CFA level 1 study note book3 2014

BOOK 3 - FINANCIAL REpORTING AND ANALYSISStudy Session 7 - Financial Rcponi.og and Analysis: An Inuoduction 10 Study Session 8 - Financial Rcponi.og and Analysis: Income Statements, Bala

Levell I Book 3

SchweserNotes'" for the CFA· Exam

BOOK 3 - FINANCIAL REpORTING AND ANALYSIS

Study Session 7 - Financial Rcponi.og and Analysis: An Inuoduction 10

Study Session 8 - Financial Rcponi.og and Analysis:

Income Statements, Balance Sheets, and Cash Flow Statcmcnts 47

Study Session 9 - Financial Rcponi.og and Analysis:

Inventories, Long-lived Assets Income Taxes and Non-current Liabilities 182

Study Session 10 - Financial Reporting and Analysis:

Evaluating Financial Reporting Quality and Other Applications 291Sdf-Test - Financial Reponing and Analysi • 322

Index • • • 334

SCHWESERNOTES"" 2014 CFA LEVEL I BOOK 3: FINANCIAL REPORTINGAND ANALYSIS

C2013 Kaplan, Inc All rights reserved

Published in 2013 by Kaplan Sehweser

Printed in ehe United States of America

ISBN: 97B-I-42n-4907-9/1-4277-4907-B

PPN: 3200-400B

I( chi book d not h the hololVan> wilh <h<Kaplan xhw_r logo on the bKk cov<r it was

diJuibuttd witbolU pcnnission of Kaplan Schwcscr, a Dj,-isioR of Kaplan, lnc., &net i.sin direct "(oi.arian

.(,Iobal copyright law• Your i.un« in~punuing pc>t<ntial ,;olaton of chi, Ia • is "",.dy_'ppr«ialod.

~uin:d CFA Institut< di.claim<" "<:FA" and Chan<n:d Financial Analy,,'" an: uacl<mub own.d by

CFA Institu.te CFA hutitutc (fonnerly the Associ.ation for ID't"Cltmcnt Manascnxnt od Rtsnlt'h) don

not C'ndonc promote review or wat1"Ult the aC'aaracyof chc producu 01 KMcC' offered by Kaplu Scinw,cr,"

urtain material, contained within this tat arc the copyrigbt~ propnty or CFA Institute The

followine i the copyrit;ht ditclo.un: for the •• mat«ial" ·Cop~it;hl 2013 <:FA Inllillll< Rcproclue<d and n:publi.hod from 2014 kuning Oul<Om< Statements 11.11 and III quntioa from CFA" Prognm Materials CFA Institule Staaduds of Pror.uional Conduet and CFA I.stitu ••• Clobal

InW'ltmcnt Performance Standard with p«mission (rom CfA Institute All Rights RcK'tWd," Thnc matcfWs mar not be copied without l\'-rmcn permission From the author The un.aathoriud

dupli<ation ef chese nol< i a ,;ol,tion of alobal <opyrisl" laws and th< CFA Inltitat< Code of Echi

YoW' usi.WlCC' in pUlsuinc potential Yiolaton of this law is IftadT appreciated.

Disdaimer: The SchWC'SCr Note •• hould be used in conjunction with the origin.al rradinp as set forth

by <:FA In.titut< in <heir 2014 <:FA Leee 11 SllIdy Cuide The information <ontai ee 4 in chese No

ccn"Cn topics contained in tbe radings referenced by CFA Institutc and i believed to be accurate Howt'\"Cr, meir aCC\lracy c.annol be &uarantn:d nor is anT warranty conwycd u to ),our ultimate exam

.\tee", The authon of the rcfelntced leadinp haft not endolsed or pon.Ofcci thcSC' Notn.

READING ASSIGNMENTS AND

LEARNING OUTCOME STATEMENTS

Tbe fDlu,wing m4Urill/ is II uui~w of tk Finan(ill/ Rrpartingllm/ Anlllysis prindpln

dtSign~d to ttdd,~ssth~ullrning outcom« stattmtnts Itt forth bJ CFA InstilJltt.

22 Financial Stat~m~nt Analysis: An Introduction

23 Financial Reponing Mechanics

24 Financial Reporting Standards

page 10pag~ 19

25 Understanding Income Stat~m~nts

26 Understanding Balance Sheets

27 Understanding Cash Flow Statements

28 Financial Analysis Techniques

pag~47

pag~86

page 109pag~ 142

page 230page 257

33 Financial Reporting Quality: Red Flags and Accounting Warning Signs page 291

34 Accounting Sh~nanigans on the Cash Flow Statement pag~ 302

020 13 Kaplan Inc

Book" - FiIW1cia1 Rtporting and Analysis

ReadingAssignmentSand lnrning Outcome StatementS

LEARNING OUTCOME STATEMENTS (LOS)

The fl'IDwing mill";,, isII "";tW of tht Finllnrill' RtJ>D,tinglind Anil/ytis p,;nripln tUsiptd to IIdJrNl tht Irllrning Ofltctlmt statement: Itt fl,th by CF-A Inuitut«

STUDY SESSION 7

The topicII' COllt11lgtcormpontis with tht fl'IDwing CF-A inrtitfltt /lSsiptd rtll"ing:

22 Financial Statement Analysis: An IntroductionThe candidate should be able to:

a describe the roles of financial reporting and financial statement analysis

d describe the objective of audits of financial statements, the types of auditreports, and the importance of effective internal controls (page 12)

e identify and describe information sources that analysts we in financial statementanalysis besid es annual financial statements and supplementary information.(page 13)

f describe the steps in the financial statement analysis framework (page 14)

The topiclI' COllt11lgtcorrtSpontis with tht fl'IDwing CF-A inrtitfltt IIssigntd ,,""ing:

23 Financial Reponing MechanicsThe candidate should be able to:

a explain the relationship of financial statement elements and accounts, andclassify accounts into the finaneial statement clements (page 19)

b explain the accounting equation in its basic and expanded forms (page 20)

c describe the process of recording business transactions using an accountingsystem based on the accounting equation (page 21)

d describe the need for accruals and other adjwtmenu in preparing financialstatements (page 22)

e describe the relationships among the income statement, balance sheet, statement

of cash Bows, and statement of owners' equiry (page 23)

f describe the Bow of information in an accounting system (page 25)

g describe the USeof the results of the accounting process in secwiry analysis.(page 25)

The topicII' COllt11lgtCO"tIPOntis with tht fl'IDwing CF-A inrtitfltt IISliptd ,,"ding:

24. Financial Reporting StandardsThe candidate should be able to:

a describe the objective of financial statements and the importance of financialreporting standards in securiry analysis and valuation (page 33)

02013 KapIan,IDe

Book3 - Financial Reponing and AnalysisReading Assignmenrs andLearning Outcome Statements

b describe roles and desirable attributes of financial reporting standard-setting

bodies and regulatory authoritic:.s in establishing and enforcing reporting

standards, and describe the role of the International Organization of Securities

Commissions (page 34)

c describe the status of global convergence of accounting standards and ongoing

barriers to developing one universally accepted set of financial reponing

standards (page 35)

d 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 (page 36)

e describe general requirements for financial statements under IFRS (page 38)

f compare key concepts of financial reponing standards under IFRS and

U.S GAAP reporting systems (page 39)

g identify characteristics of a coherent financial reporting framework and the

barriers to croting such a framework (page 39)

h describe implications for financial analysis of differing financial reporting

systems and the importance of monitoring developments in financial reporting

The topicill <DwrtlgecoTTtspontiswith tM flllDwing CFA Institutt IUsjgn~d "''''ing:

25 Undentanding Income Statements

The candidate should be able to:

a describe the components of the income statement and alternative presentation

formats of that statement (page 47)

b describe general principles of revenue recognition and accrual accounting,

specific revenue recognition applications (including accounting for

long-term contracts, installment sales, barter transactions, gro$Sand net reporting

of revenue), and implications of revenue recognition principles for financial

analysis (page49)

c calculate revenue given information that might in8uencc the choice of revenue

recognition method (page49)

d describe general principles of apense recognition, specific expense recognition

applications, and implications of expense recognition choices for financial

analysis (page 55)

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 (page 61)

f distinguish between the operating and non-operating components of the income

statement (page 63)

g describe how ornings per share is 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 (page 63)

h distinguish between dilutive and antidilutive securities, and describe the

implications of each for the earnings per share calculation (page 63)

i, convert income statements to common-si ze income statements (page 72)

