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CFA Exam Level 1

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2016 Guided Notes

Introduction to FSA

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Guided Notes for CFA® Level 1 – 2016

Copyright © 2016 by GoStudy LLC.® All Rights Reserved. Published in 2016

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Contents
SS7 - Financial Statement Analysis................................................................................................................ 3
Reading 22 – Financial Statement Analysis: An Introduction ................................................................... 3
Accounting 101 – Assuptions and Cash vs. Accrual Accounting ........................................................... 4
The Main Accounting Statements ..................................................................................................... 4
Measuring Assets and Liabilities ....................................................................................................... 5
Income Statement......................................................................................................................... 6
Cash Flow Statement .................................................................................................................... 6
Supplemental Information ............................................................................................................ 6
Financial Audits ..................................................................................................................................... 8
Steps in Financial Analysis................................................................................................................. 9
Financial Reporting Mechanics – R24 ..................................................................................................... 10
Financial Statement Elements and Accounts ...................................................................................... 11
Asset Accounts ................................................................................................................................ 11
Liability Accounts ............................................................................................................................ 11
Owners’ Equity ................................................................................................................................ 12
Revenue Accounts........................................................................................................................... 12
Expense Accounts ........................................................................................................................... 12
The Expanded Accounting Equation ................................................................................................... 12
Going deeper on Accrual Accounting ............................................................................................. 13
Relationships between the financial statements................................................................................ 14
Financial Reporting Standards – R25 ...................................................................................................... 18
Standard Setting Bodies .................................................................................................................. 19
General Requirements and Concerns under IAS ............................................................................ 20
Comparing IFRS and GAAP .................................................................................................................. 21
Summary ..................................................................................................................................... 22

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SS7 - Financial Statement Analysis

So begins one of the largest, most heavily-weighted, and often most difficult sections for
Candidates. There is no getting around it. If you want to pass Level 1 and be successful at Level
2 you will need to spend considerable time learning the ins and outs of financial statements—
what they consist of, how to calculate various line items, how each statement links to the others,
and how they are used in evaluating a business. Get ready.

In terms of what follows, the first few readings are high level. We’ll cover what accounting is,
how it works, and the main components of the financial statements and how they link together.
From there we’ll spend a few chapters drilling down into the specifics of each statement. You
should be able to visualize the line items and sequencing of a balance sheet, income statement,
statement of cash flows, and owners’ equity as well as to trace how changes in one would affect
another.

Reading 22 – Financial Statement Analysis: An Introduction

This is a basic background section filled with vital information (especially if you have little-to-no
experience in accounting). We’ll start with some of the basics about what financial statements
are and the main accounting equation, and then introduce each of the main financial statements.
Pay particular attention to the types of information contained in the footnotes/management
commentary (MD&A) as well as other sources of information that can be brought in for
financial analysis.

Accounting is all about gathering together and reporting on the financial history of an
organization. This requires a continual process of “capturing financial data associated with
operational activities, organizing this data into a useful set of accounting records and issuing
periodic reports in compliance with accounting principles.”1
Within this, the act of financial reporting is how companies show their financial performance to
investors, creditors, the market, and other stakeholders. The objective of such reporting is to
provide useful information on changes in a firm’s performance and financial position in order to
help those potentially interested in “providing resources” to the company make informed
decisions.2 Generally firms are required to file their financial statements each year with the
relevant authority and to include each statement in the annual report shared with their
stakeholders.

Financial statement analysis (FSA) is the act of using financial reports and other information to
evaluate a company in order to make economic decisions related to that company such as
buying/selling equity or lending money.

Analysts do this by comparing a company’s past performance with its current financial position
in order to try and predict how well the firm will fare in the future.

There are two very important financial metrics that FSA helps assess:

1. Liquidity – Liquidity measures a company’s ability to meet its short term obligations
1
http://www.quantfusion.com/help/fs_overview
2
Providing resources includes buying/selling/holding equity and debt or providing/settling loans and other credit.
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2. Solvency – Solvency measures a company’s ability to meet its long term obligations (i.e
stay in business)

Accounting 101 – Assuptions and Cash vs. Accrual Accounting

There are two distinct accounting methods.

The cash-basis accounting method recognizes income and expenses as soon as they happen, i.e.
it is based on when cash is deposited in the bank and when payments are actually made.

Accrual accounting recognizes revenue in the period when it is earned, i.e. when the firm
provides a product or service to a customer regardless of when cash actually changes hands.
Expenses are also recorded when they are incurred not when they are actually paid.

Under accrual accounting the timing difference and method of recording revenues and expenses
can impact the comparability of financial statements across firms (more on this later). It also
leads to the need for accrual entries, which we will cover later.

