CFA level 1 study notebook3 2015

Study Session 7 Cross-Reference to CFA InstituteAssigned Reading#22-Financial Statement Analysis: An Introductionstandards.Theauditorexaminesthecompany’saccountingand internalcontrolsyst

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BOOK 3 - FINANCIAL REPORTING AND

ANALYSIS

Reading Assignments and Learning OutcomeStatements 3

StudySession 7-Financial Reporting and Analysis:AnIntroduction 10

StudySession 8-Financial Reporting and Analysis:

IncomeStatements,BalanceSheets,and Cash FlowStatements 47

StudySession9-Financial Reporting and Analysis:

Inventories,Long-livedAssets,Income Taxes,andNon-currentLiabilities 182

StudySession10-Financial Reporting and Analysis:

Financial Reporting Quality and FinancialStatementAnalysis 290

Self-Test-Financial Reporting and Analysis 320

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SCHWESERNOTES™ 2015CFALEVEL I BOOK 3: FINANCIALREPORTING

AND ANALYSIS

Publishedin2014 by Kaplan,Inc

Printedinthe UnitedStatesofAmerica

ISBN:978-1-4754-2758-5/1-4754-2758-1

PPN:3200-5524

If this book does not have the hologram with the Kaplan Schweser logo on the back cover, it was

distributed without permission of Kaplan Schweser, a Division of Kaplan, Inc., and is in direct violation

of global copyright laws Your assistance in pursuing potential violators of this law is greatly appreciated.

Required CFA Institute disclaimer: “CFA Institute does not endorse, promote, or warrant the accuracy

or quality of the products or services offered by Kaplan Schweser.CFA®and Chartered Financial Analyst® are trademarks owned by CFA Institute.”

Certain materials contained within this text are the copyrighted property of CFA Institute The following is the copyright disclosure for these materials: “Copyright, 2014, CFA Institute Reproduced and republished from 2015 Learning Outcome Statements, Level I, II, and III questions fromCFA®

Program Materials, CFA Institute Standards of Professional Conduct, and CFA Institute s Global

These materials may not be copied without written permission from the author The unauthorized duplication of these notes is a violation of global copyright laws and the CFA Institute Code of Ethics.

Your assistance in pursuing potential violators of this law is greatly appreciated.

Disclaimer: The Schweser Notes should be used in conjunction with the original readings as set forth

by CFA Institute in their 2015 CFA Level I Study Guide The information contained in these Notes

covers topics contained in the readings referenced by CFA Institute and is believed to be accurate.

However, their accuracy cannot be guaranteed nor is any warranty conveyed as to your ultimate exam success The authors of the referenced readings have not endorsed or sponsored these Notes.

Page2

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READING ASSIGNMENTS AND

Thefollowingmaterialisa reviewofthe Financial Reporting andAnalysisprinciples

designedtoaddress the learningoutcome statements setforthby CFAInstitute

STUDY SESSION 7

ReadingAssignments

Financial Reporting andAnalysis,CFAProgram Level I 2015Curriculum,Volume 3

(CFAInstitute,2014)

22.Financial Statement Analysis:AnIntroduction

23 Financial Reporting Mechanics

24 Financial Reporting Standards

page10page19

25 UnderstandingIncomeStatements

26 Understanding Balance Sheets

27 Understanding Cash Flow Statements

28.Financial Analysis Techniques

page47page 86page 109page 142

33 Financial Reporting Quality

34.FinancialStatementAnalysis: Applications

page290

page307

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Book 3-Financial Reporting andAnalysis

ReadingAssignments and Learning Outcome Statements

LEARNING OUTCOME STATEMENTS(LOS)Thefollowing materialis a reviewofthe Financial Reporting andAnalysisprinciplesdesignedtoaddress thelearningoutcome statements setforthbyCFAInstitute

STUDY SESSION 7

The topical coverage corresponds with thefollowing CFAInstituteassigned reading:

22 FinancialStatementAnalysis:AnIntroductionThe candidate should be ableto:

a. describe the rolesof financial reporting and financialstatementanalysis

(page10)

b describe the rolesof the key financialstatements (statementof financial position,

statementof comprehensiveincome, statementof changesinequity, and

statementof cashflows) inevaluatingacompany’sperformance and financialposition, (page11)

c describe the importance of financialstatement notesand supplementaryinformation—including disclosures of accounting policies,methods,and

estimates—andmanagements commentary,(page12)

d describe the objective of audits of financialstatements,thetypesof auditreports,and the importance of effective internalcontrols,(page12)

e. identify and describe informationsourcesthat analystsuseinfinancialstatement

analysis besides annual financialstatementsand supplementary information

(page13)

f describe thestepsinthe financialstatementanalysisframework,(page14)

The topical coverage corresponds with thefollowingCFA Instituteassigned reading:

23 FinancialReportingMechanics

The candidate should be ableto:

a. explain the relationship of financialstatementelements andaccounts,andclassifyaccountsintothe financialstatementelements,(page19)

b explain the accounting equationin itsbasic and expandedforms,(page20)

c. describe theprocessof recording businesstransactionsusinganaccountingsystembasedonthe accounting equation, (page21)

d describe the needfor accruals and other adjustmentsin preparing financial

statements,(page22)

e. describe the relationshipsamongtheincomestatement,balancesheet,statement

of cashflows,andstatementof owners’ equity, (page23)

f describe the flow of informationin anaccountingsystem,(page25)

g describe theuseof the results of the accountingprocess in securityanalysis

(page25)

24 FinancialReporting StandardsThe candidate should be ableto:

a. describe the objective of financialstatementsand the importance of financialreporting standardsin securityanalysis andvaluation,(page33)

b describe roles and desirable attributesof financial reporting standard-settingbodies and regulatory authoritiesinestablishing and enforcing reporting

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Book 3 - Financial Reportingand AnalysisReadingAssignments and Learning Outcome Statements

standards,and describe the roleof the International Organization ofSecurities

Commissions,(page34)

c. describe thestatusof global convergence of accounting standards and ongoing

barrierstodevelopingoneuniversally acceptedsetof financial reportingstandards,(page35)

d describe the International Accounting Standards Board’s conceptualframework,

including the objective and qualitative characteristics of financialstatements,

required reportingelements,andconstraintsand assumptionsinpreparingfinancialstatements,(page36)

e. describegeneral requirements for financialstatementsunder International

Financial Reporting Standards(IFRS),(page38)

f comparekeyconceptsof financial reporting standards under IFRS and US

generally accepted accounting principles(US GAAP)reportingsystems.

(page39)

g identify characteristics ofacoherent financial reporting framework and the

barrierstocreating sucha framework,(page39)

h describe implications for financial analysis ofdifferingfinancial reporting

systemsand the importance of monitoring developmentsinfinancial reportingstandards,(page40)

i analyzecompanydisclosuresof significant accounting policies, (page40)

25 UnderstandingIncome Statements

a. describe thecomponentsof theincomestatementand alternativepresentation

formats of thatstatement,(page47)

b describe general principles ofrevenuerecognition and accrual accounting,

specificrevenuerecognitionapplications (including accounting for long¬

term contracts,installmentsales,bartertransactions,grossandnetreporting

ofrevenue),and implications ofrevenuerecognition principles for financialanalysis, (page49)

c. calculaterevenuegiven information thatmight influence the choice ofrevenue

recognitionmethod,(page49)

d describe general principles ofexpenserecognition,specificexpenserecognition

applications, and implications ofexpenserecognition choices for financialanalysis, (page55)

e. describe the financial reportingtreatmentand analysis of non-recurringitems

(including discontinued operations, extraordinaryitems,unusualorinfrequent

items)and changesinaccountingstandards,(page61)

f distinguish between the operating and non-operatingcomponentsof theincome

statement,(page63)

g describe how earningspershareiscalculated andcalculate and interpreta

company’searningsper share(bothbasic and diluted earnings pershare)forboth simple and complex capitalstructures,(page63)

h distinguish between dilutive and antidilutivesecurities,and describe the

implications of each for the earningspersharecalculation, (page63)

i convertincomestatements tocommon-size incomestatements,(page72)

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j evaluateacompany’sfinancialperformance usingcommon-size income

statementsand financialratiosbasedontheincomestatement,(page74)

k describe, calculate,and interpret comprehensiveincome,(page74)

1 describe other comprehensiveincome,and identify majortypesofitems

includedin it.(page74)

26 Understanding Balance SheetsThe candidate should be ableto:

a. describe the elements of the balance sheet:assets,liabilities,and equity

(page86)

b describeusesand limitationsof the balance sheetinfinancial analysis, (page87)

c. describe alternativeformats of balance sheet presentation, (page87)

d distinguish betweencurrentand non-current assets,andcurrentandnon-current

liabilities,(page87)

e. describe differenttypesofassetsand liabilities and themeasurementbases ofeach,(page88)

f describe thecomponentsof shareholders’ equity, (page96)

g convertbalance sheetstocommon-sizebalance sheets and interpret

common-sizebalancesheets,(page98)

h calculate and interpret liquidity and solvencyratios,(page100)The topical coverage corresponds with thefollowing CFAInstituteassigned reading:

27. Understanding Cash FlowStatements

a. comparecash flows from operating, investing, and financingactivitiesandclassify cash flowitemsasrelatingtooneof those three categories givenadescription of theitems,(page109)

b describe how non-cash investing and financingactivitiesarereported, (page111)

c contrastcash flowstatementsprepared under International Financial ReportingStandards(IFRS)andUSgenerally accepted accounting principles(USGAAP).

f describe thestepsinthe preparation of direct and indirect cash flowstatements,

including how cash flowscanbe computed usingincomestatementand balancesheetdata,(page115)

g convertcash flowsfrom the indirecttodirectmethod,(page121)

h analyze and interpret both reported andcommon-sizecash flowstatements.