02013 K2plan, Inc

Book" - FifWlcial Rqlorting and Analysis

ReadingAssignmentSand LearningOutcome StatementS

j evaluate a company's financial performance using common-size incomestatements and financial ratios based on the income statement (page 74)

k describe, calculate, and interpret comprehensive income (page74)

I describe other comprehensive income, and identify major types of itemsincluded in it (page 74)

The topicill tOIltTllgt to"tIPO"'" with tht following cr~Imtitute IIlIigntd rtllding:

26 Understanding Balance SheeuThe candidate should be able to:

a describe the dements of the balance sheet: assets, liabilities, and "'Iuity

(page 86)

b describe uses and limltations of the balance sheet in financial analysis (page 87)

c, describe alternative formaa of balance sheet presentation (page 87)

d distinguish bet een current and non-current assets, and current and non-currentliabilities (page 87)

e. describe different types of assets and liabilities and the measurement bases ofeach (page 88)

f describe the components of shareholders' equity, (page 96)

g analyze balance sheets and statements of changes in equity, (page 97)

h convert balance sheets to size balance sheets and interpret sitt balance sheets (page 98)

common-i calculate and interpret liquidity and solvency ratios (page 100)

The topicill tOlltrllgt (O"'IPO"'" with tht following cr~Imtituu IIJligntd WIding:

27 Understanding Cash Flow StatemenuThe candidate should be able to:

a compare cash Bows from operating, investing, and financing activities andclassify cash Bow items as relating to one of those three categories givcn adescription of the items (page 109)

b describe how non-cash investing and financing activities are reported (page 111)

c contrast cash Bow statements prepared under International FinancialReporting Standards (IFRS) and U.S generally accepted accounting principles(U.S GAAP) (page 111)

d distinguish bct een the direct and indirect methods of presenting cash fromoperating activities and describe arguments in favor of each method (page 112)

e describe how the cash Bow statement is linked to the income statement and thebalancc sheet (page 114)

f describe the sn:ps in the preparation of direct and indirect cash 110 statements,including ho cash Aows can be computed using income statement and balancesheet data (page 115)

g convert cash Aows from the indirect to direct method (page 121)

h analyze and interpret both reported and common-size cash Bow statements.(page 124)

i calculate and interpret free cash Bow to the firm, frcc cash flow to equity, andperformance and coverage cashBow ratios (page 126)

The topicill (OIltTllgt'"TTtJponds with tht following cr~Institute 'lSIigntd rtllding:

28 Financial Analysis TechniquesThe candidate should be able to:

a describe tools and techniques used in financial analysis, including their uses andlimitations, (page 142)

02013 Kaplan, Inc

Book 3 - Financial Reponing and AnalysisReading Assignmenrs and Learning Outcome Statemenrs

b classify calculate and interpret activity liquidity solvency profitabaity and

valuation ratios (page 148)

c describe relationships among rarios and evaluate a company wing ratio analysis

(page 157)

d demonstrate the application of DuPont analysis of return on equity, and

calculate and interpret effects of changes in its components (page 162)

e calculate and interpret ratios wed in equity analysis and credit analysis

(page 166)

f explain the requirements for segment reponing and calculate and interpret

segment ratios (page 170)

g describe how ratio analysis and other techniques canbe wed to model and

forecast earnings (page 171)

The topicill (()lImlge cOTrrsponaswith tM flllDwing CFA Instirut~ IlSsign~d'ruing:

29 In""Dtories

The candidate should be able to:

a distinguish betwccn costs included in inventories and coses recognized as

expenses in the period in which they arc incurred (page 183)

b describe different inventory valuation methods (cost formulas) (page 184)

c calculate cost of sales and ending inventory wing different inventory valuation

methods and explain the effect of the lnveneery valuation method choice on

gross profit (page 185)

d calculate and compare cost of sales gross profit and ending inventory wing

perpetual and periodic inventory systems (page 188)

e compare cost of sales ending inventory and gross profit using different

inventory valuation methods (page 190)

f describe the measurement of inventory at the lower of COst and net realisable

value (page 191)

g describe the financial statement presentation of and disclosures relating to

inventories (page 193)

h calculate and interpret ratios used to evaluate inventoty management (page 194)

The topicill (()1I"llge cormponas with tM flllDwing CFA Instiruu IlSsign~drtuing:

30 Long-Lived &sets

The candidate should be able to:

a distinguish between costs that arc capitali zed and costs that arcexpensed in the

period in which they arc incurred (page 204)

b compare the linancial reporting of the following rypcs of intangible assets:

purchased internally developed, acquired in a business combination (page 208)

c describe the different depreciation methods for properry plant and equipment

the effect of me choice of depreciation method on the linancial statements,

and the effccts of assumptions concerning useful life and residual value on

depreciation expense (page 211)

d calculate depreciation cxpense (page 211)

e describe the different amonization methods for intangible assets with linite lives,

the effect of the choice of amortization method on the financial statements

and the effects of assumptions concerning useful life and residual value on

amortization expense (page 216)

02013 Kaplan Inc

Book 3 - FilW1dal Rqloning and Analysis

ReadingAssignmentSand Inrning Outcome StatementS

f calculate amortization expense (page 217)

g describe the revaluation model (page 218)

h explain the imparment of property, plant, and equipment and intangible assets

a describe the differences between accounting profit and taxable income anddefine key term including deferred tax assets, deferred tax liabilities valuationallowance, taxes payable, and income tax expense (page 230)

b explain how deferred tax liabilities and assets arc created and the factors thatdetermine how a company's deferred tax liabilities and assea should be treatedfor the purposes of financial analysis (page 231)

c calculate the tax base of a company's assets and liabilities (page 232)

d calculate income tax expense, income taxes payable deferred tax assets, anddeferred tax liabilities, and calculate and interpret the adjustment to thefinancial statements relat ed to a change in the income tax rat e, (pag e 234)

e evaluate the impact of tax tate changes on a company's financial stat ements andratios (page 238)

f distinguish between tempotary and permancnt differences in pre-tax accountingincome and taxable income (page 239)

g describe the valuation allowance for deferred tax assea-when it is required andwhat impact it has on financial stat emenu (page 242)

h compar e a company's deferred tax it ems (page 243)

i analyze disclosures rdating to deferred tax items and th c efkctive tax rarereconciliation and explain how information included in these disclosures affects

a company's financial statements and financial ratios (page 245)

j identify the key provisions of and diffcrences between income tax accountingunder IFRS and U.S GMP (page 247)

The tDpical colltragr corrtsponds with the following Cr-A Instituu allign,d Trading:

32 Noo-Current (Long-Tenn) Liabilities

a determine the initial recognition, initial meuurement and subsequentmeasurement of bonds (page 258)

b describe the effective interest method and calculate interest ""Pense,amonisation of bond discounts/premiums and interest payments (page 259)

c explain the de recognition of debt (page 264)

d describe the role of debt covenants in protecting creditors (page 265)

e describe the financial statement presentation of and disclosures relating to debt.(page 266)

f explain the motivations for leasing assets inst d of purchasing them (page 266)

g distinguish between a 6nance lease and an opetating I se from the perspectives

of the lessor and the lessee (page 267)

Book 3 - Financial Reponing and AnalysisReading Assignmenrs and Ltarning Outcome StatemenlS

h determine the initial recegniricn, initial measurement, and subsequent

measurement of finance leases (page 268)

i compare the disclosures rdating to finance and operating leases (page 276)

k compare the presentation and disclosure of defined contribution and defined

benefit pension plans (page 276)

1. calculate and interpret leverage and coverage ratios (page 279)

1M topi,"1 ct1wftlge ,ormponds with tM flll#wing CFA Imtina« tlSsigntd rtding:

33 Financial Reporting Quality: Red Flags and Aceounting Warning Signs

a describe incentives that might induce a company's aecutives to manage reported

earnings financial positions and cash flows (page 291)

b describe activities that will result in a low quality of earnings (page 292)

c describe the three conditions that are generally present when fraud occurs

including the risk factors related to these eonditions (page 292)

d describe common accounting warning signs and methods for detecting each

(page 295)

1M topi,"1 ct1wftlge ,orrtsponds with tM flll#wing CFA Inttituu tlSsigntd rtding:

34 Accounting Shenanigans on the Casb Flow Statement

a describe reasons for investors to assess the quality of cash flow statements

(page 302)

b analyze and describe the following ways to manage or manipulate the cash

flow statement: stretching out payables financing of parables securitization of

receivables issuing stock options and using stock buybacks (page 302)

