This segment gets to the heart of financial statement analysis applications for investment decision-making.

Investors and analysts should understand that a company’s management retains discretion in its choice of certain accounting methodologies and accrual estimates.  This subjectivity necessitates that analysts possess a detective like skill set to hunt down accounting maneuvers and revise financial statements to create a true economic picture of the firm’s performance and financial position.

Making adjustments is imperative as future stock and bond values will be impacted by expectations of performance persistence.  A company’s management may make accounting choices which show a positive current picture, but mask future financial performance challenges.  This section will review issues in evaluating a company’s reported earnings and common techniques for scrutinizing a company’s reported financial statements.

This tutorial attempts to address differences between accounting standards; however the candidate is advised to refer to Study Session 7 of the Level II CFA Program Curriculum © to validate requirements in understanding formal discrepancies between U.S. generally accepted accounting principles (GAAP) and international standards (referred to in this tutorial as IFRS-IAS).

Understanding financial reporting quality and adjusting reported financial statements are skills developed by an analyst through extended practice.  While a candidate would do well to memorize the concepts presented in this study session, he/she will greatly improve his/her chances of passing Level II by repeatedly practicing the application of these principles until they become instinct.

The candidate will likely see three to four financial reporting item sets on the actual exam.  Financial reporting quality could cover a complete item set in isolation or be spread over parts of all of the financial reporting item sets.  Correct application of analyzing financial reporting quality could directly represent as much as 5-10% of the test.

<strong>Material:</strong>

I.          Earnings and Cash Flows

II.        Derivatives Hedging and Financial Reporting

III.       Earnings Quality and Other Financial Reporting Challenges for Analysts

CFA Level 2: Financial Reporting Part 3 – Introduction

There are a number of earnings definitions and CFAI expects candidates to know the differences among the various definitions and recognize adjustments which should be made to reported earnings in order to perform valuation analysis.
<h3>Operating Income (OI)</h3>
<div class="formula1">OI = Revenues - Cost of Goods Sold - Selling, General, &amp; Admin Expenses - Other Operating Expenses</div>
<ul>
	<li>In theory, OI represents profit from core business operations; however management may shift non-core gains into (or core losses out of) its OI reporting, in order to show better than actual core business performance.</li>
	<li><strong>Depreciation and Amortization:</strong> this is a component of OI, but might not be explicitly called out on the income statement; in this case the analyst needs to refer to the statement of cash flows and/or the footnotes for details.</li>
	<li><strong>Interest Expense &amp; Interest Income:</strong> this is reported below the OI line.</li>
	<li><strong>Unusual and Infrequent Items</strong>, such as employee severance pay as part of a restructuring are part of the OI calculation; in the U.S., extraordinary items are not included in the OI calculation.</li>
</ul>
<h3>Earnings Before Interest, Taxes, Depreciation &amp; Amortization (EBITDA)</h3>
<div class="formula1">EBITDA = Net Income + Taxes + Interest + Depreciation &amp; Amortization</div>
<h3>Income Before Taxes (or Earnings Before Taxes-EBT)</h3>
<div class="formula1">EBT = Net Income + Provision for Income Taxes</div>
<ul>
	<li>Analysts must be aware that applying this formula as stated may lead to the inclusion of discontinued operations, which are commonly eliminated when projecting a company's future earnings.</li>
</ul>
<h3>Income from Continuing Operations</h3>
<ul>
	<li>Under IFRS and GAAP, discontinued operations reflect a disposed or established plan of disposal for a business component in which there will be no future involvement. In order to qualify, the business component needs to have separately identifiable operations and assets.</li>
</ul>
<h3>Income before Extraordinary Items</h3>
<ul>
	<li>GAAP allows firms to classify certain events as extraordinary, reporting the item below continuing operations and net of tax. In order to qualify, the item must be both unusual and infrequent in nature. IFRS does not allow the classification of extraordinary items on the income statement.</li>
</ul>
<h3>Net Income</h3>
<ul>
	<li>"The bottom line", net income is the basis for calculating a firm's basic earnings per share and diluted earnings per share.</li>
</ul>
<h3>Total Comprehensive Income</h3>
<ul>
	<li>Other Comprehensive Income (OCI) reflects the changes in a company's equity during the accounting period which does not represent contributions by or distributions to the company's owners.</li>
</ul>
 

