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FRA Flashcards

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1
Q

Financial reporting

A

refers to the way companies show their financial performance to investors, creditors, and other interested parties by preparing and presenting financial statements.

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2
Q

Role of financial statement analysis

A

use the information in a company’s financial statements, along with other relevant information, to make economic decisions.

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3
Q

Financial statement notes (footnotes)

A

include disclosures that provide further details about the information summarized in the financial statements.
* Basis of presentation
* Accounting methods and assumptions
* Further information on amounts in primary statements
* Acquisitions/disposals
* Contingencies
* Legal proceedings
* Stock options, benefit plans
* Significant customers
* Segment data
* Quarterly data
* Related-party transactions

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4
Q

Management’s commentary

A
  • Nature of the business
  • Results from operations, business overview
  • Trends in sales and expenditure
  • Capital resources and liquidity
  • Cashflow trends
  • Discussion of critical accounting choices
  • Effects of inflation, price changes, uncertainties on future results
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5
Q

Audit

A

independent review of company’s financial statements
Reasonable assurance that financial statements are free of material errors
Under US GAAP, must provide opinion on company’s internal controls

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6
Q

Ranking of Audit opinion

A
  1. Unqualified – “unmodified” or “clean” opinion
  2. Qualified – exceptions to accounting principles
  3. Adverse – statements not presented fairly
  4. Disclaimer of opinion – unable to form an opinion
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7
Q

Standard auditor’s opinion includes

A
  1. Responsibilities of management to prepare accounts – independence of auditors
  2. Properly prepared accordance with relevant GAAP – reasonable assurance that the statements are free from material misstatement
  3. Accounting principles and estimates chosen are reasonable
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8
Q

Supplementary sources of financial information

A
  • Quarterly, semi-annual reports – updates of major financial statements and footnotes; SEC filings
  • Proxy statements – issued when shareholder vote is required; contain information on board elections, management compensation, stock options
  • Corporate reports, press releases – written by management
  • Economic, industry data from trade journals, reporting services, government agencies
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9
Q

steps in the financial statement analysis framework

A
  1. Purpose and context of analysis
  2. Collect data
  3. Process data
  4. Analyse/interpret data
  5. Conclusions and recommendations
  6. Update analysis periodically
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10
Q

Objective of financial reporting

A

provide financial information about the reporting entity that is useful to existing and potential investors, lenders, and other creditors in making decisions about providing resources to the entity – IASB Conceptual framework (relevance and timely)

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11
Q

Standard setting bodies:

A
  • Financial Accounting standards board (FASB) U.S.
  • International accounting standard board (IASB) most other countries
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12
Q

Financial reporting requirements and regulation:

A
  • Securities exchange commission (SEC)
  • International Organization of securities commission (IOSCO)
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13
Q

SEC Fillings/forms

A
  • S1 – registration of securities for public sale
  • 10K – annual report
  • 10Q – quarterly reports
  • DEF 14A – proxy statements
  • 8K – material event
  • Form 144 – Issuance of unregistered stock
  • Forms 3,4, &5 – share transactions with corporate insiders
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14
Q

IFRS conceptual framework, two qualitative characteristics

A
  1. Relevance
  2. Faithful representation
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15
Q

Characteristics that enhance relevance and faithful representation

A
  • Comparability
  • Verifiability
  • Timeliness
  • Understandability
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16
Q

IFRS required reporting elements

A
  • Balance sheet (statement of financial position).
  • Statement of comprehensive income.
  • Cash flow statement.
  • Statement of changes in owners’ equity.
  • Explanatory notes, including a summary of accounting policies.
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17
Q

Differences remain between US GAAP and IFRS

A

treatment of development costs, use of LIFO for inventory, reversal of inventory write downs

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18
Q

Types of income statement

A

single step (operating expense), multi-step (split out COGS and SGA)

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19
Q

Revenue Recognition Standards – five step model:

A
  1. Identify contracts with customers
  2. Identify performance obligations in contracts
  3. Determine transaction price
  4. Allocate transaction price to performance obligations
  5. Recognise revenue when/as performance obligations are satisfied
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20
Q

Revenue Recognition standards

A
  • Input percentage (% of total estimated costs incurred to date)
  • Output percentage (units produced or milestones achieved)
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21
Q

Agent vs principal revenue recognition

A

There is a distinction between acting as an agent (revenue) vs acting as a principal (revenue + expenses)

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22
Q

Expense recognition:

A
  • Accrual basis – matching principle – match costs against associated revenues. For example, inventory, depreciation/amortization, warranty expense, doubtful debt expense
  • Period expenses – expenditures that less directly match the timing of revenues. For example, admin costs.
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23
Q

Double declining depreciation (DDB) formula

A

= (2/useful life)(cost – accumulated depreciation)

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24
Q

Bad debt expense and warranty expense recognition

A

must estimate bad debts expense/warranty expense. Firm recognises this expense in period of sale rather than later period

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25
Q

Discontinued operations

A

operations that management has decided to dispose of but (1) has not done so yet or (2) did so in current year after it generated profit or loss. Reported net of taxes after net income from continuing operations (below the line). Assets, operations, and financing activities must be physically and operationally distinct from firm

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26
Q

Accounting changes and finacial reporting

A

change in accounting policy (e.g., revenue recognition method) requires retrospective application; adjust any prior year’s financials included in the current statement

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27
Q

changes in accounting estimates impact of financial reporting

A

treated prospectively and does not require restatement of prior-period earnings.

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28
Q

Prior period adjustments

A

correcting errors or changing from an incorrect accounting method to an acceptable one. Typically require retrospective application. Restate prior years principal financial statements. Must disclose the nature of the error and its effect on net income.

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29
Q

Non-operating items

A

financial services can include (interest, dividends, gains/losses as operating). Non-financial cannot treat the three categories as operating.

30
Q

Comprehensive income includes:

A
  1. Foreign currency translation gains and losses.
  2. Adjustments for minimum pension liability.
  3. Unrealized gains and losses from cash flow hedging derivatives.
  4. Unrealized gains and losses from available-for-sale securities.
31
Q

US GAAP classifications for securities and treatment in OCI vs IS

A
  • Trading securities (IFRS = fair value through profit or loss) = income statement
  • Held to maturity (IFRS = amortized cost) = not reported in either statement
  • Available for sale securities (IFRS = fair value) = OCI
32
Q

Types of balance sheet presentation

A

Report format – assets, liabilities, and equity in a single column
Account format – assets on left, liabilities, and equity on the right
Classified balance sheet – grouping of accounts into sub-categories (e.g. current vs non-current)
Liquidity-based presentation – financial institutions

33
Q

How are current assets recorded in the balance sheet

A
  • Cash and cash equivalents – amortized cost or fair value
  • Marketable securities – amortized cost or fair value
  • Accounts receivable /trade receivables – Net realizable value
  • Inventories – (standardised cost, FIFO, LIFO, average cost)
  • Prepaid expenses – operating costs paid in advance (carried at cost)
34
Q

Net Realisable Value

A

selling price – cost of completion – selling costs

35
Q

Inventory is recorded on balance sheet as

A

Lower of cost or net realizable value (NRV) - costs includes all standard costs of bringing the inventory to its current location and condition.

36
Q

Balance sheet (book) values are:

A
  • Historical cost less accumulated depreciation or depletion, unless asset values are impaired (US GAAP & IFRS)
  • Fair value less any accumulated depreciation (IFRS)
37
Q

Goodwill analysis

A

When doing analysis - Remove goodwill from assets
* Remove any impairment from income statement
* Evaluate business acquisitions considering purchase price, net assets, earnings prospects

38
Q
  • IFRS – securities measured at amortized cost
  • US GAAP - held to maturity securities
A

Debt securities company intends to hold to maturity, loans/notes receivable, unlisted equity securities if fair value cannot be determined. Interest income and realised gains/(losses) on disposal reported on income statement.