On the exam assume that all questions refer to accrual accounting unless you are specifically
told a company is using a cash basis method.

In fact, of the three main assumptions regarding accounting and financial statement analysis two
of them assume the use of accrual accounting.

The three main assumptions are:

1. The company will continue to operate (going-concern assumption)

2. Revenues are reported as they are earned within the specified accounting period
3. Expenses should match generated revenues within the specified accounting period

You should also be aware that the act of preparing financial statements is always subject to
certain constraints. Namely:

 The value of information presented should be greater than the cost of presenting it
 Information not easily quantified such as brand, reputation, innovation are not explicitly
captured in a firm’s financial statements
 There is often a balance between timeliness and verifiability

The Main Accounting Statements

We can think of each major accounting statement as containing different pieces of a firm’s
overall health, with each individual element measuring either a firm’s financial position or its
financial performance.

The former is captured by the balance sheet, also known as the statement of financial position
(or condition). The balance sheet reports a firm’s financial position at a specific point in time. It
has three elements:

 Assets – The economic resources controlled by the firm, e.g. cash, inventory etc.
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 Liabilities – The current or estimated liabilities of the firm, i.e. the debt of the firm/the
amount owed to lenders and other creditors
 Owners equity – This is the net assets of a firm after subtracting its liabilities, i.e. the
residual. It is the assets that would be left after all the creditors are paid.

In other words, the balance sheet tells us how much money a company or institution has (assets),
how much it owes (liabilities), and what is left when you net the two together (owners’ equity).

This leads to the fundamental accounting equation:

𝑨𝒔𝒔𝒆𝒕𝒔 = 𝑳𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔 + 𝒐𝒘𝒏𝒆𝒓𝒔 𝒆𝒒𝒖𝒊𝒕𝒚

The equation can be rearranged to solve for any of the other variables. It may be most intuitive to
think of it as:

𝑶𝒘𝒏𝒆𝒓𝒔 𝑬𝒒𝒖𝒊𝒕𝒚 = 𝑨𝒔𝒔𝒆𝒕𝒔 − 𝑳𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔

or

𝑬=𝑨− 𝑳

You must know and remember this equation. It will be useful in countless FSA problems.

Note that any changes in equity except for shareholder transactions (issuing/buying back stock
and paying dividends) are reported in the statement of comprehensive income.

We report an element on the balance sheet if there is a probable future benefit (or cost) of that
item and if we can reliably estimate that value/cost.

Measuring Assets and Liabilities

There are a variety of ways to measure or report the value of an asset or liability which can yield
very different values. Again we’ll repeat discussing these in the later reading on the balance
sheet but the major ones included in the conceptual framework are:

 Historical Cost – The amount for which an asset was originally purchased or, for a
liability, the amount initially received in exchange for the obligation
 Current Cost – The amount for which an asset could be purchased today or for which a
liability could be settled
 Amortized Cost – The historical cost adjusted for depreciation, amortization, depletion,
or impairment
 Realizable Value – The amount at which assets could be sold or liabilities settled today.
This will generally be less than the current cost due to the need for immediate liquidity
 Present Value – The discounted future value of cash flows (for an asset) or the PV of
future net outflows required to settle a liability
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 Fair Value – Not specifically defined, but this is the value at which an asset or liability
could be exchanged in an “arm’s length transaction” between two neutral parties. Fair
value may be based on either market value or present value.

Income Statement
The income statement, also called the statement of operations or the profit and loss statement,
shows the financial performance of a firm over a period of time. In other words it tells us if the
firm made or lost money in the form of net income. It consists of revenues, expenses, and
gains/losses (G/L).

 Revenue – Inflows from the firm’s central operations, i.e. delivering goods or services
 Expenses – Outflows relating to the firm’s revenue producing activities, results in assets
↓, liabilities ↑
 Other income – Gains and losses arising from anything not related to the ordinary course
of business

Under IFRS the income statement and statement of comprehensive income can be combined.
Under GAAP the statement of comprehensive income can instead be reported in the statement
of shareholders’ equity which reports the amount and sources of change in equity investors’
investment in the firm over a period of time.

Cash Flow Statement

The cash flow statement reports a company’s cash receipts and payments. It links the firm’s net
income to cash inflows/outflows. Within the statement, cash flows are classified in one of three
buckets:

 Operating cash flows – CFs from transactions involving the normal day-to-day business
operations of the company
 Financing cash flows – CFs related to the issuance or retirement of debt and equity,
including dividends
 Investing cash flows – CFs related to the acquisition and sale of long-term assets
 CFs resulting from sale or acquisition of Plant, property, & equipment (PPE)
 CFs from a subsidiary or investments in other firms
 CFs from securities or investments

As we will see later, the exact classification of these cash flows depends in part on the type of
business a firm is engaged in. Interest received by a bank may be an operating cash flow whereas
interest received by a restaurant chain will be classified under either the financing or investing
umbrella.

