CFA Financial Reporting and Analysis

Gross Profit

- amount that remains after the direct costs of producing a product or service are subtracted from revenue

current cost

- amount the firm would have to pay today for same asset

Operating cash flows

- cash effects of transactions that involve the normal business of the firm

Financing cash flows

- cash flows from issuance or retirement of the firm's debt and equity securities and include dividends paid to stockholders

Objective of an audit

- enable the auditor to provide an opinion on the fairness and reliability of the financial statements

How do you recognize revenue for long-term contracts when the outcome of the project can't be reliably estimated under IFRS

- revenue is recognized to the extent of contract costs during the year - costs are expensed when incurred - profit is recognized only at completion

Accrual method of accounting

- revenue is recognized when earned - expenses are recognized when incurred - it doesn't necessarily coincide with the receipt or payment of cash

What do you do if a firm receives cash before revenue recognition is complete

- the firm reports it as unearned revenue - Unearned revenue is reported on the balance sheet as a liability - The liability is reduced in the future as the revenue is earned

Gross revenue reporting

- the selling firm reports sales revenue and cost of goods sold separately - if sell $10,000 ticket and agent gets $1,000 of commission then rev = 10k COGS = 9k Profit = 1k

Adverse opinion

- the statements are not presented fairly or are materially nonconforming with accounting standards

How to account for portion of controlling interest in a subsidiary

- the subsidiary's income not owned by the parent is reported in parent's income statement as the noncontrolling interest (also known as minority interest or minority owners' interest) - The noncontrolling interest is subtracted in arriving at net income because the parent is reporting all of the subsidiary's revenue and expense

What is the objective of ISAB Conceptual Framework

- to provide financial information that is useful in making decisions about providing resources to an entity - Users of financial statements need information about the firm's performance, financial position, and cash flow

IASB stated goals

1. Develop global accounting standards requiring transparency, comparability, and high quality in financial statements 2. Promote the use of global accounting standards 3. Account for the needs of emerging markets & small firms when implementing global accounting standards 4. Achieve convergence between various national accounting standards and global accounting standards

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

historical cost

the amount originally paid for the asset

What does International Accounting Standards (IAS) No. 1 define

1. The required financial statements 2. The general features for preparing financial statements 3. Structure and content of financial statements

Barriers to convergence of accounting standards

1. different standard-setting bodies and the regulatory authorities of different countries can and do disagree on the best treatment of a particular item or issue 2. Political pressures from business groups and other affected by changes in reporting standards

Opinions of auditors

1. unqualified opinion 2. qualified opinion 3. adverse opinion

Fundamental accounting equation

Assets = Liabilities + Owner's Equity

What must be met in order to use gross revenue reporting under U.S. GAAP

The firm must: - Be the primary obligor under the contract. - Bear the inventory risk and credit risk. - Be able to choose its supplier. - Have reasonable latitude to establish the price

Cost of sales method

grouping expenses by function

installment sale

when a firm finances a sale and payments are expected to be received over an extended period

IASB Conceptual framework for financial reporting: required reporting elements

- Assets: Resources controlled as a result of past transactions that are expected to provide future economic benefits - Liabilities: Obligations as a result of past events that are expected to require an outflow of economic resources - Equity: The owners' residual interest in the assets after deducting the liabilities - Income: An increase in economic benefits, either increasing assets or decreasing liabilities in a way that increases owners' equity (but not including contributions by owners). Income includes revenues and gains - Expenses: Decreases in economic benefits, either decreasing assets or increasing liabilities in a way that decreases owners' equity (but not including distributions to owners). Losses are included in expenses

What does IASB base its standards on

- The Conceptual Framework for Financial Reporting - adopted in 2010 - includes qualitative characteristics of financial statements, specifies required reporting elements, and notes constraints and assumptions

Performance obligation

- a promise to deliver a distinct good or service

If a loss is expected, in a long-term contract when must it be recognized under GAAP and IFRS

- immediately, regardless of the method used

fair value

- price an asset could be sold, or a liability transferred, in an orderly transaction between willing parties

Statement of cash flows

- reports the company's cash receipts and payments - Operating cash flows - Investing cash flows - Financing cash flows

According to IFRS, revenue from a barter transaction

- revenue from barter transactions must be based on the fair value of revenue from similar nonbarter transactions with unrelated parties

Who issues the standards of GAAP

FASB

Statement of changes in equity

- reports the amounts and sources of changes, in equity investors' investment in the firm over a period of time