Tb« topi,"1 ,ol'''''gt (orrtsponds with tM flll#wing CFA Inttituu tlSsigntd rtding:

35 Financial Statement Analysis: Applications

a evaluate a company's past financial performance and explain how a company's

strategy is reflceted in past financial performance (page 309)

b forecast a company's future net income and cash flow (page 310)

c describe the role of financial statement analysis in assessing thc credit quality of

a potential debt investment (page 311)

d describe the use of financial statement analysis in screening for potential equity

investments (page 312)

c explain appropriate analyst adjustments to a company's financial statements to

facilitate comparison with another company (page 312)

02013 Kaplan, Inc

The following is • rnicw of h Financi&l~porti.g and Analyai principle d ig.ed '0addt tho

'carn.ine outcome u.temenc w, forth by CfA InstiNte. ni.topic il allO (oV'C'rcdin:

FINANCIAL STATEMENT ANALYSIS: AN INTRODUCTION

S.udy Se.sion 7

ExAM Focus

This introduction maybe useful to those who have no previous experience withfinancial statemcnts While the incomc statement balance sheet and statement ofcash Rows arc covered in detail in subsequent readings, candidates should pay specialattention here to the other sources of information for financial analysis The nature oftho audit rcport is important as is the information that is contained in the footnotes

to financial statements, proxy statements, Manag.m.nt's Discussion and Analysis, andthe supplementary schedules A useful framework enumerating the st.ps in financialstaeement analysis is presented

LOS 22.a: Describe the roles of financial reporting and financial statementanalysis

cr~®Prognzm CurrinilMm, Yolumt 3, pllgt 6

Financial rcpomng refers to the way compani es show their financial performance toinvestors, creditors, and other interested parties by prcparing and pr esenting financial

statements According to the IASB CDMtpt1ill1FTllmtWDTItflT Finllnrilll RtpDTting 2010:

"The objective of general purpose financial reponing is to provide financialinformation about the reporting entity that is useful to existing and potentialinvestors, lenders, and other creditors in making decisions about providingresourc es to the entity Those decisions involve buying, selling or holding equityand debt instruments, and providing or settling loans and other forms ofcredit."

The role of 6n""ciaI statement aDaIysis is to use tho information in a company'sfinancial statements, along with other rclcvant information, to make economic decisions.Examples of such dccisions includc whether to invest in thc company's securities

or recommend them to investors and whether to extend trade or bank crcdit to thocompany Analysts we financial statement data to evaluate a company's past performanccand current financial position in order to form opinions about the company's ability toearn profits and generate cash Row in the future

P",[tSSDTi Not«: This topic Ttvitw atilis with finllnciAlllnlllysis flT rxternel

users, Mllnagtment IlIsDptrfoTms finantiAl anlll,sis in millting ewry""

ateisiDns HDWtWT, mIlnagtmtnt mil, Ttly DIt internal financilll informlltiDR that is tilttly mllintllinta in II aijfrTtnt flTmllt IIna unalJllilabk tD oaernel UStri.

Study SeuioD 7

Cross-lUrt~nClO to CFA (u,titutt Asligned Rnding '22 - Fmaucial Stattmtnt Aoalysis: An Inuocluction

LOS 22.b: Describe the roles of the key financial statements (statement of

financial position, statement of comprehensive income, statement of changes in

equity, and statement of cash Bows) in evaluating a company's performance and

financial position

CFACIIProgrt1m Curriculum, Yolumt 3, pagt J J

The balance sheet (also known as the statement offinandal po,ition or stetemen: of

financial conJition) reports the firm's financial position at a point in time The balance

sheet consists of three clements:

1 AJlttI arc the resources controlled by the firm

2 Liabilitit, are amounts owed to lenders and other creditors.

3 Ownm't'luiry is the residual interest in the net assets of an entity that remains after

deducting its liabilities

Transactions arc measured so that the fundamental accounting equation holds:

ets • liabilities +owners' equity

The statement of comprehensive income reports all changes in equity except for

shareholder transactions (e.g., isswng stock repurchasing stock, and paying dividends)

The income statement (also known as me statement ofoptrrt,iom or the p",fit and Itm

uattmtnt) reports on the financial performance of the firm over a period of time The

elements of the income statement include revenues, expenses, and pns and losses

• &lItnut' are inflows from delivering or producing goods, rendering services or other

activities that constitute me entity's ongoing major or central operations

• Exptmtl are outflows from delivering or producing goods or services that constitute

the entity's ongoing major or central operations

• Oth., incomt includes gains that mayor may not arise in the ordinary course of

business

Under [FRS, the income statement can be combined with 'other comprehensive

income" and presented as a single statement of comprehensive income Alternativcly,

the income statement and the statement of comprehensive income can be presented

separately Presentation is similar under U.s GAAP except that firms can choose to

report comprehensive income in me statement of shareholders' equity

The statement of chauges in eqwty reports the amounts and sources of changes in

equity investors' investment in the firm over a period of time

The Statement of cash flows reports the company's eash receipts and payments These

cash flows arc classified as follows:

• Optrrtting cashflow, include the cash effeclS of transactions mat involve the normal

business of the firm

• Im,ming cashflow> arc those resulting from the acquisition or sale of property, plant,

and equipment; of a subsidiary or segment; of securities; and of investments in other

firms

02013 Kaplan, Inc. PaS" 11

Study SO n 7

CroSs-~f.~DcetoCFA lrutitule ~ed Reading 122 - Financial Slalement Analysis: An Inuoduction

• Financing rashfoWl ate those resulting from issuance or retirement of the firm's debtand equity securities and include dividends paid to stockholders

LOS 22.c: Describe the importance of financial statement notes andsupplementary information-including disclosures of accounting policies,methods, and estimates-and management's commentary

cr>4® PrDgram Cu"';,u/um, Volume3,pagl24

Financial statement notes (footnotes) include disclosures that provide further detailsabout the information surnmuizcd in the financial statements Footnotes allow users

to improve their assessments of the amount, timing, and uncertainty of the estimatesreponed in the financial statements Footnotes:

• Discuss the basis of presentation such as the fiscal period covered by the statementsand the inclwion of consolidated entities

• Provide information about accounting methods, assumptions, and estimates used by

management.

• Provide additional information on items such as business acquisitions or disposals,legal actions, employee benefit plans, contingencies and commitments, significantcustomers, sales to related parties, and scgmen" of the firm

Management's commentary [also known as managcment's rcpon, operating andfinancial review, and managcmcnt's discussion and analysis (MD&A)J is one of themost useful scctions of the annual rcpon In this section, managemcnt discusscs avariety of issues, including the nature of the bwiness, past performance, and futureoudook Analysts must beawan: that some parts of management's commentary may beunaudited

For publicly held firms in the United States, the SEC requires that MD&A disc,,"

trends and identify significant events and uncertainties that affeet the firm's liquidity,capital resources, and results of operations MD&A must also discuu:

• Effects of inBation and changing prices if material

• Impact of off-balance-sheet obligations and contractual obligations such as purchase

commitmcnu.

• Accounting policies that require significant judgment by managemenL

• Forward-looking expenditures and divestitures

LOS 22.d: Describe the objective of audits of financial statements, the types ofaudit reports, and the importance of effective internal controls,

An audit is an independent review of an entity's financial statements Public accountants

conduct audits and examine the financial reports and supporting records The objective

of an audit is to enable the auditor to provide an opinion on the fairness and reliability

of the financial statements

The independent eenificd public accounting firm employed by the Board of Directors isresponsible for seeing that the financial statements conform to the applicable accounting

Study SeuioD 7Ctoss-lUrerenCIOto CFA Institute Assigned IUading #22 - FtD."ciaI Stattmtnt Analysis:An Inuocluction

standards The auditor examines the company's accounting and internal control systems,

confirms assets and liabilities, and generally tries to determine that there are no material

errors in the financial statements The auditor's report is an important source of

information

The standard auditor's opinion contains three parts and states that:

1. Whereas the financial statements arc prepared by management and are its

responsibility, the auditor has performed an independent review

2 Generally accepted auditing standards were followed, thus providing rtllJo1Ulbk

assuranr. that the financial statements contain no material errors

3 The auditor is satisfied that the statements were prepared in accordance with

accepted accounting principles and that the principles chosen and estimates made

arc reasonable The auditor's report must also contain additional explanation when

accounting methods have not been used consisrently between periods

An unqualifi.d "pinion (also known as a clean opinion) indicates that the auditor believes

the statements arc free from material omissions and errors If the statements make any

exceptions to the accounting principles, the auditor may issue aqualifi.d opinion and

explain these exceptions in the audit report The auditor can issue anadwrlt opinion if

the statements arc not presented fairly or are materially nonconforming with accounting

standards If the auditor is unable to express an opinion (e.g., in the case of a scope

limitation), adilriaimtr of opinion is issued

The auditor's opinion will also contain an explanatory paragraph when a material loss

is probable but the amount cannot be reasonably estimated These "uncertainties" may

relaee to thef,'Jinl concern assumptWn (the assumption that the firm will continue to

operate for the foreseeable future), the valuation or realization of asset values, or to

litigation This type of disclosure may be a signal of serious problems and may call for

close examination bythe analyst

Internal controls arcthe processes by which the company ensures that it presents

accurate financial statements Internal controls arc the responsibility of management

Under U.S Generally Accepted Accounting Principles (GAAP), the auditor must

express an opinion on the firm's internal controls The auditor can provide this opinion

separately or as the fourth dement of the standard opinion

LOS 22.e: Identify and describe information sources that analysts use

in financial statement analysis besides annual financial statements and

supplementary information

CFA® Prol"'m Currit:rllum Yolum 3 pag.30

Besides the annual financial statements, an analyst should examine a eompany's '{uarurly

or umiannual rtports.These interim reports typically update the major financial

statements and fOOUlotesbut are not necessarily audited

Sludy Sossion7

Cro,s-lUft~Dce 10CFA lrutil\lte Amgntd Rtading ,z2 - FiIWlCial Slatemtnt Analysis: An Iouoduc:tion

Securities and Exchange Commission (SEC) filing arc available from EDGAR(Electronic Data Gathering Analysis, and Retrieval System WUlW.uc.gpv). These includePerm 8-K which a company must file to report events such as acquisitions and disposals

of major assets or changes in its management or corporate governance Companies'annual and quarterly financial statements arc also filed with the SEC (Form IO-K andForm lO-Q, respectively)

Proxy statements are issued to shareholders when there arc matters that require ashareholder vote These statements which arc also filed with the SEC and available fromEDGAR arc a good source of information about the election of (and qualifications 00board members compensation management qualifications and the issuance of stockoptions

CDrporllu "POrtsandpUtl uklllnarc written by management and are often viewed aspublic relations or sales materials Not all of the material is independently reviewed

by outside auditors Such information can often be found on the company's Web site.Firms often provide earnings guidance before the financial statements arc released.Once an earnings announcement i made a conference call may be held whereby seniormanagement is available to answer questions

An analyst should also review pertinent information on economic conditions andthe company's industry and compare the company to its competitors The neccssaryinformation can be acquired from trade journals statinical reporting services andgovernment agencies

LOS 22.f: Describe the steps in the financial statement analysis framework

The financial statement analysis framework) consists of six Steps:

Sup J: StAU tltt Dbj«t;~ """ conttxt. Determine what questions the analysis seeks to

answer, the form in which this information needs to be presented and whatresources and how much time are available to perform the analys;"

Sup 2: G.thtr dAtil.Acquire the company' financial statements and other relevant data

on its indusuy and the economy Ask questions of the eompany's management.suppliers and customers and visit company sites

Sup 3: Proem tltt dAtA. Make any appropriate adjusunents to the financial.tatements

Calculate ratios Prepare exhibits such as graphs and common-size balancesheets

Sup 4: AnIl/:f%t lind ;nrrrprtt tht dAre, Use the data to answer the questions stated in

the first step Decide what conclusions or recommendations the informationsupports

Sup 5: Rtport tht eDnclUJiDnsDr rtcommtntlat;Dns. Prepare a rcport and communicate it

to its intended audience Be sure the report and its dissemination comply withthe Code and Standards that relate to investment analysis and recommendations

Sup 6: UptiAlt tht Ilnll/ys;s.Repeat these stcps pcriodically and change the conclusions

or recommendations when necessary

1. Hennie van Grcunin.ll and Sonja Brajovic Braranovic,AnllfJ_zinJ{ anti MllnllJ{inJ{ Bllnki'!J{ Rislt:

Framework for AsuuJnt CorpD"'U wlltmllnct n' Finllndtil Risk Inttrnadoni! Bank for Reconstruction and ]J;,,·dopment April 2003 p 300.

02013 Kaplan Inc.

Study SessiOD 7Cross-lUfertnClO to CFA Institute Assigned IUading #22 - rmaucial Statement Aoalysis: An Inuocluction

KEy CONCEPTS

LOS 22.a

The role of financw reponing is to provide a variety of users with useful information

about a company's performance and finanew position

The role of financial statement analysis is to usc the data from financial statements to

suppon economic decisions

LOS 22.b

The statement of financial position (balance sheet) shows assets, liabilities, and owners'

equity at a point in time

The statement of comprehensive income shows the results of a firm's business activities

over the period Revenues, the cost of generating those revenues, and the resulting profit

or loss arc presented on the income statement

The statement of changes in equity repom the amount and sou tees of changes in the

equity ownen' investment in the firm

The statement of c:a.shBows shows the sources and uses of c:a.shover the period

LOS 22.c

Important infotmation about accounting methods, estimates, and assumptions is

disclosed in the footnotes to the financial statements and supplementaty 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 (management's discussion and analysis) contains an overview

of the company and important infotmation about business trends, future capital needs,

liquidity, significant events, and significant choices of accounting methods requiting

management judgment,

LOS 22.d

The objective of audits 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 standard

auditing procedures were used to establish reasonable assurance that the statements

contain no material errors, and that management's report on the company's internal

controls has been reviewed

Sludy Session7

CroS ~f.~Dce to CFA IrutiNl As.signed Reading ,22 - Financial Slalemenl Analysis: An Inuoduction

An auditor can issue an unqualified (clean) opinion if the statements orr frre frommaterial omissions and errors, a qualified opinion that notes any exceptions toaccounting principles, an adverse opinion if the statements arc not presented fairly inthe auditor's opinion, or a disclaimer of opinion if the auditor is unable to rxprcss anopinion

A company's management is responsible for maintaining an effective internal controlsystrm to ensure the accuracy of its financial statements,

LOS 22.eAlong with the annual linancial statements important information sources for an analystinclude a company's quanrrly and semiannual rrpons, proxy statements, press releases,and carnin~ guidance, as wdl as information on the industry and perr companies ftomexternal sources

LOS 22.fThe framework for financial analysis has six steps:

1. State the objective of the analy,is

2 Gather data

3 Process the data

4 Analyze and interpret the data

5 Report the conclusions or recommendations

6 Update the analysis

A Usc the information in financial statements to make economic decisions.

B Provide reasonable assurance that the financial statements arc free of material

errors.

C Evaluate an entity's financial position and past performance to form

opinions about its futun: abilitytocam profiu and generate cash flow

2 A firm's financial position at a specific point in time is reported in the:

A balance sheet

C cash flowstatement

3 Information about accounting estimates, assumptions, and method chosen for

n:porting ismost lilttfy found in:

A the auditor's opinion

B financial statement notes

C Management's Discwsion and Analysis

4 If an auditor finds that a company's financial statements have made a specific

exception to applicable accounting principles, she ismost li",fy to issue a:

A dissenting opinion

B cautionary note

C qualified opinion

5 Information about elections of members to a company's Board of Directorsis

most li",/y found in:

A a IO-Qfiling

B a proxy statement

C footnotes to the financial statements

6 Which of these steps is1,IIStli",1y to be a part of the financial statement analysis

framework?

A State the purpose and context of the analysis

B Determine whether the eompany's securities arc suitable for the client

C Adjwt the financial statement data and compare the company toitsindustry

peers

020 13Kaplan IDe. PaS" 17

Siudy &uion 7

Ctoss-lUfmDce ID CFA I",titulo Assisnod lUading ,22 - Financial SIatomonl ADalysis: AD lDuoduction

ANSWERS - CONCEPT CHECKERS

1 B This SIalomonl describes tho role of an auditor rather than the role of an analyst The

oth er rospon s describe tho rolo of fin.ncial statemem analysis.

2 A Tho balance sheet reporu a company's financial posilion as of a specific dare, Tho

income sIa.emont cash Row statement, and sratement of changes in owners' equity show the company's pe.rformance during spedfic period.

3 B Informalion aboul accounting me hods and estimates is con •• ined in the foo.noles 10

the financial stare menu.

4 C An auditor will issue a qualified opinion if Ihefinaneial statements make any excepuens

to applicable accounling sl.ndards and will •.xplain the effcct of these exceptions in the

auditor', reporl.

