CMA2/Unit1: Basic Financial Statement Analysis Flashcards
Financial Statements Components
The basic financial statements consist of the following:
- Statement of financial position (“balance sheet”)
- Statement of earnings (“income statement”)
- Statement of cash flows
- Statement of Comprehensive Income
- Statement of changes in shareholders’ equity (“statement of retained earnings”)
>> Disclosures and Notes to the Accounts are integral part of Financial Statements.
Users of Financial Statements
Users of financial statements may directly or indirectly have an economic interest in a specific business. Users with direct interests usually invest in or manage the business, and users with indirect interests advise, influence, or represent users with direct interests.
- *a. Users with direct interests include:**
1) Investors or potential investors
2) Suppliers and creditors
3) Employees
4) Management - *b. Users having indirect interests include:**
1) Financial advisers and analysts
2) Stock markets or exchanges
3) Regulatory authorities
The users of financial statements also may be grouped by their relation to the business.
- *a. Internal users** use financial statements to make decisions affecting the operations of the business. These users include management, employees, and the board of directors.
1) Management needs financial statements to assess financial strengths and deficiencies, to evaluate performance results and past decisions, and to plan for future financial goals and steps toward accomplishing them.
2) Employees want financial information to negotiate wages and fringe benefits based on the increased productivity and value they provide to a profitable firm. - *b. External users** use financial statements to determine whether doing business with the firm will be beneficial.
1) Investors need information to decide whether to increase, decrease, or obtain an investment in a firm.
2) Creditors need information to determine whether to extend credit and under what terms.
3) Financial advisers and analysts need financial statements to help investors evaluate particular investments.
4) Stock exchanges need financial statements to evaluate whether to accept a firm’s stock for listing or whether to suspend the stock’s trading.
5) Regulatory agencies may need financial statements to evaluate the firm’s conformity with regulations and to determine price levels in regulated industries.
Limitations of Financial Statements
The limitations of the various financial statements include the following:
a. The balance sheet shows a company’s financial position at a single point in time; accounts may vary significantly a few days before or after the publication of the balance sheet. Also, many balance sheet items, such as fixed assets, are valued at historical costs, which may bear no resemblance to the current value of those items. Even those assets reported at their current fair values may not always faithfully represent what a company could sell those items for on an open market. Also, contingent liabilities are not always shown on the balance sheet; in some cases, liabilities may arise that were not expected.
b. The income statement does not always show all items of income and expense. For example, some items of “other comprehensive income,” such as foreign exchange translation adjustments, are not reported in the calculation of net income. Instead, these items are reported on a statement of Other Comprehensive Income, which is usually effectively hidden on the statement of shareholders’ equity.
c. The limitation of the statement of cash flows is that there is not always common agreement on what is an operating flow and an investment or financing flow. In addition, some analysts complain that the option to use the indirect method of reporting cash flows (which is used by approximately 97% of reporting companies) instead of the direct method may be hiding important information.
d. The statement of changes in shareholders’ equity (or retained earnings statement) is rather straightforward, but many investors ignore this statement. Thus, the biggest limitation is user ignorance. Since the statement of shareholders’ equity typically includes items of other comprehensive income, it is important that users examine the statement closely.
Balance Sheet
(Statement of Financial Position)
According to the Financial Accounting Standards Board’s (FASB’s) Conceptual Framework, the statement of financial position (balance sheet) “provides information about an entity’s assets, liabilities, and equity and their relationships to each other at a moment in time.” It helps users to assess “the entity’s liquidity, financial flexibility, profitability, and risk.”
a. The elements of the balance sheet make up a detailed presentation of the basic accounting equation for a business enterprise:
Assets = Liabilities + Equity
1) The left side of the equation depicts the enterprise’s resource structure. The right side depicts the financing structure.
2) Balance sheet accounts are real (permanent) accounts. Their balances carry over from one period to the next.
3) The equation is based on the proprietary theory. The owners’ equity in an enterprise (residual interest) is what remains after the economic obligations of the enterprise are subtracted from its economic resources.
b. The format of the balance sheet is not standardized, and any method that promotes full disclosure and understandability is acceptable.
1) The account (or horizontal) form presents the resource structure on the left and the financing structure on the right.
2) The report (or vertical) form is also commonly used. It differs from the account form only in that liabilities and equity are below rather than beside assets.
Limitations of the Balance Sheet
A balance sheet reports a company’s financial position, but it does not report the company’s value. Reasons for this include:
1) Many assets are not reported on the balance sheet, even though they do have value and will gener-ate future cash flows. Examples of these include the company’s employees, or its human resources, its processes and procedures, and its competitive advantages.
2) Values of certain assets are measured at historical cost, not market value, replacement cost, or their value to the firm. For example, property, plant and equipment are reported on the balance sheet at their historical cost minus accumulated depreciation, although the assets’ value in use may be signif-icantly greater.
