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CFA Level 1
Unit 4: Financial Reporting and Analysis
UOLLB CFA Top Notes
Level 1 Exam
Unit 4: Financial Reporting and
Analysis
Table of Contents
Financial Statements.........................................1
Financial Reporting...........................................2
Financial Reporting Standards..........................3
FASB Framework vs IASB Framework............4
Income Statement..............................................5
Special Revenue Recognition............................5
Expenses Recognition (Matching Principle).....5
Diluted Earnings Per Share...............................6
Balance Sheet (BS)............................................6
Intangible Assets...............................................7
Balance Sheet Ratios.........................................8
Cash Flow Statement.........................................8
CFS Financing Activities: Direct Method.........9
Common Size Analysis of SCF.......................10
Cash Flow Ratios............................................10
Inventories.......................................................11
FS Adjustments for Financial Analysis...........12
Research and Development.............................12
Depreciation Methods.....................................12
Reversals of Impairments of...........................13
Income Taxes...................................................13
Treatment of Temporary Differences..............14
Long-Term Liabilities and Leases...................14
Amortization of Bond Premium / Discount....15
Leases..............................................................15
Off-Balance Sheet Financing..........................16
Financial Analysis...........................................16
Common-Size Analysis...................................16
Business Risk Ratios.......................................18
Credit Analysis................................................18
Model for Predicting Bankruptcy....................18
Segment Analysis............................................18
Reporting Quality............................................18
Cash Flow Manipulation.................................19
Screening.........................................................19
Accounting of Marketable Securities..............20
Revenue Recognition......................................20
Nonrecurring Items.........................................21
Financial Statements
position or any changes
Role of Financial Reporting
Provide info for investment decision making
Provide info about financial performance /
Scopes of Decision Making
Equity Investment
M&A
1 CFA Level 1
Unit 4: Financial Reporting and Analysis
Subsidiaries
Venture Capital / Private Equity Investment
Credit Rating
Compliance
Debt Rating
Cash Flow Forecast
Liquidity
The ability to meet short-term obligations
Solvency
The ability to meet long-term obligations
Financial Statements
Income Statement
Balance Sheet
Cash Flow Statement
Statement of Changes in Owners' Equity
Financial Notes and Supplementary
Schedules
Management's Discussion and Analysis
(Listed Companies)
Auditor's Reports
Management Report on Internal Control
(Sarbanes-Oxley Act)
Income Statement
Provide info on financial results
(performance) over a period of time
Report revenue and expenses
Net Income = Revenue - Expenses
Balance Sheet
Provide info on financial positions at a specific point in time
Owners' Equity = Assets - Liabilities
Cash Flow Statement
Provide info on financial flexibility
Cash inflows / outflows derive from operating, investing and financing activities
Auditor's Report
Unqualified Opinion (FS gives True / Fair
View)
Qualified Opinion (Some Limitations /
Exceptions to Accounting Standards)
Adverse Opinion (FS materially departs from
Accounting Standards)
Disclaimer of Opinion (Auditor are Unable to Issue an Opinion)
Accounting Organizations
International Accounting Standard Board
(London)
International Financial Reporting Standards
(IFRS)
Framework for the Preparation and
Presentation of Financial Statements
Financial Accounting Standard Board
(FASB) (US)
Statements of Financial Accounting
Standards (US GAAP)
Other Sources of Information
Interim Report (Unaudited)
Provide update info on financial position /
performance
Proxy Statement
