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“Sixty Minute Guide”Financial Reporting & Analysis
CFA- Level I
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1. Important Basic concepts
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Audit independent review of an
entity’s financial statements
Unqualified Opinion
Qualified opinion
Adverse opinion
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Basic accounting equation
Assets = Liabilities + Owners’ equity
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Two primary assumptions
1.Accrual basis
2.The Going concern assumption.
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Flow of information in Accounting system
Journal entries
General ledger
Initial trial balance
Adjusted trial balance
Financial Statementwww.FinTreeIndia.com
2.Understanding the Income Statement
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Revenue recognition(Revenue is recognized when earned and expenses are recognized when incurred)
% of completion
MethodRecognize
revenuein
proportionof cost
incurred
competedContractmethod
Recognize revenue
only when contract
is complete
Normal rev. Recognition
Recognize revenue
If collect abilityIs reasonably
assured
Installment Sales
Used if collectabilitycannot be reasonably estimated
Cost recovery Method
used ifcollectability
is highlyuncertain
Barter transaction: recognize revenue only
If fair value can be estimated
Long Term Contracts Barter transactionsInstallment sales
Expense recognition
is based on the matching principle
expenses to generate revenue are recognized in the same period as the revenue
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Discontinued operation Barter transactions is one that management has decided to dispose
off
but has not yet done so
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Unusual or infrequent items
either unusual in nature or infrequent in occurrence, but not both
These are included in income from continuing operations and are reported before tax.
IMP
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extraordinary item
Only under U.S. GAAP it is a material transaction or event that is both
unusual and infrequent in occurrencereported separately in the income statement, net of
tax, after income from continuing operations IFRS does not allow extraordinary items to be
separated from operating results in the income statement
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Change in accounting principle
prior-period financial statements are restated to reflect the change.
Change in accounting estimate
Prospective application
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Dilutive securities
are stock options,
warrants,
convertible debt
convertible preferred stock
that would decrease EPS if exercised or converted to common stock
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3.Understanding the
Balance Sheet
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Investments(Financial Instruments)
Held to maturity
1.On BS: @ Amortized Cost
2.Realised gain: taken to income
Statement
3.Unrealized gainis not recognized
Trading securities
1.On BS: @ Fair Value
2.Realised gain:Taken to income
statement
3.Unrealised gain:Taken to income
statement
Available for Sale
1.On BS: @ Fair Value
2.Realised gain:Taken to income
statement
3.Unrealised gain:Taken to otherComprehensive
income
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4.Understanding the Cash Flow Statement
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Cash Flows
CFO CFI CFF
Inflows and outflows of
cash resulting from
transactions that
affect a firm’s net income.
Inflows and outflows of
cash resulting from transactions
affecting a firm’s capitalstructure, such as
issuing or repaying debt and issuing or repurchasing
stock .
inflows and outflows
of cash resultingfrom the
acquisition or disposal of
long-term assetsand certain
investments.
CFO CFFCFI
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Item US GAAP
Treatment
IFRS
Treatment1. Dividends paid Financing activities (CFF) CFO or CFF
(Gives flexibility to management )
2. Interest
paid
Operating activities (CFO) CFO or CFF
(Gives flexibility to management )
3. Dividends received Operating activities (CFO) CFO or CFI
(Gives flexibility to management )
4. Interest received operating activities (CFO) CFO or CFI
(Gives flexibility to management )
5.Taxes paid related to operating activities
operating activities (CFO) operating activities (CFO)
6. Taxes paid related to investing and financing transactions
Operating activities (CFO) CFI and CFF respectively
IMP
IMP
FCFF Formula1.Starting From Net Income
NI + NCC – WCinv +(INT X (1-t)) – FCinv
CFO + (INT X (1-t)) –FCinv
2. Starting From EBIT
(EBIT X (1-t))+ Dep - WCinv - FCinv
CFO + (INT-tax%) -FCinv
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5.Inventories
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Inventory Cost Flow Methods
FIFO LIFO Weightd avg. Specific
identificn
FIFO1.COGS consist of older purchases
2.Ending Inventory bal consist of more recent cost
3.. In either Inflationary or deflationary Environment FIFO Ending inventory
Balance reflects economic reality
4.In Inflationary environment,FIFO COGS is lower than LIFO COGS
LIFO1.COGS consist of recent purchases
2.Ending Inventory bal consist of older cost
3.. In either Inflationary or deflationary Environment LIFO COGS reflects
economic reality
4.In inflationary environment, LIFO closing inventory is lower than
FIFO closing inventory
6.Long-lived Assets
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IFRS
Research cost Development cost
Expensed as Capitalized
incurred
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US GAAP
Research cost Development cost
Expensed as Expensed
incurred (Except, software
development cost)
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7.Income Taxes
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Create DTA if,
IT Exp. (IncomeStatement) is greater
than Tax p’ble
Create DTL if,
IT Exp. (IncomeStatement) is less
than Tax p’ble
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Asset’s Tax Base
Is its value for tax purposes.
The tax base for a depreciable fixed asset is its cost minus any depreciation previously taken on the tax return
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Income tax expense
= taxes payable + ΔDTL – ΔDTA.
Increase in DTL
Decrease in DTA
Increase in DTA
Decrease in DTL
ADD
LESS
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When income tax rate increases deferred tax
assets and deferred tax liabilities are both increased to reflect the new rate
If DTA is not likely to be realized create valuation
allowance to reduce DTA
If DTL is not likely to be reversed consider it a
part of equity for analysis purpose
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8.Non-current (Long-term) Liabilities
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The book value of the bond liability is equal to the PV of the remaining future cash flows (coupon payments and maturity value) discounted at the market rate of interest at issuance
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Premium bond1. coupon rate > market yield
at issuance
2. reported on the balance
sheet at a value greater than its face value.
3. book value of the bond
liability will decrease until it reaches its face value
at maturity.
4. interest expense is less
than the coupon payment
Discount bond1. coupon rate < market yield
at issuance
2. reported on the balance sheet at less than
its face value .
3. book value of the bond liability will increase until it reaches its face value
at maturity.
4. interest expense is greaterthan the coupon payment
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Finance lease
US GAAPTreat a lease as a capital (finance)
lease if any one of the following criteria is met:
1.Title transfer clause
2. Bargain purchase option
3.Lease period > 75% life
4.PV of lease pmts > 90% of Fair value of asset
IFRSIf substantially all the
rights and risks of ownership are
transferred to the lessee, the lease is treated as a finance lease by boththe
lessee and lessor
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Impact on financial statements
Finance lease Operating lease
Net income(early yrs)
Lower Higher
Net income(later yrs)
Higher Lower
EBIT Higher Lower
CFO Higher Lower
CFF Lower Higher
9.Financial Reporting Quality
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Fraud Triangle
Incentives and pressures—the motive to commit fraud.
Opportunities—the firm has a weak internal control system.
Attitudes and rationalizations—the mindset that fraud is justified
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US GAAP & IFRS differencesItems US GAAP IFRS
Investment: Joint control Equity method Proportionate
Consolidation
Inventory on balance sheet Lower of cost or market value
Lower of cost or
Net realizable value
Recovery of asset write down Not allowed Allowed
Upward Revaluation Not allowed Allowed
Cost of Goods Sold LIFO permitted LIFO not permitted
Operating Expenses Differentiates betn
expenses and lossesIFRS does not
Interest capitalization Must Optional
Extraordinary items
Both unusual and infrequent
reported in the income statement, net of tax, below income from continuing operations
It does not permit firms to treat items as extraordinary in the income statement.
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