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Unformatted text preview: FINANCIAL REPORTING AND ANALYSIS CFA® Program Curriculum 2018 • LEVEL I • VOLUME 3 CONTENTS How to Use the CFA Program Curriculum   Curriculum Development Process   Organization of the Curriculum   Features of the Curriculum   Designing Your Personal Study Program   Feedback   ix ix x x xii xiii Financial Reporting and Analysis Study Session 6 Financial Reporting and Analysis: An Introduction   Reading 21 Financial Statement Analysis: An Introduction   Introduction   Scope of Financial Statement Analysis   Major Financial Statements and Other Information Sources   Financial Statements and Supplementary Information   Other Sources of Information   Financial Statement Analysis Framework   Articulate the Purpose and Context of Analysis   Collect Data   Process Data   Analyze/Interpret the Processed Data   Develop and Communicate Conclusions/Recommendations   Follow-­ Up   Summary   Practice Problems   Solutions   5 6 6 11 12 29 30 31 32 33 33 34 34 35 37 40 Reading 22 Financial Reporting Mechanics   Introduction   The Classification of Business Activities   Accounts and Financial Statements   Financial Statement Elements and Accounts   Accounting Equations   The Accounting Process   An Illustration   The Accounting Records   Financial Statements   Accruals and Valuation Adjustments   Accruals   Valuation Adjustments   Accounting Systems   Flow of Information in an Accounting System   Debits and Credits   43 44 44 45 46 48 53 54 55 68 71 71 73 73 74 74 indicates an optional segment 3 ii Contents Using Financial Statements in Security Analysis   The Use of Judgment in Accounts and Entries   Misrepresentations   Summary   Appendix 23: A Debit/Credit Accounting System   Practice Problems   Solutions   75 75 76 77 78 95 98 Reading 23 Financial Reporting Standards   Introduction   The Objective of Financial Reporting   Standard-­Setting Bodies and Regulatory Authorities   Accounting Standards Boards   Regulatory Authorities   Convergence of Global Financial Reporting Standards   The International Financial Reporting Standards Framework   Objective of Financial Reports   Qualitative Characteristics of Financial Reports   Constraints on Financial Reports   The Elements of Financial Statements   General Requirements for Financial Statements   Convergence of Conceptual Framework   Effective Financial Reporting   Characteristics of an Effective Financial Reporting Framework   Barriers to a Single Coherent Framework   Comparison of IFRS with Alternative Reporting Systems   Monitoring Developments in Financial Reporting Standards   New Products or Types of Transactions   Evolving Standards and the Role of CFA Institute   Company Disclosures   Summary   Practice Problems   Solutions   101 102 102 105 106 108 113 117 118 119 120 121 123 127 129 129 130 131 133 133 134 135 138 141 144 Study Session 7 Financial Reporting and Analysis: Income Statements, Balance Sheets, and Cash Flow Statements   147 Understanding Income Statements   Introduction   Components and Format of the Income Statement   Revenue Recognition   General Principles   Revenue Recognition in Special Cases   Implications for Financial Analysis   Revenue Recognition Accounting Standards Issued May 2014   Expense Recognition   General Principles   Issues in Expense Recognition   Implications for Financial Analysis   149 150 151 155 156 159 167 168 172 172 176 181 Reading 24 indicates an optional segment Contents Reading 25 iii Non-­Recurring Items and Non-­Operating Items   Discontinued Operations   Extraordinary Items   Unusual or Infrequent Items   Changes in Accounting Policies   Non-­ Operating Items   Earnings per Share   Simple versus Complex Capital Structure   Basic EPS   Diluted EPS   Changes in EPS   Analysis of the Income Statement   Common-­Size Analysis of the Income Statement   Income Statement Ratios   Comprehensive Income   Summary   Practice Problems   Solutions   181 182 182 183 184 186 187 188 188 190 196 197 197 199 201 204 207 212 Understanding Balance Sheets   Introduction   Components and Format of the Balance Sheet   Balance Sheet Components   Current and Non-­Current Classification   Liquidity-­ Based Presentation   Current Assets and Current Liabilities   Current Assets   Current Liabilities   Non-­ Current Assets   Property, Plant, and Equipment   Investment Property   Intangible Assets   Goodwill   Financial Assets   Non-­ Current Liabilities   Long-­term Financial Liabilities   Deferred Tax Liabilities   Equity   Components of Equity   Statement of Changes in Equity   Analysis of the Balance Sheet   Common-­Size Analysis of the Balance Sheet   Balance Sheet Ratios   Summary   Practice Problems   Solutions   217 218 218 219 221 222 223 223 230 234 235 236 237 239 242 245 246 247 247 248 250 252 252 260 262 265 270 indicates an optional segment iv Reading 26 Reading 27 Contents Understanding Cash Flow Statements   Introduction   Components and Format of the Cash Flow Statement   Classification