Coverage The candidate should be able to: a. Describe the roles of financial reporting and financial statement analysis b. Describe the roles of the statement of financial position, statement of comprehensive income, statement of changes in equity, and statement of cash flows in evaluating company’s performance and financial position c. Describe the importance of financial statement notes and supplementary information – Including disclosures of accounting policies, methods, and estimates – and management’s commentary d. Describe the objective of audits of financial statements, the types of audit reports, and the importance of effective internal controls e. Identify and describe information sources that analysts use in financial statement analysis besides annual financial statements and supplementary information f. Describe the steps in the financial statement analysis framework STUDY SESSION 6 – FINANCIAL REPORTING AND ANALYSIS: AN INTRODUCTION Reading 21: Financial Statement Analysis: An Introduction
Transcript
Coverage
The candidate should be able to:
a. Describe the roles of financial reporting and financial statement analysis
b. Describe the roles of the statement of financial position, statement of
comprehensive income, statement of changes in equity, and statement of
cash flows in evaluating company’s performance and financial position
c. Describe the importance of financial statement notes and supplementary
information – Including disclosures of accounting policies, methods, and
estimates – and management’s commentary
d. Describe the objective of audits of financial statements, the types of audit
reports, and the importance of effective internal controls
e. Identify and describe information sources that analysts use in financial
statement analysis besides annual financial statements and
supplementary information
f. Describe the steps in the financial statement analysis framework
STUDY SESSION 6 – FINANCIAL REPORTING AND ANALYSIS: AN
INTRODUCTION
Reading 21: Financial Statement Analysis: An Introduction
Scope of Financial Statement Analysis
THE ROLE OF FINANCIAL REPORTING
Provide information
Company performance
Financial position
Changes in financial position
Useful to a wide range of users in making economic decisions
THE ROLE OF FINANCIAL STATEMENT ANALYSIS
Analyze financial reports and other information
Evaluate
Past, current and prospective performance and financial position of a company
Purpose
Making investment, credit and other economic decisions
Scope of Financial Statement Analysis
Examples of economic decisions:
Evaluating equity investment for inclusion in a portfolio
Evaluating a merger or acquisition candidate
Evaluating a subsidiary or operating division of a parent company
Deciding whether to make a venture capital or other private equityinvestment
Determining credit-worthiness of a company
Extending credit to a customer
Examining compliance with debt covenants
Assigning a debt rating to a company or bond issue
Valuing a security for making an investment recommendation
Forecasting future net income and cash flow
Scope of Financial Statement Analysis
Analysis of performance
Assessment of profitability and cash flow generating ability
Profitability
Earn a profit from delivering goods and services
Cash flow
Cash is needed to pay employees, suppliers etc.
Essential to continue as a going concern
Positive cash flow leads to funding flexibility
Liquidity
Ability to meet short-term obligations
Solvency
Ability to meet long-term obligations
Major Financial Statements and Other Information SourcesFINANCIAL STATEMENTS AND SUPPLEMENTARY INFORMATION
Summary of key financial statements
Income statement
Balance sheet
Statement of cash flows
Statement of changes in owners’ equity
Summary of additional information
Footnotes and supplementary schedules
Management’s discussion and analysis (MD&A)
External auditor’s report(s)
Major Financial Statements and Other Information SourcesIncome Statement
Statement of operations or profit & loss account
Results of financial performance over a period of time
Basic form equation
Revenue – Costs = Net Income
Balance Sheet
Statement of financial position/condition
Presents company’s financial position at a point in time
Accounting equation
Assets = Liabilities + Owner’s equity
Assets – Liabilities = Owner’s equity
Major Financial Statements and Other Information SourcesStatement of Cash Flows
Discloses sources and uses of cash
Evaluate company’s liquidity, solvency and financial flexibility
Financial flexibility
Ability to react and adapt to financial adversities and opportunities
Classification of cash flows
Operating, investing and financing
Sum of net cash flows = Net change in cash
Statement of Changes in Stockholders’ Equity
Statement of shareholders’ equity or statement of retained earnings
Reports changes in the owners’ investment in business over time
Assists in understanding changes in financial position
Major Financial Statements and Other Information SourcesFinancial notes and supplementary schedules
Provides explanatory information Business acquisitions/disposals, legal proceedings, stock
option plans and related-party transactionsFootnotes
Information about methods and assumptions used to preparefinancial statements Aids comparability of financial statements between companies
Required for complete presentation in conformity with US GAAP and IFRS
Management discussion and analysis (MD&A) Required by US GAAP for publicly held companies Highlight favorable or unfavorable trends Identify significant events and uncertainties
Affect liquidity, capital, resources and results of operations Provide information about effects of inflation, changing prices
or other material events Discuss critical accounting policies requiring subjective judgments Similar report required by IFRS
Major Financial Statements and Other Information SourcesAuditor’s reports
Examination by an independent accounting firm
Express an opinion on the truth and fairness of the financial statements
International standards
International Auditing and Assurance Standards Board (IAASB) of International Federation of Accountants (IFAC)
US standards
Public Company Accounting Oversight Board (PCAOB)
Sarbanes-Oxley Act
Audit report
Provides reasonable assurance financial statements are fairly presented
High degree of probability statements are free from materialerror, fraud or illegal acts
Major Financial Statements and Other Information SourcesIndependent audit report
First or “introductory” paragraph
Describes financial statements and relative responsibilities
Second or “scope” paragraph
Nature of audit process
Third or “opinion” paragraph
Unqualified audit opinion
True or fair view (IFRS)
Fairly presented (IFRS and US)
Clean opinion
Qualified opinion
A limitation or exception to accounting standards
Explanatory paragraphs regarding exception
Major Financial Statements and Other Information SourcesIndependent audit report
Adverse opinion
Financial statements materially depart from accounting standards
Not fairly presented
No point in performing any financial analysis
Statements cannot be relied on
Disclaimer of opinion
Auditors are unable to have an opinion for some reason
e.g. destruction of accounting records
Sarbanes-Oxley
Auditors must express an opinion on internal control system
Separate opinion or fourth paragraph
Major Financial Statements and Other Information SourcesOther sources of information
Interim reports
Provided semiannually or quarterly
Generally not audited
Proxy statements
Information regarding management and director compensationand company stock performance
Discloses any potential conflict of interest between management,the board and shareholders
Other sources of current information
Company websites, press releases and conference calls
Financial Statement Analysis Framework
FRAMEWORK
Phases
1. Articulate the purpose and context of analysis
2. Collect all relevant data
3. Process data
4. Analyze results of data processing
5. Conclude recommendation and communicate this
6. Follow-up
Financial Statement Analysis Framework
Phase Sources of Information Output
1. Purpose and context of the analysis
Nature of analyst’s function such as issuing a credit rating
Communication with client or supervisor
Institutional guidelines for developing specific product
Statement of purpose or objective of analysis
A list of specific questions to be answered by analysis
Nature and content of report
Timetable and budget
2. Collect data Financial statements, other financial data, questionnaires, industry and other economic data
Discussions with management, suppliers, customers and competitors
Company site visits
Organized financial statements
Financial data tables
Completed questionnaires
Financial Statement Analysis Framework
Phase Sources of Information Output
3. Process data Data from previous step Adjusted financial statements
Common-size statements
Ratios and graphs
Forecasts
4. Analyze/interpret the processed data
Input data as well as processed data
Analytical results
5. Develop and communicate conclusions and recommendations
Analytical results and previous reports
Institutional guidelines for published reports
Analytical report answering questions posed in phase 1
Recommendations regarding the purpose of the analysis
6. Follow-up Information gathered by periodically repeating above steps
