CFA 1 Financial Reporting & Accounting

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Financial Reporting and Analysis - I
Mapping to Curriculum
Reading 22: Financial Statement Analysis : An Introduction Reading 23: Financial Reporting Mechanics Reading 24: Financial Reporting Standards Reading 25: Understanding the Income Statement
Expect around 12 questions in the exam from todays lecture
Neev Knowledge Management Pristine
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Key Concepts
Accounting Equation Auditors Notes Accruals SEC Filling IFRS, US GAAP Revenue Recognition Methods Depreciation Methods Intangible Assets
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Financial Statement Analysis: An Introduction

Role of Financial reporting and Financial Statement Analysis (FSA) Role of key financial statements in evaluating a company performance Importance of Financial statement notes and supplementary information Objective of audits of financial statements. Other sources of information used by analysts. Steps in FSA framework.
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Roles of Financial reporting and Financial Statement Analysis

Financial reporting: It is the way companies show their performance to outside world
International Accounting Standards Board (IASB) has described the role of financial reporting in its Framework for the Preparation & Presentation of Financial Statements as: The objective of financial statements is to provide information about the financial position, performance and changes in financial position of an entity that is useful to a wide range of users in making economic decisions Financial Statement Analysis (FSA): The role of FSA is to use the companys financial statements & other relevant information to make economic decisions
FSA is used to
Evaluate companys past performance and current financial position Project companys ability to earn profits and future cash flows
So that economic decisions like the following can be taken:

Whether to invest in the company's securities Whether to extend bank credit to the company
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Role of key Financial Statements in evaluating a company's performance and financial position
Income statement
Shows financial performance over a particular period of time Includes following elements Revenue (inflows) generated from sales of goods or services Expenses (outflows) incurred to produce the goods or services Gains/Losses earned from continued or discontinued operations
Balance sheet
Shows financial position at a particular point of time Includes following elements Assets: resources owned by company which will produce current or future economic benefit Liabilities: obligations owed by company which will accrue future economic costs Owners equity: residual interest remains after deducting liabilities from assets
Fundamental Accounting Equation:

Assets = Liabilities + Owners' equity
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Role of key Financial Statements in evaluating a company's performance and financial position cont
Cash flow Statement:
Reports companys cash receipts & payments over a particular period Can be classified into: Operating Cash flows: generated from normal business activity Investing Cash flows : generated from investments in other firms & acquisitions etc. Financing Cash flows: generated from financial matters like dividend paid to stockholders, interest paid
Changes in owners' equity

Reports sources and uses of equity investors' investment in the firm over a particular period
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Financial Statement Notes & Supplementary schedules

Financial Statement notes (footnotes):
Provides information about accounting methods, assumptions & estimates used in preparing financial statements Provide additional information on business segment, related party transactions, acquisitions / disposals, contingencies, significant customers
Company A
Revenue Revenue through related party 100 500
Company B
100 0
Total Revenue 600 600 Since Company A has many related party transactions, company Bs revenues are more reliable. Allows users to improve their assessment of amount, timing & uncertainty of estimates reported in financial statements All footnotes are required to be audited
Supplementary schedules contains additional information like:

Operating income or sales by region or business segment Reserves for an oil and gas company Information about hedging activities and financial instruments Supplementary schedules are not required to be audited
Exam Notes: Check the differences between footnotes and supplementary schedules
Neev Knowledge Management Pristine 8 www.edupristine.com
Management's Discussion and Analysis (MD&A)

Management's Discussion and Analysis (MD&A) provides assessment of the financial performance of a firm from managements perspective In US, public companies are required to disclose following information in MD&A Result from operations with trends in sales and expense
General business overview based on known trends Capital resources and liquidity along with trends in cash flows Discussion on significant events & uncertainties
Additional information, not compulsorily required to be disclosed, under MD&A:

Discussion of effects of known trends on business Discussion over accounting policies requiring significant judgment Discussion over issues related to capital structure and liquidity Information on unusual or infrequent items and extraordinary items etc.
Exam Notes: You should remember either Compulsory or Non Compulsory but not both
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Audits of Financial Statements

Since management itself prepares financial statements, there can biasness involved thus audits are required to get an independent review of financial statements Audits are performed by independent auditors Objective of Audit
To get an independent opinion on fairness and reliability of financial statements To check whether generally accepted accounting policies (GAAP) were followed To examine efficiency of accounting & internal control system To determine financial statements contain no material errors
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Auditors Report Types
Imp
On the basis of his analysis, an auditor can issue one of the following three opinions:
Unqualified opinion
Financial statements are free from material omissions and errors
Qualified Opinion
Statements make any exception to the accounting principles Auditors must explain these exceptions in the audit report
Adverse Opinion
Statements are not presented fairly or are materially non conforming with accounting standards
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Question: Auditors Report

If an auditor issues an "adverse opinion" qualification in her opinion, she is referring to the fact that: A. The firm's financial statements do not fairly represent the company's financial performance and position. B. There is considerable uncertainty in the firm's asset-liability valuation, thus causing a concern about its operational health. C. The firm has inadequate controls in place and needs an on-going, frequent audit.
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Solution: Auditors Report

A.
The firm's financial statements do not fairly represent the company's financial performance and position. An adverse opinion is rendered in cases where financial statements are not prepared in accordance with accepted accounting principles, and this has a material effect on the fair presentation of the statements.
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Auditors Report Explanatory paragraph

Explanatory paragraph Auditors report contain explanatory paragraph when material loss is probable but the amount cant be reasonable ascertained Uncertainties are caused due to issues related to:
Going concern assumptions Any litigation Realization of assets values
For example, in the case of British Petroleum oil spill, the auditor would include an explanatory paragraph on the material loss.
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Internal controls
US GAAP requires auditor to comment on internal controls followed by company:
Internal controls are checks and systems which ensures that company uses a proper process to prepare and present accurate financial statements
Management is required to provide a report on internal control system under the Sarbanes Oxley Act that
Management is responsible for maintaining the internal control systems Description on how management evaluates the internal control systems Statement that financial statements are presented accurately Assessment of the effectiveness of most recent year of the internal control systems Statement from management that firms auditors have assessed management internal controls
Exam Notes: The Management, not the auditor is responsible for internal controls. The auditors job is to comment on the efficacy of the same.
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Other sources of information used by analysts