of Cash Flows and Non-­Cash Activities   A Summary of Differences between IFRS and US GAAP   Direct and Indirect Methods for Reporting Cash Flow from Operating Activities   The Cash Flow Statement: Linkages and Preparation   Linkages of the Cash Flow Statement with the Income Statement and Balance Sheet   Steps in Preparing the Cash Flow Statement   Conversion of Cash Flows from the Indirect to the Direct Method   Cash Flow Statement Analysis   Evaluation of the Sources and Uses of Cash   Common-­Size Analysis of the Statement of Cash Flows   Free Cash Flow to the Firm and Free Cash Flow to Equity   Cash Flow Ratios   Summary   Practice Problems   Solutions   273 274 275 275 277 Financial Analysis Techniques   Introduction   The Financial Analysis Process   The Objectives of the Financial Analysis Process   Distinguishing between Computations and Analysis   Analytical Tools and Techniques   Ratios   Common-­ Size Analysis   The Use of Graphs as an Analytical Tool   Regression Analysis   Common Ratios Used in Financial Analysis   Interpretation and Context   Activity Ratios   Liquidity Ratios   Solvency Ratios   Profitability Ratios   Integrated Financial Ratio Analysis   Equity Analysis   Valuation Ratios   Industry-­ Specific Ratios   Research on Ratios in Equity Analysis   Credit Analysis   The Credit Rating Process   Research on Ratios in Credit Analysis   Business and Geographic Segments   Segment Reporting Requirements   Segment Ratios   Model Building and Forecasting   325 325 326 327 328 330 334 338 345 347 347 348 349 355 360 364 368 376 376 379 381 382 382 384 385 385 386 388 indicates an optional segment 278 288 288 289 301 302 302 305 310 311 313 315 321 Contents v Summary   Practice Problems   Solutions   388 391 397 Financial Reporting and Analysis: Inventories, Long-­lived Assets, Income Taxes, and Non-­current Liabilities    401 Reading 28 Inventories   Introduction   Cost of Inventories   Inventory Valuation Methods   Specific Identification   First-­In, First-­Out (FIFO)   Weighted Average Cost   Last-­In, First-­Out (LIFO)   Calculation of Cost of Sales, Gross Profit, and Ending Inventory   Periodic versus Perpetual Inventory Systems   Comparison of Inventory Valuation Methods   The LIFO Method   LIFO Reserve   LIFO Liquidations   Inventory Method Changes   Inventory Adjustments   Evaluation of Inventory Management   Presentation and Disclosure   Inventory Ratios   Financial Analysis Illustrations   Summary   Practice Problems   Solutions   403 404 405 406 407 407 407 408 408 410 412 415 415 421 425 426 433 434 434 435 446 449 465 Reading 29 Long-­Lived Assets   Introduction   Acquisition of Long-­Lived Assets   Property, Plant, and Equipment   Intangible Assets   Capitalising versus Expensing: Impact on Financial Statements and Ratios   Capitalisation of Interest Costs   Capitalisation of Internal Development Costs   Depreciation and Amortisation of Long-­Lived Assets   Depreciation Methods and Calculation of Depreciation Expense   Amortisation Methods and Calculation of Amortisation Expense   The Revaluation Model   Impairment of Assets   Impairment of Property, Plant, and Equipment   Impairment of Intangible Assets with a Finite Life   Impairment of Intangibles with Indefinite Lives   Impairment of Long-­Lived Assets Held for Sale   473 474 475 475 478 Study Session 8 indicates an optional segment 481 486 489 493 493 501 502 506 506 508 509 509 vi Reading 30 Reading 31 Contents Reversals of Impairments of Long-­Lived Assets   Derecognition   Sale of Long-­Lived Assets   Long-­Lived Assets Disposed of Other Than by a Sale   Presentation and Disclosures   Investment Property   Leasing   The Lease versus Buy Decision   Finance versus Operating Leases   Summary   Practice Problems   Solutions   509 509 509 510 511 522 525 525 526 544 547 559 Income Taxes   Introduction   Differences between Accounting Profit and Taxable Income   Current Tax Assets and Liabilities   Deferred Tax Assets and Liabilities   Determining the Tax Base of Assets and Liabilities   Determining the Tax Base of an Asset   Determining the Tax Base of a Liability   Changes in Income Tax Rates   Temporary and Permanent Differences Between Taxable and Accounting Profit   Taxable Temporary Differences   Deductible Temporary Differences   Examples of Taxable and Deductible Temporary Differences   Temporary Differences at Initial Recognition of Assets and Liabilities   Business Combinations and Deferred Taxes   Investments in Subsidiaries, Branches, Associates and Interests in Joint Ventures   Unused Tax Losses and Tax Credits   Recognition and Measurement of Current and Deferred Tax   Recognition of a Valuation Allowance   Recognition of Current and Deferred Tax Charged Directly to Equity   Presentation and Disclosure   Comparison of IFRS and US GAAP   Summary   Practice Problems   Solutions   565 566 566 567 568 571 571 573 575 Non-­Current (Long-­Term) Liabilities   Introduction   Bonds Payable   Accounting for Bond Issuance   Accounting for Bond