Provide info on voting / management / stock performance / disclosures
Financial Statement Analysis Framework
Articulate Purpose and Context of Analysis
Collect Data
Process Data
Analyse / Interpret Processed Data
Develop / Communicate Conclusions and
Recommendations
Follow Up
Phase 1: Articulate Purpose and Context of
Analysis
Determine the Nature
Communicate with Client
Gather Institutional Guidelines
Provide Statement of Purpose / Objective
Formulate Questions
Provide Timetable
Phase 2: Collect Data
Financial Statements
Industry / Economic Data
Discussions with Stakeholders
Site Visits
Phase 3: Top-down Approach to Data
Collection
Analyse the Macroeconomic Environment
Analyse Industrial Competitive Environment
Analyse the Company
Phase 4: Process Data
Evaluate Financial Statements 2 CFA Level 1
Unit 4: Financial Reporting and Analysis
Make Adjustments
Compute Financial Ratios / Graphs /
Forecasts
Phase 5: Analyse / Interpret Processed Data
Give Analytical Results
Phase 6: Develop / Communicate
Conclusions and Recommendations
Provide Reports
Offer Recommendations
Phase 7: Follow Up
Update Reports
Components of Equity Analyst Report
Summary and Investment Conclusion
Business Summary
Risks
Valuation
Historical and Pro Forma Tables
Financial Reporting
Business Activities
Operating Activities (Daily Business
Functioning)
Investing Activities Acquisition / Disposal of
Long-term Assets
Financing Activities (Obtaining / Repaying
Capital)
Items in Balance Sheet
Assets (Economic Resources)
Liabilities (Creditors' Claims on Economic
Resources)
Owner's Equity (Residual Claims on
Economic Resources)
Items in Income Statement
Revenue (Inflows of Economic Resources)
Expenses (Outflows of Economic Resources)
Net Income
Types of Assets
Current Assets (Inventory, Trade
Receivables, Prepaid Expenses, Cash)
Noncurrent Assets (Property, Plant,
Equipment)
Intangible Assets (Patents, Trademarks,
Licenses, Copyright, Goodwill)
Financial Assets (Trading Securities,
Investment Securities, Derivatives)
Current Liabilities
Trade Payables
Accrued Liabilities
Tax liabilities (Current, Deferred)
Minority Interests
Unearned Revenue
Debt / Bond Payable
Owners' Equity
Capital
Non-Current Liabilities
Retained Earnings
Reserve Liabilities
Revenue
Sales Revenue
Gains
Investment Income (Interest, Dividend)
Expenses
Cost of Goods Sold
Selling / General / Administrative Expenses
Depreciation / Amortization
Interest / Tax / Dividend Expenses
Bad Debt / Losses
Accounting Equations
Owners' Equity = Assets - Liabilities
Owners' Equity = Contributed Capital +
Ending Retained Earnings
Net Income = Revenue - Expenses
Ending Retained Earnings = Beginning
Retained Earnings + Net Income -
Dividends
Contra Accounts
Used for entries that offset some part of the value of another account
Equipment (Asset) is offset in Depreciation
(Expense)
Accrual Accounting
Unearned (Deferred) Revenue
Accrued (Unbilled) Revenue
Prepaid Expenses
Accrued Expenses
Valuation Adjustments
Adjust the values of assets / liabilities when required by accounting standards
Flow of Info in an Accounting System 3 CFA Level 1
Unit 4: Financial Reporting and Analysis
Journal Entries / Adjusting Entries (business transactions sorted by date)
General Ledger / T-accounts (business transactions sorted by account)
Trial Balance / Adjusted Trial Balance
(ending account balances)
Financial Statements
Financial Reporting Standards
Standard-Setting Bodies (Private Sector
Organization)
International Accounting Standards Board
(IASB)
Financial Accounting Standards Board
(FASB)
International Organization of Securities
Commission (IOSCO)
Regulatory Authorities
Securities and Exchange Commission (SEC)
(US)
Financial Services Authority (FSA) (UK)
European Securities Committee (ESC) (EU)
Objectives of IOSCO
Protect investors
Ensure fairness, efficiency and transparency of markets
Reduce systematic risk
Significant Legislation
Securities Act 1933
Securities Exchange Act 1934 (creation of
SEC)
Sarbanes-Oxley Act 2002 (creation of Public
Company Accounting Oversight Board)
SEC Filings
Securities Offerings Registration Statement
Forms 10-K (US Registrant), 20-F (Non US
Registrant), 40-F (Canadian Registrant)
Annual Report
Proxy Statement / Form DEF-14A
Forms 10-Q / 6-K (Interim Reports)
Other Filings
Form 8-K (Interim Report on Corporate
Event)
Form 144 (Proposed Sale of Restricted