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28 FinancialAnalysis Techniques

a. describe tools andtechniques usedinfinancial analysis, including theirusesand

limitations,(page142)

b classify,calculate,and interpretactivity,liquidity, solvency, profitability, and

valuationratios,(page148)

c. describe relationships amongratiosand evaluateacompany usingratioanalysis

(page157)

d demonstrate the application of DuPont analysis ofreturn onequity, and

calculate and interpret effects of changesinitscomponents,(page162)

e. calculate and interpretratiosusedinequity analysis and credit analysis

(page166)

f explain the requirements forsegmentreporting, and calculate andinterpret

segment ratios,(page170)

g describe howratioanalysis and other techniquescanbe usedtomodel and

forecast earnings, (page171)

29 Inventories

a. distinguish betweencostsincludedin inventoriesandcostsrecognizedas

expenses inthe periodinwhich theyare incurred,(page183)

b describe different inventory valuation methods(costformulas),(page184)

c. calculatecostof sales and endinginventoryusing differentinventoryvaluation

methods and explain the effect of theinventoryvaluation method choiceon

grossprofit, (page185)

d calculate andcomparecostofsales, grossprofit, and endinginventoryusing

perpetual and periodic inventorysystems,(page188)

e. comparecostofsales,endinginventory,and gross profit using different

inventoryvaluationmethods,(page190)

f describe themeasurementofinventoryatthe lowerofcostandnetrealisable

value,(page191)

g describe the financialstatementpresentation of and disclosures relatingto

inventories,(page193)

h calculate and interpretratiosusedtoevaluateinventorymanagement,(page194)

The topical coveragecorrespondswith thefollowingCFAInstituteassigned reading:

30 Long-LivedAssets

a. distinguish betweencoststhatarecapitalized andcoststhatareexpensedinthe

periodinwhich theyare incurred,(page204)

b comparethefinancial reporting of thefollowingtypesof intangibleassets:

purchased, internally developed, acquiredinabusinesscombination,(page208)

c. describe the different depreciation methods forproperty,plant, and equipment,

theeffect of the choice of depreciation methodonthe financialstatements,

and theeffects of assumptions concerning useful life and residual valueondepreciationexpense,(page211)

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d calculate depreciation expense, (page211)

e. describe the differentamortizationmethodsfor intangibleassetswith finitelives,

theeffect of the choice ofamortizationmethodonthe financialstatements,

and the effects of assumptions concerning useful life and residual valueon

amortization expense,(page216)

£ calculateamortization expense,(page217)

g describe the revaluationmodel,(page218)

h explain the impairment ofproperty,plant, and equipment and intangibleassets.

a. describe the differences between accounting profit and taxableincome,anddefine keyterms,including deferredtax assets,deferredtaxliabilities,valuation

allowance,taxespayable, andincometaxexpense,(page230)

b explain how deferredtaxliabilities andassetsarecreated and thefactors thatdetermine howacompany’sdeferredtaxliabilities andassetsshould be treatedfor thepurposesof financial analysis, (page231)

c calculate thetaxbaseofacompany’sassetsandliabilities,(page232)

d calculateincometaxexpense, incometaxespayable, deferredtax assets,anddeferredtaxliabilities,and calculate and interpret theadjustmenttothefinancialstatementsrelatedto achangeintheincometax rate, (page234)

e. evaluate the impact oftax ratechangesonacompany’sfinancialstatementsand

ratios,(page238)

f distinguish betweentemporaryandpermanentdifferencesinpre-taxaccounting

incomeand taxableincome,(page239)

g describe the valuationallowancefor deferredtax assets—whenit isrequired andwhat impactithasonfinancialstatements,(page242)

h compareacompany’sdeferredtax items,(page243)

i analyze disclosures relatingtodeferredtaxitemsand the effectivetax rate

reconciliation,and explain how information includedinthese disclosuresaffects

acompany’s financialstatementsand financialratios,(page245)

j identify the key provisions of and differences betweenincometaxaccountingunder International Financial Reporting Standards(IFRS)and US generallyaccepted accounting principles(GAAP),(page247)

Thetopicalcoveragecorrespondswith thefollowingCFAInstituteassigned reading:

32 Non-Current(Long-Term) LiabilitiesThe candidate should be ableto:

a. determine the initial recognition, initialmeasurementand subsequent

measurementofbonds,(page258)

b describe the effectiveinterestmethod and calculateinterest expense,amortisationof bond discounts/premiums, andinterestpayments,(page259)

c. explain the derecognition ofdebt,(page264)

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d describe the roleof debtcovenantsinprotectingcreditors,(page265)

e. describe the financialstatementpresentation of and disclosures relatingtodebt

(page266)

f explainmotivationsfor leasingassetsinstead ofpurchasingthem,(page266)

g distinguish betweenafinance lease andanoperating lease from the perspectives

of the lessor and thelessee,(page267)

h determine theinitial recognition, initialmeasurement,and subsequent

measurementof financeleases,(page268)

i comparethe disclosures relatingtofinance and operatingleases,(page276)

j comparethe presentation and disclosure of defined contribution and defined

benefit pension plans, (page276)

k calculate andinterpretleverage and coverageratios,(page279)

33 Financial Reporting Quality

a. distinguish between financial reporting quality and quality of reported results

(including quality of earnings,cash flow,and balance sheetitems), (page290)

b describea spectrumfor assessing financial reporting quality, (page291)

c. distinguish betweenconservativeand aggressive accounting, (page292)

d describemotivationsthat mightcause management toissuefinancialreportsthat

are nothigh quality, (page294)

e. describe conditions thatareconducivetoissuinglow-quality,or evenfraudulent,

financialreports,(page294)

f describe mechanisms that discipline financial reporting quality and the potential

limitationsof thosemechanisms,(page295)

g describe presentationchoices,including non-GAAPmeasures,that could be

usedtoinfluenceananalyst’s opinion, (page296)

h describe accounting methods(choicesandestimates)that could be usedto

manage earnings, cashflow,and balance sheetitems,(page296)

i describe accounting warning signs and methods for detecting manipulation of

informationinfinancialreports,(page300)

34 Financial StatementAnalysis: Applications

a. evaluateacompany’spastfinancialperformance and explain howacompany’s

strategyisreflectedinpastfinancialperformance, (page307)

b forecastacompany’s futurenetincomeand cashflow,(page308)

c describe the role of financialstatementanalysisinassessing the creditquality of

apotential debtinvestment,(page309)

d describe theuseof financialstatementanalysisinscreening forpotential equity

investments,(page310)

e. explain appropriate analyst adjustmentsto acompany’sfinancialstatements to

facilitate comparison with anothercompany,(page310)

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The following is a review of the Financial Reporting and Analysis principles designed to address the learning outcome statements set forth by CFA Institute This topic is also covered in:

attentionheretothe othersourcesof information for financial analysis Thenatureofthe auditreportisimportant,asisthe information thatiscontainedinthefootnotes

tofinancialstatements,proxystatements,Management’sDiscussionand Analysis, andthe supplementary schedules A useful framework enumerating thestepsinfinancial

statementanalysisispresented

LOS22.a:Describe the rolesof financial reporting and financialstatement

analysis.

CFA®Program Curriculum,Volume3,page6Financial reporting referstothewaycompanies show their financialperformanceto investors,creditors,and other interested parties by preparing and presenting financial

statements.AccordingtotheIASBConceptual FrameworkforFinancial Reporting2010:

“The objective of general purpose financial reportingistoprovide financialinformation about the reporting entity thatisusefultoexisting andpotentialinvestors,lenders,and other creditorsinmaking decisions about providing

resourcestothe entity Those decisions involvebuying, sellingorholdingequity

and debtinstruments,and providingorsettling loans and other forms ofcredit.”

The roleoffinancialstatementanalysisis to usethe informationinacompany’sfinancialstatements,along with other relevantinformation,tomakeeconomicdecisions

Examples of such decisions include whethertoinvest inthecompany’ssecurities

orrecommend themtoinvestorsand whethertoextend tradeorbank credittothe

company.Analystsusefinancialstatementdatatoevaluateacompany’spastperformanceandcurrentfinancial positioninordertoform opinions about the company’s abilityto

earnprofits andgeneratecashflowinthefuture

Professor’sNote:Thistopicreviewdeals withfinancialanalysisforexternalusers.Management alsoperformsfinancialanalysisinmaking everydaydecisions.However, managementmayrelyoninternalfinancial information

thatislikelymaintainedin adifferentformatand unavailabletoexternalusers.

