Steps of financial statement analysis and other data sources

Steps of financial statement analysis framework

1. State the objective and context
2. Gather data
3. Process the data
4. Analyze and interpret the data
5. Report the conclusions or recommendations
6. Update the analysis

Other data sources available

• Proxy statement
• Corporate reports and press release
• Trade journals
• Statisticsal reporting services
• Government agencies

Audit and Internal Controls

Audit
Independent review of the financial statements of the firm

The auditor

• Responsible for seeing that the financial statements issued comply with generally accepted accounting principles.
• Examines the company's accounting and internal control systems, confirm assets and liabilities, and generally tries to be sure that there are no material errors in the financial statements.
• Supposed to be an independent certified public accountant

Audit report
· Also called the auditor's opinion
· Issued as part of a company's audited financial report
· Tell end users the following:

• Whether the financial statements are presented in accordance with generally accepted accounting principles.
• Identify those circumstances where the principles in the current period are not consistent with that in the preceding period.
• State in the report if any informative disclosures in the financial statements are not reasonably

Audit report is composed of:

• A cover letter, signed by the auditor, stating the opinion.
• The financial statements, including the balance sheet, income statement and statement of cash flows
• Notes to the financial statements
• The auditor often prepares a "management letter" or "management report" to the board of directors, citing areas in the organization's internal accounting control system that the auditor evaluates as weak.

Types of audit reports:
Unqualified opinion report: best type of report, clean opinion.

• The financial statements are free of material misstatements and are in accordance with GAAP. The company financial condition, position, and operations are fairly presented in the financial statements.

Qualified opinion report: very close to unqualified opinion but with a certain exception

• One or two situations of the financial statements do not comply with generally accepted accounting principles but the rest are fairly presented.

Adverse opinion: opposite of unqualified opinion

• The financial statements are materially misstated and generally do not comply with GAAP.
• Disclaimer of opinion
• The auditor could not form, and consequently refuses to present, an opinion on the financial statements due to various reasons.

Importance of effective internal controls

• Under US GAAP, auditor must state an opinion on the company’s internal controls
• Management is responsible for internal controls
• Under Sarbanes-Oxley Act, management required to provide a report including:
• A statement that the firm's management is responsible for implementing and maintaing the effectiveness of internal controls
• A description of how management evaluates the internal control system
• An assessment by management of the effectiveness over the most recent years of the firms's internal controls
• A statement that the firm's auditors have assecessed the management reports on internal controls
• A statement certifying the financial statements are presented fairly

Financial statement notes, supplementary information and management’s discussion and analysis

Financial statement notes
· Financial footnote is required by GAAP or SEC
· Allow users to improve assessment of the amount, timing & uncertainties of the estimates reported in financial statements
· Audited
· Additional information often relating to contingent loss.

Included in the footnotes are the following:
A summary of significant accounting policies such as:
· The revenues-recognition method used
· Depreciation methods and rates
· Balance sheet and income statement breakdown of items such as:

• Marketable securities
• Significant customers (percentage of customers that represent a significant portion of revenues)
• Sales per regions
• Inventory
• Fixed assets and Liabilities (including depreciation, inventory, accounts receivable, income taxes, credit facility and long-term debt, pension liabilities or assets, contingent losses (lawsuits), hedging policy, stock option plans and capital structure).

Supplementary information
· Not audited
· Contain additional information, for example:

• operating income or sales by region or business segment
• reserve for an oil and gas company
• information about hedging activities and financial instruments

Management’s discussion and analysis (MD&A)
· required by SEC
· provide assessement of financial performance & condition of a firm
· require to discuss:

• result of operation-sales & expense trend
• capital resoruces & liquidity-cash flow trend
• general business overview based on known trends
  

Revenue and Expense

Revenue - inflows of economic resources

• Sales – from daily activities
• Gains – increase in assets or equity from incidental transactions
• Investment income – e.g. interest and dividend income

Expenses – outflows of economic resources

• Cost of goods sold - direct costs related to the product or rendered service sold
• Selling, general and administrative expenses - not included in COGS but are related to the operation
• Depreciation and amortization
• Tax expense
• Interest expense
• Loss - decrease in assets or equity from incidental transactions

Owner’s equity

Qwner's eqiuity includes:

• Capital - par value of common stock
• Additional paid-in capital - proceeds from common stock sales above par value (share repurchase presented in treasury stock as contra account)
• Retained earning -accumulated income not yet paid out as dividends
• Other comprehensive income - change in carrying amounts of assets and liabilities

Liabilities – Firms obligations

Financial obligations that the company must fulfill in the future

Current Liability -paid within 1 year or operating cycle

• Account payable
• wage, rent payable
• Short-term notes payable- usually with explicit interest
• dividend payable- declared but not yet paid
• current portion of long term debt- to be paid in 1 year
• taxes payable
• unearned revenue – revenue items in future income statement
  
  Noncurrent liabilities (Long term liability)
• Not paid in 1 year, valued at present value of all future payments
• The liabilities that do not meet the criteria for current liabilities
• Long term debt - such as bonds, mortgage, lease
• Pension, other post-retirement benefit (eg life insurance / health care)
• Deferred taxe liabilities
• If include balance sheet accounts of a subsidiary that is 100% owned, report a minority interest in its consolidated balance sheet, which is the pro-rata share of the subsidiary’s net assets (equity) not owned by the parent company.
• Under IFRS, report minority interest in the equity section.
• Under US GAAP, report minority interest in liabilities section, equity section or section located between liabilities and equity.