Corporate reports and press releases
Available on companys website
Quarterly or semi-annual reports

Interim reports may not be necessarily audited
SEC filing
www.sec.gov 8-K : Current Report of any significant event 10-K: annual financial statements 10-Q: quarterly financial statements
Proxy Statements
Issued to shareholders on the matters requiring a shareholder vote Good source of information about the election of (and qualifications of) board members. compensation, management qualifications, and the issuance of stock options
Company/Industry research reports/ Other broker reports
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Steps of financial statement analysis
1. Determine the Objective and Context
2. Gather Data
6. Update the Analysis
3. Process the Data
5. Report the Conclusions or Recommendations
4. Analyze and interpret the data
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Questions
1. ABC company faces serious claims under a lawsuit filed against it. An interim judgment if goes against ABC can cause a probable material loss but this cannot be quantified at the time of preparing financial statements. Which of the following best describes desired action by auditor of ABC? A. Auditor should issue an explanatory note in audit report B. Auditor should issue qualify report C. Auditor should issue an adverse opinion 2. In U.S., which of the following information needs to be compulsorily disclosed under management discussions and analysis? A. Information on unusual or infrequent items and extraordinary items etc. B. Capital resources and liquidity along with trends in cash flows C. Discussion over accounting policies requiring significant judgment 3. A footnote in financial statement is least likely to contain information on: A. Accounting policies B. Estimations used C. Details on actual Capacities
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Questions (Cont)
4. Under Sarbanes Oxley Act A. Management is required to provide a report on internal controls B. Auditor is required to provide a report on internal controls C. Management is required to report that financial statements are their responsibility 5. Which of the following is least likely to be an objective for conducting an audit A. To get an independent opinion on fairness and reliability of financial statements B. To judge and examine efficiency of internal control system C. To uncover any financial frauds 4. An analyst is looking to get information on related party transactions. In which of the section he is most likely to find out the same A. Footnotes B. Supplementary Schedules C. Management discussion and analysis
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Solutions
1. A. When auditor faces a situation where material loss is probable but the amount cant be reasonable ascertained, he should issue a detailed explanatory note in audit report on such uncertainties and impact. 2. B. In US, public companies are required to disclose 4 types of information in MD&A out of which one is - Capital resources and liquidity along with trends in cash flows 3. C. Financial Statement notes (footnotes) includes accounting policies, estimates and assumption used in preparing Financial statements but not the Details on actual Capacities 4. A. Management is required to provide a report on internal controls under the Sarbanes Oxley Act including that management is responsible for maintaining the internal control systems 5. C. Out of four, two objectives of an audit are to get an independent opinion on fairness and reliability of financial statements & to judge and examine efficiency of internal control system 6. A. Footnotes contain additional information on business segment, related party transactions, acquisitions / disposals, contingencies, significant customers etc.
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Agenda
Reading 22: Financial Statement Analysis : An Introduction Reading 23: Financial Reporting Mechanics Financial Statement Element vs Accounts Business Activities from Financial Statements perspective Assets, Liabilities and Owners Equity Revenue and Expenses Accounting equation in its basic and expanded forms Double Entry Accounting Accruals and other adjustments Relationship among Financial Statements Reading 24: Financial Reporting Standards Reading 25: Understanding the Income Statement
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Financial Reporting Mechanics

Accounts & Financial Statement Elements Basic and expanded forms of accounting equation Double entry accounting Accruals and other adjustments Relationship among financial statements Flow of information in an accounting system Accounting process and security analysis
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Accounts & Financials Statement Elements

When a transaction happens it is first recorded in its related account
For example we have different account for each expenditures - wages, postage, stationary etc
Contra accounts are used for entries which offset some part of the value of another account
Accounts receivable has contra account as provision for bad debts)
These accounts are grouped into 5 elements of financial statements which are:
Assets Liabilities Owners equity Revenue Expenses
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Assets
Current Assets
Cash and cash equivalents: liquid securities with maturities of < 90 days Accounts receivable: adjusted for "allowance for bad debt expense" as contra a/c Inventory Prepaid expenses: items that will be expenses on future income statements. Financial assets: marketable securities etc.
Long Lived Assets and Other assets

Property, plant, and equipment: includes a contra account as accumulated depreciation Intangible assets: economic resources without physical existence such as patents, trademarks, licenses, and goodwill Investment in affiliates (accounted for using the equity method) Deferred tax assets
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Liabilities
Current Liabilities
Accounts payable & trade payables Short-Term notes payable Unearned revenue: Revenue received but not earned (related to future periods) Income taxes payable
Long Term Liabilities

Long-term debt such as bonds payable Deferred tax liabilities
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Owners' equity
Capital - Par value of common stock Additional paid-in capital: proceeds received over par value Retained earnings - Cumulative net income till date
Other comprehensive income

Changes resulting from foreign currency translation of subsidiary Minimum pension liability adjustments Unrealized gains and losses on investments.
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Revenue
Sales Gains:
Increases in assets or equity from transactions incidental to day-today activities Gain on sale of assets
Investment income
Interest income Dividend income
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Expenses
Cost of goods sold (COGS)
=Opening inventory + Purchases Closing Inventory
Selling, general and administrative expenses (SG&A)

Advertising, management salaries, rent, utilities
Depreciation and amortization

Interest expense Losses
Decreases in assets / equity from incidental transactions related to normal activities
Tax expense
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Basic and expanded forms of accounting equation

