CFA 2018 level 1 fintree FRA

Financial Statement Analysis -An Introduction1 Objective of FR - Provide financial information to existing or potential users - Evaluate financial position and past performance and form

Financial Statement Analysis -An Introduction

1) Objective of FR

- Provide financial information to existing or potential users

- Evaluate financial position and past performance and form opinion about its future ability to earn profits

2) Financial Statement Analysis helps to make economic decisions

3) Balance sheet - Financial position at a point in time

4) Statement of comprehensive income reports all changes in equity except shareholders transactions

(Change in foreign currency translation; pension liabilities adjustments; Unrealized G/L on investments)

IFRS - Can combine with P&L

US GAAP - Can combine with statement of SH's equity

5) Statement of changes in Equity (issuing stocks; repurchase stock; paying dividend)

6) Cash flow (business activities)

- Operating CF (day to day activities)

- Investing CF (Fixed Assets)

Objective - To provide fairness and reliability of financial statements

Std auditors statement contains 3 parts - Independent review; Auditing stds were followed; FS prepared based on accepted accounting principles

4 Type of opinion - Unqualified (clean); Qualified (exceptions); Adverse (-ve); disclaimer of opinion (unable to express)

10) Steps in financial statement analysis framework

State the objective

Gather data

Process the data

Analyze and interpret the data

Report the conclusion or recommendations

Update the analysis

11) Election of Board members can be found in proxy statement

Financial Reporting Mechanics

1) Accounts - where transactions are recoreded

Chart of accounts - Detailed list of all accounts

Contra accounts - Entries offsetting some part of another account (dep on asset - Contra asset) 2) Asset = Liabilities + owner capital

- Unearned revenue (Cash recd in adv + Service yet to be provided)

- Accrued revenue (Cash to be recd + Service provided)

- Prepaid expense (Cash paid in adv + Service yet to be recevied)

- Accrued expense (Cash to be paid + Service recevied)

4) Flow of information in accounting system

Journal Entry - Datewise called as General Journal - General Ledger - Trail balance - FS

Financial Reporting Standards

1) Financial Reporting is not designed solely for valuation purposes, however it does provide important inputs for valuation purposes 2) Standard setting bodies - Establish financing reporting standards (US GAAP - FASB; IFRS - IASB)

Regulatory authorities - Legal authority to enforce compliance with financial reporting standards (US - SEC; UK - FCA)

3) 3 objectives of IOSCO1 (Intl org of securities commission)

- Protect investors

- Ensure fairness, efficiency and transparency of mkts

- Reduce systemic risk (mkt risk)

- Faithful representation (Free from error and complete)

- Relevance (Materiality - Can influence economic decision)

4 characteristics that enhance FR

- Aggregation of similar items

- No offsetting of assets

- Reporting frequency (Atleast annually)

- Comparative information with prior periods

9) Barriers to financial reporting framework

- Valuation

- Standard setting (US GAAP - rule based approach ; IFRS - principal based approach i.e judegemental)

- Measurement base

10) Barriers to converge into universal accepted set of FR standard

- Different of opinion between standard setting bodies and regulatory authorities

- Political pressure from business groups

1) COGS = Beginning inventory + purchases - closing inventory

Or

Closing inventory = Beginning inventory + purchases - COGS

2) Calculation of cost is same as per IFRS and US GAAP

Includes:

Purchase cost (-) trade discount

Conversion cost including labour and O/H

Other cost to bring inventory to present location and condition

Excludes:

Abnormal waste

Adminstrative cost

Selling cost

Specific identification method (IFRS and US GAAP) Specific Specific

4) Effects when prices are increasing and stable or increasing inventory level

5) 2 Type of systems

- Periodic method (end of accounting period)

- Perpetual method (Updated continuously)

6) Measurement of inventory

Or NRV (Selling price - selling cost)

- Loss to be recognized in P&L

- subsequent reversal in P&L to the same extent

Or Mkt Value = Replacement cost provided its between range of

1) NRV 2) NRV (-) normal profit margin

if Replacement cost is > NRV; den MV = NRV

if Replacement cost is <

NRV - profit margin ; den MV = NRV - profit margin

- Loss to be recognized in P&L

- No subsequent reversal allowed

FIFO and specific idenfication ans will be same in any method; but not same for LIFO

***In certain industries - reporting inventory above historical cost is allowed

- Applies to producers of agricultural and forest products; mineral ores; precious metals

- Valued at NRV

- Changes in mkt prices to be recoreded in P&L

7) Change in method - Retrospectively and Chg to LIFO is prospectively

8) Inventory Management

Inv T/O = COGS/ Avg inventory

Low Inv T/O means slow-selling or even obsolete products

High Inv T/O means low days of inventory in hand is

desirable; however enough inventory should be in place

to satisfy demand High Inv T/O can be due to writedown of inventories

High Inv T/O with sales growth - good

Long Lived Assets

1) Expenditure providing future economic benefits over multiple accounting period is capitalized

