1. intro/mechanics/standards Flashcards
Describe the roles of financial reporting and financial analysis
FInancial reporting refers to the way companies show their financial performance to investors creditors, and other interested parties by preparing and presenting financial statements
Financial statement analysis is to use the information in a company’s financial statements, along with other relevant information, to make economic decisions
Describe the roles of key financial statements in evaluating a company’s performance and financial position
statement of financial position (balance sheet)
statement of comprehensive income
statement of changes in equity
statement of cash flows
Balance sheet reports the firm’s financial position at a point in time. Assets = liabilities and owners equity
Statement of comprehensive income reports all changes in equity except for shareholder transactions (e.g. issuing stock, repurchasing stock, and paying dividends)
Income statement reports on the financial performance of the firm over a period of time (revenues, expenses, and other income)
Statement of changes in equity reports the amounts and sources of changes in equity investors investment in the firm over a period of time
Statement of cash flows reports the company’s cash receipts and payments (operating cash flow, investment cash flow, financing cash flows)
Describe the importance of financial statement notes and supplementary information - including disclosures of accounting policies, methods, and estimates - and management’s commentary
Important information about accounting methods, estimates and assumptions is disclosed in the footnotes to the financial statements and supplementary schedules. These disclosures also contain information about segment results, commitments and contingencies, legal proceedings, acquisitions or divestitures, issuance of stock options, and details of employee benefit plans
Management’s commentary (MD&A) contains an overview of the company and important information about business trends, future capital needs, liquidity, significant events, and significant choices of accounting methods requiring managment judgment.
Describe the objective of audits of financial statements, the types of audit reports, and the importance of effective internal controls
The objective of financial statements is to provide an opinion on the statements’ fairness and reliability
The auditor’s opinion gives evidence of an independent review of the financial statements that verifies that appropriate accounting principles were used, that standaard auditing procedures were used to establish reasonable assurance that the statemnts contain no material errors
An auditor can issue an unqualified (clean) opinion if the statements are free from material omissions and errors, a qualified opinion that notes any exception to accounting principles, an adverse opinion if the statements are not presented fairly in the auditor’s opinion, or a disclaimer of opinion if the auditor is unable to express and opinion
A company’s management is responsbile for maintaining an effective internal control system to ensure the accurary of its financial statements
identify and explain information sources that analysts use in financial statement analysis besides annual financial statements and supplementary information
Quarterly or semiannual reports (not necessarily audited)
Securities and exchange commission filings are available from EDGAR
proxy statements (for matters that require a shareholder vote)
corporate reports and press releases
earnings guidance issued by the company
information on the industry and peer companies from external sources
Describe the steps in the financial statement analysis framework
6 steps
- state the objective and context
- gather data
- process the data
- analyze and interpret the data
- report the conclusions or recommendations
- update the analysis
Explain the relationships of financial statement elements and accounts and classify accounts into the financial statement elements
Financial statement elements: assets, liabilities, owner’ equity, revenues, and expenses
Accounts: specific records within each element where transactions are entered
Assets:
- cash and cash equivilents
- accounts receivable
- inventory
- financial assets
- prepaid expenses
- property, plant, and equipment
- investment in affiliates
- deferred tax assets
- intangible assets (patents etc.)
Liabilities (creditor claims on company’s resources)
- accounts payable and trade payables
- financial liabilities
- unearned revenue
- income taxes payable
- long-term debt
- deferred tax liabilities
Owners’ equity (owner’s residual claim on firms resources, assets less liabilities)
- capital (par value of common stock)
- additional paid-in capital (proceeds from common stock sales in excess of par value)
- retained earnings (net income not disributed as dividends)
- other comprehensive income
Revenue
- Sales
- gains (increases in assets)
- investment income
Expenses
- cost of goods sold
- sg&a (advertising, management salaries, rent, utilities)
- depreciation and amortization
- tax expense
- interest expense
- losses (decreases in assets)
Explain the accounting equation in its basic and expanded forms
Basic accounting equation is:
Assets = liabilities + owners equity
Expanded form:
Assets = liabilities + contributed capital + beginning retained earnings + revenue - expenses - dividends
Explain the process of recording business transactions using an accounting system based on the accounting equation
To keep in balance, must use double-entry accounting, in which a transaction has to be recorded in at least two accounts
ex.
- purchase equipment for $1000, decrease cash by $1000
Explain the need for accruals and other adjustments in preparing financial statements
Accrual accounting requires that revenue is recorded when the firm earns it and expenses are recorded as the firm incurs them, regardless of whether cash has actually been paid. 4 categories:
- Unearned revenue ex. cash for magazine subscription, cash increase, unearned revenue liability increase
- Accrued revenue a firm provides goods or services before it recieves cash, revenue increases, accounts recieveables (an asset) increases
- Prepaid expenses the firm pays cash ahead of time for an anticipated expense, cash decreases and prepaid expense (an asset) increases
- Accrued expenses the firm owes cash for expenses it has incurred, expenses increase and a liability for accrued expenses increases (i.e. wages)
The effect of accrual accounting is to recognize revenues or expenses in the appropriate period
Valuation adjustments are accounting entries that update asset values to reflect market value changes to historical values (gains or losses in other comprehensive income)
Explain the relationships among the income statement, balance sheet, statement of cash flows, and statement of owners’ equity
The balance sheet shows a company’s financial position at a point in time
Changes in the balance sheet accounts during an accounting period are reflected in the income statement, cashflow statement, and the statement of owners’ equity
Link between income statement and balance sheet is retained earnings (net income less dividends paid)
Link between cashflow statement and balance sheet is total cash flow and cash
Link between owners equity and the balance sheet is retained earnings and contributed capital
Describe the flow of information in an accounting system
4 steps:
- journal entries, list of all journal entries is called the general journal
- general ledger sorts the entries in the general journal by account
- initial trial balance is prepared at the end of the accounting period. This shows the balances of each account. Adjustments are reflected in the adjusted trial balance
- The account balances from the adjusted trial balance are presented in the financial statements
Explain the use of results of the accounting process in security analysis
Since financail reporting requires choices of method, judgement, and estimates, an analyst must understand the accounting process used to produce the financial statements in order to understand the business and the results for the period.
Analysts should be alert to the use of accruals, changes in valuations, and other notable changes that may indicate management judgement is incorrect or, worse, that the financial statements have been deliverately manipulated.
Describe the objective of financial statements and the importance of financial reporting standards in security analysis and valuation
The objectives of financial statements is to provide economic decision makers with useful information about a firm’s financial performance and changes in financial position
Reporting standards are designed to ensure that different firms’ statements are comparable to one another and to narrow the range of reasonable estimates on which financial statements are based. The aids users of the financial statements who rely on them for information about the company’s activities, profitability, and creditworthiness
Describe the 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 Oranization of Securities Commissions
Standard-setting bodies are professional organization of accountants and auditors that establish financial reporting standards
Regulatory authorities are government agencies that have the legal authority to enforce compliance with financial reporting standards (SEC in US and FSA in UK IOSCO international)
2 primary standard-setting bodies are the FASB and the IASB. FASB and GAAP is US and IASB and IFRS is international.
Desirable attributes of standard-setters:
- observe high professional standards
- have adequate authority, resources, and competencies to accomplish its mission
- have clear and consistent standard-setting processes
- guided by a well-articulated framework
- operate independently while still seeking input from stakeholders
- should not be compromised by special interests
- decisions are made in the public interest
