In this reading, we will learn the following:



<ul><li>Role of Financial Reporting</li><li>Key Financial Statements</li><li>Financial Statement Notes and Supplementary Information</li><li>Auditing of Financial Statements</li><li>Other Sources of Information used by Analysts</li><li>Financial Statement Analysis Framework</li></ul>

Introduction to Financial Statement Analysis

Though it is said organizations have an indefinite life, in reality they do have a particular life cycle. These are birth, growth, plateau and finally no growth or decline. This is not unlike a product life cycle. In periods of slow growth, product extensions are introduced to increase its life span. Similarly, companies need to make changes, adapt to new technologies and economic scenarios to survive and earn profits. Some companies are bought over, and while their names stay, the businesses change dramatically.



So corporations that have lasted a long time (e.g. Coke, IBM, Unilever, and Microsoft) have perfected to a great degree to adapt rapidly to changes in the marketplace and stay ahead in the game. Apple is an excellent example of a company that reinvented itself, introduced a slew of new products that redefined the market. It is easy for companies to get complacent and be immune to changes in the industry. Companies need to reassess their processes from time to time to stay efficient and increase profitability.Financial reports play an important role in helping monitor an organization’s health, attract investors and keep stakeholders. The information needs to be accurate and relevant. Consistent practices tend to lead to accurate reports which are useful and relevant to the user. Regular cycles of these processes lead to capturing of accurate information, say, a weekly analysis of financial reports.

Roles of Financial Reporting

Financial statements are documents that concisely communicate the monetary situation of a business. Different statements describe different areas of the business's financial situation.



The four key financial statements are:



<ol type="1"><li>The Income Statement</li><li>The Statement of Owner's Equity</li><li>The Balance Sheet</li><li>Statement of Cash Flow</li></ol>



The&nbsp;income statement&nbsp;describes how much profit a business earns over a period of time. This document shows the amounts for revenue, expenses, and net income or net loss.



The&nbsp;statement of owner’s equity&nbsp;describes all changes in owner's equity over a period of time. This document shows the amounts for owner's investments, owner's withdrawals, net income, and net loss.



The&nbsp;balance sheet&nbsp;describes the financial situation of a business at a given time. This document shows the assets, liabilities and owner's equity.



The&nbsp;statement of cash flow&nbsp;describes the amount of cash going in and out of the business over a period of time. This document shows the movement of cash in operating, investing, and financing activities.



Financial statements are important as communication tools. They report on a business's financial situation from different perspectives. Many people depend on these reports, such as banks, partners, investors, suppliers, managers, customers, shareholders, and board of directors.Financial statement analysis involves using these financial statements along with other relevant information to make various decisions. For example, an investor will perform financial statement analysis to analyse whether it’s a good investment. Similarly, a bank will analyse the financial position of a firm to understand their financial requirements and payback capacity.

Key Financial Statements

The primary financial statements provide a summary of the financial position of a firm. These financial statements are accompanied by a series of explanations, found in the footnotes. In the footnotes the company makes several important disclosures about accounting methods, valuation, excluded liabilities, assumptions made and a variety of other important issues.



Since the financial statements provide only a summary of what the company is required to report, it is important for financial analysts to read the disclosures and other supplementary information to know the real story.



The four general types of notes are:



<ol type="1"><li>Summary of significant accounting policies: assumptions and estimates.</li><li>Additional information about the summary totals.</li><li>Disclosure of important information that is not recognized in the financial statements.</li><li>Supplementary information required by the FASB, IFRS or the SEC.</li></ol>



Let’s take the example of Apple Inc. In their annual report there is a disclosure about Revenue Recognition, which reads as follows:



“The Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed or determinable, and collection is probable. Product is considered delivered to the customer once it has been shipped and title and risk of loss have been transferred”



Another note about derivative instruments reads as follows:



“The Company accounts for its derivative instruments as either assets or liabilities and carries them at fair value.”



Yet another disclosure about inventory reads as follows:



“Inventories are stated at the lower of cost, computed using the first-in, first-out method, or market. If the cost of the inventories exceeds their market value, provisions are made currently for the difference between the cost and the market value. The Company’s inventories consist primarily of components and finished goods for all periods presented.”



As you can see, the notes to financial statements provides enormous information about how the company manages its business and the practices it follows and an analyst must use such information in his analysis.



Another important section that is considered very important is the management’s commentary generally labeled as&nbsp;Management’s Discussion and Analysis (MD&amp;A).



In this section, the management discusses many important issues and uses it as an opportunity to communicate key financial activities of the company. It covers the company’s ability to pay near-term obligations, its ability to fund operations and expansion, and its results of operations. The management analyses financial activities based on currently known facts, decisions or conditions. It also discusses the current year results in comparison with prior year, with emphasis on the current year. Management must highlight favorable or unfavorable trends and identify significant events and uncertainties that affect the business. The management’s discussion contains many forward-looking statements that involve risks and uncertainties.

Financial Statement Notes and Supplementary Information

<h3>Objectives</h3>



The financial statements are the responsibility of the management of the company. The Board of Directors of the company will appoint an independent public accounting firm to conduct the audit of the firm.&nbsp;



The primary objective of the audit is to express an opinion on the financial statements. The auditor issues an opinion on fairness of financial statements. He also issues his opinion on the effectiveness of controls if it’s a public company.



As a part of the audit, the auditor examines the accounting books, financial statements, assets, liabilities, internal controls, etc., to determine that there are no material errors in the financial statements.&nbsp;



The objective is to ensure that the financial statements are presented fairly, are complete in all material aspects, and are in conformance with accounting standards such as GAAP.