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StudySession 7 Cross-Reference to CFA InstituteAssigned Reading#22-Financial Statement Analysis: An Introduction

LOS22.b: Describe the rolesof the key financialstatements(statementof

financial position,statementofcomprehensiveincome,statementofchangesin

equity, andstatementof cashflows) inevaluatingacompany’sperformanceand

financial position

CFA®ProgramCurriculum,Volume3,page11The balance sheet(alsoknownasthestatementoffinancialpositionor statementof

financialcondition) reportsthe firm’s financial positionat apointin time.The balance

sheetconsistsof three elements:

1. Assetsaretheresourcescontrolled by the firm

2 Liabilitiesare amountsowedtolenders and other creditors

3 Owners’equityisthe residualinterest inthenet assetsofan entitythatremainsafter

deductingitsliabilities

Transactionsaremeasuredsothat the fundamental accounting equation holds:

assets=liabilities+owners’ equity

Thestatementof comprehensiveincomereportsall changesinequityexceptfor

shareholdertransactions(e.g., issuingstock,repurchasingstock,and payingdividends)

Theincomestatement(alsoknownasthestatementofoperationsorthe profit and loss

statement) reports onthe financialperformance of the firmoveraperiod oftime.The

elements of theincomestatementincluderevenues,expenses,and gains and losses

• Revenuesareinflowsfrom deliveringorproducing goods, renderingservices, orother

activitiesthatconstitutethe entity’s ongoingmajororcentral operations

• Expensesareoutflowsfrom deliveringorproducing goodsorservicesthatconstitute

the entity’s ongoing majororcentraloperations

• Otherincomeincludes gains thatmay or maynotarise inthe ordinarycourseof

business

UnderIFRS,theincomestatementcanbe combined with “other comprehensive

income” and presentedas asinglestatementof comprehensiveincome.Alternatively,

theincomestatementand thestatementof comprehensiveincomecanbe presented

separately.Presentation issimilar under U.S GAAPexceptthat firmscanchooseto

reportcomprehensiveincome inthestatementof shareholders’ equity

Thestatementof changesinequityreportstheamountsandsourcesof changesin

equityinvestors’ investment inthe firmover aperiod oftime

Thestatementof cash flowsreportsthecompany’scash receipts andpayments.These

cash flowsareclassifiedasfollows:

• Operating cashflowsinclude the casheffects oftransactionsthat involve the normal

businessof the firm

• Investing cashflowsarethose resulting from the acquisitionorsaleofproperty,plant,

and equipment; ofasubsidiaryor segment;ofsecurities;andofinvestments inother

firms

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Study Session 7

Cross-Reference to CFA InstituteAssigned Reading#22- FinancialStatement Analysis: An Introduction

• Financingcashflowsarethose resulting fromissuanceor retirementof the firm’s debtand equitysecuritiesand include dividends paidtostockholders

LOS22.c:Describe the importance of financialstatement notesand

supplementaryinformation— includingdisclosuresof accountingpolicies,

methods,andestimates—andmanagement’scommentary

CFA®ProgramCurriculum,Volume3,page 24Financialstatement notes(footnotes)include disclosures that provide further detailsabout the information summarizedinthe financialstatements.Footnotesallowusers

toimprove theirassessmentsof theamount,timing, and uncertainty of theestimates

reportedinthe financialstatements.Footnotes:

• Discussthe basisof presentation suchasthe fiscal period covered by thestatements

and the inclusion of consolidatedentities

• Provide information about accountingmethods, assumptions,andestimatesused bymanagement.

• Provide additional informationonitemssuchasbusiness acquisitionsordisposals,legalactions,employee benefit plans, contingencies andcommitments,significant

customers,salestorelated parties, andsegmentsof the firm

Management’scommentary[alsoknownasmanagement’sreport,operating andfinancialreview,and management’s discussion and analysis(MD&A)]isoneof the

mostusefulsectionsof the annualreport.In thissection, managementdiscussesavariety ofissues,including thenatureof thebusiness,pastperformance, and futureoutlook.Analystsmustbeawarethatsomepartsofmanagement’scommentarymaybeunaudited

Forpublicly held firmsinthe UnitedStates,the SEC requires that MD&A discusstrends and identify significanteventsanduncertaintiesthat affect the firm’s liquidity,capitalresources,and resultsof operations.MD&Amustalso discuss:

• Effects of inflation and changing prices if material

• Impact of off-balance-sheet obligations and contractual obligations suchaspurchase

commitments

• Accountingpolicies that require significant judgment bymanagement.

• Forward-lookingexpenditures and divestitures

LOS22.d: Describe theobjectiveof audits of financialstatements,thetypesofauditreports,and the importance of effective internal controls

CFA®Program Curriculum,Volume3,page 27

Anauditisanindependentreviewofanentity’s financialstatements.Publicaccountantsconduct audits andexaminethe financialreportsand supporting records The objective

ofanauditistoenable the auditortoprovideanopiniononthefairness and reliability

of the financialstatements.

The independent certified public accounting firm employed by the Board ofDirectorsisresponsible for seeing that the financialstatementsconformtothe applicable accounting

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Study Session 7 Cross-Reference to CFA InstituteAssigned Reading#22-Financial Statement Analysis: An Introduction

standards.Theauditorexaminesthecompany’saccountingand internalcontrolsystems,

confirmsassetsandliabilities,and generallytriestodeterminethat thereare nomaterial

errorsinthe financialstatements.The auditor’sreportisanimportantsourceof

information

The standard auditor’s opinioncontainsthreepartsandstatesthat:

1 Whereasthe financialstatements areprepared bymanagementandare its

responsibility,theauditorhasperformedanindependentreview

2 Generally accepted auditing standardswerefollowed,thus providing reasonable

assurancethat the financialstatementscontainnomaterialerrors.

3 Theauditorissatisfiedthat thestatementswerepreparedinaccordance with

acceptedaccountingprinciples and thattheprincipleschosenandestimatesmade

arereasonable.Theauditor’sreport mustalsocontainadditional explanation when

accounting methods havenotbeen used consistently between periods

An unqualifiedopinion(alsoknownas acleanopinion) indicatesthat the auditor believes

thestatements arefree from materialomissionsanderrors.Ifthestatementsmakeany

exceptionstothe accountingprinciples,theauditormay issueaqualified opinion and

explain theseexceptions in theauditreport.The auditorcanissueanadverseopinionif

thestatements are notpresented fairlyor arematerially nonconforming with accounting

standards.If the auditorisunabletoexpressanopinion (e.g.,inthecaseofascope

limitation), adisclaimerofopinionisissued

The auditor’s opinion will alsocontainanexplanatory paragraph whenamaterial loss

isprobablebut theamount cannotbereasonablyestimated.These“uncertainties”may

relatetothe goingconcernassumption(theassumption that thefirmwill continueto

operateforthe foreseeablefuture),thevaluationorrealizationofassetvalues,or to

litigation Thistypeofdisclosuremaybeasignal ofseriousproblems andmaycallfor

closeexaminationby the analyst

Internal controlsaretheprocessesby which thecompanyensuresthatitpresents

accuratefinancialstatements.Internal controlsarethe responsibility ofmanagement.

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

expressanopiniononthe firm’s internal controls Theauditorcanprovidethis opinion

separatelyor asthefourthelementof thestandardopinion

LOS22.e:Identify and describe informationsourcesthat analystsuse

infinancialstatementanalysis besides annual financialstatementsand

supplementaryinformation

CFA®ProgramCurriculum,Volume3,page30Besides the annual financialstatements, ananalystshouldexamine acompany’s quarterly

orsemiannualreports.Theseinterimreportstypicallyupdatethe major financial

statementsandfootnotesbutare notnecessarily audited

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Study Session 7

Cross-Reference to CFA InstituteAssigned Reading#22- FinancialStatement Analysis: An Introduction

Securitiesand ExchangeCommission (SEC)filingsareavailablefrom EDGAR

(ElectronicDataGathering, Analysis, and Retrieval System,www.sec.gov).These include

Form8-K,whichacompanymustfileto report eventssuchasacquisitions anddisposals

of majorassets orchangesin itsmanagement or corporategovernance.Companies’

annual and quarterly financialstatementsarealso filed with the SEC(Form10-Kand

Form10-Q,respectively)

Proxystatements areissuedtoshareholders when thereare mattersthat requireashareholdervote.Thesestatements,whicharealso filed with the SEC and availablefrom

EDGAR, areagoodsourceof information about the election of(andqualificationsof)

boardmembers,compensation,managementqualifications, and theissuanceof stockoptions

Corporatereportsandpressreleasesare writtenbymanagementandareoften viewedaspublic relationsorsales materials.Notall of the materialisindependently reviewed

by outside auditors Such informationcanoften be foundonthe company’s Website

Firmsoften provide earnings guidance before the financialstatementsarereleased

Onceanearningsannouncementis made,aconference callmaybe held wherebysenior

managementisavailabletoanswerquestions

Ananalyst should alsoreviewpertinent informationoneconomicconditions andthecompany’sindustry and compare the companytoitscompetitors Thenecessary

informationcanbe acquired from trade journals, statistical reportingservices,andgovernmentagencies

LOS22.f: Describe thestepsinthe financialstatement analysis framework

CFA®Program Curriculum,Volume3,page 31Thefinancialstatementanalysisframeworkl consistsofsixsteps:

Step1: Statethe objective andcontext.Determinewhat questions the analysis seeksto

answer,theforminwhich this information needstobe presented, and whatresourcesand how muchtimeareavailabletoperform the analysis

Step2: Gather data Acquire thecompany’sfinancialstatementsand other relevant data

onitsindustry and theeconomy.Ask questions of thecompany’smanagement,suppliers, andcustomers,andvisit company sites

Step 3: Processthe data Makeanyappropriate adjustmentstothe financialstatements.

