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

LOS C requires us to:

calculate the tax base of a company’s assets and liabilities.

 

 

The tax base is the amount at which the assets and liabilities are valued for the tax base. For the purpose of financial reporting, we prepare an income statement. Whereas, for the income tax purpose, we report the revenues, expenses, and profits through the income tax return. There may be differences in the amount of income and expenses reported in the two statements (as discussed above). And due to the differences in the income and the expenses reported in the two statements, there may arise, differences in the carrying values of assets and liabilities (under the two). The carrying value of the assets and liabilities in the balance sheet, as if the income and expenses as per the income tax return was our real income statement.

1.         Assets Tax Base

It is the amount that would be deducted or expensed on the future tax returns when the economic benefits of it are realized.

For Example:

Suppose there were some research and development costs of $ 1,000,000 incurred during the year. For the financial reporting purpose, the entire amount was expensed in the year of incurring. Thus in the statements prepared for financial reporting purposes, the entire amount would be reduced from the current year’s revenue, and there would be no assets to be reported in the balance sheet.

However, suppose for the taxation purpose, the entire amount of expense on research and development is capitalized and expensed/amortized over a period of next five year, then the tax base of the asset would be:

Particulars

Year 1
($)

Year 2
($)

Year 3
($)

Year 4
($)

Year 5
($)

Research and Development Cost

1,000,000

1,000,000

1,000,000

1,000,000

1,000,000

Accumulated Amortization

200,000

400,000

600,000

800,000

1,000,000

Tax Base

800,000

600,000

400,000

200,000

0

 

The tax base, as reflected above, is the amount that would have been reported in the balance sheet if it was prepared considering the income tax return as the real income statement.

This would create a deferred tax asset, as the earnings before tax (as per the financial reporting) are less than the taxable income (as per the income tax return). This is the amount that would be expensed in the future years in the tax returns.

 

Note:

One thing that needs to be noted here is that students do get confused about the taxability issue and its effect on the tax base. The taxability of any amount of asset does not affect its tax base. The tax base simply reflects the carrying value of the assets or liabilities, if the tax return were to be considered as the actual income statement.

For example, a company has a receivable of $ 100,000 in the next year and these revenues are exempt from tax. These would be reported as assets in the actual balance sheet under accounts receivable and the carrying value would be $ 100,000. And, since the same is not recognized as revenue in the current year as well, it would be reported at $ 100,000 in the tax base as well. The future taxability does not affect the carrying value of the asset for the tax purpose.

2.        Liability Tax base

A liability tax base is the carrying value of the liability, as reduced by any amount that would be deductible on the tax return in the future. The tax base of revenue received in advance or the unearned revenue is the carrying value minus the amount of revenue that will not be taxed.

Thus, for a liability like accrued expense:

FRA CFA Level 1 Study Notes

 

This can be explained with the help of the following example:

Example:

Suppose a company has a policy of expensing 2% of the sales as warranty expense each year. And the company this year’s warranty expenses turn out to be $ 10,000 for financial reporting purposes. However, there were no warranty charges this year. Also, as per the applicable tax laws, the warranty expenses can only be deducted in the period when they actually become payable.

Thus, the carrying value of the expense would be $ 10,000, i.e. the amount actually expensed during the period.

However, the tax base is the carrying amount minus the amount tax-deductible in the future. Thus, in this case, the tax base is:

$ 10,000 – $ 10,000 = 0

The temporary difference (i.e. carrying value – tax base), would thus be:

$ 10,000 –  0 = $ 10,000

Similarly, consider there were accrued salaries of $ 100,000 at the end of the year.  For the financial reporting purpose, these are supposed to be expensed in the year they get accrued.

Thus, the carrying value of the expense in the current year would be $ 100,000.

Now, let us suppose that the income tax laws also permit that the salary expenses should be allowed in the period to which they belong.  Therefore, the tax base, i.e. the carrying amount minus the amount tax-deductible in the future, would be:

$ 100,000 – 0 = $ 100,000

Thus, the temporary difference (i.e. carrying value – tax base) here would be:

$ 100,000 – $ 100,000 = 0

 

And, for the revenue received the tax base is:

revenue received the tax base FRA CFA Level 1 Study Notes

 

This can be explained with the help of the following example:

Example:

Suppose there were unearned revenues worth $ 10,000 during the reporting period. For financial reporting purposes, these must be reported as a current liability. Thus there would not be any expense during the period. Hence, the carrying value as per the balance sheet would be $ 10,000.

Now, as per the tax laws, suppose the revenues ought to be taxed in the period in which they are received. Thus, the entire $ 10,000 would be reported as the income of the current year and be taxed as well. Thus, the tax base (i.e. carrying amount – amount already taxed) would be $ 0 (i.e. $ 10,000 – 10,000).

And the temporary difference would be $ 10,000 (i.e. $ 10,000 – 0).

 

To summarize, we can say that:

a.  A higher tax expense or lower tax revenue results in lower taxable income. Therefore, the tax payable is less than the income tax expenses. This, in turn, results in the creation of deferred tax liability.

And, any increase or decrease in the deferred tax liability also increases or decreases the total liabilities side of the balance sheet.

b.  A lower tax expense or higher tax revenue results in higher taxable income. Therefore, the tax payable is higher than the income tax expenses. This, in turn, results in the creation of deferred tax assets.

And, any increase or decrease in deferred tax assets also increases or decreases the total asset side of the balance sheet as well.