5 B Proxy statemenu con in informalion ~Ia.ed 10 mane" thai come before shareholders

for a voce such as elections of board members,

6 B Determining the uit.bili!), of an invostmenl for client is nOI one of tho six sleps in the

financial ".tem.ntanalysis framework The nalyst would only perform this function if

healsohad an adviso!)' rtlationship with the client Stating the ebjeerive and processing the data are twO of the six &leps in tho framowork The others are gathering the data anal)'1ing the d upd.ting the analysis and reporting the conclusions.

The following i a rnicw ofthefina.ncial Reporting Uld Analylis principlcs dnicncd to add,,"s tM

learning outcome staccments tet (orth by CFA Institu.cc This topic is also CO\'Cf'td ill:

FINANCIAL REpORTING MECHANICS

Study Session 7

ExA 'I Focus

The analysis of financial statements requires an understanding of how a company's

transaerions arc recorded in the various accounts Cand.idates should focus on the

financial statement clements (assets, liabilities, equity, revenues, and expenses) and

be able toclassify any account into its appropriate clement Candidates should also

learn the basic and expanded accounting equations and why every transaction must be

recorded in at lean two accounts The types of accruals, when each of them is used, how

changes in accounts affeer the financial statements, and the relationships among the

financial statements, arc all important topics

LOS 23.a: Explain the relationship of financial statement elements and

accounts, and classify accounts into the financial statement elements

Financial statement clements arc the major classifications of assets, liabilities, owners'

equity, revenues, and expenses Accounts are the specific records within each clement

where various transactions arc entered On the financial statements, accounts arc

typically presented in groups such as "inventory" or "accounts payable.· A company's

chan of accounts is a detailed liS!of the accounts that make up the five financial

statement clements and the line items presented in the financial statements

Contra accounts arc used for entries that offset some part of the value of another

account Por example, equipment is typically valued on the balance sheer at acquisition

(historical) cost, and the estimated decrease in its value over time is recorded in a contra

account titled "accumulated depreciation.·

Classifying Accounts Into the Financial Statement Elements

Assets are the firm's economic resources Examples of assets include:

• ClJShand (ash tlJuilldlmn. Liquid securities with maturities of90days or less arc

considered cash equivalents

• At'Counrs rtCtivable. Accounts receivable often have an "a1lowancc for bad debt

expense" or "allowance for doubtful accounts" as a contra account

• lnvtntory.

• Finaru:i4llJSsttssuch as marketable securities

• Prtpaid aptnJts Items that will be expenses on future income statements.

• Proptrty plant and tlJuipmmr. Includes a conua-asset account for accumulated

depreciation

Study StsJion 7

Cro, ~f.~Dceto CFA lrutitute Assi£ntd ~ading.23 - Financial ~rting Mtchania

• lnuestmrnr in 1l1ftlillw accounted for using the equity method.

• DiftTT~d tllX ItJI~tt.

• fntllngibk Illl~ts Economic resources of the firm that do not have a physical form,

such as patents, trademarks, licenses, and goodwill Except for goodwill, these valuesmay be reduced by "accumulated amortization.'

Liabilities are creditor claims on the company's resources Examples ofliabilitie include:

• Auountl paJllbl~ and trilik pllJllhkl.

• FinilMial Iillhiliti~l suelt as short-term notes payable.

• Un~llrn~d rtwnu~ Items that wiu show up on future income statements as revenues.

• lncom« tIlXll pl1,Ilh/~ The taxes accrued during the past year but not yet paid.

• LDng-ttrm tUbt suelt as bonds payable.

• Dtfrrrtd tllX IUtbi/itill.

Owners' equity is the owners' residual claim on a firm's resources, which is the amount

by whielt assets exceed liabilities Owners' equity includes:

• CllpitAl Par value of common stock.

• Adtiitionlll pllid-in (llpitllL Proceeds from common stock ala in excessof par value.(Share repurchases that the company has made arc represented in the contra account

trtlllU? nodt.)

• &tllin~d ~Ilrnings Cumulative net income that has not been distributed as dividends

• Othtr (omp"htnliut incom« Changes resulting from foreign currency uanslation,

minimum pension liability adjusunents, or unrealized gains and losses oninvestments

Revenue represents inBows of economic resources and includes:

• SIllll Revenue from the firm's day-to·day activities.

• Gilins. Increases in assets from transactions incidental to the firm's day-to-dayactivities

• fnutltmmt ineom« suelt as interest and dividend income.

Expenses arc ourBows of economic resources and include:

• COlt of goods lold.

• &lIing gmuttl lind admjnistrlltiu~ txpmltl These include such expenses as

advertising, management alaries, rent, and utilities

• Dtprtdlltion lind IlmortiUltion To reBcet the 'using up' of tangible and intangible

LOS 23.b: Explain the accounting equation in its basic and expanded forms

The basic accounting equation is the relationship among the three balance sheetelements:

assets liabilities +owners' equity

Study SessiOD 7

Croos-lUfe_ce to CFA Institute Auigncd ReadiJlg '23 - FinanciallUportin& Mechanics

Owners' equity consists of capital contributed by the linn's owners and the cumulative

earnings the lirm has retained With that in mind, WI: can state the expanded accounting

cquation:

assets liabilities contributed capital ending retained earnings

Ending retained earnings for an accounting period arc the result of adding that period's

retained earnings (revenues minus expenses minus dividends) to beginning retained

earnings So the expanded accounting equation can also be Slated as:

liabilities contributed capital

beginning retained earnings

revenue

-apcnscs

-dividends

LOS 23.c: Describe the process of recording business transactions using an

accounting system based on the accounting equation

Kceping the accounting equation in balance requires doublc-cntry accounting, in which

a transaction has to be recorded in at least two accounts An increase in an asset account,

for example, must be balanced by a decrease in another asset account or by an increase in

a liability or owners' equity account

Some typical examples of double entty accounting include:

• PllrrhllSt t'l"ipmtnt for $}O, 000 cllSh.Property, plant, and equipment (an asset)

increases by $10,000 Cash (an asset) decreases by SIO,OOO

• Borr~1II$}0, 000 to purrhllSt t'luipmtnt_ PP&E increases bySI 0,000 Notes payable

(a liability) increases by $10,000

• Blly OffictSllpplits for $}OO cllSh.Cash decreases byS100 Supply expense increases by

$100 An expense reduces retained earnings, so owners' equity decreases by5100

• Buy inrNntory for $8,000 cllShana Itil itfor $}O, 000 cllSh.The purchase decreases

eash byS8,OOOand increases inventory (an asset) by $8,000 The sale increases eash

by S10,OOOand decreases inventoty byS8,OOO,so assets increase by 52,000 At the

same time, sales (a revenue account) increase by $10,000 and "cost of goods sold"

(an expense) increases by the $8,000 cost of inventory The 52,000 difference is

an increase in net income and, therefore, in retained earnings and owners' equity

(ignoring taxes)

Siudy St.sion 7

CroSs-~f.~Dce to CFAIrutilUtt Auigntd ~ading 123 - FilWlcial ~porting Mtchanics

LOS 23.d: Describe the need for accruals and other adjwtments in preparingfinancial statements

cr-A~PrDgramCu"i(fl/um Yo/umt 3 pagt 69

Revenues and expenses arc not always recorded at the same time that cash receiptsand payments are made The principle of accrual accounting requires that revenue

is recorded when the firm earns it and expenses arc recorded as the fum incurs them.regardless of whether eash has actually been paid Aceruals fall into four categories:

1 UntarntJ rtUtnut.The firm receives cash before it provides a good or service tocustomers Cash increases and unearned revenue, a liability increases by the sameamount When the firm provides the good or service, revenue increases and theliability decreases For example, a newspaper or magazine subscription is typicallypaid in advance The publisher records the cash received and increases the unearnedrevenue liability account The firm recognizes revenues and decreases the liability as

it fulfills the subscription obligation

2 Aun"J revene« The firm provides goods or services before it receives cash payment.

Revenue increases and accounts receivable (an asset) increases When the customerpays cash accounts receivable decreases A typical example would bea manufacturerthat sells goods to retail stores "on account.' The manufacturer records revenuewhen it delivers the goods but does not receive cash until after the retailers sell thegoods 10consumers

3 PrtpaiJ aptnltJ. The firm pays cash ahead of time for an anticipated expense Cash(an asset) decreases and prepaid expense (also an asset) increases Prepaid expensedecreases and expenses increase when the expense is actually incurred For example

a retail store that rents space in a shopping mall will often pay its rent in advance