The auditor will present his views in the form of a report called auditor’s report.&nbsp;



The auditor’s report has a standardized format. A sample opinion paragraph of the Standard Auditor’s Report is provided below:



“In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of ABC Company and its subsidiaries as of December 31, 20X3 and 20X2, and the results of their operations and their cash flows for the years then ended in accordance with accounting principles generally accepted in the United States of America.”



The auditors obtain sufficient audit evidence and reasonable assurance to conclude that the financial statements as a whole are free from material misstatements.



<h3>Types of Audit Reports</h3>



There are four categories of audit reports:



<figure class="wp-block-table"><table><tbody><tr><td>Type of Report</td><td>Interpretation</td></tr><tr><td>Unqualified Opinion</td><td>Financial statements taken as a whole&nbsp;present fairly&nbsp;the financial position, results of operations, and cash flows in conformity with generally accepted accounting principles (GAAP).Unqualified opinion may be issued with an explanatory paragraph to highlight certain matter.</td></tr><tr><td>Qualified Opinion</td><td>“Except for” the effects of a particular matter, the financial statements&nbsp;present fairly&nbsp;the financial position, results of operations, and cash flows in conformity with GAAP.</td></tr><tr><td>Adverse Opinion</td><td>Financial statements&nbsp;do not present fairly&nbsp;the financial position, results of operations, and cash flows in conformity with GAAP.</td></tr><tr><td>Disclaimer of Opinion</td><td>Auditor&nbsp;does not express an opinion on&nbsp;the financial position, results of operations, or cash flows.</td></tr></tbody></table></figure>



<h3>Effective Internal Control</h3>



The internal controls are processes established by the management of a company designed to provide reasonable assurance that the organization achieves its objectives regarding effectiveness and efficiency of their operations; reliability of financial reporting; and compliance with applicable laws and regulations.



Internal controls are a responsibility of the management. Under US GAAP, it is mandatory for the auditor to provide his opinion on the internal controls followed by the firm.&nbsp;&nbsp;

Auditing of Financial Statements

Apart from the financial statements and supplementary information available about the company, a financial analyst also uses some other sources of information in his analysis. Some of these sources are discussed below:



Quarterly and semi-annual reports:&nbsp;Apart from the annual reports on Form 10-K, issuers must also submit quarterly reports on Form 10-Q. The Form 10-Q includes unaudited financial statements and provides a continuing view of the company’s financial position during the year. Form 6-K is a similar form filed semi-annually by non-US companies.



Form 8-K:&nbsp;In addition to filing annual reports on Form 10-K and quarterly reports on Form 10-Q, public companies must report certain material corporate events on a more current basis. Form 8-K is the “current report” companies must file with the SEC to announce major events that shareholders should know about.



Proxy Statement / Form DEF-14A:&nbsp;A company is required to file its annual proxy statement with the SEC no later than the date proxy materials are first sent or given to shareholders. It’s called a “DEF 14A” because it’s the “definitive,” or final, proxy statement. Proxy statement includes important information such as proposals requiring vote, details of securities owned by management, details of executive compensation, etc.



Form 3, 4 and 5:&nbsp;Corporate insiders – meaning a company’s officers and directors, and any beneficial owners of more than ten percent of a class of the company’s equity securities registered under Section 12 of the Securities Exchange Act of 1934 – must file with the SEC a statement of ownership regarding those securities. Form 3 is the initial statement, Form 4 reports changes, and Form 5 is the annual report.



Corporate Reports and Press Releases:&nbsp;These are generally viewed as sale or promotional material however may contain important information that could help analysts. The analysts may also attend conference calls held by senior management where they could get their questions answered.



The analyst can combine the company specific information with other information such as industry trends and economic parameters while preparing their research.

Other Sources of Information used by Analysts

The main job of financial analysts is to analyse various types of financial information with the objective of providing recommendation to their clients. The clients use these recommendations to make economic decision and manage their investments. Due to the nature of their job it is important that the financial analysts follow a financial statement analysis framework to bring consistency and depth in their analysis.



The CFA Institute curriculum adopts the financial statement analysis framework from the book –&nbsp;Analysis and Managing Banking Risk: A Framework for Assessing Corporate Governance and Financial Risk, Second edition by Hennie Van Greuning and Sonja Brajovic Bratanovic.



There are six steps in the financial statement analysis framework. The outcome of one step serves as the input for the next step.&nbsp;



<ol type="1"><li>State the objective and context:&nbsp;This step involves establishing objectives&nbsp;of financial analysis by defining the purpose and context of financial statements analysis</li><li>Gather data:&nbsp;In this step the analyst will collect data&nbsp;necessary for financial analysis from different sources such as company’s annual reports, industry and economy data, and ask questions to customers, management, creditors, etc.</li><li>Process the data:&nbsp;The analyst will now process the data. Processing may include a range of activities such as sorting data, adjusting data to prepare common-size financial statements, and preparing graphs of important ratios and trends.</li><li>Analyse and interpret data:&nbsp;The analyst will now conduct analysis&nbsp;on processed data and interpret the results. He will decide on the conclusions and recommendations as supported by the information.</li><li>Report conclusions and recommendations:&nbsp;Based on his analysis, the analyst will develop recommendations&nbsp;and communicate them to relevant audience. This is an important phase and the analyst must ensure that he is complying with the ethical standards related to investment recommendations.</li><li>Updated the analysis:&nbsp;The analyst is also required to follow up&nbsp;and review his analysis and recommendations on a periodic basis by repeating all the above steps and make necessary changes to his analysis and recommendations.&nbsp;</li></ol>

Financial Statement Analysis Framework

This quiz is a part of the CFA Level 1 reading 'Introduction to Financial Statement Analysis'. 

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Introduction to Financial Statement Analysis

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