Various Definitions of Earnings

<ul>
<li>Other Comprehensive Income (OCI) reflects the changes in a company's equity during the accounting period which does not represent contributions by or distributions to the company's owners.</li>
<div class="formula1">
Total Comprehensive Income = Net Income + / - Other Comprehensive Income
<br><br>
OCI = Ending Shareholders' Equity - Beginning Shareholders' Equity - Net Income + Declared Dividends
</div>

<li>Reporting Comprehensive Income: firms can report comprehensive income below net income on the income statement, as an extra column on the statement of changes in shareholders' equity, or through a statement of comprehensive income.</li>
</ul>

<h2>Items Under OCI Category</h2>

U.S. GAAP has four items that fall under the OCI category:
<ul>
<li><b>Unrealized Gains/Losses on Certain Investment Securities:</b> these are gains or losses from intercorporate investments classified as available for sale (AFS).  The unrealized gain/loss in the accounting period does not affect net income for the period, but does impact shareholders equity as part of OCI.</li>

<li><b>Unrealized Gains/Losses on Hedging Derivatives:</b> a change in the fair value of derivatives contracts used for hedging is not part of net income, but is applied to equity through OCI.</li>

<li><b>Foreign Currency Translation Adjustments:</b> when a company consolidates foreign subsidiaries using the current rate method, the gain or loss resulting from the foreign exchange adjustments is reported as part of OCI.</li>

<li><b>Pension Liability Adjustments:</b> actuarial gains and losses related to defined benefit retirement plans are recorded as part of OCI.</li>
</ul>



Total Comprehensive Income

<ul>
<li>This segment has focused on earnings; when reporting earnings management has certain discretion over the treatment of gains, losses, and expenses.</li>
<li>Cash inflows and outflows can provide the analyst with a more objective view of the company's economic reality.</li>
<li>Analysts should compare trends in net income with trends in cash flow from operations and may be rightfully skeptical of firms that report trends in earnings growth which are not matched by similar trends in cash flows from operations.</li>
<li>Summary of cash flow treatment under GAAP and IFRS</li>
<table class="mytable">
<tr>
<th scope="colspan">ITEM</th>
<th scope="colspan">U.S. GAAP</th>
<th scope="colspan">IFRS</th>
</tr>
<tr>
  <th scope="row" class="spec">Interest Received</th>
  <td>Operations</td>
  <td>Operations or Investing</td>

</tr>
<tr>
  <th scope="row" class="specalt">Interest Paid</th>
  <td class="alt">Operations</td>
  <td>Operations or Financing</td>

</tr>
<tr>
  <th scope="row" class="spec">Dividends Received</th>
  <td>Operations</td>
  <td>Operations or Investing</td>

</tr>
<tr>
  <th scope="row" class="specalt">Dividends Paid</th>
  <td class="alt">Financing</td>
  <td>Operations or Financing</td>

</tr>
<tr>
  <th scope="row" class="spec">Taxed Paid</th>
  <td>Operations</td>
  <td>Operations, Investing or Financing</td>

</tr>
</table>
</ul>
 

Earnings and Cash Flows

Companies frequently use derivatives to hedge their risk exposures.

