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Financial Reporting and Analysis

Financial Reporting Mechanics


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Graphs, charts, tables, examples, and figures are copyright 2012, CFA
Institute. Reproduced and republished with permission from CFA Institute.
All rights reserved.
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Contents
1.
2.
3.
4.
5.
6.
7.

Introduction
The Classifications of Business Activities
Accounts and Financial Statements
The Accounting Process
Accruals and Valuation Adjustments
Accounting Systems
Using Financial Statements in Security Analysis

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1. Introduction
Financial statements are the end products of a process for
recording the business transactions of a company
Reading is targeted towards a user rather than preparer of
financial reports

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2. The Classifications of Business Activities


Operating activities are activities that are part of the day to day business operations of the company
1. Sales of goods and services (R)
2. Cost of providing good and services (X)
3. Short term assets and liabilities directly related to operating activities (A), (L)
Investing activities are activities associated with acquisition and disposal of long-term assets
1. Purchase or sale of property, plant and equipment (A)
2. Purchase or sale of other entities equity and debt securities (A)
Financing activities are activities related to obtaining or repaying capital
1. Issuance or repurchase of companys own preferred or common stock (E)
2. Issuance or repayment of debt (L)
3. Dividend payments (E)
Accounting elements: Assets (A), Liabilities (L), Owners Equity (E), Revenue (R), Expenses (X)
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3. Accounts and Financial Statements


Accounting elements:
Assets (A), Liabilities (L), Owners Equity (E), Revenue (R), Expenses (X)

Assets are the economic resources of the company


Liabilities are the creditors claims on the resources of a company
Owners equity is the residual claim on those resources
Revenues are inflows of economic resources
Expenses are outflows of economic resources or increases in liabilities
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3.1 Financial Statement Elements and Accounts


Accounts are sub-classifications within financial statement elements
Accounts are individual records of increases and decreases in a specific asset,
liability, component of owners equity, revenue, or expense

Non-Current

Current

Assets
Cash and cash equivalents
Accounts receivable
Prepaid expenses
Inventory
PP&E
Investment property
Intangible assets

Liabilities
Accounts payable
Pensions or accrued liabilities
Bonds payable
Loans/debt payable
Unearned revenue

Owners Equity
Common stock par value
Additional paid-in capital
Retained earnings
Other comprehensive income
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Revenue
Revenue, sales
Gains
Investment income

Expenses
Cost of goods sold
SG&A
Depreciation, amortization
Interest expense
Tax expense
Losses
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Accounting Equations
XYX Company
Balance Sheet on 1 Jan 2001
Assets

1,000

Liabilities
Equity (CC)

400
600

Assets = Liability + Equity


XYX Company
Balance Sheet on 31 Dec 2001
Assets

1,180

Liabilities
Equity

400
780

XYX Company
Income Statement for 2001
Revenue
Expenses

300
100

Dividend = 20
Reinvested = 180

Net Income

200

Net Income = Revenue - Expenses

Equity = Contributed Capital + Retained Earnings

Assets = Liability + CC + BRE + Rev Exp Div

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Example
XYX Company
Balance Sheet on 1 Jan 2002
Assets

1,180

Liabilities
Equity

400
780

XYX Company
Balance Sheet on 31 Dec 2002

XYX Company
Income Statement for 2002
Revenue
Expenses

300
100

Dividend = 20
Reinvested = 180

Net Income

200

Assuming liabilities remain unchanged, what is the value of assets and equity?

Assets
Liabilities
Equity

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4. The Accounting Process


Record business transactions such that periodic financial statements can be prepared.

John started a small trading business. The table below shows the business activities and the
corresponding accounting treatment.
Business Activity

Accounting Treatment

1 Jan: Capitalize business with


deposit of 600

Cash (A) up 600


Contributed capital (E) up 600

2 Jan: Borrow 400

Cash (A) up 400


Debt (L) up 400

3 Jan: Buy inventory for 500

Cash (A) down 500


Inventory (A) up 500

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Show accounting treatment and the


balance sheet on 3 Jan

Link Between Income Statement and Balance Sheet


Business Activity

Accounting Treatment

28 Jan: Sell entire inventory for


$700

Cash (A) up 700


Revenue (R) up 700

Show the income statement and


balance sheet on 31 January

Inventory (A) down 500


COGS (X) up 500
30 Jan: Pay January rent
expense 200

Cash (A) down 200


Rent Expense (X) up 200

The cash flow statement can be created using the income statement and the balance sheet. This
will be covered later in the course.
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5. Accruals and Valuation Adjustments


Accrual accounting requires that revenue be recorded when earned and expenses be recorded when
incurred, irrespective of when related cash movements occur.
Cash Movement prior to Accounting Recognition

Cash Movement after Accounting Recognition

Unearned Revenue

Unbilled (Accrued) Revenue

Initial entry: record cash and create liability

Initial entry: record revenue and create A/R

Adjusting entry: reduce liability, record revenue

Adjusting entry: reduce A/R, record cash

Prepaid Expense

Accrued Expenses

Initial entry: record cash and create asset

Initial entry: record expense and create liability

Adjusting entry: reduce liability, record revenue

Adjusting entry: reduce liability, record payment

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Accruals and Valuation Adjustments


Accrual entries allocate revenues and expenses into appropriate accounting periods

Valuation adjustments are made to a companys assets or liabilities so that accounting


records reflect current market value rather than historical cost
Example: Inventory write-down

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6. Accounting Systems
Financial
Statements

Journal
Entries

Business transactions
recorded
chronologically

Debits and
Credits
Adjusted
Trial
Balance

General Business transactions


Ledger sorted by account

Trial
Balance
Account balances at a
particular point in time
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7. Using Financial Statements in Security Analysis


Imagine you are a financial analyst. How do you use financial statements for security analysis?

1. Articulate purpose and


context based on your
function, client input and
organizational guidelines

3. Process data

2. Collect data: financial


statements, other financial
data, industry/economic data;
discussions with management,
suppliers, customers and
competitors

Objective
Questions to be
answered
Content to be provided
Timetable and budget

Adjusted financial statements; commonsize statements, ratios, graphs, forecasts

5. Develop and communicate


conclusions and recommendations

4. Analyze and
interpret processed
data

Report answering questions


from Phase 1, conclusions and
recommendations
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6. Follow up

Organized financial
statements; financial
tables, completed
questionnaires

Analytical results

Updated
recommendations

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Use of Judgment in Accounts and Entries


A financial analyst must understand the judgment and estimates being used in the
creation of financial reports. This is accomplished by carefully studying the footnotes
and MD&A.
The financial analyst will have to make adjustments and infer transactions.
At times companies might deliberately misrepresent financial reports. Ratio analysis
can assist in detecting such behavior.

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Summary
Financial statement elements and accounts

Accounting equation
Recording business transactions
Relationship between income statement and balance sheet

Flow of information in an accounting system


Use of the accounting process in security analysis
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Conclusion
Read summary

Review learning objectives


Examples: few and complicated
Practice problems: good but not enough
Practice questions from other sources
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