Volume 2/3 - Financial Statement Analysis Flashcards
Introduction to Financial Statement Analysis
describe the steps in the financial statement analysis framework
describe the roles of financial statement analysis
describe the importance of regulatory filings, financial statement notes and supplementary information, management’s commentary, and audit reports
describe implications for financial analysis of alternative financial reporting systems and the importance of monitoring developments in financial reporting standards
describe information sources that analysts use in financial statement analysis besides annual and interim financial reports
Financial Statement Analysis Framework :
1- Articulate the Purpose and Context of Analysis
Produce a statement of objectives for the analysis, including a list of questions to be answered. The context of the analysis must be defined – audience, end product, timeframe, and resource constraints.
2- Collect Data
Understand the company’s business, financial performance, and financial position.
3- Process Data
Appropriate analytical tools must be used. This could include calculating ratios, growth rates, regression analysis, and simulation. Make needed adjustments for comparisons, and prepare common-size financial data.
4- Analyze/Interpret the Processed Data
Interpret the results generated during the data processing stage, supporting recommendations and conclusions.
5- Develop and Communicate Conclusions and Recommendations
Produce a report that addresses all of the questions that were formulated during the initial stage of the process. All relevant factors that support the conclusions and recommendations should be communicated to the audience.
6- Follow-Up
A periodic review is needed to make sure the recommendation is still valid. (revisit others steps if new information becomes available )
Financial reporting provides information about a company’s financial performance (i.e., its ability to generate profits and cash flows) as well as its financial position (i.e., its assets and liabilities).
Use of F/s and other reports:
Evaluating assets to add to a portfolio
Security valuation
Assessing a company’s creditworthiness and determining appropriate lending terms
Issuing debt ratings
Informing private equity investment decisions
Evaluating proposed or prospective mergers
International Organization of Securities Commissions (IOSCO) :
The principles of securities regulation are based on the core objectives of 1) protecting investors, 2) ensuring markets are fair, efficient, and transparent, and 3) reducing systematic risk.
The principles of financial reporting are 1) full, accurate, and timely disclosure of financial results, and 2) high, internationally acceptable quality.
US Securities and Exchange Commission (SEC) is a member of IOSCO
Sarbanes-Oxley Act of 2002: This act created the Public Company Accounting Oversight Board, which addresses auditor independence and strengthens corporate responsibility for financial reports. Internal controls over financial reporting must also be reported.
Disclosures to file with SEC :
1- Securities Offerings Registration Statement: This relates to new securities offerings and is required by the 1933 Act.
2- Forms 10-K, 20-F, and 40-F: These forms must be filed annually, containing information about a company’s business, financial disclosures, and legal proceedings.
3- Annual Report: Most companies provide an annual report to shareholders, but it is not required by the SEC. It is usually a user-friendly report.
4- Proxy Statement / Form DEF-14A: Shareholders must be sent a proxy statement prior to a shareholder meeting. A proxy form allows a shareholder to transfer their right to vote.
(can have additional information : management compensation or potential conflicts of interest in their annual reports or proxy statements )
5- Forms 10-Q and 6-K: These interim (quarterly or semi-annual) reports are unaudited.
6- Form 8-K: This must be filed for major events such as acquisitions and matters related to accounting and financial statements.
7- Form 144: This form is a notice for the sale of restricted security relying on Rule 144.
8- Forms 3, 4, and 5: These forms report the beneficial ownership of securities.
9- Form 11-K: This is the annual report for employee stock purchases and similar plans.
Each member of the European Union (EU) regulates its own capital markets. There is a balance between member state autonomy and the need for co-operation.
If all separately reported segments cumulatively account for less than 75 percent of total revenues, the company must continue to identify additional reportable segments until this threshold is reached.