3) Judgments and estimates are used in determining many of the items reported in the balance sheet. For example, estimates of the amount of receivables the company will collect are used to value the accounts receivable; the expected useful life of fixed assets is used to determine the amount of de-preciation; and the company’s liability for future warranty claims is estimated by projecting the number and the cost of the future claims.
4) Most liabilities are valued at the present value of cash flows at the date the liability was incurred, not at the present value of cash flows at the current market interest rate. If market interest rates in-crease, a liability that carries a fixed interest rate that is below market increases in its value to the company. If market rates decrease, a liability that is payable at a fixed rate that is higher than the market interest rate sustains a loss in value. Neither of these changes in values is recognized.
Fair value is increasingly being used to measure items presented on the balance sheet. Furthermore, many items such as derivatives that previously were not reported on the balance sheet at all are now being reported at fair value. This has improved the balance sheet’s ability to report the firm’s value.
Definition of Asset & Liability
- *An asset is something that:**
1) Arose from a past transaction,
2) Is presently owned by the company, and
3) Will provide future benefit to the company - *A liability is something that:**
1) Arose from a past transaction,
2) Is presently owed by the company, and
3) Will lead to a future economic outflow from the company
In the balance sheet, assets and liabilities are classified as either current or noncurrent. The distinction between current and noncurrent is based upon the time frame in which the asset or liability is expected to be settled (for liabilities) or converted into cash (for assets).
Note: The operating cycle is average time between the acquisition of resources (or inventory) and the final receipt of cash from their sale.
Current Assets
Current assets consist of “cash and other assets or resources commonly identified as reasonably expected to be realized in cash or sold or consumed during the normal operating cycle of the business.”
The operating cycle is the average time between the acquisition of resources and the final receipt of cash from their sale.
If the operating cycle is less than a year, 1 year is the basis for defining current and noncurrent assets.
Further, current assets are those that will be converted into cash or sold or consumed within 12 months or within one operating cycle if the operating cycle is longer than 12 months. This means that an asset that will be converted in 18 months may be classified as a current asset, but all assets that will be converted in less than 12 months will always be classified as current assets.
Current assets are usually presented in descending order of liquidity.
Non-current Assets
Noncurrent assets are those assets that will not be converted into cash within one year, or during the operating cycle if the operating cycle is longer than one year.
Non-current assets are usually presented in an order determined by convention rather than by liquidity.
1) Long-term investments and funds
2) Property, plant, and equipment (PPE) consist of tangible items used in operations. PPE are recorded at cost and are shown net of accumulated depreciation if depreciable.
3) Intangible assets are defined as nonfinancial assets without physical substance. Examples are patents, copyrights, trademarks, trade names, franchises, and purchased goodwill.
4) Other noncurrent assets include noncurrent assets not readily classifiable elsewhere.
5) Deferred charges (long-term prepayments) appears on some balance sheets. Many of these items, for example, bond issue costs and rearrangement costs, which involve long-term prepayments, are frequently classified as other assets.
Current Liabilities
Current liabilities are those liabilities that will be settled within one year, or during the operating cycle if it is longer than one year.
Current liabilities are obligations whose liquidation will require either the use of current assets or the creation of other current liabilities to be settled.
Their order of presentation is usually governed by nearness to maturity.
*Unearned revenues represent cash received in advance of the delivery of goods (such as subscriptions) or performance of services (such as a legal retainer fee).
Current maturities of long-term debt are that portion of long-term debt (e.g., bonds issued) that must be retired using current assets.
Because current liabilities require the use of current assets or the creation of other current liabilities, they do not include:
a) Short-term obligations intended to be refinanced on a long-term basis when the ability to consummate the refinancing has been demonstrated. i) This ability is demonstrated by a post-balance-sheet-date issuance of long-term debt or by entering into a financing agreement that meets certain criteria.
b) Debts to be paid from funds accumulated in accounts classified as noncurrent assets. i) Hence, a liability for bonds payable in the next period will not be classified as current if payment is to be from a noncurrent fund.
Non-current Liabilities
Noncurrent liabilities are those that will not be settled within one year, or the operating cycle if the operating cycle is longer than one year.
Examples of noncurrent liabilities are:
• Long-term notes or bonds payable,
• Liabilities from capital leases,
• Pension obligations,
• Deferred tax liabilities,
• Obligations under warranty agreements,
• Advances for long-term commitments to provide goods and services, and
• Long-term deferred revenue.
Owners’ Equity
Owners’ Equity:
This is the remaining balance of assets after the subtraction of all liabilities. This is the amount of the company’s assets owned by and owed to the owners. If the company were to liquidate, this is the amount that would theoretically be distributable to the owners.
Owners’ equity is split into three different categories.
1) Capital contributed by owners from the sale of shares,
2) Retained earnings - profits of the company that have not been distributed through dividends, and
3) Accumulated other comprehensive income items - specific items that are not included in the income statement but are included in equity and do adjust the balance of equity, even though they do not flow to equity by means of the income statement as retained earnings do.