Calculateratios.Prepare exhibits suchasgraphs andcommon-sizebalancesheets

Step 4: Analyzeand interpret the data Use the datatoanswerthe questions statedin

thefirststep.Decide what conclusionsorrecommendations the informationsupports.

Step5: Report the conclusionsorrecommendations Preparea reportandcommunicate it

toitsintended audience.Be surethereportanditsdissemination comply withthe Code and Standards that relatetoinvestmentanalysis and recommendations

Step 6: Update the analysis Repeat thesestepsperiodically and change the conclusions

orrecommendations whennecessary

Hennie vanGreuning and SonjaBrajovic Bratanovic,Analyzing andManagingBanking

FrameworkforAssessingCorporateGovernance and Financial Risk,InternationalBank for Reconstruction andDevelopment, April2003, p 300.

Risk:

1.

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StudySession 7 Cross-Reference to CFA InstituteAssigned Reading#22-Financial Statement Analysis: An Introduction

LOS22.a

The roleof financial reportingistoprovideavarietyofuserswith useful information

aboutacompany’sperformance and financial position

The roleof financialstatementanalysisisto usethe datafrom financialstatements to

supporteconomicdecisions

LOS22.b

Thestatementof financial position(balance sheet)showsassets,liabilities,andowners’

equityat apointin time

Thestatementof comprehensiveincomeshows theresultsofafirm’s businessactivities

overthe period.Revenues,thecostof generating thoserevenues,and the resulting profit

orlossarepresentedontheincomestatement.

Thestatementof changesinequityreportstheamountandsourcesof changesinthe

equity owners’investment inthe firm

Thestatementof cash flows shows thesourcesandusesof cashoverthe period

LOS22.c

Important information about accountingmethods,estimates,and assumptionsis

disclosedinthefootnotestothe financialstatementsand supplementary schedules

Thesedisclosures alsocontaininformation aboutsegmentresults, commitmentsand

contingencies, legal proceedings,acquisitions or divestitures, issuanceof stock options,

and detailsof employee benefit plans

Management’scommentary(management’s discussion andanalysis)containsanoverview

of thecompanyandimportantinformation about businesstrends,future capitalneeds,

liquidity, significantevents,and significant choices of accounting methods requiring

managementjudgment

LOS22.d

The objective of audits of financialstatementsistoprovideanopiniononthe

statements’ fairness and reliability

The auditor’s opinion gives evidence ofanindependentreviewof the financial

statementsthat verifies that appropriate accounting principleswere used,that standard

auditingprocedureswereusedtoestablish reasonableassurancethat thestatements

containnomaterialerrors,and that management’sreport onthecompany’sinternal

controls has been reviewed

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Study Session 7

Cross-Reference to CFA InstituteAssigned Reading#22-Financial Statement Analysis: An Introduction

Anauditorcanissuean unqualified(clean)opinionif thestatements arefree from

materialomissionsanderrors, aqualifiedopinionthatnotesanyexceptionsto

accountingprinciples,anadverse opinion if thestatements are notpresented fairlyin

the auditor’s opinion,or adisclaimerof opinion if the auditorisunabletoexpressan

opinion

Acompany’smanagementisresponsible for maintaininganeffective internal controlsystem to ensuretheaccuracyofitsfinancialstatements.

LOS22 eAlong with the annual financialstatements,important informationsourcesforananalystincludeacompany’s quarterly and semiannualreports,proxystatements,press releases,

and earnings guidance,aswellasinformationonthe industry andpeercompaniesfromexternal sources

LOS 22.fThe frameworkforfinancial analysis hassix steps:

1 Statetheobjectiveof theanalysis

2. Gatherdata

3 Processthedata

4 Analyze andinterpret thedata

5 Reporttheconclusionsorrecommendations

6 Updatetheanalysis

Page 16

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Study Session 7 Cross-Reference to CFA InstituteAssigned Reading#22-Financial Statement Analysis: An Introduction

CONCEPT CHECKERS

Whichof the followingstatementsleast accurately describesaroleof financial

statementanalysis?

A Use the information in financialstatements tomakeeconomicdecisions

B Provide reasonableassurancethatthefinancialstatements arefreeof materialerrors.

C Evaluateanentity’s financial position and pastperformancetoformopinions aboutitsfuture abilityto earn profits andgeneratecash flow

A firm’s financial positionat aspecificpoint intime isreportedin the:

Informationaboutaccountingestimates,assumptions,and methodschosenfor

reportingismostlikely foundin:

A the auditor’s opinion

B financialstatement notes.

C Management’sDiscussionand Analysis

Ifanauditor finds thatacompany’s financialstatementshavemadeaspecific

exceptiontoapplicable accounting principles, sheis mostlikelytoissuea:

A dissenting opinion

B cautionarynote.

C qualifiedopinion

Information about electionsof membersto acompany’s Board ofDirectors is

mostlikely foundin:

Statethe purpose andcontextof theanalysis

Determinewhether thecompany’ssecuritiesaresuitablefor the client

Adjustthe financialstatementdata andcompare the companyto itsindustry

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Study Session 7

Cross-Reference to CFA InstituteAssigned Reading#22-Financial Statement Analysis: An Introduction

This statementdescribesthe role of an auditor, rather than the role of ananalyst.The other responses describe the role of financial statementanalysis

1 B

A The balance sheet reports acompany’sfinancial position as of aspecificdate The income statement, cash flow statement, and statement ofchangesinowners’equity show thecompany’sperformanceduringa specific period.

2.

B Information about accounting methods and estimates iscontainedin the footnotes to

the financial statements.

3.

4 C An auditor will issue aqualifiedopinionifthe financial statements make any exceptions

toapplicableaccounting standards and willexplainthe effect of these exceptions in the

auditor’sreport.

Proxy statements contain informationrelatedto matters that come beforeshareholders

for a vote, such as elections of board members.

Trang 19

The following is a review of the Financial Reporting and Analysis principles designed to address the

learning outcome statements set forth by CFA Institute This topic is also covered in:

FINANCIAL REPORTING MECHANICS

Study Session 7

EXAMFOCUS

Theanalysis of financialstatementsrequiresanunderstandingofhowacompany’s

transactionsarerecordedinthevariousaccounts.Candidates shouldfocusonthe

financialstatementelements(assets,liabilities,equity,revenues,andexpenses)and

be abletoclassifyanyaccount intoits appropriate element.Candidates shouldalso

learn the basicand expandedaccounting equationsand whyeverytransaction mustbe

recordedinatleasttwo accounts.Thetypesof accruals,when eachof themisused,how

changesinaccountsaffect the financialstatements,and the relationshipsamongthe

financialstatements, areall important topics

LOS23.a:Explaintherelationshipof financialstatementelements and

accounts,and classifyaccountsintothe financialstatementelements

CFA®ProgramCurriculum, Volume3,page42Financialstatementelementsarethe major classificationsofassets,liabilities,owners’

equity,revenues,andexpenses Accountsarethe specific records within each element

wherevarious transactionsareentered.Onthe financialstatements, accounts are

typically presentedingroupssuchas“inventory”or“accountspayable.”Acompany’s

chartofaccounts is adetailedlistof theaccountsthat make up the five financial

statementelementsandthe lineitemspresentedinthe financialstatements.

Contraaccounts areusedforentriesthat offsetsome partof thevalueof another

account.Forexample,equipmentistypically valuedonthe balancesheetatacquisition

(historical) cost,and the estimated decreasein itsvalueover timeisrecordedina contra

accounttitled “accumulated depreciation.”

ClassifyingAccounts Into the FinancialStatementElements

Assetsarethe firm’seconomicresources.Examplesofassetsinclude:

• Cashand cashequivalents.Liquidsecuritieswithmaturitiesof 90 daysorlessare

consideredcashequivalents

• Accountsreceivable Accountsreceivableoftenhavean“allowanceforbad debt

expense”or“allowancefordoubtfulaccounts”as a contra account.

• Inventory

• Financialassets,suchasmarketablesecurities

• Prepaidexpenses.Items that will be expensesonfutureincomestatements.

• Property,plant,andequipment.Includesa contra-asset accountforaccumulated

depreciation

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Study Session 7

Cross-Reference to CFA InstituteAssigned Reading#23-Financial Reporting Mechanics

• Investment inaffiliatesaccountedforusing theequitymethod

• Deferredtax assets.

• Intangibleassets.Economicresourcesof the firm that donothaveaphysicalform,

suchas patents,trademarks, licenses,and goodwill Except for goodwill,these valuesmay bereducedby “accumulatedamortization.”

Liabilitiesarecreditor claimsonthe company’sresources.Examples of liabilities include:

• Accountspayableand tradepayables

• Financial liabilities suchasshort-term notespayable

• Unearnedrevenue.Itemsthatwill showuponfutureincome statements asrevenues

• Incometaxespayable.Thetaxesaccrued during thepastyearbutnot yetpaid

• Long-term debt suchasbonds payable

• Deferredtaxliabilities

Owners’equityistheowners’residual claimon afirm’sresources,whichistheamount

by whichassetsexceed liabilities Owners’equityincludes:

• Capital.Parvalueofcommonstock

• Additionalpaid-in capital Proceedsfromcommonstocksalesinexcessof parvalue

(Sharerepurchases that thecompanyhas madearerepresentedinthecontra account treasurystock.)