Securities)
Forms 3, 4, and 5 (Beneficial Ownership of
Securities)
Form 11-K (Annual Report of Employee
Stock Purchase)
Qualitative Characteristics of Financial
Statements
Understandability
Relevance (Materiality)
Reliability (Faithful, Substance over Form,
Neutral, Prudent, Complete)
Comparability (Over Time / Across
Companies)
Constraints on Financial Statements
Time
Cost
Measurement of FS Elements
Historical Cost
Current Cost (Cost to Replace an Asset)
Realizable (Settlement) Value (Sold Items)
Present Value (Discounted)
Fair Value (Expected Value of an Item if
Sold)
FS Fundamental Principles
Fair Presentation
Going Concern
Accrual Basis
Consistency
Materiality
Presentation Requirements
Aggregation (of similar items)
Separation (of dissimilar items)
No offsetting
Classified Balance Sheet (Current /
Noncurrent)
Min Info
Comparative Info (info of previous years)
Disclosure in FS Notes
Accounting Policies
Estimated Uncertainty
Description of Company
Nature of Operations
Parent Company
FASB Framework vs IASB Framework
Purpose of the Framework
Both have similar a purpose
Purpose of IASB Framework is at the top of
GAAP but FASB is not
4 CFA Level 1
Unit 4: Financial Reporting and Analysis
FS Objectives
Both focus on providing relevant info
Same objectives for business / non-business
FS in IASB, but different in FASB,
Grouping by Function
Grouping together expenses into a category
COGS = Material Costs + Direct SalesRelated Expenses
Underlying Assumption
IASB gives more emphasis on accrual and going concern assumptions
FASB Recognition of Revenue
Evidence of an arrangement between Buyer and Seller
Product has been delivered / Service has been rendered
Price is determined / determinable
Seller is reasonably sure of collecting money
Primary Qualitative Characteristics
IASB: Relevance, Reliability, Comparability,
Understandability
FASB Primary: Relevance, Reliability
FASB Secondary: Comparability,
Understandability
Standard Setting Approach
IFRS (Principles-based Approach)
FASB (Changing from Rule-based Approach to Objective-oriented Approach)
Effective Financial Reporting
Transparency
Comprehensiveness
Consistency
Barriers to Coherent Framework
Different Valuation
Different Standard Setting Approach
Different Measurement
Income Statement
Revenue
Amounts charged for the delivery of goods /
service
Increases in economic benefits
Net Revenue
Revenue after adjustment (e.g. return inwards)
Items in Income Statements
Operating Income = Sales - Cost of Goods
Sold - All Expenses
Net Income = Operating Income - All
Provisions (e.g. Tax / Interest / MI)
Grouping by Nature
Grouping together expenses into a single line item
Depreciation = Depreciation on Equipment +
Depreciation on Facilities
IASB Recognition of Revenue for Sale of
Goods
Firm has transferred risks and ownership to
Buyer
Firm has no effective control / management of the goods sold
Revenue can be measured reliably
Economic benefit will flow to Firm
Transaction costs can be measured reliably
IASB Recognition of Revenue for Sale of
Services
Revenue can be measured reliably
Economic benefit will flow to Firm
Transaction costs can be measured reliably
Stage of completion (percentage of completion) can be measured reliably
Special Revenue Recognition
Revenue from Contracts
Long-term Contracts: Percentage of
Completion Method
Short-term Contracts: Completed Contract
Method
Instalment Sales (Proceeds to be Paid in
Several Instalments)
Instalment Method: Revenue recognized in proportion to the cash received)
Cost Recovery Method: Revenue is not recognized until receipt of cash equal to cost)
Barter Transactions (e-Commerce)
Two parties exchange goods / services without cash payments
IFRS: Measure revenue based on fair value
FASB: Measure revenue based on fair value computed from previous transaction
Gross vs Net Reporting (e-Commerce)
5 CFA Level 1
Unit 4: Financial Reporting and Analysis
Gross Revenue Reporting: Selling Firm reports sales revenue and COFS separately
Net Revenue Reporting: Only the difference in sales and cost is reported
Capital Structure
Ordinary Shares (Common Stocks)
Preference Shares
Convertible Preference Shares
US GAAP Gross Revenue Reporting
Selling Firm must be the obligor under the contract
Selling Firm bear the inventory / credit risk
Selling Firm is able to choose its supplier
