Study session seven in the Level I CFA Program curriculum begins your study into Financial Reporting & Analysis, arguably the most important topic across the curriculum and your career. The session includes three readings covering an introduction, the mechanics of FRA and the two international accounting standards. It is all basic material and probably repeat for those with a finance background.
Financial Statement Analysis
This is really basic material and fairly intuitive. If you’ve got a background in finance, I would skim it while checking off the Learning Outcome Statements to make sure you have the general idea. There’s no calculations and you’re more likely to get questions from other sections of FRA.
Understand why different entities may have different uses for the statements; i.e. creditors, analysts and investors.
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.
Beyond the three statements, the curriculum constantly emphasizes the importance of the Notes and Supplementary Information. The real detail in a company’s statements are buried within the notes so understand that you need to check there throughout your analysis. The curriculum spends some time on Other Comprehensive Income but only the basic need behind the statement.
Understand what an audit is and what kind of internal controls the company has, i.e. an independent board that is available to the auditors. Remember the basic language given in the four types of auditor reports:
- Unqualified opinion – the most common and indicates no material misstatements and in accordance with GAAP.
- Qualified opinion – some exceptions or limitations to accounting standards, possibly concerns to assumptions or valuations of certain items.
- Adverse opinion – Not presented fairly or are materially misstated or not in accordance with GAAP
- Disclaimer of opinion – the auditor is unable to issue an opinion
Understand that there are also other sources of information including: interim reports, proxy statements, the company’s website and press releases.
Financial Reporting Mechanics
The reading covers the standard conventions for developing the financial statements and is a great primer for deeper study. If you do not have a background in accounting or finance, this reading is a lifesaver because it will help get you up to speed.
The balance sheet is broken into current and non-current assets, current and non-current liabilities, and stockholder’s equity. Assets, whether current or not, are the resources the company uses in its operations. Current assets are those that the company plans to use or convert to cash within a year. Long-term assets are longer-lived and include PP&E, intangible assets and goodwill.
Liabilities are creditors’ claims on assets, and are drawn against assets to find the amount left to the owners. The curriculum does not spend quite as much time with Owner’s Equity. Just remember that it is contributed capital plus retained earnings and understand the basics behind the accounts.
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.
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.
The Accounting Process is about a year’s worth of accounting classes packed into one reading. It is general information and you shouldn’t have too much trouble understanding it. While important, it’s secondary to the financial statement material.
The section on Accruals and Valuation Adjustments is very important and core to your job. As an analyst, you need to see through the ways management adjust accounts and be able to arrive at a fair value. Understand unearned (deferred) revenue and prepaid expenses and the assumptions/adjustments made for both in the income statement.
Lastly, understand how the three statements are related. The income statement flows through to the balance sheet through retained earnings. The cash flow statement relates to the balance sheet through change in cash. Additionally, there are many accounts that are linked (i.e. depreciation, working capital).
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 gives you your first glimpse into the financial statements and is extremely important. Be ready to spend a lot of time and master the material or you will not only have problems on the first exam, will need to relearn the material for the other two exams.
‘til next time, happy studyin’
Joseph Hogue, CFA