Note: When a corporation repurchases shares of its own stock from the market, these shares are called treasury shares. Treasury shares purchased reduce owners’ equity, because those shares are no longer outstanding.
Disclosures & Footnotes
The first footnote accompanying any set of complete financial statements is generally one describing significant accounting policies, such as the use of estimates and rules for revenue recognition.
Footnote disclosures and schedules specifically related to the balance sheet include 1) Investment securities 2) Property, plant, and equipment holdings 3) Maturity patterns of bond issues 4) Significant uncertainties, such as pending litigation 5) Details of capital stock issues
Income Statement
(Statement of Earnings)
The results of operations are reported in the income statement (statement of earnings) on the accrual basis using an approach oriented to historical transactions.
a. The traditional income statement reports the results of activities during a period of time.
b. Revenue and expense accounts are nominal (temporary) accounts. They are zeroed out (closed) periodically and their balances transferred to real (permanent) accounts on the balance sheet.
1) Revenues and expenses stem from a firm’s central and ongoing operations.
2) Gains and losses report the results of peripheral or incidental transactions.
All transactions affecting the net change in equity during the period are included except 1) Transactions with owners 2) Prior-period adjustments 3) Items reported initially in other comprehensive income 4) Transfers to and from appropriated retained earnings 5) Adjustments made in a quasi-reorganization
Definition of:
Revenue & Expenses
and
Gains & Losses
Revenues are inflows of assets or a reduction of liabilities as a result of delivering goods or providing services that are the entity’s main or central operations.
Revenues are usually recognized when the earnings process (the provision of goods or services to the customer) is complete and an exchange has taken place. The exchange does not need to include cash, but may include a promise to pay in the future (a receivable).
Additionally, revenue may also be recognized under the following methods in the right circumstances:
• Percentage-of-completion – for long-term contracts,
• Production basis – for agricultural products and precious metals,
• Installment basis – used when we are not certain of the collectability of the account, and
• Cost-recovery basis – used when we are unable to measure the certainty of collectability.
Expenses are outflows of assets or the incurrence of liabilities as a result of delivering goods or providing services that are the entity’s main or central operations.
Expenses are recognized based upon one of the following three methods:
• Cause and effect – cost of goods sold are recognized when the item is sold,
• Systematic and rational allocation – such as depreciation, and
• Immediate recognition – if an expense will not provide future benefit, it is immediately recognized.
Gains are increases in equity as a result of transactions that are not part of the company’s main or central operations and that do not result from revenues or investments by the owners of the entity.
Losses are decreases in equity as a result of transactions that are not part of the company’s main or central operations and that do not result from expenses or distributions made to owners of the entity.
Gains and losses can be classified as either operating or non-operating, depending on the events they are related to.
3 Income Statement Formats
Three formats are commonly used for presentation of income or loss from continuing operations:
- single-step income statement
- multiple-step income statement
- condensed income statement
1. Single-step Income Statement Format
Single-step Income Statement provides one grouping for revenue items and one for expense items. The single step is the one subtraction necessary to arrive at net income.
Note: In addition to this information regarding Earnings per Share (EPS) must also be disclosed on the face of the income statement.
2. Multiple-step Income Statement Format
The multiple-step income statement matches operating revenues and expenses section separate from nonoperating items, enhancing disclosure by presenting intermediary totals rather than one net income figure.
The standard multiple-step income statement format includes the following sections:
Sales
− Cost of Goods Sold (COGS)
= Gross Profit
− Other Expenses and Losses
+ Other Revenues and Gains
= Pretax income from continuing operations
− Provision for income taxes from continuing operations
= Income from continuing operations
+/− Discontinued Operations (net of applicable taxes)
+/− Extraordinary Events (net of applicable taxes)
= Net Income
3. Condensed Income Statement Format
The condensed income statement includes only the section totals (not sub headings & details) of the multiple- step format.
Reporting Irregular Items
in Income Statement
Reporting irregular items:
When an enterprise reports discontinued operations or extraordinary items, these must be presented in a separate section after income from continuing operations.
a. Discontinued Operations are reported in two components:
1) Income or loss from operations of the division from the first day of the reporting period until the date of disposal
2) Gain or loss on the disposal of the divisions
b. Extraordinary Items must meet two criteria:
1) To be considered extraordinary, an item must be both unusual in nature and infrequent in occurrence in the environment in which the entity operates.
2) Write-downs of receivables and inventories, translation of foreign currency amounts, disposal of a segment, sale of productive assets, effects of strikes, and accruals on long-term contracts can never be considered extraordinary.
c. Because these items are reported after the presentation of income taxes, they must be shown net of tax.
d. Appropriate per share amounts must be disclosed, either on the face of the statement or in the accompanying notes.