Otherwise expensed

2) Recorded at cost = Acq cost + other expense to prepare the asset for use

3) Subsequent expenditure = if future economic benefit den Capitalized (Rebuilt, installation cost)

Otherwise expense (training cost, repairs and maintenance)

4) Capitalized interest (Investing activity under CF)

- If Interest is accrued while building asset is capitalized only to the extent of debt used

- Under IFRS - income earned on temporarily investing borrowed funds reduces the interest to be capitalized

Same methods of dep to caln amortization 7) R&D

Under IFRS

- Research cost is expensed

Intangible Assets

Type

- Development cost is capitalized

Under US GAAP

- Research cost is expensed

- Development cost is expensed

S/W development cost

Under IFRS - Capitalized only after product feasibility is established (Developed for sale or own use) Under US GAAP - Completely Capitalized (Developed for only own use)

8) Goodwill internally developed is expensed in the period incurred

Goodwill created in business combination is capitalized

SLM

Dep = (Cost - Salvage value)/Life

Accelerated depreciation method (DDB)

Units of prodn method

Dep = (Cost - Salvage value)/Life in units * units produced in that year

10) Change in estimates like useful life, salvage cost = effect is prospectively

11) Component depreciation - IFRS requires firms to do it; US GAAP - allowed but rarely used

12) Amortization Expense - Only for assets having definate life

If asset can be renewed at minimal cost for indefinate period, the same needs to be excluded from caln 13) Revaluation method (only IFRS allows it)

Normally long lived assets are valued at dep cost known as cost model

However IFRS allows to report asset at F.V if active market exists

If F.V less den cost - recored loss in P&L

Subsequent recover is allowed to the same extent and balance into SH's equity

*** No Dep Exp

*** FV to be done annually and recog P&L

14) Impairment (Both IFRS and US GAAP)

IFRS

or Recoverable amount

or Value in use Loss in P&L

Subsequent receoveries are allowed bt not above carrying value

US GAAP

Impaired only if events and circumstances indicates firm may not be able to recover the carrying value thru future use

Carrying value or

Future undiscounted cash flow 15) Long lived asset held for sale

Since this has been classified as sale, hence no depreciable will now be allowed

or NRV (-) selling cost Loss in P&L

Subsequent receoveries are allowed bt not above carrying value

16) Long lived asset - Invt proprerties

Cost model = same

Revaluation = same except Surplus above cost is recog in P&L and not in SH's statement

Understanding Income Statement

1) Statement of Other comprehensive income reports all changes in equity except shareholders transactions

- Foreign currency translation

- Adjustment for minimum pension liability

- Unrealized G/L from cash flow hedging derivatives

- Unrealized G/L from available for sale securities (Reported in B/S at F.V)

IFRS - Can combine with P&L

US GAAP - Can combine with statement of SH's equity

2) Minority interest should be dedcuted from Income (Since subsidiary profits are wholly included in P&L)3) P&L presentation

- Single step statement

- Multiple step statement - Pg 49

4) Revenue Recongnition

IFRS - Sale of goods

- Risk and reward of ownership is transferred

- No continuing control over goods

- Revenue can be measured

- Probable flow of economic benefit

- Cost can be measured

IFRS - Services

- Revenue can be measured

- Probable flow of economic benefit

- Cost can be measured

- Stage of completion can be measured

US GAAP - Sale of goods and services

- Evidence of buyer and seller

- Product has been delivered or service has been rendered

- Price is determined or determinable

- Seller is reasonably sure of collecting money

Long Term contracts - 2 methods; PCM and CCM

- Percentage completion method (PCM); Outcome can be measured

IFRS and US GAAP

Steps:

a) % completed = Cost/Total Cost

b) Revenue to be recg = % completed * Total Revenue

- Completed contract method (CCM); Outcome cannot be measured

IFRS; Revenue = Cost & profit only on completion

US GAAP; Revenue, cost and Income to be recg only when contract is completed

If loss is expected The loss must be immediately recognized under IFRS/US GAAPInstallment Sales

US GAAP - 3 methods

- Collectibility is certain; Revenue at the time of sale

- Installment sale (Collectibility cannot be reasonably estimated)

Profit = cash collected * Profit margin on sales

- Cost Recovery method (Collectibility is highly un-certain)

Profit = cash received > cost

IFRS

Interest income = Installment value - Disc P.V of installment value

- Cost Recovery method (Collectibility is highly un-certain)

Barter transactions

US GAAP; Revenue = F.V if received cash for such goods, otherwise C.V of the goodsIFRS; Revenue = F.V from similar non barter transaction with unrelated parties5) Gross and Net reporting of revenue

US GAAP

- Primary obligator

- Bear inventory and credit risk

- Be able to choose its supplier

- reasonable attitude to establish the price

6) Matching concept - Income should be recg when expense is made or vice versa (Warranty/Bad debts)