Basic Equation: Assets = liabilities + owners' equity
Imp
Equity can be broken into contributed capital (preferred and common both) and retained earnings: Assets = Liabilities + Contributed capital + Retained earnings
Retained earnings can be further broken as: Retained earnings = Beginning retained earnings + Net profits during the year dividends
Net profits can be broken into: Net profits = Revenue Expenses Expanded accounting equation: Assets = liabilities + contributed capital + opening retained earnings + revenues expenses dividends
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Double entry accounting
Imp
Each transaction effects two accounts so that assets and liabilities are balanced For example: A) An increase in an asset account must be balanced by either:
Increase in a liability or owners' equity account Decrease in another asset account
B) An expenses incurred (causing reduced earning leading to low retained earning to low equity hence lower liability) must be balanced by either:
Reduction in cash (if expenses is incurred in cash) Increase in liability (if expenses is incurred on credit)
Account 1 Asset Asset Asset
Account 2 Example Asset Liability Equity Purchase inventory with cash Purchase inventory on credit Company pays out Salary
When an asset is increased/decreased and it affects an account on the balance sheet, it either affects another asset account or a liability account When an asset is increased/decreased and it affects the P&L (salary), it affects equity.
Examples
Purchase furniture for $1,000 cash
Furniture (an asset) increases by $1,000 Cash (an asset) decreases by $1,000. Both assets and liabilities are balanced Both assets and liabilities are balanced
Purchase furniture for $1,000 through raising $1,000 notes Furniture (an asset) increases by $1,000
Notes (liability) increases by $1,000 Both assets and liabilities are balanced
Pay $1000 for salary in cash

Salary (expenses) reduces net income, leading to low equity and lower liabilities by $1000 Cash reduces by $1000 Both assets and liabilities are balanced
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Accruals and other adjustments

Timing difference between revenues/expenses earned & and cash collected/paid Accrual concept causes revenues to be recorded when they are earned (instead collected) and expenses when they are incurred (instead paid) Accrual concept results into 4 type of accounts:
1. 2. 3. 4. Accrued revenue Unearned revenue Prepaid expenses Accrued expenses
Example
Airline Tickets
Salary
Party 1
Airlines - Unearned Revenue
Company Accrued Expenses
Party 2
Customer Prepaid Expense
Employee Accrued Revenue
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Accruals and other adjustments (Cont)

Accrued Revenue

Imp
Goods or services are sold but cash is not received Hence revenue increases and accounts receivable (an asset) increases On receipt of cash, cash increases and accounts receivable decreases For example employee works in a company for a month & receives the payment on last day of month
Unearned revenue:
Receives cash in advance before it provides goods or render services Cash increases and unearned revenue (a liability) increases by the same amount When firm provides goods or services, revenue increases and the liability decreases For example - magazine subscription, payment is done first & then the service is received
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Accruals and other adjustments (Cont)
Prepaid expenses:
Pays cash for expenses before they are incurred Cash (an asset) decreases and prepaid expense (also an asset) increases When the expense is actually incurred, prepaid expense decreases and expenses increase For example: advance rent / electricity
Accrued expenses:
Expenses incurred but cash not paid Expenses increase and a liability for accrued expenses increases as well Liability decreases when the firm pays cash for expenses For example: companies receives the services of its employees for the complete month & then pays the salary at the end of the month
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Important Relationships among financial statements

Income Statement and Balance Sheet
Net income(income statement item) is added to retained earnings(balance sheet item)
Retained Earningst+1 = Retained Earningst + Net Income Cash flow and Balance Sheet
Sum of net cash flow from all three activities must match with the difference between opening and closing cash flows
Casht+1 = Casht + Net Cash Flow
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Flow of information in an accounting system

Journal entries (record every transaction)
General ledger (sorts the entries in the general journal by account)
Trial balance (initial trial balance & adjusted trial balance)
Financial statement (Grouping into various financial line items)
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Question: Accounting System

Which of the following would you refer to if you wanted the maximum insight into a companys financial transaction?
A. Financial Statements B. General Ledger C. Journal Entries
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Solution: Accounting System

C.
The Journal shows every single transaction a company executes. It contains maximum detail. Financial statements are the most concise form.
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Questions
1. ABC Corp is bank operating in UK and receiving dividend income out of the investments it made in equity securities. This activity is most likely to be described as A. Operating Activity B. Investing Activity C. Financing Activity
2. Under an expanded accounting equation; A. Liabilities = Assets - Contributed capital + Retained earnings B. Dividends = Beginning retained earnings + Net profits during the year - Closing Retained Earning C. Contributed capital = Assets Liabilities + Retained Earnings
3. Under double entry accounting, how a $1000 purchase of trading goods on credit will impact different accounts A. Purchase account will increase by $1000 and Creditors will decrease by $1000 B. Purchase account will increase by $1000 and creditors will increase by $1000 C. Purchase account will increase by $1000 and equity will decrease by $1000
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Questions (Cont)
4. ABC company pays current months salary to its employee on 1st day of next month, how this transaction will be reported on financial statement at year end: A. Report one day salary as outstanding expenses B. Report one month salary as outstanding expenses C. Report one day salary as prepaid expenses
5. Kingfisher Airlines, on last day of its financial year, received an amount of $1000 for flights booking in next month. This amount will most likely be reported as: A. Accrued revenue of $1000 on liability side B. Advance from customers of $1000 on liabilities side C. Unearned revenue of $1000 on liability side
6. Value of ABCs investments have declined substantially in the market though ABC company is still holding these investments while preparing BS, how this will be adjusted in books? A. Adjust valuation by decreasing assets value and decreasing equity B. Adjust valuation by decreasing assets value and increasing equity C. No adjustment is needed
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Solutions
1. A. Since ABC Corp is a bank, doing investments and receiving return on such investments are part of operating activity. 2. B. In an expanded accounting equation, Assets = Liabilities + Contributed capital + Closing Retained earnings; Closing Retained earnings = Beginning retained earnings + Net profits during the year dividends hence dividend = Beginning retained earnings + Net profits during the year Closing retained earnings 3. B. Here, purchase is on credit, thus an associated expense will increase with associated increase in creditors (i.e. liability) 4. B. Since company is paying one months salary in arrears, at the year end, it would report this as outstanding expenses in liabilities. 5. C. Since Kingfisher has received money in advance against its future revenues which is booked today, it will report this as unearned revenue. 6. A. Valuation adjustment requires assets to be valued at its market value and hence investments should be decreased. To maintain the accounting equation, this will decrease owners equity.
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Agenda
Reading 22: Financial Statement Analysis : An Introduction Reading 23: Financial Reporting Mechanics Reading 24: Financial Reporting Standards Standard Setting Bodies IASB Goals Regulatory Authorities and Sec Filings Barriers to develop a Universal Accounting Standards IFRS - Recognition and measurement of bases IFRS Description Financial Statements Elements Constraints and Assumptions Financial Statements requirements-International Accounting Standard-1 Financial Reporting - FASB and IASB framework Coherent Financial Statements and Barriers to it Importance of monitoring developments in financial reporting standards
Reading 25: Understanding the Income Statement
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Financial Reporting Standards

