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
About Lesson

The LOS B requires us to:

describe the roles of financial reporting standard-setting bodies and regulatory authorities in establishing and enforcing reporting standards.

 

There are two types of bodies responsible for the formation and implementation of the financial reporting standards in any country. They are: the standard setting bodies and the regulatory authorities.

Reporting Standards - Responsible Bodies FRA CFA Level 1 Study Notes

1.         Standard-Setting Bodies

The standard-setting bodies are usually:

a.  the private, self-regulated, not-for-profit organizations;

b.  consisting of people like accountants, auditors, industry veterans, users of financial statements, academicians, etc.

c.  responsible for setting financial reporting standards.

The examples of standard-setting bodies are:

a.  IASB or International Accounting Standard Board (responsible for giving IFRS).

     i.  IASB is governed by its board of trustees. These trustees have diverse geographical and professional backgrounds.

    ii.  The trustees of the board are responsible for:

          #  appointment of the members of the organization;

          #  appointment of members related entities such as IFRS Interpretation Committee and IFRS Advisory Council;

          #  financing the foundation;

          #  establishing the budget; and

          #  establishing and monitoring the strategies of the board.

   iii.  IASB is committed to working in the public interest towards:

          #  developing and promoting the adoption of a unified set of high-quality financial reporting standards;

          #  ensuring that the standards result in transparent, comparable, and decision-useful information, keeping in mind the geographical and volume-based diversity of its potential implementers; and

          #  promoting convergence of national accounting standards of different countries with the internationally accepted IFRS.

    iv.  IASB follows a series of processes while developing and issuing the reporting standards (Usually other standard-setting bodies spread across the earth, also follow a similar procedure). This includes:

          #  Step 1: An issue is identified as a priority for consideration and placed on the IASB’s agenda in consultation with the Advisory Council.

          #  Step 2: The issue is then considered in its meetings, after which the IASB may publish an exposure draft for public comment. In addition to soliciting public comment, the IASB may hold public hearings to discuss proposed standards

          #  Step 3: After reviewing the input of others, the IASB may issue a new or revised financial reporting standard.

    v.  FASB or Financial Accounting Standards Board of USA (responsible for giving US GAAP).

          #  Like IASB, FASB is also governed by a board of trustees, who are responsible for the appointment of its members and the related entities.

          #  The steps in the process of setting and improving the standards are also similar to that of IASB.

          #  The standards so set by the board after following the procedure are contained in the FASB Accounting Standards CodificationTM (Codification).

1.1.     Desirable attributes of Standard-Setting Bodies

In order for the standard-setting bodies to provide high-quality financial reporting standards, they must have the following attributes:

a.  The bodies should observe a very high quality of ethical, professional, and confidentiality standards.

b.  The responsibilities of all the parties involved in standard-setting should be clearly defined, providing adequate authority, resources, and competencies; in order to have proper functioning and accountability.

c.  The process to be followed in a standard-setting should be clearly defined, guided by a well-articulated framework with a clearly stated objective.

d.  The board may seek inputs from various stakeholders, but it should operate independently, going by the stated objectives.

e.  Decisions should be made in public interests only.

2.         Regulatory Authorities

The standards set by the regulatory authorities cannot be implemented and enforced properly unless there are bodies regulating the same. The regulatory authorities are the bodies (mainly government organizations), responsible for the enforcement of financial reporting requirements based on the standards set by the standard-setting bodies, on the entities participating in the capital markets and falling under their jurisdictions.

There are many regulatory authorities around the world to ensure that there is proper enforcement of accounting and financial reporting standards. The major of them are:

2.1.     International Organization of Securities Commissions (IOSCO)

a.  IOSCO was formed in the year 1983 as a successor to the inter- American regional association, as a cooperative body.

b.  IOSCO has three categories of members:

     i.  Ordinary Members (currently 126) are the national securities commissions or similar governmental bodies with significant authority over securities or derivatives markets in their respective jurisdictions.

    ii.  Associate Members (currently 23) are usually supranational governmental regulators, sub-national governmental regulators, inter-governmental international organizations, and other international standard-setting bodies, as well as other governmental bodies with an appropriate interest in securities regulation.

   iii.  Affiliate Members (currently 65) are self-regulatory organizations, securities exchanges, financial market infrastructures, international bodies other than governmental organizations with an appropriate interest in securities regulation, investor protection funds, and compensation funds, and other bodies with an appropriate interest in securities regulation.

c.  IOSCO’s core standards are set in the form of The Objectives and Principles of Security Regulations (2010). These standards give three major objectives for financial reporting regulations. They are:

     i.  protecting investors;

    ii.  ensuring that the markets are fair, transparent, and efficient; and

   iii.  reducing systematic risk.