Supplemental Information
An analyst should not just rely on the information in the financial statements. In order to fully
assess a company’s health he or she needs to understand the reporting choices and estimates used
by management. Specifically an analyst must gauge whether management’s assumptions and
choices around accruals and adjustments make the financial statements an accurate reflection of
a company’s true performance (and future prospects).
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Analysts also need to be vigilant for any deliberate attempts by management to manipulate
reporting of the firm’s financial performance, because after all:

Where to find supplemental information

This supplementary information is found in the footnotes of a firm’s financial statements. Here
management typically discloses:

 The basis of the presentation including the fiscal period covered & which entities are
included
 The accounting methods, assumptions, and estimates used
 Information on business acquisitions, divestitures, legal actions, contingencies and
commitments, significant customers, and employee benefit plan info
All of this information allows for a better assessment of the amount, timing, and uncertainty of
any reported values in the financial statements. For example this is where we would learn about
management’s choice of revenue recognition and assumptions around depreciation expense,
which is especially important when attempting to compare companies that prepare their financial
statements using GAAP and IFRS respectively.

The second source of vital information is found in management’s commentary, often called
management’s discussion and analysis (MD&A).

This is the section where management talks about the business’s strategic considerations, past
performance, & future outlook. It can also include discussion of significant trends or events that
might impact capital resources, liquidity, extra-ordinary items, and operations. Management may
also discuss any material accounting assumptions that required subjectivity.

In the U.S., under GAAP, mandated sections of the MD&A include:

 Impact of off-balance sheet obligations and contractual commitments

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 Discussion of inflation and changing prices if material to the business

 Accounting policies requiring significant judgement by management

IFRS is also beginning to provide more guidance on what should be discussed in management
commentary. These recommendations include:

 The general nature of the business

 Key objectives and strategies
 Operational results and discussion of critical performance measures
 Any significant resources, key risks, or vital business relationships

Be aware that the MD&A section is not audited (despite its importance).

Other sources of company information

There are other important sources of company-related information, some provided by the
company and some from outside sources.

 Interim reports – Semiannual or quarterly reports containing the four financial

statements. Unlike the annual reports these are not audited
 Proxy statements – Documents distributed to shareholders before they vote. Usually
contain information on management compensation, stock performance, and potential
conflicts of interest
 Corporate reports and press releases
 Economic & Industry Conditions – Industry coverage, government reports, and trade
journals
 Comparisons against competitors

Financial Audits
In order for a firm to have a coherent financial reporting framework their reporting must display
three key characteristics.

Their reports must be:

1. Transparent – Full disclosure & fair presentation reveal accurate picture of the firm
2. Comprehensive – Include all material transactions that have financial significance
3. Consistent – Similar transactions should be treated consistently across companies,
geographies, and time periods

While it is an analyst’s job to review these statements and look to uncover any discrepancies
their work can be greatly assisted by the work of auditors.

Audits are independent reviews of a firm’s financial statements conducted by public accountants.
They are overseen by a company’s Board of Directors and are required for publically listed
companies.
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Goals of an Audit
Audits seek to provide a sense of the fairness and a sense of the reliability of a firm’s financial
statements. They do this by assessing a firm’s accounting and internal control systems,
confirming its assets and liabilities, and determining whether there are any material errors in the
financial statements.

Components of a standard auditor opinion

 Verification of independent review by the auditor

 Assurance that generally accepted auditing standards were followed
 Auditor is satisfied that the financial statements were prepared with generally accepted
accounting standards and that the estimates are reasonable
 Under GAAP only: An opinion about the firm’s internal controls

Qualified Opinions
An auditor can issue several different types of opinions, ranked by the level of confidence they
have in a management’s presentation:

 An unqualified opinion – Also known as a clean opinion. States that financial

statements have been fairly presented in accordance with the applicable accounting
standards and are free from material omissions or errors.
 A qualified opinion – Can be issued if the statements contain any exceptions to using
applicable accounting standards. These exceptions will then be detailed in the audit
report.
 An adverse opinion – Issued if the auditor finds that the statements are not presented
fairly or deviate from applicable accounting standards.
 A disclaimer of opinion – Issued when the auditor cannot, for any reason, issue an
opinion on the statements
Auditors may also explain any potential issues related around material losses, the violation of the
ongoing concern assumption, or any litigation possibilities. Finally note that under GAAP an
auditor must also comment on the strength of a company’s internal controls.

Steps in Financial Analysis

You don’t need to memorize this, but it can provide helpful context.

