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8/7/2019 FSA Level 1

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Financial Statement Analysis


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Financial StatementsFinancial Statements

Financial statements are a snapshot of a company's well being at a specific point intime. The length of time (the accounting period) that these financial statementsrepresent varies; they can be annual (fiscal) or quarterly (every three months),among others. Fiscal year-end is normally defined as 12 months of operations.

The timing and the methodology used to record revenues andexpenses may also impact the analysis and comparability of financialstatements across companies. Accounting statements are prepared in mostcases on the basis of these three basic premises:

1. The company will continue to operate (going-concern assumptions).

2. Revenues are reported as they are earned within the specified accountingperiod (revenues-recognition principle).

3. Expenses should match generated revenues within the specifiedaccounting period (matching principle).


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Basic Accounting Methods:

1. Cash-basis accounting This method consists of recognizing revenue(income) and expenses when payments are made (checks issued) or cash is

received (deposited in the bank).

2. Accrual accounting This method consists of recognizing revenue in theaccounting period in which it is earned (revenue is recognized when thecompany provides a product or service to a customer, regardless of when thecompany gets paid). Expenses are recorded when they are incurred instead of

when they are paid.


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Cash Vs. Accrual AccountingCash Vs. Accrual Accounting

A. ACCRUAL ACCOUNTING

Within this section, we will review cash vs. accrual accounting methodologies.Note that the material set forth in this section is intended as a review and CFAInstitute will most likely not ask a question directly based on this material.

However, we recommend a read of this section is you are unfamiliar withaccounting as you will need this knowledge in order to succeed in futuresections.

I. Cash vs. Accrual Accounting

Within this section we will explain how income measurement issues areresolved, accrual accounting, and why the accrual basis of accounting producesmore useful income statements and balance sheets than the cash basis.


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Benefits ofCash Accounting

Benefits

It is easy to use and implement because the company records income only

when it gets paid and records expenses only when it pays them.

If accepted by the IRS (limited cases only), the company is taxed when it hasmoney in the bank.

On average, fewer transactions will be recorded (bookkeeping).

Biggest Drawback

Cash accounting can distort a company's actual income and expenses,especially if it extends credit to its customers, purchases raw materials oncredit from its suppliers or keeps inventory.


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Benefits of Accrual Accounting

Generally, it provides a clearer picture of the financial performance (incomestatement) and financial health (balance sheet).

It allows management to keep track of accounts receivables and payables moreefficiently.

It is more representative of the economic reality of the business. A serviceprovider may not require upfront payment for an annual service; this revenuewill be recorded as it is performed, not when it is paid. Similarly, expenses thatare paid in advance - such as property taxes, which are paid semiannually - will

be recognized on a monthly basis. It enhances comparability of performance (income statement) and financial

stability (balance sheet) from one period to the next.

There is a smoother earning stream.

There is enhanced predictability of future cash flow.


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Let's consider a practical example to fully understand the impact of Cash versusAccrual Accounting on XYZ Corporation's Income Statement and Balance Sheet.

Cash Basis Accounting

Taken as is, the financial statements in below indicate that XYZ Corporation isnot doing well, with a net loss of $43,200, and may not be a good investmentopportunity.

XYZ Corporation's Financial Statements using Cash Basis Accounting


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AccrualBasis Accounting

Armed with some additional information, let's see what the income statementwould look like if the accrual-basis accounting method was used.

Additional Information:A1. June 12, 2005 The company received a rush order for $80,000 of woodpanels. The order was delivered to the customer five days later. The customerwas given 30 days to pay. (With the cash-basis method, sales are not recordedin the income statement and not recorded in accounts receivables: no cash, norecord).

A2. June 13, 2003 The company received $60,000 worth of wood panels toreplenish their inventory, and $40,000 was related to the rush order. Thecompany paid the invoice in full to take advantage of a 2% early-paymentdiscount. (With the cash-basis method, this is recorded in full on the incomestatement, and there is no record of inventory on hand).


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A3. June 1, 2005 The company launched an advertising campaign that will rununtil the end of August. The total cost of the advertising campaign was $15,000and was paid on June 1, 2005.


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XYZ Corporation'sRestated Financial Statements using AccrualBasis

Accounting.


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Adjustments:To obtain the figures in the restated financial statements in figure 6.2 above,the following adjusting entries were made:

A1. Product sales and Accounts receivable Even though the client has notpaid this invoice, the company still made a sale and delivered the products. Asa result, sales for the accounting period should increase by $80,000. Account sreceivables (reported sales made but awaiting payment) should also increaseby $80,000.

Adjusting entries:


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A2. June 13, 2003 Since the entire $60,000 order was paid during the accountingperiod, the full amount was included in production costs under the cash-basismethod. Only $40,000 of the order was related to product sales during thataccounting period, and the rest was stored as inventory for future product

sales.

Adjusting entries:


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A3. June 1, 2005 Marketing expenses included in the income statement totaled$15,000 for a three-month advertising campaign because it was paid in full atinitiation (cash-basis accounting). The reality is that this campaign will last forthree months and will generate a benefit for the company every month. As a

result, under accrual-basis accounting, the company should record in thisaccounting period only one-third of the cost. The remainder should beallocated to the next period and recoded as prepaid expenses on the assetsside of the balance sheet.

Adjusting entries:


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Income StatementBasicsIncome StatementBasics

I. Basics

Within this basics section, we will define each component of a multi-stepincome statement, and prepare a multi-step income statement.

Multi-StepI

ncome StatementA multi-step income statement is a condensed statement of income as opposedto a single-step format, which is the more detailed format. Both single andmulti-step formats conform to GAAP standards. Both yield the same netincome figure.

The main difference is how they are formatted, not how figures are calculated.