Assets – firm’s economic resources

Current Assets

• Cash
• Assets that will be converted into cash
• Assets that will be used up within one year or operating cycle.

Major types of current assets:

• Cash or cash equivalents- <90>
• Short-term investment (marketable securities)-within 1 year, valued at market value
• Account receivable -can be used as collateral for borrowing; factoring-sold or transferred to another party; “allowance for bad debt” as contra account.
• Inventory- the lower of cost or market value, if cost is greater than market value, ending inventory is written down to the lower replacement market prices.
• prepaid expense – become expense items in future income statement

Non-Current Assets

• Assets that will not be converted into cash
• Assets that will not be used up within one year or operating year Types of non-current assets
  
• Property, plant, equipment – accumulated depreciation as contra account
• Investment in affiliates – accounted for using equity method
• Deferred tax assets
• Intangible assets – not in physical form, e.g. patents, trademarks, license and goodwill.
• Long-term investments: Often referred to simply as investments. They are to be held for many years, and are not acquired with the intention of disposing of them in the near future.
  
  

Role of key financial statement and their elements

Financial statement elements

• Assets
• Liabilities
• Owner’s equity
• Revenue
• Expenses

Accounts

• Specific records within each element where specific transaction are entered.

Contra accounts

• For entries that offset other accounts

Income statement (profit and loss statement)

• Report the financial performance of the firm
• Describe how the assets and liabilities were utilized in the stated accounting period.
  

Elements

• Revenues
• Expenses
• Gains and losses

The income statement is divided into two parts:
Operating section

• Discloses information about revenues and expenses that are a direct result of the regular business operations.

Non-operating section

• Disclose revenue and expense information about activities that are not tied directly to a company's regular operations.

Balance sheet
Summarize a company's assets, liabilities and shareholders' equity

Elements:

• Assets - economic benefits controlled by the company Liabilities – debts or obligations settled over time through the transfer of economic benefits.
• Owners’ equity – residual interest in the assets after deducting the liabilities

The balance sheet must follow the following formula:

Assets = Liabilities + Shareholders' Equity

Cash flow statement

• Explain cash inflows and outflows
• Reveal the amount of cash the company has on hand

Classification:

• Operating cash flows: invovle in normal business of the firms
• Investing cash flows: result from acquisition or sales of property, plant, equipment and purchase or sale of investments in other firms
• Financing cash flows: result from issuance or retirement of debts and equity securities and dividend paid to stockholders.

Statement of changes in owners’ equity
Repot the amount and source of changes in equity investor's investment in the firm

The components that comprise the contributed capital part of stockholders’ equity:

• Contributed Capital - total legal capital of the corporation (par value of preferred and common stock) plus the paid-in capital.
• Par value –a value of preferred and common stock that is arbitral (artificial); it is set by management on a per share basis. This artificial value has no relation or impact on the market value of the shares.
• Legal capital of the corporation – par value per share multiplied by the total number of shares issued.
• Additional paid-in capital (paid-in capital) – This is the difference between the actual value the company sold the shares for and their par value.

Accounting period, assumption, basic methods and terms

Accounting period:
Annual (fiscal) or quarterly and others as defined. Should be uniform to allow comparison across time.

Assumptions for accounting statement

• Going-concern - the company will continue to operate.
• Revenues-recognition principle - revenues are reported as they are earned within the specified accounting period
• Matching principle - report expenses and revenue in same period

Basic accounting methods
Cash-basis accounting

• Recognize revenue (income) and expenses when payments are made (checks issued) or cash is received (deposited in the bank).

Advantages

• easy to use and implement
• Few transactions (bookkeeping) recorded on average
• Tax when it has money in the bank

Disadvantages

• Distort actual income and expenses

Accrual accounting

• Recognize revenue in the accounting period in which it is earned (when a product or service is provided to a customer, regardless of when the company gets paid). Expenses are recorded when they are incurred instead of when they are paid

Advantages:

• More accurate measurement
• Economic effect of revenue & expenses
• enhance comparability of income statement across periods
• A smoother earning stream
• enhanced predictability of future cash flow

Tips:

• In the exam, assume all financial statements use accrual-basis accounting unless specified otherwise.

Accounting term
Debit

• Refer to an entry that increases an expense or asset account, or decreases an income, liability or net-worth account.

Credit

• Refer to an entry that decreases an expense or asset account, or increases an income, liability or net-worth account.

Objectives of financial reporting identified in SFAC 1 are to do the following:

• Useful information to investors and creditors for their decision making
• Allow comparability
• Provide relevant (timeliness) information - the capacity to alter decision
• Provide reliable information

Notes:

• market value is relevant but not reliable; Historic data is reliable but not relevant;
• Equity investor concern long term earning power and dividend; Short term investor concern liquidity;
• Long term creditors concern long term asset position and earning power.