STUDY SESSION 6 FINANCIAL REPORTING AND ANALYSIS: AN INTRODUCTION Reading 21: Financial Statement Analysis: An Introduction

Transcription

1 Coverage STUDY SESSION 6 FINANCIAL REPORTING AND ANALYSIS: AN INTRODUCTION Reading 21: Financial Statement Analysis: An Introduction The candidate should be able to: a. Describe the roles of financial reporting and financial statement analysis b. Describe the roles of the statement of financial position, statement of comprehensive income, statement of changes in equity, and statement of cash flows in evaluating company s performance and financial position c. Describe the importance of financial statement notes and supplementary information Including disclosures of accounting policies, methods, and estimates and management s commentary d. Describe the objective of audits of financial statements, the types of audit reports, and the importance of effective internal controls e. Identify and describe information sources that analysts use in financial statement analysis besides annual financial statements and supplementary information f. Describe the steps in the financial statement analysis framework

2 Scope of Financial Statement Analysis LOS 6.21.a The role of financial reporting Provide information Company performance Financial position Changes in financial position Useful to a wide range of users in making economic decisions The role of financial statement analysis Analyze financial reports and other information Evaluate Past, current and prospective performance and financial position of a company Purpose Making investment, credit, and other economic decisions

3 Scope of Financial Statement Analysis LOS 6.21.a Evaluating equity investment for inclusion in a portfolio Evaluating a merger or acquisition candidate Evaluating a subsidiary or operating division of a parent company Deciding whether to make a venture capital or other private equity investment Determining credit-worthiness of a company Examples of economic decisions Valuing a security for making an investment recommendation Extending credit to a customer Examining compliance with debt covenants Assigning a debt rating to a company or bond issues Forecasting future net income and cash flow

4 Scope of Financial Statement Analysis LOS 6.21.b Analysis of performance Assessment of profitability and cash flow generating ability Profitability Earn a profit from delivering goods and services Cash flow Cash is needed to pay employees, suppliers etc. Essential to continue as a going concern Positive cash flow leads to funding flexibility Liquidity Ability to meet short-term obligations Solvency Ability to meet long-term obligations

5 LOS 6.21.b Summary of key financial statements Income statement Balance sheet Statement of cash flows Statement of changes in owners equity Summary of additional information Footnotes and supplementary schedules Management s discussion and analysis (MD&A) External auditor s report(s)

6 LOS 6.21.b Income Statement Statement of operations or profit & loss account Results of financial performance over a period of time Basic form equation Revenue Costs = Net income Balance Sheet Statement of financial position/condition Presents company s financial position at a point in time Accounting equation Assets = Liabilities + Owner s equity Assets Liabilities = Owner s equity

7 LOS 6.21.b Statement of Cash Flows Discloses sources and uses of cash Evaluate company s liquidity, solvency, and financial flexibility Financial flexibility Ability to react and adapt to financial adversities and opportunities Classification of cash flows Operating, investing and financing Sum of net cash flows = Net change in cash Statement of Changes in Stockholders Equity Statement of shareholders equity or statement of retained earnings Reports changes in the owners investment in business over time Assists in understanding changes in financial position

8 Financial notes and supplementary schedules Provides explanatory information Business acquisitions/disposals, legal proceedings, stock option plans and related-party transactions Footnotes Information about methods and assumptions used to prepare financial statements Aids comparability of financial statements between companies Required for complete presentation in conformity with US GAAP and IFRS Management discussion and analysis (MD&A) Required by US GAAP for publicly held companies Highlight favorable or unfavorable trends Identify significant events and uncertainties Affect liquidity, capital, resources and results of operations Provide information about effects of inflation, changing prices or other material events Discuss critical accounting policies requiring subjective judgments Similar report required by IFRS LOS 6.21.c

9 LOS 6.21.d Auditor s reports Examination by an independent accounting firm Express an opinion on the truth and fairness of the financial statements International standards International Auditing and Assurance Standards Board (IAASB) of International Federation of Accountants (IFAC) US standards Public Company Accounting Oversight Board (PCAOB) Sarbanes-Oxley Act Audit report Provides reasonable assurance financial statements are fairly presented High degree of probability statements are free from material error, fraud, or illegal acts

10 Independent audit report LOS 6.21.d First or introductory paragraph Describes financial statements and relative responsibilities Second or scope paragraph Details the nature of the audit process 3. Third or opinion paragraph Provides unqualified audit opinion True or fair view (IFRS) Fairly presented (IFRS and US) Clean opinion Also provides qualified opinion, giving a limitations or exceptions to accounting standards and explanatory paragraphs regarding exceptions

11 LOS 6.21.d Independent audit report Adverse opinion Financial statements materially depart from accounting standards Not fairly presented No point in performing any financial analysis Statements cannot be relied on Disclaimer of opinion Auditors are unable to have an opinion for some reason E.g. destruction of accounting records Sarbanes-Oxley Auditors must express an opinion on internal control system Separate opinion or fourth paragraph

12 Other sources of information Interim reports Provided semiannually or quarterly Generally not audited Proxy statements Information regarding management and director compensation and company stock performance Discloses any potential conflict of interest between management, the board and shareholders Other sources of current information Company websites, press releases and conference calls LOS 6.21.e

13 Financial Statement Analysis Framework LOS 6.21.f Phases Step 1 Articulate the purpose and context of analysis Step 2 Collect all relevant data Step 3 Process data Step 4 Analyze results of data processing Step 5 Conclude recommendation and communicate this Step 6 Follow-up

14 Financial Statement Analysis Framework LOS 6.21.f Phase of Information Output 1. Purpose and context of the analysis Nature of analyst s function such as issuing a credit rating Communication with client or supervisor Institutional guidelines for developing specific product Statement of purpose or objective of analysis A list of specific questions to be answered by analysis Nature and content of report Timetable and budget 2. Collect data Financial statements, other financial data, questionnaires, industry and other economic data Discussions with management, suppliers, customers and competitors Company site visits Organized financial statements Financial data tables Completed questionnaires

15 Financial Statement Analysis Framework LOS 6.21.f Phase of Information Output 3. Process data Data from previous step Adjusted financial statements Common-size statements Ratios and graphs Forecasts 4. Analyze results of data processing 5. Conclude recommendation and communicate this Input data as well as processed data Analytical results and previous reports Institutional guidelines for published reports Analytical results Analytical report answering questions posed in phase 1 Recommendations regarding the purpose of the analysis 6. Follow-up Information gathered by periodically repeating above steps Updated reports and recommendations