Study Session 7 - Financial Reporting and Analysis

Reading 29: Financial Statement Analysis: An Introduction

a. discuss the roles of financial reporting and financial statement analysis;

• The role of financial reporting is to provide a variety of users with userful information about a company's performance and financial position.


• The role of financial statement analysis si to use the data from financial statements to support economic decisions.

b. discuss the role of key financial statements (income statement, balance sheet, statement of cash flows, and statement of changes in owners’ equity) in evaluating a company’s performance and financial position;

• The income statement shows the results of a firm's business activities over the period. Revenues, the cost of generating those revenues, and the resulting profit or loss are presented on the income statement.


• The balance sheet shows assets, liabilities, and owner's equity at a point in time


• The cash flow statements shows the sources and uses of cash over the period


• The statement of changes in owners' equity reports the amount and sources of changes in the equity owners' investment in the firm

c. discuss the importance of financial statement notes and supplementary information, including disclosures of accounting methods, estimates, and assumptions, and management’s discussion and analysis;

• Important information about accounting methods, estimate, and assumptions is disclosed in the footnotes to the financial statements and supplementary schedules.
  
• These disclosures also contain info about segment results, commitments and contingencies, legal proceedings, acquisitions or divestitures, issuance or stock options, and details of employee benefit plans
  
• Management's Discussion and Analysis contains an overview of the company and important info about business trends, future capital needs, liquidity, significant events, and significant choices of accounting methods requiring mgmt judgment
  

d. discuss the objective of audits of financial statements, the types of audit reports, and the importance of effective internal controls;

• audit is to provide an opinion on the statements' fairness and reliability - unqualified, qualified, adverse
  
• opinion gives evidence of an independent review that verifies that
  
• appropriate accounting principles were used,
  
• that standard auditing procedures were used to establish reasonable assurance that the statements contain no material errors,
  
• and that management's report on the company's internal controls has been reviewed.
  
• company's management is responsible for maintaining effective internal control system to ensure the accuracy of financial statements
  
• for US Public Companies, Sox requires management report on firm's internal controls, description of the method used to evaluated their effectiveness, and a statement as to their effectiveness over the accounting period
  

e. identify and explain information sources other than annual financial statements and supplementary information that analysts use in financial statement analysis;

• Along with financial statements, important info sources are:
  
• company's quarterly and semi-annual reports,
  
• proxy statements (info about board members, stock options, compensation),
  
• press releases as well as information on industry and peer companies from external sources
  

f. describe the steps in the financial statement analysis framework.

1. state the objective of the analysis
2. gather data
3. process the data
4. analyse and interpret the data
5. report the conclusions or recommendations
6. update the analysis

Reading 30: Financial Reporting Mechanics


a. explain the relationship of financial statement elements and accounts, and classify accounts into the financial statement elements;

Transactions are recorded in accounts that form the financial statement elements:

• Assets - the firm's economics resources
• Liabilities - creditor's claims on the fimr's resources
• Owner's equity - paid in capital (common and preferred sotck), retained earnings, and cumulative other comprehensive income
• Revenues - sales, investment income, and gains
• Expenses - COGS, selling and admin expenses, depreciation, interest, taxes, and losses

b. explain the accounting equation in its basic and expanded forms;

• basic accounting equation:
  assets = liabilities + shareholders' equity


• expanded accounting equation:
  assets = liabilities + contributed capital + ending retained earnings


• also:
  assets = liabilities + contributed capitals + beginning retained earnings + revenue - expenses - dividends

c. explain the process of recording business transactions using an accounting system based on the accounting equations;

• Keeping the accounting equation in balance (A-L=E) in balance requires double entry accounting i.e. every transaction is recorded in at least two accounts that offset one another;


• e.g. an increasse in an asset account must be balanced by a decrease in another asset account or by an increase in a liability or owner's equity account

d. explain the need for accruals and other adjustments in preparing financial statements;

• firm must recognise revenues when they are earned and expenses when they are incurred;


• accruals are required when the timing of cash flows in and out do not match timing of the revenue or expense recognition on the financial statements e.g. wages or unearned revenue

e. explain the relationships among the income statement, balance sheet, statement of cash flows, and statement of owners’ equity;

• balance sheet shows a company's financial position at a point in time


• changes in balance sheet accounts during an accounting period are reflected in the income statement, the cash flow statement, and the statement of owners's equity

f. describe the flow of information in an accounting system;

1. info enters accounting system as journal entries


2. sorted by account into general ledger GL


3. trial balances are formed at the end of an accounting period


4. accounts are then adjusted and presented in financial statements

g. explain the use of the results of the accounting process in security analysis.

