CFA Level I- Financial Reporting and Analysis- SMG.pdf

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“Sixty Minute Guide”Financial Reporting & Analysis

CFA- Level I

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1. Important Basic concepts


Audit independent review of an

entity’s financial statements

Unqualified Opinion

Qualified opinion

Adverse opinion


Basic accounting equation

Assets = Liabilities + Owners’ equity


Two primary assumptions

1.Accrual basis

2.The Going concern assumption.


Flow of information in Accounting system

Journal entries

General ledger

Initial trial balance

Adjusted trial balance

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2.Understanding the Income Statement


Revenue recognition(Revenue is recognized when earned and expenses are recognized when incurred)

% of completion

MethodRecognize

revenuein

proportionof cost

incurred

competedContractmethod

Recognize revenue

only when contract

is complete

Normal rev. Recognition

Recognize revenue

If collect abilityIs reasonably

assured

Installment Sales

Used if collectabilitycannot be reasonably estimated

Cost recovery Method

used ifcollectability

is highlyuncertain

Barter transaction: recognize revenue only

If fair value can be estimated

Long Term Contracts Barter transactionsInstallment sales

Expense recognition

is based on the matching principle

expenses to generate revenue are recognized in the same period as the revenue


Discontinued operation Barter transactions is one that management has decided to dispose

off

but has not yet done so


Unusual or infrequent items

either unusual in nature or infrequent in occurrence, but not both

These are included in income from continuing operations and are reported before tax.

IMP


extraordinary item

Only under U.S. GAAP it is a material transaction or event that is both

unusual and infrequent in occurrencereported separately in the income statement, net of

tax, after income from continuing operations IFRS does not allow extraordinary items to be

separated from operating results in the income statement


Change in accounting principle

prior-period financial statements are restated to reflect the change.

Change in accounting estimate

Prospective application


Dilutive securities

are stock options,

warrants,

convertible debt

convertible preferred stock

that would decrease EPS if exercised or converted to common stock


3.Understanding the

Balance Sheet


Investments(Financial Instruments)

Held to maturity

1.On BS: @ Amortized Cost

2.Realised gain: taken to income

Statement

3.Unrealized gainis not recognized

Trading securities

1.On BS: @ Fair Value

2.Realised gain:Taken to income

statement

3.Unrealised gain:Taken to income

statement

Available for Sale

1.On BS: @ Fair Value

2.Realised gain:Taken to income

statement

3.Unrealised gain:Taken to otherComprehensive

income


4.Understanding the Cash Flow Statement


Cash Flows

CFO CFI CFF

Inflows and outflows of

cash resulting from

transactions that

affect a firm’s net income.

Inflows and outflows of

cash resulting from transactions

affecting a firm’s capitalstructure, such as

issuing or repaying debt and issuing or repurchasing

stock .

inflows and outflows

of cash resultingfrom the

acquisition or disposal of

long-term assetsand certain

investments.

CFO CFFCFI


Item US GAAP

Treatment

IFRS

Treatment1. Dividends paid Financing activities (CFF) CFO or CFF

(Gives flexibility to management )

2. Interest

paid

Operating activities (CFO) CFO or CFF


3. Dividends received Operating activities (CFO) CFO or CFI


4. Interest received operating activities (CFO) CFO or CFI


5.Taxes paid related to operating activities

operating activities (CFO) operating activities (CFO)

6. Taxes paid related to investing and financing transactions

Operating activities (CFO) CFI and CFF respectively

IMP

IMP

FCFF Formula1.Starting From Net Income

NI + NCC – WCinv +(INT X (1-t)) – FCinv

CFO + (INT X (1-t)) –FCinv

2. Starting From EBIT

(EBIT X (1-t))+ Dep - WCinv - FCinv

CFO + (INT-tax%) -FCinv


5.Inventories


Inventory Cost Flow Methods

FIFO LIFO Weightd avg. Specific

identificn

FIFO1.COGS consist of older purchases

2.Ending Inventory bal consist of more recent cost

3.. In either Inflationary or deflationary Environment FIFO Ending inventory

Balance reflects economic reality

4.In Inflationary environment,FIFO COGS is lower than LIFO COGS

LIFO1.COGS consist of recent purchases

2.Ending Inventory bal consist of older cost

3.. In either Inflationary or deflationary Environment LIFO COGS reflects

economic reality

4.In inflationary environment, LIFO closing inventory is lower than

FIFO closing inventory

6.Long-lived Assets


IFRS

Research cost Development cost

Expensed as Capitalized

incurred


US GAAP

Research cost Development cost

Expensed as Expensed

incurred (Except, software

development cost)


7.Income Taxes


Create DTA if,

IT Exp. (IncomeStatement) is greater

than Tax p’ble

Create DTL if,

IT Exp. (IncomeStatement) is less

than Tax p’ble


Asset’s Tax Base

Is its value for tax purposes.

The tax base for a depreciable fixed asset is its cost minus any depreciation previously taken on the tax return


Income tax expense

= taxes payable + ΔDTL – ΔDTA.

Increase in DTL

Decrease in DTA

Increase in DTA

Decrease in DTL

ADD

LESS


When income tax rate increases deferred tax

assets and deferred tax liabilities are both increased to reflect the new rate

If DTA is not likely to be realized create valuation

allowance to reduce DTA

If DTL is not likely to be reversed consider it a

part of equity for analysis purpose


8.Non-current (Long-term) Liabilities


The book value of the bond liability is equal to the PV of the remaining future cash flows (coupon payments and maturity value) discounted at the market rate of interest at issuance


Premium bond1. coupon rate > market yield

at issuance

2. reported on the balance

sheet at a value greater than its face value.

3. book value of the bond

liability will decrease until it reaches its face value

at maturity.

4. interest expense is less

than the coupon payment

Discount bond1. coupon rate < market yield

at issuance

2. reported on the balance sheet at less than

its face value .

3. book value of the bond liability will increase until it reaches its face value

at maturity.

4. interest expense is greaterthan the coupon payment


Finance lease

US GAAPTreat a lease as a capital (finance)

lease if any one of the following criteria is met:

1.Title transfer clause

2. Bargain purchase option

3.Lease period > 75% life

4.PV of lease pmts > 90% of Fair value of asset

IFRSIf substantially all the

rights and risks of ownership are

transferred to the lessee, the lease is treated as a finance lease by boththe

lessee and lessor


Impact on financial statements

Finance lease Operating lease

Net income(early yrs)

Lower Higher

Net income(later yrs)

Higher Lower

EBIT Higher Lower

CFO Higher Lower

CFF Lower Higher

9.Financial Reporting Quality


Fraud Triangle

Incentives and pressures—the motive to commit fraud.

Opportunities—the firm has a weak internal control system.

Attitudes and rationalizations—the mindset that fraud is justified


US GAAP & IFRS differencesItems US GAAP IFRS

Investment: Joint control Equity method Proportionate

Consolidation

Inventory on balance sheet Lower of cost or market value

Lower of cost or

Net realizable value

Recovery of asset write down Not allowed Allowed

Upward Revaluation Not allowed Allowed

Cost of Goods Sold LIFO permitted LIFO not permitted

Operating Expenses Differentiates betn

expenses and lossesIFRS does not

Interest capitalization Must Optional

Extraordinary items

Both unusual and infrequent

reported in the income statement, net of tax, below income from continuing operations

It does not permit firms to treat items as extraordinary in the income statement.

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CFA Level I- Financial Reporting and Analysis- SMG.pdf

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