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 […]
Financial Reporting Part 3
Various Definitions of Earnings
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. Operating Income (OI) OI = Revenues – Cost of Goods Sold – Selling, General, & Admin Expenses – Other Operating […]
Total Comprehensive Income
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. Total Comprehensive Income = Net Income + / – Other Comprehensive Income OCI = Ending Shareholders’ Equity – Beginning Shareholders’ Equity – Net Income + Declared Dividends Reporting […]
Earnings and Cash Flows
This segment has focused on earnings; when reporting earnings management has certain discretion over the treatment of gains, losses, and expenses. Cash inflows and outflows can provide the analyst with a more objective view of the company’s economic reality. Analysts should compare trends in net income with trends in cash flow from operations and may […]
Derivatives Hedging and Financial Reporting
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: Exposure to changes in the value of assets and liabilities or a company commitment. This is also called a fair value hedge. The […]
Cash Basis Accounting vs. Accrual Basis Accounting
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 […]
Management Motivations for Financial Statement Manipulation
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. Capital Market Incentives: 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 […]
Measures of Earnings Quality
Conceptually, earnings quality refers to the accuracy of the income statement reported by a company in predicting future financial performance. 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. High quality […]
Analyzing Earnings Quality – the Accruals Ratio
A company’s accrual earnings has two components: cash earnings and aggregate accruals Accrual Basis Earnings = Cash Earnings + Aggregate Accruals Aggregate Accruals = Accrual Basis Earnings – Cash Earnings 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 […]
Financial Reporting Problems and Warning Signs
The table below summarizes some (i.e. not comprehensive) common financial reporting problems and the warning signs associated with those problems. FINANCIAL STATEMENT ITEM REPORTING PROBLEM WARNING SIGN ANALYTICAL TOOL Revenue Overstated revenue. Large increases in accounts receivable. Look for increases in days sales outstanding (DSO) as this may indicate questionable credit sales by the company. […]