Selling Firm has reasonable flexibility to establish the price
Basic Earnings Per Share
= (Net Income - Preferred Dividends) /
Weighted Average Shares
Expenses
Decreases in economic benefits
Outflows of economic resources
Expenses Recognition (Matching
Principle)
Doubtful Accounts
Estimate the amount of revenue to be uncollectible
Warranties (Guarantee)
Estimate the amount of expenses on warranties to be incurred at the time of sales
Depreciation (Long-live Assets) and
Amortization (Intangible Assets)
Method 1: Straight-line Method (SL)
SL Depreciation Expense = (Cost - Residual
Value) / Useful Life
Method 2: Diminishing (Declining) Balance
Method (DB)
DDM Depreciation Expense = (2 / Useful
Life) (Cost - Accumulated Depreciation)
Inventory
FIFO (Allowed by US GAAP and IFRS)
LIFO (Allowed by US GAAP, but prohibited by IFRS)
Weighted Average Cost (Allowed by US
GAAP and IFRS)
Nonrecurring / Nonoperating Items
Discontinued Operation
Extraordinary Items (Unusual and Infrequent in Occurrence)
Unusual or Infrequent Items (No both)
Nonoperating Items
No. of Weighted Average Shares
No. of Shares at the Beginning of Fiscal Year
(S0)
No. of Shares after Change (e.g. repurchase,
issue) during Fiscal Year (S1)
Time Weighted Average (TWA)
= No. of Months / 12
No. of Weighted Average Shares
= S0 Time Weighted Average + S1 Time
Weighted Average
Diluted Earnings Per Share
Potentially Dilutive Securities
Convertible Preferred Shares
Convertible Debt
Employee Stock Options
EPS Diluted by Preferred Shares
= Net Income / (Weight Average Shares +
Newly Converted Shares)
EPS Diluted by Convertible Debt
= (Net Income + After-tax Interest on
Convertible Debt - Preferred Dividend) /
(Weighted Average Shares + Newly
Converted Shares)
EPS Diluted by Stock Options
= (Net Income - Preferred Dividend) /
(Weighted Average Shares + All Option
Shares - Option Shares Bought back by
Company)
Income Statement Ratios
Net Profit Margin = Net Income / Revenue
Gross Profit Margin = Gross Profit /
Revenue
Operating Margin = Operating Margin /
Revenue
Pretax Margin = Pretax Margin 6 CFA Level 1
Unit 4: Financial Reporting and Analysis
Mutual Fund
Comprehensive Income (CI)
All changes in owners' equity resulted from business transactions with non-owners
Other Comprehensive Income (OCI)
All changes in equity excluded from net income calculation (foreign currency)
CI = Net Income + OCI
Unrealized Holding Gain / Loss (e.g.
Securities, Funds)
Gain / Loss from holding an asset whose value has changed
Common Size Analysis of Income Statement
State each Income Statement (IS) item as a percentage of Revenue
Balance Sheet (BS)
Characteristics of Company
Permanent
No Mandatory Fixed Charges against
Earnings
Legal Subordination to the Rights of
Creditors
Balance Sheet
Assets (A)
Liabilities (L)
Equity (E)
E=A-L
Assets
Accrued Revenue (Accounts Receivable)
Prepaid Expense
Liabilities
Unearned (Deferred) Revenue
Accrued Expenses
Current Assets (CA)
Held primarily for trading
Expected to be realized within 12 months after the BS date
To be used up within 12 months
CA Marketable Securities
T-Bills
Notes
Bonds
Equity Securities
CA Trade Receivables
Allowance for bad debt expenses
CA Inventories
Measured at the lower of cost or net realizable value (NRV)
NRV = Selling Price - Estimated Costs to
Make the Sale
CA Other Current Assets
Short-term Items (e.g. prepaid expense)
Noncurrent Assets
Not to be consumed / disposed in the current period (e.g. pant / equipment)
Current Liabilities (CL)
Expected to be settled in the normal operating cycle
Held primarily for the purpose of being trade
To be settled within one year (no deferral)
Noncurrent Liabilities
Provide financing on a long-term basis
Working Capital
= Current Assets - Current Liabilities
Assets Disclosed on Balance Sheet
Cash / Cash Equivalent
Inventories
Trade / Other Receivables
Prepaid Expenses
Deferred Tax Assets
Property / Plant / Equipment (Less
Depreciation)
Investment Property
Intangible Assets (Less Amortization /
Impairment)
Security Investments
Natural Resource Assets
Assets to be Sold
Liabilities Disclosed on Balance Sheet
Bank Borrowings / Payable
Trade / Other Payable
Provisions (Bad / Doubtful Debt)
Financial Liabilities
Accrued Liabilities (Accrued Expenses /
Unearned Revenue)
Deferred Tax Liabilities 7
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