Study session eight in the curriculum is your first real look at the three financial statements and some techniques in analysis. I won’t say that the material absolutely must be a pleasure but this is going to be a big part of your job as an analyst. If you are not the slightest bit interested in dissecting the financial statements and analyzing what you find…you might want to consider another career path.
The study session is a long one and important enough to take a little extra time to work through. We’ll cover the first two readings this week and then finish up next week.
It’s hard to distinguish any significantly important material in the curriculum covering the financial statements because it is all extremely important.
- Understand each individual line item that shows up on the statements,
- which accounts can be manipulated by management and how,
- how each account is valued,
- which accounts are used in ratio and other financial analysis, and
- how the three financial statements are related to each other.
Understanding Income Statements
The income statement measures the company’s performance over a period of time. The main point is that revenues and related expenses are matched during the period in which they occur, i.e. accrual accounting. This is supposed to give a better measure of performance than a cash accounting because cash does not always come in at the same time as the work is done. The problem is that management often has a strong incentive to manipulate the revenues, expenses and other items to show earnings in a different light.
It’s important to understand the basic structure of the statement and what each line item represents:
- Net Sales is gross revenue minus any allowances for returns
- Cost of goods sold is really what it sounds like and is the inventory cost, here it is important to understand inventory accounting procedures like LIFO, FIFO, or average cost to understand how management is expensing it
- Gross Profit is the difference between net revenue and COGS (also used to find Gross Margin) and is your first measure of profitability
- Selling, General & Administrative is all direct and indirect expenses that can be linked to operations (salaries, rent, utilities, marketing, pretty much everything that is not associated with the cost of inventory itself)
- Operating income (profit) is the result of operations and your second measure of profitability. This is also sometimes referred to as EBIT or earnings before interest and taxes. (profit margin = operating income/ net revenue)
- Interest expense is just the interest on debt for the period
- Nonrecurring items- discussed below
- Provision for income taxes represents the estimated tax liability and gives an indication of the effective tax rate
- Net income is your final measure of profitability (net margin = net income/net revenue)
Firms with a controlling interest in a subsidiary will also report the amount of net income from the subsidiary on their own income statement. You will see much more detail on how and when this income is consolidated on the parent company’s statements in Level 2. For the first exam, just remember the basic definitions for minority interest and consolidation.
A theme throughout the curriculum is the preference for conservative accounting principles, as opposed to aggressive practices. Conservative principles are those that take the ‘safe’ bet when recognizing revenues or expenses (and usually less favorable to short-term reporting). The idea is that if management is taking a conservative approach on some accounting practices, they are less likely to be trying to manipulate the data to show the financials in a better light.
There is quite a bit of information on revenue recognition. Start with remembering the ‘criteria’ for recognizing different types of revenue and the ‘procedural steps’ for recognition. This kind of list material is easily testable.
Understand how to calculate the two methods for revenue recognition of long-term projects and the SEC’s four criteria for revenue recognition:
- Legitimate arrangement between buyer and seller
- Delivered or rendered the product or service
- Price is or can be determined
- The seller can be reasonably assured of collection
Revenue recognition for long-term contracts is particularly important for the idea of accrual accounting, i.e. matching revenue with appropriate expenses in the current period. Remember the steps to the different methods:
Percentage of completion
- Percent complete = total costs to date/total expected costs
- Recognizable revenue total = estimated total revenue * percent complete
- Current period revenue = Recognizable revenue total – prior revenue recognized
- When the expenses and sales for a project cannot be measured until completion, U.S. GAAP allows the completed-contract method. All billings and expenses are capitalized on the balance sheet until the project is completed then everything is moved to the income statement.
- Percentage of completion method is more aggressive because revenues are booked immediately even if they will not actually be received until later. It is also subject to considerable assumptions and shows smoother earnings.
The material on LIFO and FIFO is extremely important and you will need this introductory knowledge for detailed analysis in the Level 2 exam.
- FIFO expenses the oldest inventory on the income statement first (first-in, first out). This means that ending inventory (the materials still held for production after the current period) better matches current replacement costs.