An analyst who wants to examine a firm's financing transactions during the most recent period is most likely to evaluate the firm's statement of

- Cash flows

Unqualified opinion

- Clean opinion - indicates that the auditor believes the statements are free from material omissions and errors

Financial accounting standards board (FASB) is equivalent to

- International accounting standards board (ISAB)

IASB Conceptual framework for financial reporting: Assumptions

- Accrual accounting: financial statements should reflect transactions at the time they actually occur, not necessarily when cash is paid - Going concern: assumes the company will continue to exist for the foreseeable future

IFRS required financial statements

- Balance sheet (statement of financial position) - Statement of comprehensive income - Cash flow statement - Statement of changes in owners' equity - Explanatory notes, including a summary of accounting policies

Generally accepted accounting principles (GAAP) is equivalent to

- International financial reporting standards (IFRS)

Why can an identical activity be accounted for differently under GAAP and IFRS under the converged standards

- Collectability must be probable for a contract to exist, but "probable" is defined differently under IFRS and U.S. GAAP

Characteristics that enhance relevant and faithful representation

- Comparability: consistent among firms and across time periods - Verifiability: Independent observers, using the same methods, obtain similar results - Timeliness: Information is available to decision makers before the information is stale - Understandability: Users with a basic knowledge of business and accounting and make a reasonable effort should be able to readily understand the information the statements present. Useful information should not be omitted just because it is complicated

How do you recognize revenue for long-term contracts when the outcome of the project can't be reliably estimated under GAAP

- Completed-contract method - revenue, expense, and profit are recognized only when the contract is complete

IFRS general features for preparing financial statements

- Fair presentation: faithfully representing the effects of the entity's transactions and events - Going concern basis: - Accrual basis of accounting: - Consistency: between periods in how items are presented and classified - Materiality: free of misstatements or omissions that could influence the decisions of users - Aggregation: of similar items and separation of dissimilar items - No offsetting: of assets against liabilities or income against expenses unless a specific standard permits or requires it - Reporting frequency: must be at least annually - Comparative information: for prior periods should be included

The SEC is equivalent to

- Financial conduct authority

Multi-Step Income Statement

- Format that includes gross profit: revenue - cost of good sold

How do you recognize revenue for an installment sale when the collectibilty is certain under GAAP

- revenue is recognized at the time of sale using the normal revenue recognition criteria

amortized cost

- Historical cost adjusted for depreciation, amortization, depletion, and impairment

Differences between GAAP and IFRS

- IASB lists income and expenses as elements related to performance, while the FASB includes revenues, expenses, gains, losses, and comprehensive income - FASB defines an asset as a future economic benefit, whereas the IASB defines it as a resource from which a future economic benefit is expected to flow - FASB uses the word probable when defining assets and liabilities - FASB doesn't allow the upward valuation of most assets

In standards setting what approach does GAAP use, IFRS use, and the common conceptual framework use

- IFRS = principles-based approach - GAAP = rules-based - Common conceptual framework is moving toward an objectives-oriented approach

Disclaimer of opinion

- If the auditor is unable to express an opinion (e.g., in the case of a scope limitation) - should be interpreted to mean the auditor is unable to express an opinion about the financial statements

Qualified opinion

- If the statements make any exceptions to the accounting principles - Auditor explains these exceptions in audit report

How do you recognize revenue for an installment sale when the collectibilty can't be reasonably estimated under GAAP

- Installment method - profit is recognized as cash is collected - Profit is equal to the cash collected during the period multiplied by the total expected profit as a percentage of sales

Converged standards for revenue recognition

- May 2014 IASB and FASB issued converged standards - Principles-based approach - firm should recognize revenue when it has transferred a good or service to a customer

Desirable attributes of standard setters

- Observe high professional standards - Have adequate authority, resources, and competencies to accomplish its mission - Have clear and consistent standard-setting processes - Guided by a well-articulated framework - Operate independently while still seeking input from stakeholders - Should not be compromised by special interests - Decisions are made in the public interest

Which method provides smoother earnings and better matching of revenues over time completed-contract method or percentage of completion method

- Percentage of completion method - but cash flows are the same under both methods

How do you recognize revenue for long-term contracts when the outcome of the project can be reliably estimated under GAAP and IFRS

- Percentage of completion method - revenue, expense, and therefore profit, are recognized as the work is performed - The percentage of completion is measured by the total cost incurred to date divided by the total expected cost of the project

Which method is more aggressive completed-contract method or percentage of completion method