Management Commentary or Management’s Discussion and Analysis :
Important but often unaudited
The International Accounting Standards Board (IASB) recommends the following five elements be included:
- Nature of business
- Management’s objectives and strategies
- Company’s significant resources, risks, and relationships
- Results of operations
- Critical performance measures
The Securities and Exchange Commission (SEC) requires :
- Any favorable and unfavorable trends
- Information about effects of inflation, changing prices, or other material events
- Off-balance-sheet obligations and contractual commitments
- Critical accounting policies
Under the international standards for auditing (ISAs), the auditor’s objectives are:
1- Obtain reasonable assurance the financial statements are free from material misstatement and determine if statements are prepared according to the applicable financial reporting framework
2- Report the findings
The auditor cannot provide absolute assurance. Only reasonable assurance (high probability)
The opinion can be one of several forms.
1- Unqualified audit opinions state the financial statements give a true and fair view. This is referred to as a clean opinion.
2- Qualified audit opinions point out limitations or exceptions to the accounting standards.
3- Adverse audit opinions are issued when the statements materially depart from accounting standards.
4- A disclaimer of opinion occurs when the auditor is unable to issue an opinion.
Sarbanes-Oxley Act requires auditors to provide an additional opinion on the internal control systems that companies used to ensure that a sound process is used to prepare financial reports.
Companies may use new types of transactions as “window dressing” to obscure their true performance and financial position until financial standards are updated.
Company managers tend to be more rigorous about calculations of figures that appear in the main elements of their financial statements compared to the level of scrutiny that they give to items that appear in the accompanying notes.
Analysts should also use outside sources of information on peer companies, the industry, and the overall economy.
CFAI’s proposed model : Specific recommendations include the provision of more detailed information about the fair value of assets and liabilities and the use of the direct method of presenting the statement of cash flows.
Public third-party sources :
Industry whitepapers available freely online
Economic or industry indicators prepared by governments or private organizations
General news reports
Industry-specific publications
Social media as a gauge of consumer sentiment
Proprietary third-party sources
Reports from sell-side equity analysts and credit analysts
Data platforms (e.g., Bloomberg, FactSet)
Report from industry-focused consultancies
Proprietary primary research
Includes any surveys, studies, product tests, or comparisons that are commissioned and/or undertaken directly by the analyst.
New companies are least likely to result in changes to financial reporting standards
Analyzing Income Statements
describe general principles of revenue recognition, specific revenue recognition applications, and implications of revenue recognition choices for financial analysis
describe general principles of expense recognition, specific expense recognition applications, implications of expense recognition choices for financial analysis and contrast costs that are capitalized versus those that are expensed in the period in which they are incurred
describe the financial reporting treatment and analysis of non-recurring items (including discontinued operations, unusual or infrequent items) and changes in accounting policies
describe how earnings per share is calculated and calculate and interpret a company’s basic and diluted earnings per share for companies with simple and complex capital structures including those with antidilutive securities
evaluate a company’s financial performance using common-size income statements and financial ratios based on the income statement
One of the basic principles of accounting is that revenue must only be recognized when it is earned, which is often not the same time (or accounting period) that cash is received.
If goods or services are sold on credit, revenue is recognized on the income statement, and an account receivable is created on the balance sheet. Cash that is received as payment before the good or service is delivered goes on the balance sheet as an unearned revenue liability that is reversed when the associated revenue is earned and recognized (Ex: subscription fee in advance).
The new standards are based on the core principle that companies should recognize revenue according to what they expect to collect in exchange for delivering goods and services. This principle calls for a multi-step revenue recognition process:
1- Identify the contract with a customer.
2- Identify the rights and obligations specified in the contract.
3- Determine the transaction price.
4- Allocate the transaction price to each performance obligation.
5- Recognize the revenue when/as performance obligations are met.
Standars for both IFRS and US GAAP
A contract only exists if it is probable that payment will be collected. –> US GAAP defines probable as “likely to occur,” while IFRS interprets this term to mean “more likely than not.”
IFRS 15 ; revenue is recognized when control of an asset has been transferred to the customer :
- The customer has physical possession of the asset
- The customer accepts that the asset meets the terms of the contract
- Legal title of the asset belongs to the customer
- The seller has met all contractual obligations and is entitled to payment
- The “significant risks and rewards” of owning the asset belong to the customer