Amortisation, Interest Expense, and Interest Payments   Current Market Rates and Fair Value Reporting Option   Derecognition of Debt   603 604 604 604 indicates an optional segment 576 577 577 578 580 581 581 581 582 583 583 586 591 594 596 601 608 612 615 Contents vii Debt Covenants   Presentation and Disclosure of Long-­Term Debt   Leases   Advantages of Leasing   Finance (or Capital) Leases versus Operating Leases   Introduction to Pensions and Other Post-­Employment Benefits   Evaluating Solvency: Leverage and Coverage Ratios   Summary   Practice Problems   Solutions   617 619 622 622 623 640 643 647 650 656 Financial Reporting and Analysis: Financial Reporting Quality and Financial Statement Analysis   663 Reading 32 Financial Reporting Quality   Introduction   Conceptual Overview   GAAP, Decision-­Useful, Sustainable, and Adequate Returns   GAAP, Decision-­Useful, but Sustainable?   Biased Accounting Choices   Departures from GAAP   Differentiate between Conservative and Aggressive Accounting   Context for Assessing Financial Reporting Quality   Motivations   Conditions Conducive to Issuing Low-­Quality Financial Reports   Mechanisms That Discipline Financial Reporting Quality   Detection of Financial Reporting Quality Issues   Presentation Choices   Accounting Choices and Estimates   Warning Signs   Conclusion   Practice Problems   Solutions   665 665 667 668 669 670 677 678 683 683 684 684 690 691 696 713 718 721 725 Reading 33 Financial Statement Analysis: Applications   Introduction   Application: Evaluating Past Financial Performance   Application: Projecting Future Financial Performance   Projecting Performance: An Input to Market-­Based Valuation   Projecting Multiple-­Period Performance   Application: Assessing Credit Risk   Application: Screening for Potential Equity Investments   Analyst Adjustments to Reported Financials   A Framework for Analyst Adjustments   Analyst Adjustments Related to Investments   Analyst Adjustments Related to Inventory   Analyst Adjustments Related to Property, Plant, and Equipment   Analyst Adjustments Related to Goodwill   Analyst Adjustments Related to Off-­Balance-­Sheet Financing   729 730 731 739 740 745 749 752 756 756 756 757 761 762 764 Study Session 9 indicates an optional segment viii Contents Summary   Practice Problems   Solutions   771 773 775 Glossary G-1 Index I-1 indicates an optional segment Financial Reporting and Analysis STUDY SESSIONS Study Session 6 An Introduction Study Session 7 Income Statements, Balance Sheets, and Cash Flow Statements Study Session 8 Inventories, Long-­lived Assets, Income Taxes, and Non-­current Liabilities Study Session 9 Financial Reporting Quality and Financial Statement Analysis TOPIC LEVEL LEARNING OUTCOME The candidate should be able to demonstrate a thorough knowledge of financial reporting procedures and the standards that govern financial reporting disclosure. Emphasis is on basic financial statements and how alternative accounting methods affect those statements and the analysis of them. Financial statement analysis is critical in assessing a company’s overall financial position and associated risks over time. Security and business valuation, credit risk assessment, and acquisition due diligence all require an understanding of the major financial statements including general principles and reporting approaches. Because no set of accounting standards has universal acceptance, companies around the world may differ in reporting treatment based on their jurisdiction. © 2017 CFA Institute. All rights reserved. Note: In 2009, the US Financial Accounting Standards Board (FASB) released the FASB Accounting Standards Codification™. The Codification is the single source of authoritative nongovernmental US generally accepted accounting principles (US GAAP) effective for period endings after 15 September 2009. The Codification supersedes all previous US GAAP standards. We have attempted to update the readings to reference or cross-­r eference the Codification as appropriate. Candidates are responsible for the content of accounting standards as addressed in the readings, not for the actual reference numbers. 2 Financial Reporting and Analysis Financial statement analysis requires the ability to analyze a company’s reported results with its economic reality, normalize differences in accounting treatment to make valid cross company comparisons, identify quality issues that may exist in reported financial statements, and discern evidence of financial statement manipulation by management. F inancial R eportin g an d A nalysis 6 STUDY SESSION Financial Reporting and Analysis An Introduction This study session introduces the principal information sources used to evaluate a company’s financial performance. Primary financial statements (income statement, balance sheet, cash flow statement, and statement of changes in equity) in addition to notes to these statements and management reporting are examined. A general framework for conducting financial statement analysis is