• Retainedearnings.Cumulativenetincomethat hasnotbeen distributedasdividends

• Othercomprehensiveincome.Changesresultingfromforeigncurrency translation,minimum pensionliability adjustments,orunrealizedgains and losseson investments.

Revenuerepresentsinflowsofeconomicresourcesand includes:

• Sales.Revenue from the firm’sday-to-dayactivities

• Gains.Increases inassetsfromtransactionsincidentaltothe firm’s day-to-day

activities

• Investmentincomesuchasinterestand dividendincome

Expensesareoutflowsofeconomic resourcesand include:

• Costofgoods sold

• Selling, general,and administrativeexpenses.Theseinclude suchexpensesasadvertising,managementsalaries,rent,and utilities

• Depreciation andamortization.To reflectthe “using up” of tangible and intangible

LOS23.b:Explainthe accounting equationin itsbasic andexpandedforms

CFA®ProgramCurriculum,Volume3,page 46

The basic accounting equationistherelationshipamong the three balance sheetelements:

assets=liabilities+owners’equity

Page 20

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StudySession 7 Cross-Reference to CFA InstituteAssigned Reading#23-Financial Reporting Mechanics

Owners’ equityconsistsof capital contributed by the firm’sownersand the cumulative

earnings the firm has retained With thatin mind,wecanstatethe expanded accounting

equation:

assets=liabilities+contributed capital+ending retained earnings

Ending retained earnings foranaccounting periodarethe resultof adding that period’s

retained earnings(revenues minusexpensesminus dividends)tobeginning retained

earnings So theexpanded accounting equationcanalso be statedas:

LOS 23.c: Describe the process ofrecordingbusinesstransactionsusingan

accountingsystembasedonthe accounting equation

CFA®ProgramCurriculum,Volume3,page49Keeping the accounting equationinbalance requires double-entry accounting,inwhich

atransactionhastobe recordedinatleasttwo accounts.An increase in anasset account,

for example,mustbe balanced byadecreaseinanotherasset account orbyan increase in

aliabilityorowners’ equityaccount.

Sometypical examples of doubleentryaccounting include:

• Purchase equipmentfor$10,000cash Property, plant, and equipment(anasset)

increasesby$10,000.Cash(an asset)decreasesby$10,000

• Borrow $10,000topurchase equipment.PP&E increasesby$10,000 Notespayable

(aliability)increasesby$10,000

• Buyofficesuppliesfor$100 cash Cash decreases by $100 Supply expenseincreasesby

$100.An expensereduces retained earnings,soowners’ equity decreasesby $100

• Buyinventoryfor$8,000cash and sellitfor$10,000cash Thepurchase decreases

cash by$8,000andincreasesinventory(an asset)by$8,000.The saleincreasescash

by$10,000and decreasesinventoryby$8,000,so assetsincreaseby$2,000.At the

sametime,sales(a revenue account) increaseby$10,000and“cost of goods sold”

(anexpense)increasesby the$8,000costof inventory The$2,000differenceis

anincrease innetincome and, therefore, inretained earnings and owners’ equity

(ignoringtaxes).

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Study Session 7

LOS23.d: Describe the need for accruals and otheradjustmentsinpreparingfinancialstatements.

CFA®Program Curriculum, Volume3,page 69

Revenuesandexpensesare notalways recordedatthesametimethat cashreceipts

andpayments aremade The principle of accrual accounting requires thatrevenue

isrecorded when the firmearnsitandexpensesarerecordedasthe firmincurs them,

regardlessof whether cash hasactuallybeenpaid Accrualsfallintofourcategories:

1 Unearnedrevenue.The firmreceivescashbeforeitprovidesagoodorserviceto customers.Cashincreasesand unearnedrevenue, aliability,increasesby thesame amount.Whenthe firm provides the goodor service, revenueincreasesand theliability decreases.Forexample,anewspaperormagazinesubscriptionistypicallypaidinadvance The publisher records the cash received andincreasesthe unearnedrevenueliabilityaccount.The firm recognizesrevenuesand decreases the liabilityas

itfulfills the subscription obligation

2. Accruedrevenue.Thefirm provides goodsorservices beforeit receivescashpayment.

Revenue increasesandaccountsreceivable(an asset)increases.Whenthecustomer

pays cash,accountsreceivable decreases.Atypicalexample would beamanufacturerthat sells goodsto retailstores“on account.” The manufacturer recordsrevenuewhenitdelivers the goods but doesnotreceivecash untilafter the retailers sell thegoodsto consumers.

3 Prepaidexpenses.Thefirmpays cashaheadoftimeforananticipatedexpense Cash

(an asset)decreases and prepaidexpense(also an asset)increases.Prepaidexpense

decreases andexpensesincreasewhen the expenseisactually incurred.Forexample,

aretailstorethatrentsspace inashopping mall willoften pay itsrentinadvance

4 Accruedexpenses.Thefirmowescashfor expenses it has incurred.Expensesincreaseandaliabilityforaccruedexpensesincreases aswell.The liabilitydecreases whenthefirmpays cashtosatisfyit.Wages payableare a commonexampleofanaccrued

expense,ascompaniestypicallypay theiremployeesat alaterdatefor worktheyperformedin the prior weekormonth

Accruals requireanaccountingentrywhen the earliestevent occurs(payingorreceivingcash,providingagoodor service, orincurringanexpense)and requireone or moreoffsettingentries astheexchangeiscompleted With unearnedrevenueand prepaid

expenses,cash changes handsfirstandthe revenueorexpenseisrecordedlater.Withaccruedrevenueand accruedexpenses, therevenue orexpense isrecorded first andcash

isexchanged later.Inall thesecases,theeffect of accrual accountingistorecognizerevenues orexpenses inthe appropriate period

OtherAdjustments

Mostassets arerecordedonthefinancialstatements attheir historicalcosts However,accounting standardsrequire balance sheet values ofcertainassets toreflect theircurrent

marketvalues Accountingentriesthatupdate these assets’ valuesarecalled valuation

adjustments.Tokeepthe accounting equation inbalance,changesinassetvaluesalso

Page 22

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Study Session 7 Cross-Reference to CFA InstituteAssigned Reading#23-Financial Reporting Mechanics

change owners’equity,through gainsorlosses recordedontheincome statement orin

“other comprehensiveincome.”

LOS 23.e:Describe therelationships among theincomestatement,balance

sheet,statementof cashflows,andstatementof owners’ equity

CFA®ProgramCurriculum,Volume3,page65Figures1through 4containthe financialstatementsforasamplecorporation The

balance sheet summarizes thecompany’sfinancial positionattheendof thecurrent

accountingperiod(andin thisexample,italso shows thecompany’spositionattheend

ofthe previousfiscal period) Theincomestatement,cash flowstatement,andstatement

of owners’ equity show changes that occurred during themost recentaccountingperiod

Notethese key relationshipsamongthe financialstatements:

• Theincome statementshows thatnet income was $37,500in 20X8 Thecompany

declared$8,500of thatincome asdividendsto itsshareholders.The remaining

$29,000 is anincreaseinretained earnings Retained earningsonthe balancesheet

increased by$29,000,from$30,000in20X7to $59,000in20X8

• The cash flowstatementshowsa $24,000 netincrease incash.Onthe balancesheet,

cash increasedby$24,000,from$9,000in20X7to $33,000in 20X8

• Oneof theusesof cash shownonthecash flowstatementisarepurchaseof stock for

$10,000 The balance sheet shows this $10,000 repurchaseas adecreaseincommon

stock,from$50,000in20X7to $40,000in 20X8

• Thestatementof owners’equityreflects the changesinretained earnings and

contributed capital(commonstock).Owners’ equity increased by$19,000,from

$80,000in20X7to $99,000in 20X8 Thisequalsthe$29,000 increasein retained

earnings less the$10,000decrease incommonstock

Figure1: IncomeStatement for 20X8

Income from continuing operations

Gain from sale of land

$52,500 47,500 10,000

$57,500

20,000

$37,500 8,500

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Study Session 7

Figure2:Balance Sheet for20X7 and20X8

20X8 20X7

IV

c

Assets.2to

Current assets

Q)

9,000 7,000

10,000 5,000

Accounts receivable Inventory

Noncurrent assets

Land Grossplantand equipment less: Accumulateddepreciation

Netplantand equipment

~o

a

to

$35,000 85,000 (16,000)

$40,000 60,000 (9,000)

$69,000

10,000

$51,000

10,000 Goodwill

Total assets

Liabilities and Equity

$162,000 $126,000

Current liabilities AccountspayableWages payable

Interest payable Taxes payable Dividendspayable

Noncurrent liabilities Bonds

$5,000

8,000 3,000

4,000

1,000

$9,000 4,500

3,500 5,000

6,000

$15,000

20,000

$10,000 15,000 Deferred taxes

Stockholders’ equity Common stock Retained earnings Total liabilities & stockholders’ equity

$40,000 59,000

$50,000

30,000

$162,000 $126,000Figure3:CashFlowStatement for 20X8

Cash collections Cash inputs Cash expenses Cash interest Cash taxes

Cash flow from operations Cash from sale of land Purchase of plant and equipment Cash flow from investments Sale of bonds

Repurchaseof stock Cashdividends

Cash flow fromfinancing

Total cash flow

$99,000 (34,000) (8,500) 0 (14,000)

$42,500

$15,000 (25,000) ($10,000)

$5,000 (10,000) (3,500) ($8,500)

$24,000

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StudySession 7 Cross-Reference to CFA InstituteAssigned Reading#23-Financial Reporting MechanicsFigure 4: Statement of Owners’Equityfor20X8

ContributedCapital

LOS23.f:Describe the flowof informationinanaccountingsystem

CFA®ProgramCurriculum,Volume3,page 71Information flowsthroughanaccountingsysteminfoursteps:

whatamounts.Alisting of all thejournalentries inorder of their datesiscalled the

general journal

2 The general ledgersortstheentries inthe general journal byaccount.

3 At the end of the accounting period,aninitial trialbalance isprepared that shows the

balancesineachaccount.Ifanyadjustingentries are needed,they will be recorded

and reflectedinanadjustedtrial balance

4 Theaccountbalancesfrom the adjusted trial balancearepresentedinthe financial

statements.