7) Inventory

8) Depreciation

9) Amortization

10) Non-Recurring Items

a) Discontinued opertaions (Reported separately, net of tax after income from continuing operations)

Measurement date = Company develops a plan for disposing of operations

Phaseout period = Time between actual disposal and measurement date

On measurement date = Company will estimate loss during phaseout period and loss on sale of business; gains cannot be reportedb) Unusual or infrequent items (Included in income from continuing operations before tax)

G/L from sale of business, write off

c) Extra ordinary items (Natural disaster)

US GAAP - Net of tax seprately after Income from continuing operations

IFRS - Does not allow to disclose separately

11) Change in Accounting stds

- Change in accouting principles (LIFO to FIFO) - Retrospectively

- Change in accouting estimates (Useful life of asset) - Prospectively

- Change in prior period adjustment - re-instating prior period in FS

12) Operating and Non operating components in Income statement

Non financial firm - Interest income and dividend - not a operating income

Financial firm - Interest income and dividend - operating income

13) EPS (only reported for common shares)

- Simple capital structure - No potential dilutive securities

- Complex capital structure - Potential dilutive securities (Report both basic EPS and dilutive EPS)

Basic EPS = (Net income - Pref.dividend)/ weighted avg number of shares

Stock dividend and Stock split - Proportional Ownership is unchanged

Dilutive options means EPS will decrease if option is exercised

Dilutive shares = Add income in numerator and no of shares in denominator

Conv Pref Shares - Add Pref dividend in numerator and no of shares in denomiatorConv Debt - Add Interest income after tax in numerator and no of shares in denomiatorStock/Warrant options - Only shares are added in denominator

Quick way to check if dilutive

Conv Pref Shares - Pref dividend/ no of new equity shares on conversion

Conv Debt - Int (1-t) / no of new equity shares on conversion

Stock/Warrant options - (AMP - EP)/AMP * N

Understanding Balance Sheet

1) Liquidity is the ability to meet short term obligations; Solvency is the ability to meet long term obligations

Liquidity Ratio

a) Current ratio = Current assets/Current liabilities

b) Quick ratio = (Cash + marketable securities + receivables)/current liabilties

c) Cash ratio = (Cash + marketable securities)/current liabilties

Solvency ratio

a) L.T debt to equity ratio = L.T debt/Equity

b) Total debt to equity ratio = Total debt/Equity

c) Total debt ratio = Total debt/Assets

d) Financial leverage = Total assets/Equity

2) US GAAP needs current assets/liab and non current assets/liab to be reported seprately - Called as classified balance sheetUseful in evaluating liquidity

IFRS- Can choose to use liquidity based format - Normally banking industry use it

Present Assets and Liab in order of liquidity

3) Current Asset/Liabilities:

One year

or

One operating cycle (Purchase inventory, Sell product and collect cash)

Current asset reveals information about operating activities of the firm

Non - Current asset reveals information about firm's investing activities

Non - Current Liabilities reveals information about firm's Long term financing activities

4) Costing methods for valuation

Standard costing (Predetermined cost)

Retail method (Inv cost = Sale price - Profit margin)

5) Financial Assets

- Held to maturity

- Trading securities

- Available for sale securities

Income statement - Unrealized P&L

c) Available for sale securities (Debt and equity)

Not to hold security till maturity

Other comprehensive Income statement - Unrealized P&L

*** Dividend, Interest and realized gains for all 3 types are recorded in Income statement

6) Contributed capital - Amount contributed by SH's

Par value - Stated or legal value

Authorized shares - No of shares that may be sold

Issued shares - Shares actually sold

Outstanding shares - Issued shares - shares acquired by firm (treasury stock which are not entitled to dividend and are not yet retired)7) Vertical common size statements - Expressed in %

B/S - % of Total Assets

P&L - % of Revenue

C.F - % of Revenue

Understanding Cash flow statements

1) Cash flow is based on cash accounting (Non cash activities are not reported)

2) 3 type of activities:

Operating activities Cash collected from customers Cash paid to suppliers and employees

Interest and dividend received Cash paid for expensesSale proceeds from trading activities Acquisition of trading securities

Interest paidTaxes paidInvesting activities Sale proceeds from fixed assets*** Acquisition of fixed assets

Sale proceeds from debt and equity investments*** Acquisition of debt and equity investmentsPrincipal recd from loans made to others Loan made to others

Financing activities Principal amount of debt issued Principal paid on debt

Proceeds from issuing stock Payment to reacquire stock

Dividend paid to SH's

*** Income from the investments are recoreded as operating activities

3) Dividend/Interest:

Dividend recd,Interest paid,Interest recd Operating activityIFRS Dividend paid, Interest paid Operating/Financing activity

Dividend recd,Interest recd Operating/Investing activity

4) Taxes:

US GAAP Operating activities

IFRS Normal income tax - Operating

Other taxes - Depends on activity