Reporting Standards Standard setting bodies Barriers to develop a universal accounting standard IFRS FS requirements Financial Reporting - FASB and IASB framework Coherent Financial Reporting & Barriers to it Importance of monitoring developments in financial reporting standards
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Reporting standards
If reporting standards didnt exist then financial statements can take any form because of possible assumptions & estimates Reporting standards
Makes financial statements much more comparable
Fixes a range on management estimates which otherwise could have substantially varied
Makes Financial statements useful to a wide range of users including security analysts For e.g.: Depreciation methods, inventory valuation methods, representation of assets at book value etc are made standardized by reporting standards
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Standard - setting bodies & Regulatory authorities

Standard-setting bodies: professional organizations of accountants & auditors that establish financial reporting standards Regulatory authorities: government agencies that have the legal authority to enforce compliance with the reporting standards Standard-setting bodies: 1. Financial Accounting Standard Board (FASB)
FASB is governing body in U.S. Sets forth generally accepted accounting principles (GAAP) 2. International Accounting Standard Board (IASB): Establishes International Financial Reporting Standards (lFRS) outside U.S. Most of the nations have their own accounting standard bodies Most of these are now converging and trying to fill the gap with IFRS
3. India (ICAI)
Regulated by SEBI
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Standard - setting bodies & Regulatory authorities (Cont)

IASB has following 4 goals:
Imp
Develop global accounting standards to bring transparency, comparability, and high quality in financial statements Promote use of such global accounting standards Achieve convergence between various national accounting standards and global accounting standards. Take care of needs of emerging markets and small firms while implementing global accounting standards
Regulatory authorities established by national governments

Securities and Exchange Commission (SEC) in the United States Financial Services Authority (FSA) in the United Kingdom Most national authorities belong to International Organization of Securities Commissions (IOSCO) which has led three objectives: Protect Investors Ensure fairness, efficiency & transparency Reduce systemic risk IOSCO goal is to bring uniformity in financial regulation across countries Both SEC and FSA have legally enforceable power IOSCO does not have legally enforceable power
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SEC Filings
Form S-1:
Registration statement filed prior to the sale of new securities to the public.
Form 10-K:
Disclosure about business and its management , audited financial statements, legal matters etc. 40-F: corresponding form for Canadian companies listed on US exchanges 20-F: corresponding form for foreign issuers listed on US exchanges
Form 10-Q:
Quarterly Report: Financial statements may not be audited
6-K:
Non-U.S. companies file for semiannual financial report
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SEC Filings (Cont)

Form 8-K:
Filed to disclose material event like: Acquisitions and disposals Changes in management or corporate governance Accountants, financial statements, or other related matters Press Releases
Form DEF-14A:
Proxy statement for its shareholders (prior to the annual meeting or other shareholder vote)
Form 144:
When a company issues securities to certain Qualified Institutional Buyers (QIB) without registering the securities with the SEC
Form 3,4,5
Details on beneficial ownership of securities by company's officers and directors Can learn about purchases and sales of company securities by corporate insiders
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Barriers to develop a universal accounting standard

Accounting standards differ across countries:
Depending upon the economic structure of a nation and prevalent conditions in a particular country Treatment of a particular item or issue is different in different countries
This is a major barrier for setting up universal accounting standards
Other reasons are:

Political pressures from business groups who will be affected by changes in reporting standards
Pressure from others who will be affected by changes in reporting standards
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IFRS Financial Statements Objectives

Ideas on which IASB bases its standards are expressed in the IFRS Framework for Preparation & Presentation of Financial Statements According to IFRS, objective of financial statements are:
To provide information on financial position, performance and changes in the financial position of an entity Provide information that is useful to a wide variety of users for taking economic decisions
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IFRS Financial Statement Characteristics

Financial statements should have following qualitative characteristics:
Comparable: across firms and across time periods
Imp
Understandable: users with a basic knowledge should be able to readily understand the information Relevant: should provide timely and sufficient detailed information without material omissions or misstatements Reliable Faithful representation of all transactions and events in FSs Not biased Complete (based on materiality limits and costs limits) Substance matters over form (reflects economic reality) Prudent and conservative in making estimates
For example, the Quarterly results of a companies are not audited. Here, relevance/timeliness is given preference over reliability. In the case of Annual reports, they are always audited. Here, reliability is given preference over relevance/timeliness.
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IFRS - Recognition and measurement of bases

Financial statements should recognize any transaction / item when
Economic benefit / cost is probable Such benefits / costs can be measured reliably
How to measure benefits / costs:

Historical cost: amount originally paid for an asset
Current cost: current replacement costs Realizable value: amount which can be realized from selling the asset
Present value: Discounted cash flow of future economic benefit

