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

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“Sixty Minute Guide” Financial Reporting & Analysis CFA- Level I www.FinTreeIndia.com

1. Important Basic concepts

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Audit  independent review of an entity’s financial statements

Unqualified Opinion

Qualified opinion

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Adverse opinion

Basic accounting equation Assets = Liabilities + Owners’ equity

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Two primary assumptions 1.Accrual basis 2.The Going concern assumption.

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Flow of information in Accounting system Journal entries

General ledger

Initial trial balance

Adjusted trial balance

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Financial Statement

2.Understanding the Income Statement

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

Long Term Contracts

% of completion competed Contract Method method Recognize revenue in proportion of cost incurred

Recognize revenue only when contract is complete

Installment sales

Normal rev. Recognition

Recognize revenue If collect ability Is reasonably assured

Installment Sales Used if collectability cannot be reasonably estimated

Barter transactions

Cost recovery Method used if collectability is highly uncertain

Barter transaction: recognize revenue only If fair value can be estimated

Expense recognition  is based on the matching principle  expenses to generate revenue are recognized in the same period as the revenue

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Discontinued operation  Barter transactions is one that management has decided to dispose off  but has not yet done so

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IMP 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.

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extraordinary item

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

unusual and infrequent in occurrence reported 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 www.FinTreeIndia.com

Change in accounting principle  prior-period financial statements are restated to reflect the change.

Change in accounting estimate  Prospective application www.FinTreeIndia.com

Dilutive securities    

are stock options, warrants, convertible debt convertible preferred stock that would decrease EPS if exercised or converted to common stock

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3.Understanding the Balance Sheet

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Investments (Financial Instruments)

Held to maturity

Available for Sale

Trading securities

1.On BS: @ Amortized Cost

1.On BS: @ Fair Value

1.On BS: @ Fair Value

2.Realised gain: Taken to income statement

2.Realised gain: Taken to income statement

3.Unrealised gain: Taken to other Comprehensive income

3.Unrealised gain: Taken to income statement

2.Realised gain: taken to income Statement

3.Unrealized gain is not recognized

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4.Understanding the Cash Flow Statement

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Cash Flows CFO CFO Inflows and outflows of cash resulting from transactions that affect a firm’s net income.

CFI CFI inflows and outflows of cash resulting from the acquisition or disposal of long-term assets and certain investments.

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CFF CFF Inflows and outflows of cash resulting from transactions affecting a firm’s capital structure, such as issuing or repaying debt and issuing or repurchasing stock .

Item

US GAAP Treatment

IFRS Treatment

1. Dividends paid

Financing activities (CFF)

CFO or CFF (Gives flexibility to management )

2. Interest paid

Operating activities (CFO)

CFO or CFF (Gives flexibility to management )

3. Dividends received

Operating activities (CFO)

CFO or CFI (Gives flexibility to management )

4. Interest received

operating activities (CFO)

CFO or CFI (Gives flexibility to management )

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 Formula 1.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 CFO + (INT-tax%) www.FinTreeIndia.com

- FCinv

-FCinv

5.Inventories

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Inventory Cost Flow Methods

FIFO

LIFO

Weightd avg.

Specific identificn

FIFO

1.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

LIFO

1.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

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IFRS Research cost

Development cost

Expensed as incurred

Capitalized

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US GAAP Research cost

Development cost

Expensed as incurred

Expensed (Except, software

development cost)

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7.Income Taxes

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Create

DTA if,

IT Exp. (Income Statement) is greater than Tax p’ble

Create

DTL if,

IT Exp. (Income Statement) is less than Tax p’ble

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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

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Income tax expense = taxes payable + ΔDTL – ΔDTA. Increase in DTL Decrease in DTA Increase in DTA Decrease in DTL

ADD LESS www.FinTreeIndia.com

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

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8.Non-current (Long-term) Liabilities

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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

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Premium bond

Discount bond

1. coupon rate > market yield at issuance

1. coupon rate < market yield at issuance

2. reported on the balance

2. reported on the balance sheet at less than its face value .

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

3. book value of the bond liability will increase until it reaches its face value at maturity. 4. interest expense is greater than the coupon payment

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Finance lease US GAAP Treat 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

IFRS If substantially all the rights and risks of ownership are transferred to the lessee, the lease is treated as a finance lease by both the lessee and lessor

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

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Impact on financial statements Finance lease

Operating lease

Lower

Higher

Higher

Lower

EBIT

Higher

Lower

CFO

Higher

Lower

CFF

Lower

Higher

Net income (early yrs)

Net income (later yrs)

9.Financial Reporting Quality

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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

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US GAAP & IFRS differences Items

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 losses

IFRS 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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