LOS 23.g:Describe theuseof the results of the accounting processin security

analysis

Ananalyst doesnothaveaccess tothe detailed information that flows througha

company’s accountingsystembutseesonly the end product(thefinancialstatements).

Ananalyst needstounderstand thevarious accruals,adjustments, andmanagement

assumptions thatgo intothe financialstatements.Muchof this detailiscontainedinthe

footnotestothestatementsand Management’sDiscussionand Analysis,soit iscrucial

forananalysttoreviewthesepartsof the financialstatements.With thisinformation,

the analystcanbetterjudgehow well the financialstatementsreflect the company’strue

performance and what adjustmentstothe dataarenecessaryforappropriateanalysis

Because adjustments and assumptions within the financialstatements are, atleastto

someextent, atthe discretionofmanagement,the possibilityexiststhatmanagement

mayattempt tomanipulateormisrepresent thecompany’sfinancialperformance.Agood

understanding of the accounting processcanhelpananalyst identify financialstatement

entriesthatappeartobeoutof line

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Transactionsarerecordedinaccountsthat form the financialstatementelements:

• Assets—the firm’seconomicresources.

• Liabilities—creditors’claimsonthe firm’sresources.

• Owners’equity—paid-in capital(commonand preferredstock),retainedearnings,

and cumulative other comprehensiveincome

• Revenues—sales, investmentincome,and gains

• Expenses—costof goodssold,selling and administrativeexpenses,depreciation,interest, taxes,and losses

assets=liabilities+owners’equity

Theexpandedaccountingequation:

assets=liabilities+contributed capital+ending retained earnings

Theexpandedaccountingequationcanalso bestatedas:

assets= liabilities+contributedcapital+beginning retained earnings+ revenue

expenses—dividends

LOS23.c

Keeping the accountingequation(A—L=E)in balance requiresdoubleentryaccounting,inwhichatransactionisrecordedinatleasttwo accounts.An increase inan asset account,forexample,mustbebalanced byadecreaseinanotherasset account or

byanincrease inaliabilityorowners’equityaccount.

LOS 23.d

Afirmmustrecognizerevenueswhen theyareearned andexpenseswhen theyareincurred Accrualsarerequired when the timing of cashpaymentsmade and receiveddoesnotmatchthetiming of therevenue orexpenserecognitiononthefinancial

statements.

LOS 23.eThe balance sheet showsacompany’s financial positionat apointin time

Changesin balance sheetaccountsduringan accountingperiodarereflectedin theincomestatement,the cash flowstatement,and thestatementofowners’equity

Page 26

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LOS23.f

Informationenters anaccountingsystem asjournalentries,whicharesortedbyaccount

intoageneral ledger Trial balancesareformedatthe endofanaccountingperiod

Accountsarethenadjustedandpresentedinfinancialstatements.

LOS 23.g

Sincefinancial reporting requires choices ofmethod, judgment, andestimates, ananalyst

mustunderstand the accountingprocessusedtoproducethefinancialstatementsin

ordertounderstand thebusinessand theresultsfor theperiod Analysts shouldbe

alerttotheuseof accruals,changesinvaluations,andother notablechangesthat may

indicatemanagementjudgmentis incorrector, worse,that thefinancialstatementshave

beendeliberatelymanipulated

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.2 Accountsreceivable andaccountspayableare mostlikely classifiedaswhich

financialstatementelements?

~o

B

to

Annualdepreciation and accumulated depreciationare mostlikely classifiedas

which financialstatementelements?

The accountingequationisleast accurately statedas:

A owners’ equity=liabilities-assets.

B ending retained earnings=assets -contributed capital-liabilities

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

revenue—expenses-dividends

Adecreaseinassetswould least likely beconsistentwitha(n):

Anelectrician repaired the light fixturesinaretail shoponOctober 24 andsent

thebilltothe shoponNovember3.If both the electrician and the shopprepare

financialstatementsunder the accrual methodonOctober31,how will theyeach record thistransaction?

Prepaidexpense

Accruedexpense

Ifafirmraises$10millionbyissuing newcommon stock,whichofitsfinancial

statementswill reflect thetransaction?

A Incomestatementandstatementofowners’equity

B Balancesheet, incomestatement,and cash flowstatement.

C Balancesheet,cash flowstatement,andstatementof owners’ equity

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Study Session 7 Cross-Reference to CFA InstituteAssigned Reading#23-Financial Reporting MechanicsPaulSchmidt,arepresentative forWestbyInvestments, isexplaining how

securityanalystsusethe resultsofthe accountingprocess Hestates,“Analysts

donothaveaccess toall theentriesthatwentintocreatingacompany’sfinancialstatements.If the analyst carefullyreviewsthe auditor’sreportforany

instanceswhere the financialstatementsdeviate fromtheappropriate accountingprinciples,hecanthen beconfidentthatmanagement is notmanipulatingearnings.” Schmidtis:

A correct.

B incorrect,because theentriesthatwentintocreatingacompany’s financial

statements arepublicly available

C incorrect,becausemanagement canmanipulateearningsevenwithin theconfinesofgenerallyacceptedaccountingprinciples

8.

Trang 30

Allowance for bad debts Bondspayable

Cashequivalents

Common stock Cost ofgoodssold Current portion oflong-termdebt Deferred tax items

Depreciation Dividends payable Dividends received Gain onsaleof assets

Notes payable Othercomprehensiveincome

Prepaidexpenses Property, plant, and equipment Retained earnings

Trang 31

Accounts receivable are an asset and accounts payable are a liability.

4 C Theexpandedaccounting equation shows that assets = liabilities + contributedcapital

+beginningretained earnings + revenue - expenses - dividends A decrease in assets is consistent with an increase in expenses or adecreasein revenuesbutnot with an increase

in contributedcapital

The service isperformedbefore cash ispaid.This transaction represents accrued revenue

to the electrician and an accrued expense to the retail shop Since the invoice has not

been sent as of the statement date, it is not shown in accountsreceivableor accounts

payable

5 A

The$10million raised appears on the cash flow statement as a cash inflow from

financingand on the statement ofowners’equity as an increase in contributedcapital

Both assets (cash)andequity (common stock) increase on the balance sheet The income

statement is unaffectedbystock issuance.

6 C

Thegeneral journallists all of thecompany’stransactionsbydate Thegeneral ledger

lists them by account.

7 B

Schmidt is correct in stating that analysts do not have access to the detailed accounting entries that went into acompany’sfinancial statements However, he is incorrect in stating that an analyst can be sure management is notmanipulatingearningsifthe audit report does not list deviations from accountingprinciples.Because accruals and manyvaluationsrequiremanagement’s judgment,there isconsiderableroom within the accounting standards for management tomanipulateearnings.

8 C

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Study Session 7

Financial statement element Account

Accountspayable

Accounts receivable Accumulateddepreciation

Contra to the assetbeing depreciated

Additionalpaid-in capital

Allowance forbad debts

Contra to accounts receivable.

L A A

O A

BondspayableCashequivalents

Common stock Cost ofgoodssold Current portion oflong-term debt

Deferred tax items

Depreciation Dividends payable Dividends received Gain on sale of assets

Goodwill

Intangibleasset.

Inventory Investment securities Loss on sale of assets

Notespayable

Other comprehensive income

Prepaidexpenses Accrual account.

L A

O

X L

R R A

A A

X L

O A

Property,plant,and equipment Retained earnings

Sales

A

O R Unearned revenue

Accrual account.