39
Q
  • IFRS – securities measured at fair value through OCI
  • US GAAP – available for sale securities
A

Debt securities acquired with intent to collect interest payments but sell prior to maturity. Fair (market) value on balance sheet, changes in value to OCI, interest income and realized gain/(losses) on disposal on income statement

40
Q
  • IFRS – securities measured at fair value through profit and loss
  • US GAAP – trading securities
A

Debt securities that will be sold in near term, equity securities, derivatives. Fair value on balance sheet. Dividend income and realised and unrealised gains/losses to income statement

41
Q

Components of owner equity:

A
  • Capital contributed by owners (issued and authorised)
  • Preferred stock (irredeemable)
  • Treasury stock (reduces equity)
  • Retained earnings
  • Noncontrolling (minority) interest
  • Accumulated other comprehensive income
42
Q

Liquidity ratios:

A

Current ratio = current assets / current liabilities
Quick ratio = (current assets – inventory) / current liabilities
Cash ratio = (cash + marketable securities) / current liabilities

43
Q

Direct method

A

identify actual cash inflows and outflows (e.g. collections from customers, amounts paid to suppliers)

44
Q

Indirect method

A

begin with net income and make necessary adjustments to get operating cash flow

45
Q

Converting balance sheet items to cash

A

asset outflow = increase
asset inflow = decrease
liability/equity inflow = increase
liability/equity outflow = decrease

46
Q

Common size cashflow statements are shown as a percentage of

A

net revenue or (inflows as a percentage of total inflows and outflows as a percentage of total outflows)

47
Q

Free Cash Flow Firm (FCFF)

A

= NI + NCC + [Int × (1 − tax rate)] − FCInv − WCInv
or
= CFO + [Int × (1 − tax rate)] − FCInv

NI = net income
NCC = noncash charges (depreciation and amortization)
Int = cash interest paid
FCInv = fixed capital investment (net capital expenditures)
WCInv = working capital investment

48
Q

Free Cash Flow Equity (FCFE)

A

= CFO − FCInv + net borrowing

where:

CFO = cash flow from operations

FCInv = fixed capital investment (net capital expenditures)

net borrowing = debt issued – debt repaid

49
Q

Reinvestment ratio

A

= CFO / cash paid for long-term assets

50
Q

Interest coverage ratio

A

= CFO + interest + tax / interest paid (IFRS if interest treated as CFF no addition required)

51
Q

Limitations of Financial ratios:

A
  • Not useful in isolation – only valid when compared to other firms or other historical performance
  • Different accounting treatments – particularly when analysing non US firms
  • Finding comparable industry ratios – for companies that operate in multiple industries
  • Relativity – all rations must be viewed as relative to one another
  • Range of acceptable values – needs to be determined for target of comparison purposes
52
Q

ROE (DuPont) (NI/Equity)

A

= (NI/Rev) x (Rev/Assets) x (Assets/Equity)

53
Q

ROE (DuPont 5-Way) (NI/Equity)

A

= (NI/EBT) x (EBT/EBIT) x (EBIT/Rev) x (Rev/Assets) x (Assets/Equity)
= (Tax burden) x (interest burden) x (EBIT margin) x (asset turnover) x (financial leverage)

54
Q

ending inventory formula

A

= Beginning inventory + purchases – COGS

55
Q

Types of analysis to forecast earnings.