Under U.S. GAAP there are three classes of exposures to derivatives hedging activities which require specific accounting treatment in a company's financial reporting:

<ol>

	<li>Exposure to changes in the value of assets and liabilities or a company commitment.</li>
		<ul>
			<li>This is also called a fair value hedge.</li>
			<li>The change in market value of the derivative is recognized on the income statement for the accounting period.</li>
		</ul>
	
	<li>Exposure to variable cash flows of a future transaction.</li>
		<ul>
			<li>The effective portion of the hedging instrument is first reported as part of OCI.</li>
			<li>This portion is later transferred to the income statement once the business transaction has taken place.</li>
			<li>The ineffective portion of the hedge is immediately recognized on the income statement.  This portion can be thought of as the derivative's tracking error or the change in the value of the derivative which did not mirror the change to the underlying investment's value.</li>
		</ul>	
	
	<li>Foreign currency exposure of an investment in a foreign operation.</li>
		<ul>
			<li>The gain or loss on the derivative security is reported as a component of OCI as part of the cumulative translation adjustment.</li>
		</ul>
</ol>


Derivatives Hedging and Financial Reporting

<ul>
<li>In cash basis accounting, the revenue is recognized when the cash is collected, and expenses are recognized when the cash is paid. However, the problem with this is that the cash flow may not occur at the same time when the revenue is earned or the expenses are incurred. For example, a business may make a sale in 2012, but expects to be paid for it only in 2013.</li>
  <li>Rooted in the concept of the matching principle, where revenues and expenses are recognized in the period in which the transaction occurs and not when cash actually exchanges hands, accrual basis accounting provides more timely insights for analysts and investors.</li>
  <li>Both U.S. GAAP and IFRS mandate accrual basis accounting.</li>
  <li>However, accrual basis accounting relies on estimates and assumptions from management, providing management with the opportunity to manipulate the appearance of its financial performance.</li>
  <li>While cash basis accounting is less timely than accrual accounting, it is much more objective in its reporting of transactions.</li>
  <li>Accrual based earnings can be separated into two distinct components:</li>
  <ol class="list3">
	<li>Cash flow component</li>
	<li>Accrual component</li>
  </ol>
	The accrual component of a company's earnings is commonly less persistent over time.  When making comparisons of companies, generally those with a higher proportion of accrual based earnings are considered to have weaker earnings than those with a higher proportion of cash flow based earnings.
</ul>

<strong>NOTE:</strong> CFAI expects candidates to possess the ability to scrutinize management estimations used in financial reporting and make analytical adjustments in order to better forecast future financial performance.  This ability is a core competency of the Level 2 exam.


Cash Basis Accounting vs. Accrual Basis Accounting

The management of a company has two types of motivations or incentives for manipulating financial reporting through accrual discretions: capital market incentives and contract based incentives.
<ul class="list2">
  <li><b>Capital Market Incentives:</b> Financial reporting affects the price of a company's stock and the price of its bonds. Therefore management has the incentive to exceed the market expectations. Management may attempt to manipulate net income in order to meet analyst forecasts.  Management may also become more publicly pessimistic as its fiscal year progresses, in order to generate positive earnings surprises later in the year, as positive earnings surprises tend to elevate stock prices.
  </li>
  <li><b>Contract Based Incentives:</b> When management is heavily compensated with stock or has bonuses tied to earnings then incentives exist to manipulate financial statements. In addition, companies with debt may be motivated to manipulate financial statements in order to maintain debt covenants.

  </li>


</ul>


Management Motivations for Financial Statement Manipulation

<ul>
<li>Conceptually, earnings quality refers to the accuracy of the income statement reported by a company in predicting future financial performance.</li>
<li>The term earnings quality can be extended more broadly by stating financial reporting quality.  As the management of a company makes more aggressive assumptions, the quality of its financial statements tends to deteriorate.</li>
<li>High quality financial reporting is commonly associated with the application of <b>conservative</b> assumptions by management.</li>

<li>When looking at earnings quality, a financial analyst or investor is trying to determine if the company in question is applying aggressive or conservative assumptions.</li>
<li><b>Conservative Accounting examples:</b> 

	<ul>
	<li>Accelerated depreciation methods,   
	<li>High allowances for doubtful accounts, and </li>
	<li>Large unearned revenue balances.</li>
	