L

Page 32

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The following is a review of the Financial Reporting and Analysis principles designed to address the

learning outcome statements set forth by CFA Institute This topic is also covered in:

Study Session 7

EXAMFOCUS

This topicreviewcoversaccounting standards: why theyexist,whoissues them,and

whoenforces them.Knowthe difference between the rolesof private standard-setting

bodies andgovernmentregulatory authorities and be ableto namethemostimportant

organizations of both kinds.Becomefamiliarwith theframework for International

Financial Reporting Standards(IFRS),including qualitativecharacteristics, constraints

and assumptions, and features for preparing financialstatements.Beabletoidentify

barrierstoconvergence of national accounting standards(suchasU.S.GAAP)with

IFRS,key differences between the IFRS and U.S.GAAP frameworks,and elementsof

and barrierstocreatingacoherent financial reporting network

LOS24.a:Describe theobjectiveof financialstatementsand the importance of

financial reporting standardsinsecurity analysis and valuation

CFA®ProgramCurriculum,Volume3,page100

Accordingtothe IASB Conceptual FrameworkforFinancial Reporting2010,the objective

of financial reportingistoprovide information about the firmto currentand potential

investorsand creditors thatisuseful for making their decisions about investinginor

lendingtothefirm

The conceptual frameworkisusedinthe development of accounting standards.Given

the variety andcomplexity ofpossibletransactionsand theestimatesand assumptionsa

firmmustmake when presentingitsperformance, financialstatementscould potentially

takeanyform if reporting standards didnotexist Thus,financial reporting standards

areneededtoprovide consistency by narrowing therangeof acceptableresponses

Reporting standardsensurethattransactionsarereported by firms similarly.However,

standardsmustremainflexible and allow discretionto management toproperly describe

theeconomicsof the firm

Financial reportingisnotdesigned solely for valuationpurposes; however, itdoes

provide important inputs for valuationpurposes

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Study Session 7

Cross-Reference to CFA InstituteAssigned Reading#24- FinancialReporting Standards

LOS24.b: Describe roles and desirable attributes of financial reporting

standard-settingbodies and regulatoryauthoritiesinestablishingandenforcing

reportingstandards,and describe the roleof the International Organization ofSecurities Commissions

CFA®ProgramCurriculum,Volume3,page 103Standard-setting bodiesareprofessional organizations ofaccountantsand auditors thatestablish financial reporting standards Regulatory authoritiesaregovernmentagenciesthat have the legal authoritytoenforce compliance with financial reporting standards

Thetwoprimarystandard-setting bodiesarethe FinancialAccounting Standards Board(FASB)and the InternationalAccounting Standards Board(IASB).In the UnitedStates,

the FASBsetsforth Generally Accepted Accounting Principles(GAAP).OutsidetheUnitedStates,the IASB establishes International Financial Reporting Standards(IFRS)

Othernational standard-setting bodiesexistaswell Many of them (including theFASB)

areworking towardconvergencewithIFRS Someof the olderIASBstandardsarereferredto asInternational Accounting Standards(IAS).

Desirable attributes of standard-setters:

• Observe high professional standards

• Haveadequate authority,resources,and competenciestoaccomplishits mission

• Haveclear andconsistentstandard-settingprocesses

• Guided byawell-articulated framework

• Operate independently while stillseekinginput from stakeholders

• Shouldnotbe compromised by specialinterests

• Decisionsaremadeinthe publicinterest

Regulatoryauthorities,suchastheSecuritiesand ExchangeCommission (SEC) intheUnited States and the FinancialServicesAuthority(FSA)inthe United Kingdom,areestablished by nationalgovernments.Figure1 summarizestheSEC’s filingrequirements

for publicly traded companiesinthe United States These filings, whichareavailablefrom the SEC Website (www.sec.gov),arearguably themostimportantsourceofinformationfor the analysis of publicly traded firms

Mostnational authorities belongtothe International Organization ofSecuritiesCommissions (IOSCO).The three objectives of financial market regulation accordingto

IOSCOl areto (1) protect investors; (2)ensurethefairness,efficiency, andtransparency

ofmarkets;and(3)reduce systemic risk Because of the increasingglobalizationof

securities markets,IOSCOhasagoal of uniform financial regulationsacross countries

1 International Organization of Securities Commissions,“ObjectivesandPrinciplesof SecuritiesRegulation,”June2010.

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StudySession 7 Cross-Reference to CFA InstituteAssigned Reading #24-Financial Reporting StandardsFigure1:Securitiesand ExchangeCommissionRequired Filings

Form S-l.Registrationstatementfiled priortothe saleofnewsecuritiestothe

public The registrationstatementincludes audited financialstatements,risk

assessment,underwriteridentification,and the estimatedamountanduseof the

offeringproceeds

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

itsmanagement,audited financialstatementsanddisclosures,and disclosures about

legalmattersinvolving the firm InformationrequiredinForm 10-K issimilarto

that whichafirm typically providesin itsannualreport toshareholders.However, a

firm’s annualreportisnot asubstitute for therequired10-Kfiling.EquivalentSEC

forms forforeignissuers in theU.S.marketsareForm40-Ffor Canadian companies

andForm 20-Ffor other foreignissuers

Form10-Q U.S firmsarerequiredtofile this form quarterly, with updated

financialstatements(unlike Form 10-K,thesestatementsdonothavetobe

audited)and disclosures aboutcertaineventssuchassignificant legal proceedingsor

changesinaccountingpolicy Non-U.S companiesaretypicallyrequiredtofile the

equivalentForm6-Ksemiannually

FormDEF-14A Whenacompany preparesaproxystatementforitsshareholders

priortothe annual meetingorother shareholdervote,italso files thestatementwith

the SECasFormDEF-14A

Form 8-K.Companiesmustfile thisformtodisclose materialeventsincluding

significantassetacquisitions anddisposals, changesinmanagement or corporate

governance,ormattersrelatedtoitsaccountants,itsfinancialstatements,orthe

marketsinwhichits securitiestrade

Form144.A company can issue securitiestocertainqualified buyers without

registering thesecuritieswith the SEC butmustnotify the SEC thatitintendstodo

so.

Forms3,4,and5involve the beneficialownership ofsecuritiesbyacompany’s

officers and directors Analystscanusethese filingstolearn about purchases and

salesof companysecuritiesbycorporateinsiders

LOS24.c: Describe thestatusofglobalconvergenceof accounting standards

and ongoing barrierstodevelopingoneuniversallyacceptedsetof financial

reporting standards

The EuropeanUnionrequires IFRS financial reporting by publicly listedcompanies

Inmostmajorcountriesthat havenotfully adoptedIFRS,accounting standardsetters

areattemptingtoconvergetheir standards with IFRS Manyaspectsof U.S GAAP

andIFRS,for example, have convergedoverthepastdecade,and theSecuritiesand

ExchangeCommissionnolongerrequires IFRS reporting firmstoreconcile their

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Study Session 7

financialstatements toU.S.GAAP IFRS convergence effortsarealso ongoinginJapan,

China,andmanyothercountries

Onebarriertoconvergence (developingoneuniversally acceptedsetof accounting

standards) issimply that different standard-setting bodies and the regulatory authorities

of differentcountriescanand do disagreeonthe besttreatmentofaparticularitemor

issue.Other barriers result from the politicalpressuresthat regulatory bodies face frombusinessgroupsand others who will be affectedby changesinreporting standards

LOS 24.d: Describe the International Accounting Standards Board’sconceptual

framework,includingtheobjectiveandqualitativecharacteristicsof financialstatements,required reportingelements,andconstraintsand assumptionsinpreparing financialstatements.

CFA®ProgramCurriculum,Volume3,page 116The ideasonwhich theIASBbasesitsstandardsareexpressedinthe “ConceptualFramework for Financial Reporting” that the organization adoptedin 2010.TheIASB

framework details thequalitative characteristics of financialstatementsand specifiesthe required reporting elements The framework alsonotescertain constraintsandassumptions thatareinvolvedinfinancialstatementpreparation

At thecenterof the IASB Conceptual Frameworkisthe objectivetoprovide financialinformation thatisusefulinmaking decisions about providingresourcestoan entity

Theresourceproviders includeinvestors,lenders,and other creditors.Usersof financial

statementsneed information about the firm’sperformance, financial position, and cashflow

QualitativeCharacteristicsThereare twofundamental characteristics that make financial information useful:

relevance and faithfulrepresentation.2

• Relevance Financialstatementsarerelevant if the informationinthemcaninfluenceusers’economicdecisionsoraffectusers’ evaluations ofpast events orforecasts offutureevents.To berelevant,information should have predictivevalue,confirmatoryvalue(confirmprior expectations),orboth Materialityisan aspectofrelevance.3

• Faithfulrepresentation Information thatisfaithfully representativeiscomplete,neutral(absenceofbias),andfree fromerror

Therearefour characteristics that enhance relevance and faithful representation:

comparability, verifiability,timeliness,and understandability

• Comparability Financialstatementpresentation should beconsistentamong firmsandacrosstimeperiods

• Verifiability.Independentobservers,using thesamemethods,obtain similar results

• Timeliness Informationisavailabletodecision makers before the informationis

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StudySession 7 Cross-Reference to CFA InstituteAssigned Reading #24-Financial Reporting Standards