4 AunltJ txptnus. The firm owes cash for expenses it has incurred Expenses increaseand a liability for accrued expenses increases as well The liability decreases whenthe firm pays cash to satisfy it Wage payable arc a common example of an accruedexpense as companies typically pay their employees at a later date for work Iheyperformed in the prior week or month

Accruals require an aceeuming entry when the earliest event occurs (paying or receivingcash, providing ageed or service or incurring an expense) and require one or moreoffsetting entries as the exchange is completed With unearned revenue and prepaidexpenses cash changes hands first and the revenue or expense is recorded later, Withaccrued revenue and accrued expenses the revenue or expense is recorded first and eash

is exchanged later, In all these eases, the effect of accrual accounting is to recognizerevenues or expenses in the appropriate period

Other Adjustments

Most assets arc recorded on the financial statements at their historical costs However.accounting standards require balance sheet values of certain assets to rdlect their currentmarket values Accounting entries that update these asseu' values arc called valuationadjustments To keep the accounting equation in balance, changes in asset values also

StudySessioo 7

Croos-Rd',ren« to CFA Instin.tt Asngncd Reading '23 - Fioancial ~portio& ~ics

change owners' equity through gains or losses recorded on the income statement or in

"ethercomprehensive income.·

LOS 23.e: Describe the relationships among the income statement, balance

sheet, statement of cash Bows, and statement of owners' equity

CFAfI)Prol""m Curriculum Volume 3 pllge 66

Figures I through 4contain the financial statements for a sample corporation The

balance sheet summarizes the company's 6nancial position at the end of the current

accounting period (and in this example it also shows the company's position at the end

of the previous fiscal period) The income statement cash lIow statement and statement

of owners' equity show changes that occurred during the rnose recent accounting period

Note these key relationships among the financial statemenu:

• The income statement shows that net income was$37.500 in20XB.The company

declared $S.500 of that income as dividends to its shareholders The remaining

S29.000 is an increase in retained earnings Retained earnings on the balance sheet

increased byS29.000 from $30.000 in 20X7 to$59.000 in 20XS

• The cash lIow statement shows aS24.000 net increase in cash On the balance sheet

cash increased by S24.000 from S9.000 in20X7 to S33.000 in 20XS

• One of the uses of cash shown on the cash lIow Statement is a repurchase of stock for

SI0.000 The balance sheet shows this SI0.000 repurchase as adecrease in common

stock from S50.000 in 20X7 to$40.000 in 20XS

• The statement of owners' equity rellects the changes in retained earnings and

conuibuted capital (common stock) Owners' equity increased by$19.000 from

SSO.OOOin 20X7 to$99.000 in20XS This equals the $29.000 increase in retained

earnings less the S10.000 decrease in common stock

Figure 1:Income Statement for 20XS

Income from continuing optrations

Glin from sal ofland

7.000 500 552.500

>17.500 10.000 557.500 20.000

S37.5008.500

Study Souion 7

Cross-lWfm_ to CFA Insti<u<e Auij;ned lWadU>Sn3 -FilWlCia1lWportiDg Meehani

Figure 2: Balance Sheet for 20X7 and 20XB

Gross plant and equipmenr a5.000 60.000

less: Accumubred deprcciarion (16.000) (9.000)

Net plant and equipment 569.000 S51.000

Retained ca,ning> 59.000 30.000

To,aIliabiliti •• & ockhold • quity $162.000 5126.000

Figure 3: Ca.sh Flow Statement for 20XB

Caah flow f,om op.rations 5"2.500

Cash from sal ofland 515.000

Pureh ase of planr and equipment (25.000)

Caah flow f,om inv.stm.nu

~ ($10.000)

Sal of bonds 55.000

Repurch ase of srock (10.000)

Cash dividends (3.500)

Cash flow f,om 6nancing (SS.500)

Total cuh Sow 52".000

SludySesSiOD 7Crou·lUr.rm« 10CFA Instilult Assigned Reading '23 - FinanciallUportin& ~icsFigun: 4: Statement of Ownen'Equity for 20XS

um,rih,,'t" IUl4i,,," To,,,,Utpi"" urninxr

LOS 23.f: Describe the Bow of information in an accounting system

CFA® Progrrtm Curriculum, Volumt 3 plItt 72

Information Bows through an accounting system in four Sleps:

1 Journal entries record every transaction showing which accounts arc changed and by

what amounts, Alisting of all the journal entries in order of their dates is called the

general journal

2 The geeeral ledger sorts thc entries in thc gencral journal by account

3 AIthe end of the accounling period, an initial trial balance is prepared that sbows the

balances in each account If any adjusting entries arc needed, thcy will be recorded

and reBected in an adjusted trial balance

4 The account balances from the adjusted trial balance arc presented in the financial

statements.

LOS 23.g: Describe the we of the results of the accounting process in security

analysis

CFA® Progrrtm Curriculum Volumt 3, plItt 73

An analyst dna; not have acCCS5to the detailed information that Bows through a

company's accounting system but sees only the end product (the financial statements)

An analyst needs to understand the various accruals, adjustments, and management

assumptions that go into the financial statements Much of this detail is contained in the

footnotes to the statements and Management' Discussion and Analysio, so it is crucial

for an analyst to review these parts of the financial statements With this information,

the analyst can better judge how wellthe financial statements reBcet the company's true

performance and what adjustments to the data arc necessary for appropriate analysis

Because adjustments and usumptions within the financial statements are, at least to

some extent, at the discretion of management, the possibility exists that management

may attempt to manipulate or misrepresent the company's financial performance Agood

understanding of the accounting process can help an analyst identify financial statement

entries that appear to be out of line

Study SHolon 7

Cro ~f.~Dceto CFA Institute ~d ~adin8 23 - FiIWlcial ~porting Mtehania

KEY CONCEPTS

LOS 23.aTransactions arc recorded in accounu that form the financial statement c1emenu:

• Assets:-thc 6rm's economic resources.

• Liabilities-crediton' claims on the firm's resources

• Owners' equity-paid-in capital (common and preferred stock), retained earnings,and cumulative other comprehensive income

• Revenues=-sales, investment income, and gains.

• Expenses-c05t of goods sold, selling and administrative expenses, depreciation,interest, taxes,and losses

LOS 23.bThe basic accounting equation:

asscu • liabilities owners' equity

The expanded accounting equation:

assets • liabilities contributed capital ending retained earnings

The expanded accounting equation can also be stated as:

assets w liabilities contributed capital beginning retained carnings revenuc

-expenses - dividends

LOS 23.eKeeping the accounting equation (A - L • E) in balance requires double entryaccounting, in which a transaction is recorded in at least two accounu An increase in anasset account, for example, must be balanced by a decrease in another asset account or

by an increase in a lillbility or own en' equity account

LOS 23.d

A firm must recognize revenues when they arc earned and expenses when they areincurred Accruals are required when tbe timing of essh paymenu made and receiveddocs not match the timing of the revenue or expense recognition on the financial

statements.

LOS 23.eThe balance sheet shows a company's financial position at a point in time

Changes in balance sheet accounu during an accounting period arc refleCled in theincome statement, the cash Sow statement, and the statement of owners' equity

02013 Kaplan, Inc

Study Session7

Crocs·lUrtrmct to CFA Institutt Assigned JUading'23 - FinanciallUportin& ~ics

LOS 23.f

Information enters an accounting system as journal entries, which are SOrted by account

into a general ledger Trial balances are formed at the end of an accounting period

Accounts ate then adjusted and presented in financial statements

LOS 23.g

Since financial reporting requires choices of method, judgment, 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 usc of accruals, changes in valuations, and other notable changes that may

indicate management judgmenr is incorrect or, worse, that the financial statements have

been deliberately manipulated

Study SHsion 7

CroSs-~f.~Dce to CFA lrutitute Assigned ~ading 23 - FifWlCial ~rting Meciwlia

~28

CONCEPT CHECKERS

1. Accounts receivable and accounts payable arc ,,",It liltt/y classified as which

financial statement clements?

Accounts receivable Accounts payable

2 Annual depreciation and accumulated depreciation arc most liltt/y classified as

which financial statement clements?

Contra assetsContra assers

3. The accounting equation iskttJt lIuumtdJ stated as:

A owners' equity = liabilities - assets

B ending retained earnings assets - contributed capital - liabilities

C assets a liabilities +contributed capital +beginning retained earnings +

revenue - expenses - dividends

4. A decrease in assets would klllt Ii"." be consistent with a(n}:

A increase: in apcnscs.