	</ul>	This conservatism should wash out over time, as lower current period earnings lead to higher future period earnings.
</li>
<li><b>Mean Reversion in Earnings:</b> extremely high earnings levels are typically not persistent and tend to revert to normal levels.</li>
	<ul>
		<li>Within the context of simple economic theory, if a new and highly profitable market or industry is established, the first to enter may enjoy high profits. However, over time these profits will attract new entrants and drive down profitability, in the absence of barriers to market entry.</li>
	</ul>	
</ul>

 

Measures of Earnings Quality

<ul>
  <li>A company's accrual earnings has two components: cash earnings and aggregate accruals</li>
  <div class="formula1">
	Accrual Basis Earnings = Cash Earnings + Aggregate Accruals
	<br><br>
	Aggregate Accruals = Accrual Basis Earnings - Cash Earnings

  </div>
  <li>When aggregate accruals are the dominant component of a company's earnings, mean reversion tends to occur more quickly and so earnings with a high accrual component can be considered lower quality.</li>
	<li><b>Accruals Ratio</b> - the accruals ratio is a simple measure for analyzing earnings quality.  There are two approaches: the balance sheet approach and the cash flow statement approach.</li>
	<li>Two approaches to the Accruals Ratio:</li>
		<ul>
			<li>Balance sheet approach</li>
			<li>Cash flow statement approach</li>
		</ul>
</ul>
<h2>Balance Sheet Approach to the Accruals Ratio</h2>


Steps in evaluating aggregate accruals: the Balance Sheet Approach to the Accruals Ratio

<p style="text-align:center;"><img src="https://financetrain.com/wp-content/uploads/bs_approach.gif" /></p>

Steps in evaluating aggregate accruals: the Cash Flow Statement Approach to the Accruals Ratio.

<p style="text-align:center;"><img src="https://financetrain.com/wp-content/uploads/cf_approach.gif" /></p>

NOTE: The two approaches to calculating a company's accruals ratio will not result in the same value, but there is a high correlation between the methodologies.



Analyzing Earnings Quality - the Accruals Ratio

The table below summarizes some (i.e. not comprehensive) common financial reporting problems and the warning signs associated with those problems.
<br><br>
<table class="mytable">
<tr>
<th scope="colspan">FINANCIAL STATEMENT ITEM</th>
<th scope="colspan">REPORTING PROBLEM</th>
<th scope="colspan">WARNING SIGN</th>
<th scope="colspan">ANALYTICAL TOOL</th>
</tr>
<tr>
  <th scope="row" class="spec">Revenue</th>
  <td>Overstated revenue.</td>
  <td>Large increases in accounts receivable.</td>
  <td>Look for increases in days sales outstanding (DSO) as this may indicate questionable credit sales by the company.</td>

</tr>
<tr>
  <th scope="row" class="specalt">Revenue</th>
  <td class="alt">Misclassification of non-operating or non-recurring revenue as operating revenue.</td>
  <td class="alt">The company changes items included in calculation of earnings.</td>
  <td class="alt"></td>
</tr>
<tr>
  <th scope="row" class="spec">Expenses</th>
  <td>Understating expenses.</td>
  <td>Changing depreciation method; increasing useful life or salvage values.</td>
  <td>Analyze depreciation ratios; review footnotes to see if changes have been made to company's methodology.</td>