• Understandability.Userswithabasic knowledge of business and accounting and who

makeareasonableefforttostudy the financialstatementsshould be abletoreadily

understand the information thestatements present.Usefulinformation shouldnot

be omittedjustbecauseit iscomplicated

RequiredReporting Elements

The elementsof financialstatementsarethe by-now familiar groupings ofassets,

liabilities,andowners’ equity(formeasuring financialposition) andincomeand

expenses(formeasuringperformance) The Conceptual Framework describes each of

theseelements:4

• Assets.Resources controlledas aresultofpasttransactionsthatareexpectedto

provide futureeconomicbenefits

• Liabilities Obligationsas aresultofpast eventsthatareexpectedtorequirean

outflow ofeconomic resources

• Equity The owners’ residualinterest intheassetsafter deducting the liabilities

• Income.An increase in economic benefits,either increasingassets ordecreasing

liabilitiesinawaythatincreasesowners’ equity(but notincluding contributions by

owners) Incomeincludesrevenuesand gains

• Expenses.Decreases in economic benefits,either decreasingassets orincreasing

liabilitiesinawaythat decreases owners’ equity(butnotincluding distributionsto

owners).Lossesareincludedin expenses

An itemshould be recognizedin itsfinancialstatementelement ifafutureeconomic

benefitfrom theitem(flowingto orfrom thefirm) isprobable and the item’s valueor

cost canbe measured reliably

Theamounts atwhichitemsarereportedinthe financialstatementelements depend

ontheirmeasurementbase.Measurementbases include historicalcost(theamount

originallypaid for theasset),amortizedcost(historicalcostadjusted fordepreciation,

amortization,depletion, and impairment),current cost (the amountthe firm would have

topay today for thesame asset),realizable value(theamountfor which the firm could

sell theasset),presentvalue(thediscounted valueof theasset’s expected future cash

flows),andfairvalue(theamount atwhichtwopartiesinanarm’s-lengthtransaction

would exchange theasset)

Professor’sNote:In thenextStudySessions, wewill discuss thesemeasurementbasesinmoredetail and thesituations inwhich eachisappropriate

Constraintsand Assumptions

Accordingtothe ConceptualFramework,thereiscost-benefit tradeoffof the enhancing

characteristics.5Accordingly, the benefit thatusersgain from the information should

begreaterthan thecostof presentingit.Anotherconstraint, notspecifically mentioned

inthe ConceptualFramework, isthefact that non-quantifiable information abouta

company(itsreputation, brand loyalty, capacity forinnovation, etc.) cannotbe captured

directly infinancialstatements.

4 Ibid.,paragraphs4.4-4.23

5 Ibid.,paragraphsQC35-39.

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Study Session 7

Two important underlying assumptions of financialstatementsareaccrual accountingandgoingconcern.6Accrual accountingmeansthat financialstatementsshould reflect

transactionsatthetimethey actuallyoccur, notnecessarily when cashispaid Goingconcernassumesthecompanywillcontinuetoexistfor the foreseeable future If thisis

notthecase,then presenting the company’s financial position fairly requiresanumber

of adjustments (e.g.,its inventory orotherassetsmayonly be worth their liquidation

values)

LOS24.e:Describegeneralrequirements for financialstatementsunderInternational Financial Reporting Standards(IFRS)

International Accounting Standard(IAS) No 1defines which financialstatements arerequired and how theymustbe presented The required financialstatementsare:

• Balance sheet(statementof financial position)

• Statementof comprehensiveincome

• Cash flowstatement.

• Statement ofchangesinowners’ equity

• Explanatorynotes,includingasummaryof accounting policies

The general features for preparing financialstatements arestatedinIASNo 1:

• Fairpresentation, definedasfaithfully representing the effects of the entity’s

transactionsandeventsaccordingtothe standardsfor recognizingassets,liabilities,

revenues,andexpenses

• Goingconcernbasis,meaning the financialstatements arebasedonthe assumptionthat the firm willcontinuetoexistunlessitsmanagementintendsto (or must)liquidateit

• Accrual basisof accountingisusedtopreparethe financialstatementsother than the

statementof cash flows

• Consistency betweenperiodsinhowitemsarepresented andclassified,with periodamountsdisclosed for comparison

prior-• Materiality,meaning the financialstatementsshould be free ofmisstatements oromissionsthat could influence the decisions ofusersof financialstatements.

* Aggregation of similaritemsandseparationof dissimilaritems

• Nooffsetting ofassetsagainst liabilitiesor incomeagainstexpenses unlessaspecificstandard permitsorrequiresit

• Reportingfrequencymustbeatleast annually

• Comparativeinformationfor prior periods should be included unlessaspecificstandardstatesotherwise

Also statedinIASNo 1arethestructureandcontentof financialstatements:

• Most entitiesshouldpresent aclassifiedbalance sheet showingcurrentandnoncurrent

assetsand liabilities

• Minimuminformationisrequiredontheface of each financialstatementandinthe

notes.Forexample, the face of the balance sheetmustshow specificitemssuchascash and cash equivalents, plant,propertyand equipment, andinventories.Items

6 Ibid.,paragraphs OB17and4.1

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StudySession 7 Cross-Reference to CFA InstituteAssigned Reading #24-Financial Reporting Standards

listedontheface of the comprehensiveincomestatement mustincluderevenue,

profitor loss,taxexpense, and financecosts,among others

• Comparativeinformationfor prior periods should be included unlessaspecific

standardstatesotherwise

LOS24.f: Compare keyconceptsof financial reporting standards under

IFRSand USgenerally acceptedaccountingprinciples(US GAAP)reporting

systems

CFA®ProgramCurriculum,Volume3,page 127U.S.GAAPconsistsof standards issued by theFASB,along withnumerousother

pronouncementsandinterpretations.Like theIASB,the FASB hasaframeworkfor

preparing and presenting financialstatements.Thetwoorganizationsareworking toward

a commonframework, butat presentthetwoframeworks differinseveralrespects.

• The IASB framework listsincomeandexpensesaselements relatedtoperformance,

while the FASB framework includesrevenues,expenses,gains,losses,and

comprehensiveincome

• The FASB definesan asset as afutureeconomic benefit,whereas the IASB defines

itas aresourcefrom whichafutureeconomicbenefitisexpectedtoflow.Also,the

FASBusesthe wordprobablein itsdefinition ofassetsandliabilities

• The FASB doesnotallow the upward valuation ofmost assets.

Until these frameworksconverge,analysts will needtointerpret financialstatementsthat

areprepared under different standards Inmanycases,however,acompanywillpresent

areconciliationstatementshowing whatitsfinancial results would have been underan

alternative reportingsystem.Forexample, firms that list their sharesinthe United States

but donot useU.S.GAAPorIFRSarerequiredtoreconcile their financialstatements

with U.S.GAAP.ForIFRSfirms listing their sharesinthe UnitedStates,reconciliation

isnolonger required

Evenwhenaunified frameworkemerges,special reporting standards that applyto

particular industries (e.g.,insuranceand banking) willcontinuetoexist

LOS24.g:Identify characteristics ofacoherent financial reporting framework

and the barrierstocreating suchaframework

CFA®Program Curriculum,Volume3,page129

Acoherent financial reporting frameworkisonethat fits together logically Sucha

framework should betransparent,comprehensive, andconsistent

• Transparency—Full disclosure and fair presentation reveal theunderlyingeconomics

of thecompanytothefinancialstatementuser

• Comprehensiveness—Alltypesoftransactionsthat have financial implications should

bepartof theframework,includingnewtypesoftransactionsthat emerge

• Consistency—Similartransactionsshould be accountedforinsimilarwaysacross

companies, geographicareas,andtimeperiods

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Study Session 7

Barrierstocreatingacoherent financial reporting framework includeissuesrelatedto

valuation,standard setting, andmeasurement.

• Valuation—Measurement bases forvaluation that require little judgment, suchashistoricalcost,maybe less relevant thanabasislike fair value that requiresmore

judgment

• Standardsetting—Three approachestostandard settingarea“principles-based”

approach that relieson abroadframework,a“rules-based” approach that givesspecific guidance about howtoclassifytransactions,andan“objectives-oriented”

approach that blends the othertwoapproaches.IFRS islargelyaprinciples-basedapproach U.S GAAP has traditionally beenmore rules-based,but thecommon

conceptual frameworkismoving towardanobjectives-orientedapproach

• Measurement—Another trade-offinfinancial reportingisbetween properly valuingthe elementsat onepointin time (asonthe balancesheet)and properly valuing thechanges between pointsin time(as ontheincomestatement).An“asset/liability”

approach, which standardsettershave largelyused,focusesonbalance sheetvaluation.A“revenue/expense” approach would tendtoplacemoresignificanceon

theincomestatement.

LOS24.h: Describeimplicationsfor financialanalysisofdifferingfinancialreportingsystemsand the importance of monitoring developmentsinfinancialreporting standards

Asfinancial reporting standardscontinuetoevolve,analysts needtomonitorhow thesedevelopments will affect the financialstatementstheyuse.Ananalyst should beaware

ofnewproducts andinnovations inthe financial markets thatgeneratenewtypesoftransactions.These mightnotfall neatlyintothe existing financial reporting standards

The analystcanusethe financial reporting frameworkas aguide for evaluating whateffectnewproductsortransactionsmight haveonfinancialstatements.

To keepuptodateonthe evolvingstandards,ananalystcanmonitorprofessionaljournals and othersources,suchasthe IASB(www.ifrs.org) and FASB(www.fasb.org)Websites.CFAInstituteproduces positionpapersonfinancial reportingissuesthroughthe CFAInstitute Centrefor Financial Market Integrity

Finally, analystsmustmonitor companydisclosures for significant accounting standardsandestimates

LOS 24.i:Analyzecompany disclosures ofsignificantaccountingpolicies.

CFA®ProgramCurriculum,Volume3,page 134Companies thatpreparefinancialstatementsunder IFRSorU.S.GAAPmustdisclosetheir accounting policies andestimates inthefootnotes Significant policies and

estimatesthat requiremanagementjudgementarealso addressedinManagement’s

Discussionand Analysis.Ananalyst shouldusethese disclosurestoevaluate whatpoliciesare discussed,whether theycoverall the relevant datainthe financialstatements,

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