- LIFO expenses the newest inventory on the income statement first (last-in, first-out). The method is permitted under U.S. GAAP but not IFRS. It better matches current costs with revenues.
- Weighted Average Costs is not used as much in the curriculum as LIFO or FIFO but you still need to know how it is calculated and how it relates to the other two methods.
** Understand the implication of these three costing methods on Net Income, Ending Inventory and Cost of Goods Sold in two scenarios (rising prices and falling prices).
- FIFO reports the highest net income and ending inventory but the lowest cost of goods in an environment of rising prices. This is because older (cheaper) inventory is expensed first.
- LIFO reports the highest net income and ending inventory but the lowest cost of goods in an environment of falling prices. This is because newer (cheaper) inventory is expensed first.
- Weighted Average Cost always reports NI, EI and cost of goods in the middle of these two in both pricing environments
Depreciation is another topic where you will need to master the introductory information to do well on the Level 2 exam. The three methods are easily testable because they lend themselves well to quick calculations.
- Straight line depreciation spreads the value out over the useful life = (cost – residual value)/useful life
- Accelerated depreciation takes higher depreciation charge earlier in the equipment’s life = (2/remaining useful life)*(cost – accumulated depreciation)
- Units of production matches the depreciation with production
Nonrecurring items that are unusual or infrequent (but not both) are reported as part of earnings from continuing operations and are often a way for management to take large expenses up front instead of in the future. Examples are: restructuring costs, asset impairment charges, gains or losses on sale of long-lived assets.
Those nonrecurring items that are unusual and infrequent (extraordinary) or discontinued operations are reported net of taxes below income from continued operations. Because these are so out of the ordinary, analysts do not normally consider them against performance. As with those nonrecurring items included in continuing operations, analysts must decide whether they are appropriately reported.
Remember that some items are not reported on the income statement but go “direct to equity” as other comprehensive income. The easiest way to remember these is by the PUFE acronym for:
- Pensions or additional minimum pension liability
- Unrealized gains or losses on available for sale securities
- Foreign currency exchange translations on hedging
- Effective portion of cash flow hedges
You are not asked to do much with the Statement of Comprehensive Income at level I but just understand the basic relationship and what each of the four items represents.
Understand which changes to accounting standards must be reported retrospectively (changes to accounting principles) and which must be treated prospectively with no adjustments to prior periods (changes to estimates) and that corrections of prior period errors require a restatement of financial statements.
Be able to calculate earnings per share for both a simple (just NI minus preferred dividends over weighted average common shares) and complex capital structure (basic EPS adjusted for After-tax interest on convertible and common share adjustments for assumed conversions).
Understanding Balance Sheets
Unlike the other two statements, the balance sheet is a ‘snapshot’ in time. The figures reflect the state of accounts at that moment, the last day of the quarter or year. The other two statements represent activity over the period. For this reason, and this is very important, when you perform ratio analysis comparing numbers across the statements you will take an average of the beginning and ending figures for balance sheet accounts. For example, the cash debt coverage is cash-flow from operations divided by average total debt from beginning and ending balance sheet date.
You’re going to get tired of people saying, “Assets = Liabilities + Equities.” This is the basic balance sheet equation and around which much of the material will revolve around. Understand what it shows when you change around the equation (i.e. A-L = E) and you’ll get the importance of the concept.
One of the most important topics on the statement is valuation. Some accounts are shown at historical or amortized price, while others are shown at fair (market) value. Obviously this makes a big difference in overall valuation and when comparing numbers. Further, analysts often will adjust the numbers to arrive at a number they feel is more realistic or comparable. You aren’t asked to do this but just to understand where it might be needed and why. The definitions below will each describe the method of valuation for the account.
Assets represent a future probable economic benefit and could be accumulated items, amounts spent but not yet expensed (matched with revenues) or amounts earned but not yet received (accounts receivable).
Current assets are the most liquid and are accumulated or planned to be used in the ‘current’ operating period. Normally recorded at fair market value.