</tr>
<tr>
  <th scope="row" class="specalt">Expenses</th>
  <td class="alt">Improper capitalization of items that should be expensed (done to defer expenses).</td>
  <td class="alt">Peculiar growth in non-current assets.</td>
  <td class="alt">Compare growth of sales to growth of non-current assets.  If sales growth is low, but non-current asset growth is abnormally high, future performance may be poor.</td>
</tr>
<tr>
  <th scope="row" class="spec">Expenses</th>
  <td>Classifying operating expenses as non-recurring or non-operating.</td>
  <td>Growth in operating margin accompanied by a growth in non-recurring or non-operating items.</td>
  <td>Monitor company operating margin trends and trends in non-operating expenses.</td>
</tr>
<tr>
  <th scope="row" class="specalt">Liabilities</th>
  <td class="alt">Off balance sheet financing.</td>
  <td class="alt">Significant amount of operating leases.</td>
  <td class="alt">Monitor operating lease trends in financial statement footnotes and add operating leases to the company's reported balance sheet.</td>
</tr>
<tr>
  <th scope="row" class="spec">Goodwill</th>
  <td>Avoiding goodwill impairment.</td>
  <td>Maintaining a goodwill balance on the balance sheet when the stock's market capitalization exceeds the book value of equity.</td>
  <td>Monitor trends in goodwill, especially during periods of economic contraction (recession).</td>

</tr>
<tr>
  <th scope="row" class="specalt">Cash Flows</th>
  <td class="alt">Cash flow statement excludes non-cash investing and non-cash financing activities, as cash flow based aggregate accruals will exclude these items.</td>
  <td class="alt">Company regularly acquires assets with stock instead of cash purchasing.</td>
  <td class="alt">Study both the balance sheet method and cash flow method of aggregate accruals.</td>
</tr>
</table> 


Financial Reporting Problems and Warning Signs

Financial analysts commonly use financial ratios to evaluate the investment worthiness of a company’s equity or debt.  Ratio analysis is commonly done in comparison to other companies of similar industry.

When analyzing financial ratios, the analyst should consider the values in the context of the business cycle, trends, and industry or competitor standards.
<h2>5 Ratio Categories</h2>
<strong>Activity Ratios</strong>

Activity ratios measure the efficiency in which management runs the company.

Activity Ratio Examples: <a href="https://financetrain.com/receivables-turnover-and-days-of-sales-outstanding-dso/">Receivables turnover</a>, <a href="https://financetrain.com/inventory-turnover-and-days-of-inventory-on-hand-doh/">inventory turnover</a>, <a href="https://financetrain.com/payables-turnover-and-number-of-days-of-payables/">payables turnover</a>, <a href="https://financetrain.com/fixed-asset-and-total-asset-turnover-ratio/">fixed asset turnover, and total asset turnover</a>.

<strong>Liquidity Ratios</strong>

Measure the company’s capacity to meet its short-term financial commitments.

Liquidity Ratio Examples: quick ratio (also called acid test ratio), cash ratio, defensive interval ratio, and <a href="https://financetrain.com/cash-conversion-cycle-ccc/">cash conversion cycle</a>.

<strong>Solvency Ratios</strong>

Solvency ratios measure the company’s capacity to fulfill long-term financial commitments.

Solvency Ratio Examples: Debt to assets ratio (also called total debt ratio), debt to capital ratio, debt to equity ratio, financial leverage ratio, interest coverage ratio (also called times interest earned ratio), and fixed financial charge ratio.

<strong>Profitability Ratios</strong>

Measure the company’s management effectiveness in driving earnings from sales and/or assets.

Profitability Ratio Examples: gross margin, operating margin, pre-tax margin, net profit margin, operating return on assets, return on assets, return on total capital, return on equity.

ROE note: CFAI emphasizes that candidates understand the DuPont model for ROE, which provides insights into the different levers driving a firm’s profitability.
<ul>
	<li>DuPont Traditional ROE = (Net Inc. / Net Revenue) * (Net Revenue / Avg. Total Assets) * (Avg. Total Assets / Avg. Shareholders Equity)</li>
	<li>DuPont Extended ROE = (Net Inc. / Earnings Before Tax) * (EBT / EBIT) * (EBIT / Net Revenue) * (Net Revenue / Avg. Total Assets) * (Avg. Total Assets / Avg. Shareholders Equity)</li>
	<li>DuPont Extended ROE = tax burden * interest burden * EBIT margin * Asset Turnover * Financial Leverage.</li>
</ul>
<strong>Valuation Ratios</strong>

Valuation ratios associate stock price to a performance metric.

