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Cfa1 4 Financial Reporting And Analysis Notes

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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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