Fair value: Amount at which two parties willing to enter in an arms length transactions
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IFRS Description Financial Statements Elements

IFRS describes the financial statement elements as:
Assets: Resources which are expected to accrue economic benefits in future periods
Liabilities: Obligations which are expected to accrue economic costs in future periods Equity: Residual interest equal to Assets Liabilities Income: Includes revenue and gains; result of past transaction which accrued economic benefits either by way of increasing assets or decreasing liabilities Expenses: Includes expenses and losses; result of past transaction which accrued economic costs either by way of decreasing assets or increasing liabilities
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IFRS Financial Statements Constraints and assumptions

Constraints:
FSs can directly present only quantitative information but not the non-quantifiable information like brand loyalty, capacity for innovation, etc.
Strike a balance between reliability (free of errors) v/s timeliness Strike a balance between cost of preparing FSs v/s benefits to users through FSs
Assumptions
Accrual basis: financial statements should reflect transactions at the time they actually occur, not necessarily when cash is paid Going concern: entity is expected to continue its operations in foreseeable future
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General requirements for financial statements

International Accounting Standard (IAS) No. 1 states that:
Financial statements required are: Balance sheet Statement of comprehensive income Cash flow statement Statement of changes in owners equity explanatory notes, including a summary of accounting policies
Imp
Fundamental principles while preparing financial statements are: Fair presentation Going concern basis Accrual basis of accounting Consistency Materiality (no omissions and misstatements)
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General requirements for financial statements (Cont)
Fundamental principles while presenting financial statements are

No offsetting of assets against liabilities unless specific standard permits it Aggregation of similar items Should present a classified balance sheet showing current & non-current assets & liablities Minimum information on the face supported by detailed information in footnotes Comparative information with information on prior periods
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Question: General Requirements for financial statements

Which of the following is not a principle for preparing financial statements according to the International Accounting Standard?
A. Consistency B. Materiality C. Accuracy
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Solution: General Requirements for financial statements

C.
Accuracy is not one of the fundamental principles for preparing financial statements.
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Comparison of FASB and IASB framework

Differences in Principles:
Imp
FASB framework, unlike the IASB framework, is not at top GAAP hierarchy IASB framework places more emphasis on the going concern assumption IASB requires management to consider the framework if no explicit standard exists on an issue, but the FASB does not FASB pushes for relevance and reliability as primary characteristics IASB lists comparability and understandability as primary characteristics
Differences in Financial Elements:

Assets is source of economic benefits under IASB and is economic benefit itself under FASB IASB considers income and expenses for performance whereas FASB considers slight differently through revenue, expenses, gains, losses & comprehensive income FASB uses words probable for assets/ liabilities unlike IASB FASB does not allow values of most assets to be adjusted upwards Select companies need to report reconciliation between different standards (IASB / FASB) like company listed in US but incorporated outside US needs to report such statement
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Coherent Financial Reporting & Barriers to it
Imp
Coherent financial reporting framework (CFRF) contains following characteristics:

Comprehensive Consistent Transparent framework
There are three barriers to create a CFRF:

1. Valuation: tradeoff between reliability v/s relevance Historical cost is more reliable but may not be relevant in present context whereas Fair Value which is more relevant in current context requires more judgment
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Coherent Financial Reporting & Barriers to it (Cont)

2. Standard Setting: While preparing accounting standards 3 approaches are followed:
Principles-based: relies on broad framework / goals Rules-based: rule for each transaction Objectives oriented: blends above two approaches IFRS is principal based, whereas U.S. GAAP is rules based standard setting approach 3. Measurement: Two different approaches are followed None of the approach focuses on all financial statements comprehensively Approaches are: Assets and Liability approach - focuses on balance sheet valuation Revenue and expense approach- focuses more on income statement valuation
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Importance of monitoring developments

An analyst needs to monitor the developments in financial reporting standards
This will an analyst better equipped to understand the impact on companys performance and financial position in present and future
An analyst should go through accounting policies as presented in footnotes and management discussion and analysis statement to evaluate the impact on financial statements and make projections An analyst should be cautious on uncertainty caused by not following new standard by management even when its required while reporting financial results
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Questions
1. Which of the following is least likely to be a stated goal of International Accounting Standard Board (IASB)? A. Develop global accounting standards to bring transparency, comparability, and high quality B. Promote use of accounting standards with highest quality and transparency C. Achieve convergence between various national accounting standards and global accounting standards 2. Which of the following characteristics is most likely cause financial statement (FSs) to become reliable? A. FSs must be comparable across firms and across time periods B. FSs provide timely and sufficient detailed information C. FSs must provide faithful representation of all transactions and events
3. Which of the following is least likely to be primary assumptions followed while preparing FS under IFRS A. Accrual basis B. Going concern C. Materiality
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Questions (Cont)
4. Which of the following best describes difference between principles followed by FASB and IASB A. IASB pushes for relevance and reliability while FASB lists comparability and understandability as primary characteristics B. IASB framework places more emphasis on the going concern assumption C. FASB uses word probable for assets/ liabilities unlike IASB 5. Which of the following statement is correct A. IFRS is principal based whereas U.S. GAAP is rules based standard setting approach B. IFRS is rule based, whereas U.S. GAAP is principal based standard setting approach C. There is no difference in standard setting approach between IFRS and US GAAP 6. Which of the following is not a principle for presenting financial statements? A. Aggregation B. Comparative Information C. Materiality
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Solutions
1. B. IASB promotes use of global accounting standards and brings convergence between national and global accounting standards. 2. C. FSs should provide faithful representation of all transactions and events, should not be biased, should be complete, favor to substance over and prudent and conservative in making estimates to become reliable 3. C Under IFRS, FSs should follow two primary assumptions like accrual basis and going concern 4. B. IASB framework places more emphasis on the going concern assumption and lists comparability and understandability as primary characteristics. 5. A. IFRS is principal based (relies on broad framework) whereas U.S. GAAP is rules based (Specific rule for each transaction) standard setting approach 6. C. Materiality is a principal for preparing not presenting financial statements
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Extra Questions
1. IASB expresses the objective of financial statements in "Framework for preparation and presentation of financial statements" What is the objective? A. Financial implications, measurement and changes in assets and liabilities. B. Financial position, performance and changes in financial position of an entity. C. Changes in income and expenses, financial position and changes in assets and liabilities. 2. Which of the following is a qualitative characteristic described by the FASB framework: A. Reliability B. Transparency C. Relevance 3. Which of the following is not a feature of preparing financial statement stated in IAS No. 1: A. Going concern basis B. Consistency and materiality. C. Reporting frequency must be at least quarterly.
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Extra Questions (cont)