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Multi-Step Income Statement


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Sales These are defined as total sales (revenues) during the accountingperiod. Remember these sales are net of returns, allowances and discounts

Cost of goods sold (COGS) These are all the direct costs related to the

product or rendered service sold and recorded during the accounting period.(Reminder: matching principle.)

Operating expenses These include all other expenses that are not includedin COGS but are related to the operation of the business during the specifiedaccounting period. This account is most commonly referred to as "SG&A"

(sales general and administrative) and includes expenses such as selling,marketing, administrative salaries, sales salaries, maintenance, administrativeoffice expenses (rent, computers, accounting fees, legal fees), research anddevelopment (R&D), depreciation and amortization, etc.


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Other revenues & expenses These are all non-operating expenses such asinterest earned on cash or interest paid on loans.

Income taxes This account is a provision for income taxes for reporting

purposes.


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Income StatementComponentsIncome StatementComponents

Income Statement Format

The following figure demonstrates which components are used to calculate acompany's net income, which is the income available to shareholders.


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Recurring (pre-tax) income from continuing operations This componenttakes the company's financial structure into consideration as it deductsinterest expenses.

Pre-tax earning from continuing operations This component considers allunusual or infrequent items. Included in this category are items that are eitherunusual or infrequent in nature but cannot be both. Examples are anemployee-separation cost, plant shutdown, impairments, write-offs, write-downs, integration expenses, etc.

Net income from continuing operations This component takes intoaccount the impact of taxes from continuing operations.


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Non-Recurring ItemsDiscontinued operations, extraordinary items and accounting changes are allreported as separate items in the income statement. They are all reported netof taxes and below the tax line, and are not included in income from continuing

operations. In some cases, earlier income statements and balance sheets haveto be adjusted to reflect changes.Income (or expense) from discontinued operations This component isrelated to income (or expense) generated due to the shutdown of one or moredivisions or operations (plants). These events need to be isolated so they donot inflate or deflate the company's future earning potential. This type ofnonrecurring occurrence also has a nonrecurring tax implication and, as aresult of the tax implication, should not be included in the income tax expenseused to calculate net income from continuing operations. That is why thisincome (or expense) is always reported net of taxes. The same is true forextraordinary items and cumulative effect of accounting changes (see below).


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Extraordinary items - This component relates to items that are both unusualand infrequent in nature. That means it is a one-time gain or loss that is notexpected to occur in the future. An example is environmental remediation.

Cumulative effect of accounting changes - This item is generally related tochanges in accounting policies or estimations. In most cases, these are non

cash-related expenses but could have an effect on taxes.


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Income Statement: Non-recurring ItemsIncome Statement: Non-recurring Items

INCOME STATEMENT:NONRECURRINGITEMS

Within this section we will further our discussion on the non-recurringcomponents of net income, such as unusual or infrequent items, discontinuedoperations, extraordinary items, and prior period adjustments.

Unusual or InfrequentItems

Included in this category are items that are either unusual or infrequent innature but cannot be both.

Examples of unusual or infrequent items:

Gains (or losses) as a result of the disposition of a company's businesssegment including:

Plant shutdown costs

Lease-breaking fees

Employee-separation costs


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Gains (or losses) as a result of the disposition of a company's assets orinvestments (including investments in subsidiary segments) including:

Plant shut-down costs

Lease-breaking fees

Gains (or losses) as a result of a lawsuit Losses of operations due to an earthquake

Impairments, write-offs, write-downs and restructuring costs

Integration expenses related to the acquisition of a business

Extraordinary ItemsEvents that are both unusual and infrequent in nature are qualified asextraordinary expenses.

Example of extraordinary items:

Losses from expropriation of assets

Gain (or losses) from early retirement of debt


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DiscontinuedOperationsSometimes management decides to dispose of certain business operations buteither has not yet done so or did it in the current year after it had generatedincome or losses. To be accounted for as a discontinued operation, the

business must be physically and operationally distinct from the rest of thefirm. Basic definitions:

Measurement date - The date when the company develops a formal plan fordisposing.

Phaseout period - Time between the measurement date and the actualdisposal date

The income or loss from discontinued operations is reported separately, andpast income statements must be restated, separating the income or loss fromdiscontinued operations.


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In general, prior years' financial statements do not need to be restated unless it isa change in:

Inventory accounting methods (LIFO to FIFO)

Change to or from full-cost method (This is used in oil & gas exploration. Thesuccessful-efforts method capitalizes only the costs associated with successfulactivities while the full-cost method capitalizes all the costs associated with allactivities.)

Change from or to percentage-of-completion method (look at revenue-recognition methods)

All changes just prior to a company's IPO


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Prior Period AdjustmentsThese adjustments are related to accounting errors. These errors are typicallyNOT reported in the income statement but are reported in retained earnings.(These can be found in changes in retained earnings.) These errors are

disclosed as footnotes explaining the nature of the error and its effect on netincome.


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Balance SheetBasicsBalance SheetBasics

I. BasicsWithin this section we'll define each asset and liability category on thebalance sheet, and prepare a classified balance sheet

B

alance SheetC

ategoriesThe balance sheet provides information on what the company owns (itsassets), what it owes (its liabilities) and the value of the business to itsstockholders (the shareholders' equity) as of a specific date.

Total Assets = Total Liabilities + Shareholders' Equity


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Assets are economic resources that are expected to produce economic benefitsfor their owner.

Liabilities are obligations the company has to outside parties. Liabilitiesrepresent others' rights to the company's money or services. Examples include

bank loans, debts to suppliers and debts to employees. Shareholders' equity is the value of a business to its owners after all of its

obligations have been met. This net worth belongs to the owners.Shareholders' equity generally reflects the amount of capital the owners haveinvested, plus any profits generated that were subsequently reinvested in thecompany.

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