A

Sensitivity analysis, scenario analysis, simulation

56
Q

Product costs

A

are capitalised as inventory
* Purchase cost less discounts and rebates
* Conversion costs including labor and overhead
* Other costs necessary to bring the inventory to its present location

57
Q

Period costs

A

are expensed when incurred
* Abnormal waste
* Storage costs (unless a required production cost)
* Selling and admin costs

58
Q

LIFO to FIFO conversion formulas

A

Balance sheet:
FIFO inventory = LIFO inventory + LIFO reserve
FIFO Cash = LIFO Cash – (reserve x t)
FIFO Equity = LIFO Equity + (reserve x (1-t)
Income Statement:
FIFO COGS = LIFO COGS – change in reserve
FIFO taxes = LIFO taxes + (change in reserve x t)
FIFO net income = LIFO Net Income + (change in reserve x (1-t)

59
Q

Rising prices LIFO vs FIFO

A
  • LIFO inventory < FIFO inventory.
  • LIFO COGS > FIFO COGS.
  • LIFO net income < FIFO net income.
  • LIFO tax < FIFO tax.
    Profitability – FIFO better
    Liquidity – FIFO better
    Activity – LIFO better
    Solvency – FIFO better
60
Q

Inventory valuation (standard)

A

lower of costs and net realisable value. All costs of brining the inventory to its current location and condition. Excludes abnormal amounts, storage costs, admin overheads, selling costs.
* Reversal of write-downs allowed under IFRS but not under US GAAP.
* All IFRS firms and US GAAP except firms using LIFO or retail inventory cost methods

61
Q

Inventory valuation (US GAAP using LIFO or retail inventory)

A

Lower of cost or market value
Cost – same as IFRS
Market value – current replacement cost, subject to:
Upper limit = NRV, lower limit = NRV – normal profit margin
No reversal on write-downs under US GAAP

62
Q

Inventory valuation above cost

A

under IFRS and US GAAP, reporting inventory above cost is permitted in some industries, primarily producers and dealers of commodity-like products
* Reported on the balance sheet at net realizable value
* If active markets exists, quoted market price is used; otherwise, recent market transactions are used
* Unrealised gains/losses recognized in the income statement and affect inventory, assets, equity, net income and related ratios

63
Q

financial statement presentation of and disclosures relating to inventories

A
  • cost of sales
  • Valuation method and accounting policies used
  • Carrying value of total inventory, carrying values by appropriate classification
  • Carrying value of any inventory reported at fair value less selling costs
  • Any writedowns (or revesals) of inventory value
  • Carrying value of any inventory pledged as collateral
64
Q

Explain issues that analysts should consider when examining a company’s inventory disclosures and other sources of information

A

Condition – increase in raw materials and work-in-progess, increase in finished good alone, finished goods growing faster than sales
Possible interpretation – expected increase in demand, decrease in demand, decrease in demand – may be result of excessive (costly) or obsolete inventory

65
Q

LIFO vs FIFO (Profitability, Liquidity, Activity, and Leverage)

A

Profitability – LIFO is a better measure of economic cost in the income statement (based on more recent prices that LIFO)
Liquidity – FIFO is a better measure of economic cost on the balance sheet (based on more recent prices than LIFO)
with increasing prices, FIFO results in higher inventory value than LIFO. Both assets and equity are greater than for LIFO, resulting in lower leverage ratios. Lower debt to assets ration and lower debt to equity ratio (higher denominators)

66
Q

Capitalising

A

spreading an asset’s cost over multiple periods, creating a balance sheet asset

67
Q

Expensing

A

taking an asset’s cost as an expense on the income statement in the current period

68
Q

Research and development costs

A
  • IFRS – research costs expensed, but development costs may be capitalised
  • US GAAP – research and development costs expensed
69
Q

Software developed for internal use:

A
  • IFRS – same as software developed for sale
  • US GAAP – capitalise all software developments costs
70
Q

evaluate how capitalising versus expensing costs in the period in which they are incurred affects financial statements and ratios

A

Net income – capitalising increases NI in the first period and reduces it over the following
Shareholders equity – capitalising increases NI -> increases retained earning & increases assets on balance sheet (reverse over time)
Cashflow statement – capitalising expenditure will increase operating cashflow and lower investing cash flow (depreciation won’t impact cashflows going forward)

CFA Level 1 (9 decks)

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