B decrease in revenues

C increase in contributed capital

5. An electrician repaired the light fixtures in a retail shop on October 24 and sent

the bill to the shop on November 3 If both the electrician and the shop preparefinancial statements under the accrual method on October 31, how will theyeach record this transaction?

A Accrued revenue Accrued expense

B Accrued revenue Prepaid expense

C Unearned revenue Accrued expense

If a firm raises S 10 million byissuing new common stock, which of its financialstatements will reflect the transaction?

A Income statement and statement of owners' equity

B Balance sheet, income statement, and cash flow statement

C Balance sheet, cash Bow statement, and statement of owners' equity

6.

7. An auditor needs to review all of a company's transactions that took place

between August 15 and August 17 of the current year To find this information,she would most Ii"./y consult the company's:

A gcneralledgcr

B general journal

C financial statements

02013 Kaplan Inc

Study Session 7

Crocs·JUro_co to CFA InsatutoAssigntd Reading '23 - Financial JUportin&~ics

8 Paul Schmidt, a representative for Westby Investments, is explaining how

security analysts usc the results of the accounting process He States, "Analysts

do not have access to all the entries that went into creating a company's

financial statements If the analyst carefully reviews the auditor's report for any

instances where the financial statements deviate from the apptopriate accounting

principles, he can then be confident that management isnot manipulating

earnings." Schmidt is:

A correct

B. incorrect, beeause the entries that went into creating a company's financial

statements arc publicly available

C Incorrect, because management can manipulate earnings even within the

confines of generally accepted accounring principles

Study SaSiOD 7Croos-Refe"'lICe to CFA InStitute Assignt<! Reading '23 - Financial Reporting ~cN.nica

ANSWERS - CONCEPT CHECKERS

I. A Aecounu reeei ble are an asset and accounts payable arc a liability

2 B Annual depreciation is an expense Accumulated depreciarion is a eon, asset account

thattypieally offsets me hinori.aI COstof property, plant, and equipment

3 A Owners' <quity is equal to assets minus liabilities

4 C The expanded accounting equation show> mat asseu • liabiliti •• +contributed capital

+beginning "'taint<! earnings +revenue - expenses - dividends A decrease in asseu is

consistent with an increase in expenses or a decrease in revenues but not with an increase

in contributed capital

5 A The service is performed before cash is paid This tran.action "'p",senu accrued revenue

to the electrician and an accrued expense to the retail shop Since me invoice has nor

been sent as of mtstatement date, it is not shown in accounu receivable or accounts

payable

6 C The $10 million raised appears on the cash Row statement asa cash inBow from

financing and on ehe sta temem of owners' equity as an incr eas e in eemributed capital

Both assets (cash) and equity (common stock) incr ease on the balance sheer The income

staremem is unaffecled by scock issuance.

7 B The general journal lists all of the company's transaaions by date The general ledger

lim them by account

8 C Schmidt is correct in stating that analysIS do not have access to me detailed accounting

entries thatwene into a company's 6nancial statements, However, he is incorrect in

stating that an analyst can be sure management is not manipulating earnings if me

audit report does not list deviations from accounting principles Because accruals and

many valuations require management's judgment there is considerable room withi.n the

accounting standards (or management to manipulate earnings

Study Sesslon 7

ero,,·Refo"'Dce to CFA lruticutt Assignod Reading '23 - FiIWlCial Rtportiog Meclw>ia

ANSWERS - CHALLENGE PROBLEMS

Account onaIKYlJgl'~n' ,1ml'D[

u.ntrll'" th, IIJ'" brinK"-prtrilllbi.

untrtl'II ttttounu TrtrilNlbk.

&,h "-!mta "'" _U IIna a,!mtJ "'" fillbili,ks "" rtttmba.

The following is a rnicw of the fina.ncja) Reporting Uld Anal,.js principlcs dnisncd to add,,"s tM

learning outcome statcments set (Orth by CFA Institu.cc This topic i. altocevered ill:

FINANCIAL REpORTING STANDARDS

Study Session 7

EXA.111 Focus

This topic review eevers accounting standards: why they exist, who issues them and

who enforces them Know the difference bCIWCenthe roles of private standard-setting

bodies and government regulatory authorities and be able to name the most important

organiutions of both kinds Become familiar with the framework for International

Financial Reporting Standards (lFRS) including qualitative characteristics, eonstraints

and assumptions and features for preparing financial statements Beable to idc:ntify

barriers to con""rgencc of national accounting standards (such as U.S GAAP) with

IFRS kcy differences between the IFRS and U.S GAAP frameworks and dements of

and barriers to creating a coherent financial reporting network

LOS 24.a: Describe the objective of financial statements and the imporrance of

financial reporting standards in security analysis and valuation

CFA® Program Cu"iculum Volume 3 pagt 102

According to the lASB Conctptulll Framt_rltfor Financial Rrporting 2010. the ebjecuve

of financial reporting is to provide information about the firm to current and potential

investors and creditors that is useful for making their decisions about investing in or

lending to the firm

The conceptual framework is used in the development of accounting standards Given

the variety and complexity of possible tr:onsactions and the estimates and assumptions a

firm must make when presenting its performance financial statements could potentially

take any form if reporting standards did not exist, Thus financial reporting standards

are needed to provide consistency by narrowing the range of acceptable responses

Reponing standards ensure that tnansactions arc reported by firms similarly However

standards must remain ftexible and allow discretion to management to properly describe

the economics of the firm

Financial reporting is not designed solely for valuation purposes; however it docs

provide important inputs for valuation purposes

Study St";on 7

Cros lUft~Dce to CFA lrutitute AssignedlUading ,z4 - FinanciallUponJng Standards

LOS 24.b: Describe roles and desirable attributes of financial reportingstandard-setting bodies and regulatory authorities in establishing and enforcingreporting standards, and describe the role of the International Orgaoization ofSecurities Commissions

Standard-setting bodies arc professional organizations of accountants and auditors thatestablish financial reporting standards Regulatory authorities are govrrnment agenciesthat have ehe legal authority to enforce compliance with financial reporting standards.The two primary standard-setting bodies are the Fi"""ti"J Auou"ti"g Stllnti"rds Board

(FASS) and the inttT""titI"al Accounti"g Sta1lt/arJs Boar"(lASS) In the United States.the FASS sets forth Generally Accepted Accounting Principles (GAAP) Outside theUnited States the lASS establishes International Financial Reporting Standards (IFRS).Other national standard-setting bodies exist as well Many of them (including the FASS)are working toward convergence with IFRS Some of the older lASS standards arcreferred to as International Accounting Standards (lAS)

Desirable attributes of standard-sene rs:

• 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

Regulatory authorities such as the &curitin anti Excha"ge Commissio" (SEC) in theUnited States and the Fi"a"tilll Str"i"s Authority (FSA) in the United Kingdom arcestablished by national governments Figure 1 summarizes the SEC's filing requirementsfor publicly traded companies in the United States These filings, which arc availablefrom the SEC Web site (www.su.go ).arc arguably the most important source ofinformation for the analysis of publicly traded firms

Most national authorities belong to the Intemarional Organization of SecuritiesCommissions (IOSCO) The three objectives of financial market regulation according toIOseO 1 are to (1) protect investo rs; (2) ensure the fairness efficiency and transparency

of markets: and (3) reduce systemic risk Because of the increasing globalization ofsecurities markets IOSCO has a goal of uniform financial regulations across countries

I International Organiution of Securities Commissions "Objectives and Principles ofSecurities IUgulation.· June 2010

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StudySesSiOD 7C" ·Rtr nee to CFA" titUleAssigned Rtading '2 - rlJW)ciai Rtporting SwodanlsFigure I: Securities and Exchange Commission Required Filings

Form S-} Registration statement filed prior to the sale of new securities to the

public The registration statement includes audited financial state menu, risk

assessment, underwriter identification, and the estimated amount and usc of the

offering proceeds

Form 10-K Required annual filing that includes information about the business and

its management audited financial statements and disclosures, and disclosures about

legal matters involving the firm Information required in Form IO-K is similar to

that which a firm typically provides in its annual repon to shareholders However, a

firm's annual report is not a substitute for the requited IO-K filing Equivalent SEC

forms for foreign issuers in the U.S markets are Form 40-F for Canadian companies

and Form 20-F for other foreign issuers

Form IO-Q U.S firms arc required to file this form quarterly, with updated

financial statements (unlike Form IO-l(, these statements do not have to be

audited) and disclosures about certain events such as significant Icgal proceedings or

changes in accounting policy Non-U.S_ companies arc typically required to file the

equivalent Form 6-K semiannually,

Form DEF-I4A When a company prepares a proxy statement for its shareholders

prior to the annual meeting or other shareholder vote, it also files the statement with

the SEC as Form DEF-I4A

Form 8-K Companies must file this form to disclose material events including

significant asset acquisitions and disposals changes in management or corporate

governance, or matters related to its accountants, iu financial statements, or the

markets in which its securities trade

Form 144 A company can issue securities to certain qualified buyers without

registering the securities with the SEC but must notify the SEC that it intends to do

so

Forms 3, 4, and 5 involve the beneficial ownership of securities bya company's

officers and directors AnalystS can usc these filings to learn about purchases and

sales of company securities by corporate insiders

LOS 24.c: Describe the status of global convergence of accounting standards

and ongoing burien to developing one universally accepted set of financial

reporting standards.