Valuation Ratio Examples: cash flow per share, EBITDA per share, dividend per share, price to earnings ratio, price to cash flow ratio, price to sales ratio, price to book value.

When looking at financial ratios, analysts should: apply their prior experience in evaluating firms and industries; consider the company’s publicly stated objectives; and determine industry norms, as the nuances of economic differences across industries can be reflected in their ratios.
<h2>Financial Ratio Uses</h2>
<ul>
	<li>Valuing a company’s stock.</li>
	<li>Determining a company’s systemic risk (beta risk) exposure.</li>
	<li>Creating a company’s credit rating.</li>
	<li>Predict a company’s likelihood of financial distress (i.e. bankruptcy).</li>
</ul>
<h2>Financial Ratio Analysis Limitations</h2>
While financial ratios can provide valuable insights to analysts, they cannot be considered all knowing.  Ratio analysis can be limited by:
<ul>
	<li>Application of different accounting methods by firms which are being compared.</li>
	<li>Multiple firm operations; when a company has multiple business units, it can be difficult to determine the appropriate industry norms for ratio analysis.</li>
	<li>Need to consider all ratio categories when analyzing a company, as one category of ratios may not tell the complete story.</li>
	<li>Analyst judgment; ultimately the analyst must decide what an appropriate ratio range is for a given firm or industry.</li>
</ul>
 

&nbsp;

Financial Statement Analysis - Ratio Analysis

<ul>
<li>At the core of financial analysis is the ability of an analyst to revise a company's reported financial statements in order to create a "true" economic picture of performance and financial positions.</li>
<li>In this article, we will look at:</li>
	<ul>
		<li>Balance Sheet: Common Analyst Adjustments </li>
		<li>Income Statement: Common Analyst Adjustments </li>
		<li>Statement of Cash Flows: Common Analyst Adjustments </li>
	</ul>
</ul>
<h2>Balance Sheet: Common Analyst Adjustments (not exhaustive)</h2>

<ul>
<li>Create an approximate fair market value of inventory by restating LIFO inventories to FIFO on the balance sheet.</li>
<li>When available data permits, restate the balance sheet's historic value of property, plant, and equipment to fair market value.</li>
<li>Attempt to estimate the value of a company's intangible assets.  Note that some analysts eliminate goodwill on the asset side of the balance sheet altogether and make the corresponding reduction to retained earnings in the equity segment of the balance sheet.</li>
<li>Revalue company liabilities to their fair market value by using current interest rates to determine the present value of future cash flows needed to service the liabilities.</li>
<li>Move off-balance sheet liabilities, such as operating leases, onto the balance sheet.</li>
</ul>

<h2>Income Statement: Common Analyst Adjustments (not exhaustive)</h2>

<ul>
	<li>Remove non-recurring items from current year evaluation, but incorporate them if evaluation of multi-year trends.</li>
	<li>Make the necessary adjustments to account for different accounting methodologies or estimates when comparing multiple firms.</li>
	<li>Adjust net income to include direct to equity gains and losses that are captured as part of other comprehensive income.</li>
	<li>Apply LIFO expensing method (if company does not already employ the LIFO method) for calculating cost of goods sold.</li>
</ul>

<h2>Statement of Cash Flows: Common Analyst Adjustments (not exhaustive)</h2>
<ul>
	<li>Isolate and remove cash flows from non-recurring items as these cash flows are not likely to be generated by the company in future periods.</li>
	<li>When looking at investing cash flows, separate capital expenditure cash flows from other investing cash flows.</li>
	<li>Transfer cash interest and dividend income received from operating cash inflows to investing cash inflows.</li>
	
</ul>

 

Adjusting a Company's Reported Financial Statements

Financial Reporting Part 3

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Financial Reporting Part 3

Lessons

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