Study session seven in the Level I CFA Program curriculum includes three readings (22-24) for an introduction to financial reporting and analysis. How much time you spend here really depends on how well you know basic financial accounting. The material is extremely important as a step to more detailed concepts but will most likely be repeat information for any student of finance.
Financial Statement Analysis
If you’ve had any previous finance classes, most of the reading will be pretty basic and you can probably just skim it for new information. The material on the procedural steps of statement analysis is secondary to the definitions of the major accounts in the financial statements.
If you are unfamiliar with financial statements, spend some time getting the basic role and parts of the statements. This basic understanding and definitions is critical to understanding how the statements work and are related but it will be repeated in study session eight within the readings on the individual statements.
Understand that different entities use the financial statements for different reasons, whether for investment, M&A evaluation, creditworthiness or internal evaluations.
The balance sheet is a point in time measure of the firms assets, liabilities and equity capital. The numbers presented are as of a certain date. This is important because the other statements are presented for activity in the period. For many of the ratios, you will be using an average of the beginning and ending value to get a better representation of the account over the period. Another important thing to remember is that values on the balance sheet do not necessarily reflect fair market value. You will spend a lot of time learning how each line item is recorded and held on the books.
The income statement is a report of the firm’s operations over the period. How many sales they recorded and what it cost to make those sales. The most important thing to remember here is that sales do not mean cash flow. Understand the concept of the accrual method of accounting and how revenues and expenses are matched.
The statement of cash flows is a reconciliation of the other two accounts and reports how the firm’s cash changed over the period. You will be shown how to construct the statement two different ways, direct and indirect. Resist the temptation to just learn one way and hope that you don’t need to use the other. Understanding how cash payments and receipts are reported is one of the best ways to understand the company and will pay off big time in your analysis.
Financial Reporting Mechanics
This reading covers all the basics of financial accounting and is must know material. It’s hard to point out the important information here because it is almost all key to understanding the financial statements and how they are reported. If you did well in previous finance classes then it may again be repeated information. Read through the material and highlight everything which you do not already have a firm understanding.
Understand the difference between operating, investing and financing activities. This is the key to analyzing how the business works. Operating activities are the core business including sales and how those sales are made. Investing activities relate to the acquisition of long-term assets and investments and help to generate more operations in the future. Financing activities relate to the firm’s capital transactions involving equity or debt.
If you are not familiar with accrual accounting, spend some time running through the scenarios provided by the curriculum. It’s pretty basic at this point but you need to understand how revenue is booked against expenses, how long-term assets are capitalized and expensed over time through depreciation, and how payables and deferred items work.
As part of learning the cash flow statement, remember the difference between a source of cash and a use of cash, and how it relates to the other statements. An increase in liabilities or equity or a decrease in assets is a source of cash because either an asset is being converted to cash or a liab/equity is being accrued in exchange for cash now. On the other hand, an increase in assets or a decrease in liab/equity is a use of cash. Buying an asset or paying off a liability/equity account decreases cash.
Financial Reporting Standards
While you will need to understand how the statements are reported differently under IFRS and GAAP, a lot of this background information is secondary to the mechanics. Understand the relationship between each framework and the private sector organizations that establish rules (FASB and IASB) and the difference in framework between IFRS and GAAP.
Knowing some of the forms will be necessary in your professional life, even if you don’t see a specific question on the exam. 10-K is the annual report to the SEC while 10-Q is a quarterly report. Material events outside of the quarterly or annual reports are required in an 8-K form. Forms 3, 4 and 5 are required to report changes in ownership.
Remember, IFRS does not permit LIFO as an inventory costing method and uses a single-step method for impairment rather than the two-step method used in GAAP. IFRS also requires capitalization of development costs when certain criteria are met.
An important difference between GAAP and IFRS is the difference between a principles-based method, providing a broad reporting framework and more judgment, and a rules-based method which provides specific rules for each transaction and requires less judgment.
Study session eight in the Level I CFA Program curriculum covers the three main financial statements and will make or break your CFA future. Make sure you are ready to spend some time on the readings to get a good base for deeper analysis down the road.
‘til next time, happy studyin’
Joseph Hogue, CFA