CFjf~ Progmm GtrriCllfllm, Vofllmt 3.pal' JJiThe European Union requires IFRS financial reporting bypublicly listed companies

In most major countries that have not fully adopted IFRS accounting standard setters

arc attempting to converge their standards with IFRS Many aspects of U.S GAAP

and IFRS for example, have converged over the past decade, and the Securities and

Exchange Commission no longer requires IFRS reporting firms to reconcile their

Sludy So";"n 7

Cro,,-~f.~Dce 10CFA IrutilUlt Aui£ntd ~ading 24 - FiIWlCial ~porting SWldards

financial statements to U.S GMF IFRS convergence ~ffotts are also ongoing in Japan,China, and many other countries

One barrier [0convergence (devdoping one universally accepted set of accountingscandards) is simply that diff«ent standard-setting bodies and the regulatory authorities

of different countries can and do disagree on the best treatment of a particular item orissue Other barriers result from the political pressures that regulatory bodies face frombusiness groups and othen who will beaffi:ct~ by changes in teporting standards

LOS 24.d: Describe the International Accounting Standards Board's conceptualframework, including the objective and qualitative characteristics of linancialstatements, required reporting elements, and constraints and assumptions inpreparing financial statements

The ideas on which the lASB bases its standards arc expressed in the "ConceptualFramework for Financial Reporting" that the organization adopted in 2010 The IASBfram~work decails th~ qualitative characteristics of financial statements and specifiesthe required reporting elements The framework also notes certain constraints andassumptions that are involved in financial statement preparation

At the center of the lASB Conceptual Framework is the objective to provide financialinformation that is useful in making decisions about providing resources to an entity.The resource providers include investors, lenders, and other creditors Users of financialstatements need information about rbe firm's performance, financial position, and cashflow

Qualitative Characteristics

There arc rwo fundam~ntal characterisrics that make financial information useful:relevance and faithful representation 2

• RrulI4nu Financial statements arc relevant if the information in them can influence

users' economic decisions or affect users' evaluations of past events or forecasts offuture events To be relevant, information should have predictive value, confirmatoryvalue (confirm prior expectations), or both Materiality is an aspect of relevance.'

• Faithful rtpmtntatiDn. Information that is faithfully representative is complete,neutral [absence of bias), and free from error

There arc four characteristics that enhance relevance and faithful representation:

comparability, v~rifiability, timeliness, and understandability

• Compllrability. Financial statement presentation should be consistent among firmsand across time periods

• VtrijiAbi/ity. Independent observers, using the same methods, obtain similar results

• Timt/inm. Information is available to decision makers before the information isstale,

2 unupllllli F",mnuo,kfo,Fin"nri,,1RtpDrlinS(2010) par2{lraphsQC5-18

3 Ibid., paragraph QCI9-34

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StudySesSiOD 7ClOss-Rtr.rence 10 CfA I",titut Assigned Rtading 24 - FUWlCial Rtporting Swodanls

• Untkntandability. Users with a basic knowlcdge of business and accounting and who

nuke a reasonable effort to study the financial statements should be able to readily

understand the information the statements present Useful information should not

be omitted just beaus" it iscomplicated,

Required Reporting Elements

The clements of financial statements arc the by-now familiar groupings of assets,

liabilities, and owners' equity (for measuring financial position) and income and

expenses (for measuring performance) The Conceptual Framework describes each of

these clements:·

• Asstts. Resources controlled as a result of past transactions that are expected to

provide future economic benefits

• LiitbilUi".Obligations as a result of past events that arc expected to require an

outflow of economic resources,

• Equity.The owners' residual interest in the assets after deducting the liabilities

• In(omL.An increase in econcmic benefits, either increasing assets or decreasing

liabilities in a way that increases owners' equity (but not including contributions by

owners) Income includes revenues and gains

• Exptnus. Decreases in economic benefits, either decreasing assets or increasing

liabilities in a way that decreases owners' equity (but not including distributions to

owners) Losses arc included in expenses

An item should be rtrogniad in its financial statement dement if a IUtun: economic

benefit from the item (flowing to or from the firm) is probable and the item's value or

cost can be measured reliably

The amounts at which items arc reported in the financial statement elements depend

on their measurement base Measurement bases include historit'alant (the amount

originaUy paid for the asset], amortiud (ost(historical cost adjusted for depreciation,

amortization, depletion, and impairment), current(olt(the amount thc fitm would have

to pay today for the same assct), r~a1izabkva/u~(the amount for which the firm could

sell the asset),proem valu~(the discounted value of the asset's expected furure cash

flows), andfoir valu~(the amount at which two parties in an arm's-length transaction

would exchange the asset)

~ Pro/mor; Not«: In th~ next Stud, S~lJionl, "" will discull th~u m~lIlurtmtnt

~ bill" in mort dtrail and the situations in which Mch is appropriau.

Constraints and Assumptions

According to the Conceptual Framework, there is cost-benefit tradeoff' of the enhancing

characteristics.' Accordingly, the benefit that users gain from the infornution should

be greater than the cost of presenting it Anothcr constraint, not specifically mentioned

in the Conceptual Framework, is the fact that ncn-quanrifiable information about a

company (its rcputation, brand loyalty, capacity for innovation etc.) cannot be captured

dircctly in financial statements,

4 Ibid paraaraph.4.4.4.23

5 Ibid., pataaraphs QC35-39

Sludy S.ssion 7

Cro,s-~f.~Dce 10CFA Institute Assisn.d ~ading 24 - FinaACial ~portiog Srandards

Two imponant underlying a.ssumptions of financial statements areaccrulllllccounting

and going conum.6 Acxrual accounting means that financial statements should rdl=transactions at the time they actually occur, not necessarily when cash is paid Goingconcern assumes the company will continue to exist for the foreseeable future If this isnot the case, then presenting the company's financial position fairly requires a number

of adjustments (e.g • its inventory or other assets may only be wonh their liquidationvalues)

LOS 24.e: Describe general requirements for fill2ncial statements under IFRS.

CFA~ Propm Curriculum, li&lumr3, pllgr 124

International Accounting Standard (lAS) No.1 defines which financial statements arcrequired and how they must be presented The required financial statements arc:

• 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

The general features for preparing financial statements arc stated in lAS No.1:

• Feir pmm,ation, defined as faithfully representing the effects of the entity'stransactions and events according to the standards for recognizing assets, liabilities,revenues, and ocpenscs

• Going cancer» basis,meaning the financial statements arc based on the a.ssumptionthat the firm will continue to exist unless its management intends to (or must)liquidate it

• Accrual bllJisof accounting is used tD prepare the financial statements other than thestatement ofcash flows

• Consistfncy berween periods in how items arc presented and classified, with period amounts disclosed for comparison

prior-• MlI,criality, meaning the financial statements should be free of misstatements Dromissions that could influencc the decisions of users of financial statements

• Aggrtgation of similar items and separation of dissimilar items

• No offiming Df assets against liabilities or income against expenses unless a specificstandard permits Dr requires it

• &portingfrrf{umcy must be at lca.st annually

• ComplJ,atiur informll,ion for prior periods should be included unless a specificstandard states otherwise

A1sDstated in lAS ND 1 arc the structure and content Df financial statements:

• Most entities should present aclllssifirJ ba"'nct shu, showing current and noncurrent

assets and liabilities

• Minimum informatiDn is required on the face of each financial statement and in thenotes For example, the face of the balance sheet must show specific items such a.scash and cash equivalents, plant, property and equipment, and inventories Items

6 Ibid., pangraphs 0817 and 4.1