- Percentage of completion method because it reports revenue sooner - It's also more subjective because it involves cost estimates

Expenses

- The amounts incurred to generate revenue - cost of goods sold, operating expenses, interest, and taxes - expenses are grouped together by their nature or function

What classifies a good or service as distinct

- The customer can benefit from the good or service on its own or combined with other resources that are readily available OR - The promise to transfer the good or service can be identified separately from any other promises

Financial reporting

- The way companies show their financial performance to investors, creditors, and other interested parties by preparing and presenting financial statements - Not designed solely for valuation purposes but does provide inputs for it

Objective of financial reporting

- To provide information about the firm to current and potential investors and creditors that is useful for making their decisions about investing in or lending to the firm

Characteristics of a coherent financial reporting framework

- Transparency: full disclosure and fair presentation - Comprehensiveness: all types of transactions that have financial implications should be part of the framework - Consistency: similar transactions should be accounted for in similar ways across companies, geographic areas, and time periods

Barriers to creating a coherent financial reporting framework

- Valuation: measurement bases for valuation that require little judgment, such as historical cost, may be less relevant than a basis like fair value that requires more judgment. - Standard setting: 1. "principles-based" approach: relies on a broad framework 2."rules-based" approach: gives specific guidance about how to classify transactions 3. "objectives-oriented" approach: blends two approaches I - Measurement: 1. "asset/liability" approach: (most common) focuses on balance sheet valuation 2. "revenue/expense" approach: places more significance on the income statement

Single-step income statement

- all revenues are grouped together and all expenses are grouped together

Balance sheet

- also called statement of financial position - reports the firm's financial position a A POINT IN TIME - Includes Assets, Liabilities, and Owner's Equity

Income statement

- also called statement of operations or profit and loss statement - reports the financial performance of the firm OVER A PERIOD OF TIME - includes revenues, expenses, and other income (gains that may or may not arise in the ordinary course of business)

IASB Conceptual framework for financial reporting: Constraints

- benefit users gain from the information should be greater than the cost of presenting it - non-quantifiable information about a company can't be captured directly in financial statements

Investing cash flows

- cash flows resulting from the acquisition or sale of property, plant, and equipment; of a subsidiary or segment; of securities; and of investments in other firms

How do you recognize revenue for an installment sale when the collectibilty is highly uncertain under GAAP

- cost recovery method - profit is recognized only when cash collected exceeds costs incurred

Financial statement notes (footnotes)

- disclosures that provide further details about the information summarized in the financial statements - Discuss the basis of presentation - Provide information about accounting methods, assumptions, and estimates - Provide additional information on items (business acquisitions, legal, employee benefit plans, contingencies, commitments, customers, sales)

net realizable value

- estimated selling price of the asset minus selling costs

An analyst should use the disclosures of accounting policies and estimates to

- evaluate what policies are discussed - whether they cover all the relevant data in the financial statements - which policies required management to make estimates - whether the disclosures have changed since the prior period

Regulatory authorities

- government agencies that have the legal authority to enforce compliance with financial reporting standards - in U.S = SEC - in UK = Financial conduct authority - They enforce GAAP and IFRS

Operating profit/ operating income

- gross profit - operating expenses, such as selling, general, and administrative expenses - profit before financing costs, income taxes, and non-operating items are considered

Measurement Bases

- historical cost: the amount originally paid for the asset - amortized cost: historical cost adjusted for depreciation, amortization, depletion, and impairment - current cost: amount the firm would have to pay today for same asset - net realizable value: estimated selling price of the asset minus selling costs - present value: discounted value of the asset's expected future cash flows - fair value: price an asset could be sold, or a liability transferred, in an orderly transaction between willing parties

What must users of financial information consider when analyzing a firm's revenue

- how conservative the firm's revenue recognition policies are (recognizing revenue sooner rather than later is more aggressive) - the extent to which the firm's policies rely on judgment and estimates

When should an item be recognized in a financial statement

- if a future economic benefit from the item (flowing to or from the firm) is probable and the item's value or cost can be measured reliably

Where do firms disclose revenue recognition policies

- in financial statement footnotes

Proxy statements

- issued to shareholders when there are matters that require 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 - Available on EDGAR website - filed with the SEC

International Organization of Securities Commissions (IOSCO)

- most national authorities belong to it - Goal of uniform financial regulations across countries - 3 objectives of financial market regulation 1. protect investors 2. ensure the fairness, efficiency, and transparency of markets 3. reduce systematic risk