There are also a set of nine principles for the regulators; the ones in relation to financial reporting are:

     i.  There should be full, accurate, and timely disclosure of financial results, risk, and other information which is material to investors’ decisions.

    ii.  Accounting standards used by issuers to prepare financial statements should be of a high and internationally acceptable quality.

d.  Though mostly the regulatory authorities work within the jurisdiction of individual countries, with the desire to have a unified set of financial reporting standards like IFRS across the world; there is a need to have an international regulatory authority like IOSCO to oversee its enforcement. Thus, IOSCO assists in attaining this goal of uniform regulation as well as cross-border cooperation in combating violations of securities and derivatives laws.

2.2.     The Security Exchange Commission (SEC)

SEC is also a member of IOSCO. Its primary responsibility is the regulation of securities and capital markets in the United States. It was basically formed after the great depression of 1929.

SEC has given many sets of laws and acts to regulate the auditors, dealers in the security markets, brokers, etc. The major of them being:

a.  Securities Act, 1933. This act specifies the financial and other significant information that investors must receive when securities are sold, prohibits misrepresentations, and requires initial registration of all public issuances of securities.

b.  Securities Exchange Act, 1934. This act created the SEC, gave the SEC authority over all aspects of the securities industry, and empowered the SEC to require periodic reporting by companies with publicly traded securities.

c.  Sarbanes-Oxley Act, 2002. This act was created to oversee the functioning of the auditors, and for this purpose, it created the Public Company Accounting Oversight Board (PCAOB). The main focus of this board is to ensure the independence of the auditors so that they can function properly.

The companies comply with the regulations of the SEC through various fillings it makes in the form of reports, statements, and forms. Almost all the filings made with SEC are in electronic mode.

Some of the important filings required are:

a.  Securities Offering Registration Statement. Whenever there is new security offered for sale to the public, the companies are required to file Form S-1 with SEC. In this form they are required to declare about:

     i.  the details about the security being offered for sale, especially the amount and use of proposed offerings proceeds;

    ii.  the information typically provided in the annual filings;

   iii.  underwriters identification;

   iv.  risk assessment;

    v.  relationship of the new securities with the existing capital instruments of the issuer; etc.

b.  Forms 10-K, 20-F, and 40-F. These are the annual filing requirements for the US and non-US assessments. These forms require a comprehensive overview, including information concerning a company’s business, financial disclosures, legal proceedings, and information related to management. The financial disclosures include a historical summary of financial data (usually 10 years), management’s discussion and analysis (MD&A) of the company’s financial condition and results of operations, and audited financial statements

c.  Annual Report. Though it is very much similar to the Form 10-K, the focus is slightly different. This report is mainly aimed to present the company’s information to its shareholders, unlike Form 10-K, which is more of a legal document. Some companies do not prepare a separate annual report; they modify the Form 10-K to inculcate the features of the annual report.

d.  Proxy Statements. Proxy statements are filed with SEC in Form DEF-14A. These are the statements circulated to the shareholders prior to the general meetings, giving the shareholders the authority to give rights to others to cast vote. These statements typically give information about the proposals likely to be considered and voted for in the meetings.

e.  Form 10-Q and 6-K. These are the interim reports required to be filed by the US and non-US companies respectively. The companies are required to file the updated non-audited financial statements, disclosing information about certain events such as significant legal proceedings or changes in accounting policies.

f.  Form 8- The companies are required to file this form to make disclosures about the significant asset acquisition and disposals.

g.  Form 144 can be filed by the issuers of the securities to qualified buyers without registering the securities with SEC.

h.  Form 3, 4, and 5. These forms are required to report beneficial ownership of securities by the company’s directors and officers. These forms give information about the transfer of securities by the company insiders.

i.  Form 11. This form is filed to make disclosures regarding the employee stock purchase, and other benefit plans.

2.3.     Capital Market Regulation in Europe

In Europe, two committees regulate the securities market for the members of the European Union. These are: European Securities Committee (ESC) and the Committee of European Securities Regulators (CESR). ESC provides advisory services on the security policy issues, CESR however, assists in the technical issues.

 

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