4. On analyzing a balance sheet, it has been observed revenue recognition has been accounted as a liability for the large cash received for future airline travel. In accrual accounting, it is termed as: A. Unearned or deferred revenue. B. Unbilled or accrued revenue. C. Accounts payable. 5. In recording accounting entries on accrual basis, for cash movement prior to accounting recognition, adjusting entry will consider for Unearned (Deferred) Revenue A. Reducing the liability while recording revenue. B. Increasing the liability while recording revenue. C. Eliminate the receivable on cash collection. 6. Which of the following actions was least likely a warning signs of earnings manipulation? A. Decrease in discount rate used in pension liability assumptions B. Aggressive revenue recognition by using bill and hold strategy C. Extending the useful lives of long term assets
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Solutions
1. 2. 3. 4. 5. 6. B. C. B. A. A. A.
Decrease in the discount rate results in the increase in liability, therefore it is not a warning sign for earnings manipulation.
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Agenda
Reading 22: Financial Statement Analysis : An Introduction Reading 23: Financial Reporting Mechanics Reading 24: Financial Reporting Standards Reading 25: Understanding the Income Statement
Understanding the Income statement Revenue Recognization Expenses Recognization Methods of Depriciation & Depreciation of long-term assets
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Income Statement
Understanding the Income statement Revenue Recognization Expenses Recognization Methods of Depriciation & Depreciation of long-term assets Operating and Non-operating income Unusual or infrequent items EPS Diluative and antidilutive securities Financial Ratios Other comprehensive income includes
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Understanding The Income Statement

Income statement is also known as:
Statement of operations,/ statement of earnings,/ "profit and loss statement (P&L)
An income statement equation:

Revenues - Expenses = Net Income (gains/loss)
Revenue
Gross Revenue Net Revenue : Gross revenue adjusted for estimated returns & allowance
Expenses can be grouped based on their function / nature:

By Function Manufacturing Expenses: Raw material, labor and direct expenses related to manufacturing are included in cost of goods sold Selling and General & Administrative expenses By Nature Depreciation: Both on assets in manufacturing and administration are combined together based on nature Research and development expenses
Estimated Gains/ Losses from discontinued operations:

Gain or loss which are not related to their normal business activities For ex. Gain (Loss) on sale of fixed assets (difference between book value sale vale)
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Understanding The Income Statement (Cont)

Presentation formats of Income Statements:
1. Single-step Revenue less Expenses : all items are grouped together as revenue or expenses 2. Multi-step Shows detailed presentation including calculation of gross profit, operating profit & net income Gross profit / loss: Revenue Cost of Good Sold (direct costs of producing a product / service) Operating profit / loss (EBIT): Gross profit Other Operating expenses (including selling, general. and administrative & depreciation expenses ) Income from continuing operations: Operating profit - Interest expense - Income taxes Net Income = Income from continuing operations + Earnings/ loss from discontinued operations
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Understanding The Income Statement (Cont)

Single Step Revenue Expenses Multi-Step 3855.38 Revenue 3318.29 COGS 3855.38 2590.99
Profit
537.09 Other Operating Expenses Depreciation Operating Profit Interest Earnings Before Tax Tax Profit After Tax
362.86 80.65 820.88 10.29 810.59 273.5 537.09
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Revenue Recognition: IASB/FASB definition of the term income

According to the IASB, the term "income includes revenue and gains:
Income is defined as increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants
According to the FASB, revenue is recognized in the income statement when:

It is realized or realizable or It is earned
IASB GUIDELINES FOR REVENUE RECOGNITION: Following conditions must be satisfied:

1. Transfer of ownerships risk and rewards to buyer 2. Reliable Measurement of Revenues 3. Reliable Measurement of associated costs
Probable that economic benefits on sale will flow to the entity
Income is broad concept and includes gains / losses from non operating activities as well.
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SEC guidelines for revenue recognition
Imp
Agreement, delivery, price determination and surety of collection are SEC criteria to recognize revenue
There is evidence of an arrangement between the buyer and seller The product has been delivered or the service has been rendered The price is determined or determinable The seller is reasonably sure of collecting money.
Specific Revenue Recognition Applications:

Revenue is usually recognized at delivery using the revenue recognition criteria previously discussed However, in some cases, revenue may be recognized before delivery occurs
Long Term Contracts: Generally for the entities engaged in construction projects Methods for revenue recognition:
Percentage of completion method Completed-contract method Equal recognition: In some cases involving service contracts or licensing agreements, the firm may simply recognize revenue equally over the term of the contract or agreement
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Revenue - Recognition methods

Percentage of completion method:
Imp
Appropriate when the project's cost and revenue can be reliably estimated Amount of revenue to be recognized = Total contract value x total cost incurred to date / total expected cost of the project Accordingly, revenue, expense, and therefore profit, are recognized based on the % completed
Completed Contract Method:

Used when the outcome of a project cannot be reliably measured or The project is short-term Revenue, expense, and profit are recognized only when the contract is completed But, if a loss is expected, the loss must be recognized immediately (Principal of conservatism)
Compared to completed contract method, percentage of completion method:

Recognizes revenue early hence it is more aggressive Requires estimation of total costs hence subjectivity is involved Provides smoother earnings and results in better matching of revenues and expenses over time
No impact on Cash flow: cash flows is same under both methods
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Installment Sales
Occurs when a firm finances a sale and amount is collected over an specified extended time period Revenue recognition can be of following types:
If collectability is certain: Recognize revenue at time of sale using normal revenue recognition criteria If collectability cant be reasonably estimated: Recognize revenue using installment method If collectability is highly uncertain: Recognize revenue using cost recovery method
Installment method: Profit is recognized as cash is collected

Profit = Cash collected during the period x Total expected profit / Total Sales
Used in limited circumstances, usually involving the sale of real estate or other firm assets Cost Recovery Method: Book profits after recovering costs
Profit is recognized when cash collected exceeds costs (costs + interest) incurred
There is no difference when installment sales and cash sales from revenue recognition point of view if collections are certain but if they are not, an installment or cost recovery method is used to recognize revenue.`
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IFRS guidelines on revenue recognition :

IFRS guideless for long-term contracts: If the firm cannot reliably measure the outcome of the project,
Revenue is recognized to the extent of contract costs Costs are expensed when incurred (actual costs) Profit is recognized only at completion
IFRS treatment of installment sales:

Installment sale treatment is appropriate for certain real estate transactions Risks and rewards of ownership are not transferred (as seller remains involved in the property) Buyers acquire a vested interest in the assets on the date which is different from the date of title transfer
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Barter transactions
Two parties exchange goods or services without exchanging cash Issues like fair value of transaction arises Dealt differently in US GAAP & IFRS US GAAP
Recognized revenue at fair value based on historical transactions / experience But when firm has historically received cash payments for such goods
IFRS
Recognized revenue at fair value based on similar non barter transactions with unrelated parties E.g. Advertising space on internet companies
Note: Give special attention to difference in treatments given by US GAAP & IFRS to various transactions
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Gross or net revenue

An ecommerce company selling goods on portal what should be revenue?
Equal to total value of goods sold Equal to commissions on total value of such sales
If following criteria are met, revenue should equal to total value

Entity bears inventory risk and customer credit risks related to payments Can choose suppliers with reasonable freedom to establish prices E.g.: Big Bazaar
Otherwise, revenue should be recognized on net basis meaning equal to commissions

E.g.: Agent selling flight tickets of Air India, makemytrip.com, amazon.com
Implications for Financial Analysis:

Firms disclose revenue recognition policies at financial statement footnotes Analysis shows whether a firm is aggressive or conservative Analysis also shows extent to which firms policies rely on judgment or estimates
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Revenue Calculation
Example: Mountain Infrastructure Ltd has a contract spanning over the next 3 years. The total revenue earned by the contract is $20 Million. The total estimated costs are $10 Million. What is the revenue to be recognized in year 2 using the percentage of completion method? What is the revenue recognized in year 2 by the completed contract method? The costs projection for the contract are as of the table below.
Project Costs Year 1 Year 2 $6 Million $3 Million
Year 3
$1 Million
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Revenue Calculation
Solution:
Project Costs Year 1 Year 2 Year 3 Total $6 Million $3 Million $1 Million $ 10 Million Percent of Total Project 60% 30% 10% 100% Revenue Earned $12 Million $6 Million $2 Million $20 Million
In case of the completed contract method, since the project completed in year 3, no revenue is recognized in year 2.
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Question: Installment and Cost Recovery Method

ABC Inc. purchases land at $400 million. It sells it to company XYZ for $600. The payment is to be collected over a period of three years. Below is the payment schedule to ABC Inc.
Year
Year 1 Year 2 Year 3 Total
Payment to ABC (in $ million)

200 200 200 600
Which of the following is the profit recognized in year 2 by both installment sales method and by cost recovery method:
Installment Sales A B C 66 0 66
Cost Recovery 66 66 0
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Solution: Installment and Cost Recovery Method

By Installment Sales Method:
Profit = Cash collected during the period x Total expected profit / Total Sales = 200 * 200 / 600 = 66
By Cost Recovery Method Profit is recognized when cash collected exceeds costs incurred. In this case, a profit is not observed till year 3, since all costs are recovered in year 2. Thus the correct option is C
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Expenses Recognization: IASB definition of expense

According to the IASB: Expenses are decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrence of liabilities that result in decreases in equity other than those relating to distributions to equity participants Just opposite of income definition
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Matching concept: Accrual accounting, Period Costs and Depreciation
Imp
Both revenue and associated expenses are matched and recognized in same period Matching concept requires expenses to be recognized in the same period when revenues are recognized for which expenses were incurred E.g. inventory is purchased Q4, 2008 and Q1 2009, using the matching principle, both the revenue and the cost of goods sold are recognized in Q1 2009 Period Costs: expenses are recognized in the period they are incurred Meaning Electricity Bills of Q1,09 must be recognized in Q1, 09 even if revenue generated is very less compared to other quarters Administrative costs, rent are period costs Depreciation: Long-lived assets provide economic benefits beyond one accounting period hence their cost must be matched with revenues of more than one accounting period Depreciation is a charge for allocation of cost of long lived assets over their economic lives It is the cost of using long-lived assets in business matched with revenues Hence it requires to estimate the life as well as the rate of depreciation Depreciation is charged for assets like plant and equipments whereas amortization is charged for intangible assets like patents / copyrights Land is the fixed asset which is not depreciated
Matching concept: Warranty expense, Provision for bad debt

Method
Depreciation Amortization Impairment
Used for
Tangible Fixed Assets Intangible Fixed Assets with finite lives Intangible Fixed Assets with infinite lives
Warranty expense: If a firm provides a warranty to the customer, the matching principle : Requires the firm to estimate warranty expense Recognize these expenses in the period of sale to match these expenses with revenues rather than a later period when these are actually incurred Provision for Bad Debt: If firm is selling goods or services on credit, they may not be able to collect the whole money as some of the customers default Hence the matching principle requires: Firms to estimate bad debt expense and Recognize these expenses in the period of the sale rather than a later period when these are actually incurred
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Implications for Financial Analysis - Expense
Imp
Like revenue recognition, expense recognition requires a number of estimates