• financial reporting requires choices of method, judgment and estimates


• analyst must understand the accounting process used to produce the financial statements in order to understand the business and the results for the period


• analysts should be alert to the use of accruals, changes in valuations, and other notable changes that may indicate management judgment is incorrect or that the financial statements have been deliberately manipulated

Issues from Problem Sets

I find expenses versus liabilities confusing in certain cases. I also find contra-assets confusing

• accumulated depreciation and allowance for bad debts are both assets (since they are contra assets to offset the corresponding asset)


• depreciation is an expense


• deferred tax items - deferred tax assets are assets and deferred tax liabilities are liabilities

Reading 31: Financial Reporting Standards

a. explain the objective of financial statements and the importance of reporting standards in security analysis and valuation;

• objective of financial statements = to provide economic decision makers with useful information about a firm's financial performance and changes in a financial position
• reporting standards ensure comparability and narrow reasonable estimates on which statements are based
• users of financial statemetn rely on them for info about the company's activities, profitability, and creditworthiness

key SEC filings:

• S-1 prior to sale of new securities
• 10-K annual filing similar to annual report; 40-F for Canadians; 20-F for other foreign issuers
• 10-Q quarterly unaudited statements
• DEF-14A company prepares a proxy statement
• 144 issue of unregistered securities to certain qualified buyers
• 3,4 and 5 beneficial ownership of securities by company's officers and directors; learn about purchases by insiders

b. explain the role of standard-setting bodies, such as the International Accounting Standards Board and the U.S. Financial Accounting Standards Board, and regulatory authorities such as the International Organization of Securities Commissions, the U.K. Financial Services Authority, and the U.S. Securities and Exchange Commission in establishing and enforcing financial reporting
standards;

• standard setting bodies are private sector organisations that establish financial reporting standards e.g. IASB (international i.e. IFRS) and FASB (US i.e. GAAP)
• regulatory authorities are gov agencies that enforce compliance with financial reporting standards e.g. SEC in USA and FSA in UK. Many belong to Interntational Organisation of Securities Commissions (IOSCO)

c. discuss the ongoing barriers to developing one universally accepted set of financial reporting standards;

• barriers to convergence = differences of opinion among standard-setting bodies and regulatory agencies from difference countries and political pressure within countries from groups affected by changes in reporting standards

d. describe the International Financial Reporting Standards (IFRS) framework, including the qualitative characteristics of financial statements, the required reporting elements, and the constraints and assumptions in preparing financial statements;

• IFRS "Framework for the Preparation and Presentation of Financial Statements" defines the qualitative characteristics of financial statements, specifies the required reporting elements, and notes the constraints and assumptions involved in preparing financial statements
• Qualitative characteristics of financial statements include understandability, relevance, reliability, and comparability
• Elements of financial statements are assets, liabilities, and owners' equity (for measuring financial position) and income and expenses (for measuring performance)
• Constraints on financial statement preparation include cost, the need to balance reliability with timeliness, and the difficulty of capturing non-quantifiable information in financial statements
• the two primary assumptions: (1) accrual basis and (2) going concern assumption

e. explain the general requirements for financial statements;

required financial statements are (as expected):

• balance sheet
• income statement
• cash flow statement
• statement of changes in owners' equity
• explanatory notes

Principles for preparing financial statements stated in IAS No. 1 are:

• Fair presentation
• going concern basis
• accrual basis
• consistency between periods
• materiality
• aggregation (like with like, no mixing of dissimilar items)
• no offsetting (unless required or permitted specifically to do so)
• classified balance sheet showing current and non-current assets and liabilities
• minimum required information e.g. bs must show specific items such as cash and cash equivalents, plant property and equipment, and inventories; income statement must show revenue, profit or loss, tax expense, and finance costs, etc.
• comparative information

f. compare and contrast key concepts of financial reporting standards under IFRS and alternative reporting systems, and discuss the implications for financial analysis of differing financial reporting systems;

IFRS and GAAP usually agree in overall framework and purpose and are working toward convergence, however:

• IFRS requires users to consider framework in the absence of specific standard;
• US GAAP distinguishes between objectives for business and non-business entities;
• the IASB framework gives more emphasis to the importance of the accrual and going concern assumptions than FASB
• GAAP framework establishes a hierarchy of qualitative financial statement characteristics;
• some differences in how each defines, recognises, and measures individual elements of financial statements
• companies reporting under standards other than GAAP that trade in USA must reconcile their statements with GAAP but the analyst must reconcile differences in other cases.

g. identify the characteristics of a coherent financial reporting framework and barriers to creating a coherent financial reporting network;

• A coherent financial reporting framework should exhibit transparency, comprehensiveness and consistency
• barriers to coherent framework include issues of valuation, standard setting and measurement

h. discuss the importance of monitoring developments in financial reporting standards and of evaluating company disclosures of significant accounting policies.

• an analyst should be aware that sh*t changes and new stuff doesn't always fit neatly into the categories i.e. these are living documents in many ways
• under IFRS and GAAP, companies must disclose accounting policies and estimates in the footnotes and MD&A
• public companies are also required to disclose the likely impact of recently issued accounting standards on their financial statements