CFA Level I - Financial Statement Analysis: An Introduction

For other CFA Level I topics, click here.

This topic will cover the following items:

• basic accounting methods
• 3 important financial statements
• footnotes and supplementary information
• audit and internal controls
• financial statement analysis framwork

1. Basic Accounting Methods:

• Cash-basis accounting - this method recognizes revenue and expenses when payments are made or cash is received.
• Accrual accounting - This method recognizes  revenue in the accounting period in which it is earned (revenue is recognized when the company provides a product or service to a customer, regardless of when the company gets paid). Expenses are recorded when they are incurred instead of when they are paid.

2. The Financial Statements (3)

The Income statement shows the performance of a company over a specific period of time. The main elements of income statement include:

• Revenues measures how much company earns by delivering goods or services in a specific period.
• Expenses measures how much cost incurs when delivering goods and services in a specific period
• Other Income includes gains that may or may not arise in the ordinary course of business

 

The Balance sheet shows the firm’s financial position at a point of time.

• Assets are economic resources controlled by the firm.
• Liabilities represents economic obligations (debts) payable to a person or organization outside the business.
• Owner’s equity is the residual interest in the net assets of a firm after deducting liabilities.

Fundamental accounting equation: Asset = Liabilities + Owners’ equity

The Cash flow statement is the report of company’s cash receipts or payments during a period of time. Cash flows are classified as follows:

• Operating cash flow involves transactions from the day-to-day business activities of the company.
• Investing cash flow is associated with the acquisition and disposal of fixed or long-term assets of the companies.
• Financing cash flow is related to the receipt or payment of capital to be used in business such as from retirement of long-term debt, issuance of new shares or dividend payment. 

3. Financial statement notes and supplementary information

Footnotes contain information about the methods of calculation or assumptions used in preparing financial statements. Information such as acquisition and disposals, legal actions, or sales to related parties or segments of the firm is also included. Footnotes are audited.

Supplementary schedules are additional disclosures such as operating sales by regions or business segments, reserves for an oil and gas company, or information about hedging activities and financial instruments. Supplementary schedules are not audited.

Management discussion and analysis (MD&A): Under U.S GAAP, publicly held companies are required to include in their financial reports a section for MD&A. It is also possible to include this section in the financial statements of companies reporting under IFRS. Management must highlight any favorable or unfavorable trends and identify significant events that affect the company’ solvency and performance and operation. MD&A must include:

• Effects of inflation and changing prices of material.
• Impact of off-balance-sheet obligations and contractual obligations such as purchase commitments.
• Accounting policies that require significant judgement by management.
• Forward-looking expenditures and divestitures.

4. Audit activities on financial statements and internal controls

Audit refers to the activities of reviewing company financial statements by independent parties such as public accounting practices or audit firms. The audit process provides auditors with opinion on fairness and accuracy the company’s accounting and internal control systems. Standard auditor’s opinion contains 3 parts:  

• Auditors perform independent review whereas the financial statements are prepared by management.
• General auditing standards are followed, thus providing reasonable assurance that the  financial statements contains no material errors.
• The auditors are satisfied that the statements were prepared according with accepted accounting principles and that the principles chosen and estimates should be reasonable. Auditor’s report must contain additional explanation when accounting method is not used consistently between periods.

Under Us General Accepted Accounting Principles (GAAP), auditor’s opinion must be indicated in companies’ internal control. There are:

• Unqualified opinion indicates that the auditor believe that the statements are sound, i.e. free from material errors or omission 
• Qualified opinion is issued when there are exceptions to the accounting principles and these must be explained in audit reports.
• Adverse opinion shows that the financial statements are not presented fairly and contains materials not in compliance with accounting standards.

Auditor’s opinion should also contain explanatory paragraph when a material loss is probable but the amount cannot be reasonably estimated. These uncertainties may relate to the going concern assumption, the valuation or realization of asset values.

Internal controls are the process by which a company ensures accuracy in financial reports. Under US GAAP, auditors must state opinion on the company’s internal control.

5. Other sources of information useful for financial statement analysis

Quarterly or Semi-annual Report: these are interim financial reports that include major updates in financial statements and footnotes. These statements are not audited.

Securities and Exchange Commission (SEC) filings are documents that need to be filed to the Securities and Exchange Commission annually or quarterly regarding the consolidated financial statements of a company. Common forms are:

• Form 10-K are required annual fillings. It includes information about the business and its managements, audited financial statements and disclosures about legal issues.
• Form 10-Q contains quarterly financial statements and disclosure of important events
• Form 8-K includes disclosure of company’s events such as acquisition, disposals of major assets or changes in governance

Proxy statements are issued to shareholders when there are matters that require a shareholder vote. They are also filed with SEC and are a major source of information about board members, compensations, management qualifications and stock options.

Corporate report and press releases includes information used for public relation or sales materials and are not audited.

6. Financial statement analysis framework

Step 1: State the purpose and context of the analysis. Identify questions that the analysis needs to answer, information that needs to be presented, the time and resources to perform the analysis.

Step 2: Collect data from financial statements, industry and economic research, customers, suppliers and site visits.

Step 3: Process Data. Make appropriate adjustments to the financial statements, calculate ratios, and prepare necessary exhibits (graphs, common-size balance sheets, etc.)

Step 4: Analyze and Interpret Data. Use the processed data to answer the questions that are specified in the first step and decide the appropriate conclusion and recommendation

Step 5: Report Conclusions or Recommendations to the intended audience.

Step 6: Update the Analysis. Update data in the analysis and change the conclusions or recommendations if necessary.