Cash or cash equivalents- is usually short-term money market, CDs, commercial paper or treasuries that can be converted to cash quickly. This is used in all your liquidity ratios and is (duh) valued at market.
Accounts receivable– Sales made on credit but not collected, usually offset by an allowance for uncollectable (estimated) but shown net realizable (fair) value. Trends in AR are an important indication of performance and estimates.
Inventories- A key item and one you’ll spend a lot of time on through the curriculum. Reported at lower of cost or market on the balance sheet but estimated through different practices (LIFO, FIFO, or average). Could be broken down into three sub-accounts: raw materials, work-in-process, and finished goods.
Prepaid expenses– Where the company has paid in advance for a service or product, i.e. insurance and rent. Valued at market with an adjustment when they are expensed through the income statement.
Long-term assets have a useful life of more than a year (or operating cycle) and are usually not going to be sold to customers. These accounts are usually recorded at cost and then depreciated or amortized over the estimated life.
Property, Plant, & Equipment – valued at cost and depreciated over its estimated useful life, shown as net. These are also referred to as ‘tangible’ assets because they generally have physical substance and are easily counted.
Goodwill & other intangibles– Goodwill is the amount paid for acquisitions above their market value. It is basically a premium paid for things like brand and proprietary technology. It is recorded at cost and tested annually for impairment, which is an estimation of the value that no longer exists.
Liabilities are future probable sacrifices from obligations or transactions and could be: amounts received but not earned yet as revenue, amounts received that must be repaid or amounts expensed on the income statement but not yet paid (accounts payable, accruals, etc).
Current liabilities are those that will be paid or settled in the ‘current’ operating cycle.
Accounts Payable– suppliers have sold something to the company on credit that must be repaid. As with AR, you’ll look for trends in this to see that the company is not taking longer to pay. Valued at market.
Accrued liabilities– Those items expensed in the current period but that will not be paid until the next period, kind of a carry-over effect of timing, i.e. wages and interest owed but not paid yet. Valued at market.
Short-term debt- includes lines of credit and notes with an original maturity of less than a year (negotiated debt).
Current portion of long-term debt – principal portion of long-term notes including any capital lease obligations.
Unearned revenue- sales collected in advance but not yet earned so they sit here until delivered or performed. Settled as revenue on the income statement instead of through a cash adjustment.
Long-term liabilities is often a single line item for debt but can also be broken out into items like: bonds and notes payable, long-term lease obligations, deferred taxes and pension liabilities.
Equity is the residual after assets and liabilities and that which is due the owners of the company. It includes: capital contributed by owners through stock, recognized on the income statement but not yet paid out to owners (retained earnings) and adjustments to assets or liabilities that did not go through the income statement (see other comprehensive income in prior post).
Contributed capital– is supplied by stockholders and broken into common, preferred and additional paid-in-capital.
Minority interest – This is the cumulative, noncontrolling ownership held in other companies.
Retained earnings– accumulated net income due to owners but not yet paid out.
Treasury stock – amount paid to repurchase company stock usually shown as a negative number because it decreases equity.
There differences between IFRS and U.S. GAAP are probably the most important here on the balance sheet and you should try to remember the list material for the exam. Make out a flash card for each line item where valuation or reporting differ between the two (Inventories, PP&E, Intangible assets, goodwill). Place U.S. GAAP standards on one half with IFRS next to it to quickly compare the differences.
The three types of financial assets (Held-to-Maturity, Held-for-Trading, Available-for-Sale) are important to understand. Remember the criteria for each, how it is valued on the balance sheet and how unrealized gains are reported.
Deferred tax assets and liabilities will also be a big section on the next exam but you only need the basic definition for the first exam.
That is a ton of information for a blog post and only the high-level stuff you need to know about financial statements. Take the extra time on these next few study sessions and master the material. We will wrap up SS8 next week with a review of the Statement of Cash Flows and an introduction to Financial Analysis Techniques.
‘til next time, happy studyin’
Joseph Hogue, CFA