provided. The process of recording a business’s activities through the accounting process including necessary accruals and adjustments is then described. The session concludes with an explanation of the roles played by financial reporting standard-­setting bodies and regulatory authorities, the Internal Accounting Standards Board’s conceptual framework, and the movement toward global accounting standards. READING ASSIGNMENTS Reading 21 Financial Statement Analysis: An Introduction by Elaine Henry, PhD, CFA, and Thomas R. Robinson, PhD, CFA Reading 22 Financial Reporting Mechanics Thomas R. Robinson, PhD, CFA, Jan Hendrik van Greuning, DCom, CFA, Karen O’Connor Rubsam, CFA, Elaine Henry, PhD, CFA, and Michael A. Broihahn, CPA, CIA, CFA Reading 23 Financial Reporting Standards by Elaine Henry, PhD, CFA, Jan Hendrik van Greuning, DCom, CFA, and Thomas R. Robinson, PhD, CFA © 2017 CFA Institute. All rights reserved. Note: New rulings and/or pronouncements issued after the publication of the readings in financial reporting and analysis may cause some of the information in these readings to become dated. Candidates are expected to be familiar with the overall analytical framework contained in the study session readings, as well as the implications of alternative accounting methods for financial analysis and valuation, as provided in the assigned readings. Candidates are not responsible for changes that occur after the material was written. Candidates should be aware that certain ratios may be defined and calculated differently. Such differences are part of the nature of practical financial analysis. For examination purposes, when alternative ratio definitions exist and no specific definition is given in the question, candidates should use the ratio definitions emphasized in the CFA Institute copyrighted readings. READING 21 Financial Statement Analysis: An Introduction by Elaine Henry, PhD, CFA, and Thomas R. Robinson, PhD, CFA Elaine Henry, PhD, CFA, is at Stevens Institute of Technology (USA). Thomas R. Robinson, PhD, CFA, is at AACSB International (USA). LEARNING OUTCOMES Mastery The candidate should be able to: a. describe the roles of financial reporting and financial statement analysis; b. describe the roles of the statement of financial position, statement of comprehensive income, statement of changes in equity, and statement of cash flows in evaluating a company’s performance and financial position; c. describe the importance of financial statement notes and supplementary information—including disclosures of accounting policies, methods, and estimates—and management’s commentary; d. describe the objective of audits of financial statements, the types of audit reports, and the importance of effective internal controls; e. identify and describe information sources that analysts use in financial statement analysis besides annual financial statements and supplementary information; f. describe the steps in the financial statement analysis framework. © 2011 CFA Institute. All rights reserved. Note: New rulings and/or pronouncements issued after the publication of the readings in financial reporting and analysis may cause some of the information in these readings to become dated. Candidates are expected to be familiar with the overall analytical framework contained in the study sessions readings, as well as the implications of alternative accounting methods for financial analysis and valuation, as provided in the assigned readings. Candidates are not responsible for changes that occur after the material was written. 6 Reading 21 ■ Financial Statement Analysis: An Introduction 1 2 INTRODUCTION Financial analysis is the process of examining a company’s performance in the context of its industry and economic environment in order to arrive at a decision or recommendation. Often, the decisions and recommendations addressed by financial analysts pertain to providing capital to companies—specifically, whether to invest in the company’s debt or equity securities and at what price. An investor in debt securities is concerned about the company’s ability to pay interest and to repay the principal lent. An investor in equity securities is an owner with a residual interest in the company and is concerned about the company’s ability to pay dividends and the likelihood that its share price will increase. Overall, a central focus of financial analysis is evaluating the company’s ability to earn a return on its capital that is at least equal to the cost of that capital, to profitably grow its operations, and to generate enough cash to meet obligations and pursue opportunities. Fundamental financial analysis starts with the information found in a company’s financial reports. These financial reports include audited financial statements, additional disclosures required by regulatory authorities, and any accompanying (unaudited) commentary by management. Basic financial statement analysis—as presented in this re...
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