Management's commentary or Management's discussion and analysis (MD&A)

- one of the most useful sections of the annual report - May be unaudited - IFRS recommends management discusses the nature of the business, management's objectives, past performance, the performance measures used, and key relationships, resources, and risks - SEC requires MD&A discuss overview of company, trends and significant events, uncertainties that affect the firm's liquidity, capital resources, and results of operations, effects of inflation and changing prices, Impact of off-balance-sheet obligations & contractual obligations (purchase commitments), accounting policies that require significant judgment, forward-looking expenditures & divestitures

Net revenue reporting

- only sales - cost is reported - - if sell $10,000 ticket and agent gets $1,000 of commission report $1k of revenue and no expense

IFRS structure and content of financial statements

- present a classified balance sheet showing current and noncurrent assets and liabilities - groups assets and liabilities by subcategories - assets and related liabilities are reported separately, they are not netted - Minimum information is required on the face of each financial statement and in the notes - Comparative information for prior periods

Standard setting bodies

- professional organizations of accountants and auditors that establish financial reporting standards - In U.S = Financial accounting standards board (FASB) - Outside U.S = International accounting standards board (ISAB) - they make GAAP and IFRS

Financial reporting standards are needed to

- provide consistency by narrowing the range of acceptable responses - ensure that transactions are reported by firms similarly but must remain flexible and allow discretion to management

Statement of comprehensive income

- reports all changes in equity except for shareholder transactions (issuing / repurchasing stock, dividends)

net revenues

- revenues reported from the sale of goods and services in the normal course of business - adjustments for estimated returns and allowances

When do you use installment and cost recovery methods

- sales of real estate

Reconciliation statement

- shows what a company's financial results would have been under an alternative reporting system

According to U.S. GAAP, revenue from a barter transaction can be recognized at fair value only if

- the firm has historically received cash payments for such goods and services and can use this historical experience to determine fair value - Otherwise, the revenue is recorded at the carrying value of the asset surrendered

Relationship between income statement and other comprehensive income

- they can be presented as a single statement of comprehensive income OR - can be presented separately

Role of financial statement analysis

- use the information in a company's financial statements to make economic decisions - whether to invest in the company -whether to extend trade or bank credit to the company - evaluate a company's past performance and current financial position in order to form opinions about the ability to earn profits and generate cash flow in the future

According to the Financial Accounting Standards Board (FASB), revenue is recognized in the income statement when

- when it is realized or realizable and earned

The converged standards five-step process for recognizing revenue

1. Identify the contract(s) with a customer 2. Identify the separate or distinct performance obligations in the contract 3. Determine the transaction price 4. Allocate the transaction price to the performance obligations in the contract 5. Recognize revenue when (or as) the entity satisfies a performance obligation

Two fundamental characteristics that make financial information useful (IASB Conceptual framework for financial reporting: Qualitative characteristics)

1. Relevance: influence users' economic decisions or affect users' evaluations of past or future events. information should have predictive value, confirmatory value (confirm prior expectations), materiality 2. Faithful representation: complete, neutral (absence of bias), and free from error information

According to the International Accounting Standards Board (IASB), revenue is recognized from services rendered when

1. The amount of revenue can be reliably measured 2. There is a probable flow of economic benefits 3. The stage of completion can be measured 4. The cost incurred and cost of completion can be reliably measured

According to the International Accounting Standards Board (IASB), revenue is recognized from the sale of goods when

1. The risk and reward of ownership is transferred. 2. There is no continuing control or management over the goods sold. 3. Revenue can be reliably measured. 4. There is a probable flow of economic benefits. 5. The cost can be reliably measured.

SEC criteria to determine whether revenue should be recognized

1. There is evidence of an arrangement between the buyer and seller 2. The product has been delivered or the service has been rendered 3. The price is determined or determinable 4. The seller is reasonably sure of collecting money

The standard auditor's opinion states that

1. financial statements are prepared by management and the auditor has performed an independent review 2. Generally accepted auditing standards were followed, providing reasonable assurance that the financial statements contain no material errors 3. The auditor is satisfied that the statements were prepared in accordance with accepted accounting principles and that the principles chosen and estimates made are reasonable 4. If publicly traded need opinion on firm's internal controls

Internal controls

process by which the company ensures that it presents accurate financial statements - responsibility of management

income statement equation

revenues - expenses = net income

net income =

revenues - ordinary expenses + other income - other expenses + gains - losses