRS and 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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Introduction
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Bonds
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Methods of Accounting for Bonds
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Derecognition of Bonds
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Debt Covenants
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Presentation and Disclosure of Bonds
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Leases
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Benefits of Leasing
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Financial Reporting From Lessee’s and Lessor’s Perspective
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Pension Plans
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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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Introduction
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Difference between Financial Reporting Quality and Quality of Reported Results
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Spectrum for Assessing the Financial Reporting Quality
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Conservative and Aggressive Accounting
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Motivation Behind Low Quality Financial Reports
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Conditions Conducive to Low Quality Reporting
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Mechanisms That Discipline Financial Reporting Quality and Limitations to Mechanisms
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Presentation Choices That Could Influence Analyst’s Opinion
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Methods Used to Manage Earnings, Cash Flow & Balance Sheet Items
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Warning Signs Indicating Manipulation of 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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Introduction
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Evaluation of Performance Vis-à-vis Strategy
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Forecasting Company’s Net Income Cash Flow
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Assessing the Credit Quality
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Screening for Potential Equity Investment
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Adjustment Necessary to Facilitate Comparisons
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Financial Reporting and Analysis

LOS D requires us to:

distinguish between the direct and indirect methods of presenting cash from operating activities and describe arguments in favor of each method.

 

The U.S. GAAP and IFRS, both accept the two methods of preparing the cash flow statement i.e. the direct method and the indirect method. Both IFRS and GAAP encourage the use of direct methods for the preparation of cash flow statements. Though, U.S. GAAP requires the reconciliation of net income with the cash from operations, even if the direct method of preparing cash flow statements is used. However, most of the firms worldwide prefer to use the indirect method, despite the stress by the trendsetters towards the use of the direct method.

There are three major components of a typical cash flow statement: cash flow from operating activities, cash from financing activities, and cash from investing activities. The presentation under both the methods (i.e. direct method and indirect method) for cash from financing activities and investing activities is the same; the only difference is in the presentation of cash from operations. So, let us discuss the presentation of cash from operations under the direct and indirect methods.

1.         Operating Cash Flows – Direct Method

a.  Preparing the cash flow statement using the direct method is pretty simple. Under this method, each line item of the accrual-based income statement is converted into the cash-based one, i.e. cash receipts and payments.

b.  Under the cash-based system, instead of reporting the revenues and expenses that have become due or accrued, they are reported as and when the cash is received, and payment is made.

c.  The commonly used format for presenting the ‘cash from operating activities’ section of a cash flow statement is:

Operating Cash Flows – Direct Method

Particulars

For the Year Ended

Current Year (20XX)

Previous Year (20XX)

Cash collected from customers

xxx

xxx

Less:

 

 

Cash paid to the suppliers

(xxx)

(xxx)

Cash paid to employees

(xxx)

(xxx)

Cash paid for operating expenses

(xxx)

(xxx)

Cash paid for interest

(xxx)

(xxx)

Cash paid for taxes

(xxx)

(xxx)

Operating Cash Flows

xxx

xxx

 

d.  Here, we can notice that the presentation of the cash flow statement as per the direct method is very much similar to the income statement. The line items under both the statements are the same, it is just the figures that differ. The accrual-based values are replaced by the actual cash flows under the cash from operations.

e.  Thus, the cash from operations using the direct method explicitly lists the actual sources of inflows and outflows, rather than just the net results.

f.  It is also useful in evaluating the past performance and evaluating the future cash flows.

2.         Operating Cash Flows – Indirect Method

a.  As per the indirect method of preparing the cash flow statement, the operating cash flow is calculated by adjusting the net income figure, as found in the income statement, by:

     i.  non-cash expenses,

    ii.  non-operating expenses, and

   iii.  changes in the working capital accounts, as found in the balance sheet, resulting from the accrual accounting.

In short, we start with the net income figure and reach to the operating cash flow by making adjustments for the transactions that affect the net income but are non-cash transactions.

Kindly Note:

Ø  The non-cash expenses are added back to the net income and non-cash income is reduced from the net income because it has not resulted in any cash inflow or outflow during the year. Some of the examples of non-cash income and expenses are depreciation, amortization, barter sales, etc.

Ø  The non-operating items such as gains and losses are not the real economic transactions; they are only the accounting conventions. Therefore they must be adjusted to arrive at the figure of cash from operations.

Ø  Any increase or decrease in those accounts in the balance sheet that does impact the working capital, such as current assets and current liabilities are also adjusted for in the ‘cash from operations’ section of the cash flow statement as per the indirect method. Any increase in the current asset is considered as an economic outflow, thus the use of resources. Similarly, an increase in liability, decrease in current asset, and decrease in current liability is considered as inflow, inflow, and outflow respectively.

 

b.  A typical format for the ‘cash from operations’ section of a cash flow statement prepared according to the indirect method is:

Operating Cash Flows – Indirect Method

Particulars

For the Year Ended

Current Year (20XX)

Previous Year (20XX)

Net Income

xxx

xxx

Adjustments to reconcile net income to cash from operations:

 

 

Depreciation and amortization

xxx

xxx

Deferred income taxes

xxx

xxx

Increase in current assets

(xxx)

(xxx)

Decrease in current liabilities

Increase in current liabilities

(xxx)

xxx

(xxx)

xxx

Decrease in current assets

xxx

xxx

Operating Cash Flows

xxx

xxx

 

c.  This statement shows the reasons for the difference between the net income and cash from operations.

d.  It also facilitates the forecasting of future cash flows and net income.

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