Ex. Depreciation (estimate of rate and period); Bad debts & Warranty (rate)
Judgment comes for estimation giving management a tool to delay or accelerate the recognition of expenses and fluctuate the earnings Aggressive policy: delaying the expenses thereby increasing net income
Conservative: Accounts expenses early
Analysts role probe management estimates Must understand the reasons for a change in an expense estimate
Changes in rate of bad debts / depreciation / warranty or any other
For example, if a firm's bad debt expense has recently decreased

Is this the result of better collection practices / experience Is the expense decreased to manipulate net income Compare a firm's estimates with those of other firms within the firm's industry to understand the trends for such changes
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Depreciation Methods
1. Straight-line depreciation
SL Deprecation expense = (Cost - Residual value) / Useful life Requires significant estimate for residual value and useful life
2. Units of production method

(Assets Value X Units produced in a particular period / Total units to be produced during assets economic life)
3.
Accelerated method of depreciation:

Allocates high depreciation in early period of assets life Most important method of depreciation Works on the principal that the maintenance expense in lower in beginning year compared to later years. Thus, by having more depreciation in beginning year it tries to maintain the overall expense constant over the years Declining balance method is one of these methods Applies a constant rate of depreciation to a declining book value Double-declining balance method DDB depreciation = ( 2 / useful life) * (cost accumulated depreciation) DB does not explicitly use the asset's residual value in the calculations, but depreciation ends once the estimated residual value has been reached.
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Depreciation Methods (Cont)
Imp
Example of double-declining method: Suppose a machine is purchased at $10000 & its residual value is $3000 & expected life is 5 years
Depreciation expense for : Year 1 = (2/5) * 10000 = $4000 Year 2 = (2/5) * (10000-4000) = $2400 Year 3 = (2/5) * (10000 - 6400) = $1440
Comparison / Analysis:
In early periods: Higher profits using straight-line method compared to an accelerated method (because of low depreciation) In later periods: Opposite occurs Accelerated method is conservative method because of low net income in early periods
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Intangible assets
Amortization expense is a depreciation charge for intangible assets with limited lives
Goodwill and other intangible assets with indefinite lives are not amortized The expense should match the proportion of the asset's economic benefits used during the period. Most firms use the straight-line method for financial reporting
Goodwill:
Intangible assets with indefinite lives (e.g., goodwill) are not amortized. Must be tested for impairment (check whether goodwill has or lost its value) at least annually In such test, the cost of goodwill (as appearing in BS) is compared with the estimated value of goodwill If the estimated value is less than the value appearing in BS The asset value is said to be impaired, an expense equal to such difference is recognized on the income statement
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Five Minute Recap

Key Financial Statements: Income statement : Financial performance over a particular period of time. Balance Sheet: Financial position at a particular point of time. Expanded accounting equation: Assets = liabilities + contributed capital + opening retained earnings + revenues expenses dividends FS qualitative characteristics : Comparable Understandable Relevant Reliable Revenue- Recognition methods: Percentage of completion method: Completed Contract Method Auditors Reports Opinion: Unqualified opinion : Free from material omissions and errors Qualified Opinion : make any exception to the accounting principles Adverse Opinion : Financial Statements are not presented fairly or are materially non conforming with accounting standards
Revenue Recognition Methods: Installment method: Profit is recognized as cash is collected. Profit = Cash collected during the period x Total expected profit / Total Sales Cost Recovery Method: Book profits after recovering costs Profit is recognized when cash collected exceeds costs (costs + interest) incurred Method Depreciation Amortization Impairment Used for Tangible Fixed Assets Intangible Fixed Assets with finite lives Intangible Fixed Assets with infinite lives
Accruals and other adjustments Accrued Revenue Unearned revenue: Prepaid expenses: Accrued expenses:
Fundamental principles while preparing financial statements are : Fair presentation Going concern basis Accrual basis of accounting Consistency Materiality
Depreciation Method: 1. Straight-line depreciation 2. Units of production method 3. Accelerated method
Relationships among financial statements : Income Statement and Balance Sheet : Retained Earningst+1 = Retained Earningst + Net Income Cash flow and Balance Sheet Casht+1 = Casht + Net Cash Flow
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CFA 1 Financial Reporting &amp; Accounting

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Financial Reporting and Analysis - I

Expect around 12 questions in the exam from todays lecture

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Financial Statement Analysis: An Introduction

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Roles of Financial reporting and Financial Statement Analysis

So that economic decisions like the following can be taken:

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Fundamental Accounting Equation:

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Changes in owners' equity

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Financial Statement Notes & Supplementary schedules

Supplementary schedules contains additional information like:

Management's Discussion and Analysis (MD&A)

Additional information, not compulsorily required to be disclosed, under MD&A:

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Audits of Financial Statements

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Auditors Report Types

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Question: Auditors Report

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Solution: Auditors Report

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Auditors Report Explanatory paragraph

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Other sources of information used by analysts

Quarterly or semi-annual reports

Company/Industry research reports/ Other broker reports

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Steps of financial statement analysis

1. Determine the Objective and Context

6. Update the Analysis

3. Process the Data

5. Report the Conclusions or Recommendations

4. Analyze and interpret the data

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Financial Reporting Mechanics

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Accounts & Financials Statement Elements

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Long Lived Assets and Other assets

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Long Term Liabilities

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Other comprehensive income

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Selling, general and administrative expenses (SG&A)

Depreciation and amortization

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Basic and expanded forms of accounting equation

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Double entry accounting

Account 1 Asset Asset Asset

Pay $1000 for salary in cash

CFA 1 Financial Reporting & Accounting

CFA 1 Financial Reporting & Accounting