1. State the objective & context – What questions do you want answered
2. Gather the data – Financial statements and other relevant data
3. Process the data – Adjust FS as needed, calculate ratios, prepare exhibits
4. Analyze & interpret the data – Use data to answer questions from #1
5. Report the conclusions and recommendations
6. Update the analysis
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Financial Reporting Mechanics – R24

This is the second high-level introductory reading around FSA. Here we lay out the basics of
accrual accounting and then expand on the accounting equation. Having a firm grasp of these
fundamentals is a prerequisite to diving deeper into the composition of individual financial
statements in the next chapters.

Accounting systems take the cash & accruals from all transactions and uses these to generate
financial reports and statements. There are 4 basic steps in the process (which we don’t expect to
be tested directly):

1. Create journal entries & adjusting entries – A general journal is a list of each
transaction, its amount, and the accounts affected listed in chronological order.

2. Build the general ledger – The general ledger shows the journal entries by the account
rather than chronological order.

3. Prepare the beginning and ending balances for each account (the initial trial
balance). Making any necessary adjustments to record accruals not yet accounted for in
an adjusted trial balance.

4. Prepare the financial statements based on the totals from the adjusted balances.

Accounting employs a system of double-entry booking. Double-entry booking means each

transaction has to be recorded in at least two accounts. That is, an increase in an asset account
must be balanced by a decrease in another asset account or an increase in either liabilities or
equity. Double-entry booking is necessary to keep our basic accounting equation A = L + E in
balance.

Here are a few examples of double-entry accounting:

Example 1: Purchase equipment for $50,000:

 PPE3 ↑ by $50k, cash ↓ $50k

Example 2: Buy $10k inventory and sell it for $14k:

 Purchase causes cash ↓10k, inventory ↑10k.
 Sale causes cash ↑14k, Inventory ↓10k, Assets ↑4k.
 Sale also causes sales account ↑14k, COGS ↑10k
 This 4k increase in assets would show up as ↑ in net income and flows through to
retained earnings and owner’s equity (ignoring taxes)

Don’t worry if those examples are still confusing. We’ll break down the flows within the
financial statements in much more detail in the coming chapters.

3
Property, Plant, and Equipment
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Financial Statement Elements and Accounts

Financial statement elements are the main classifications within financial reporting. There are
five main reporting elements within the financial systems. They consist of:

 Assets
o Noncurrent assets – Expected to benefit the company over the long term (> 1
year)
o Current assets – Expected to be used or converted to cash within 1 year
 Liabilities – Any claims on the company
 Owner’s equity – The residual claim by owners on a company’s assets
 Revenues – The inflows of economic resources
 Expenses – The outflows of economic resources

Within these elements, accounts are the narrower records where we actually record the specific
transactions. They could include things such as “inventory” or “accounts payable.” Contra
accounts are entries that offset some part of the value of another account. This could include
something like depreciation for assets recorded on the balance sheet at historical cost.

Let’s cover some of the accounts that fall under each FS element.

Asset Accounts
Assets are the firm’s economic resources. Again, Assets = Liabilities + owner’s equity.

Examples include:

 Cash and cash equivalents

 Accounts receivable
 Inventory
 Financial assets – marketable securities
 Prepaid expenses – Items that will be expenses on future income statements
 PPE – Property, plant, and equipment including a contra asset for accumulated
depreciation

Liability Accounts
Liabilities are all the claims creditors have on a company. Liabilities = Assets – owner’s equity.

Examples include:

 Accounts payable
 Financial liabilities – short term debt obligations
 Unearned revenue – Items that will show up in future as revenue on I.S.
 Income taxes payable – Taxes owed but not yet paid
 Long-term debt
 Deferred tax liabilities
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Owners’ Equity
Owner’s equity is the owners’ residual claim on a firm’s assets after all creditors have been paid
off. Owner’s equity = Assets – Liabilities.

Examples include:

 Capital – The par value of the stock

 Additional paid-in capital – Proceeds from common stock sale that exceed par value
 Retained earnings – Cumulative net income not distributed as dividends
 Other comprehensive income – Changes from foreign currency translation, pension
liability adjustments, unrealized G/L on investments

Revenue Accounts
Revenue is the inflow of economic resources. It consists of:

 Sales – Revenue from day-to-day operations

 Gains – Increases in assets from firm’s day-to-day operations
 Investment income – Interest and dividend income

Expense Accounts
Expenses are outflows of economic resources. They consist of:

 Cost of goods sold (COGS)

 Selling, General, and administrative expenses (SGA) – Firm’s overhead
 Depreciation and Amortization
 Tax expenses
 Interest expenses
 Losses – Decrease in assets from firm’s day-to-day operations

The Expanded Accounting Equation

As we’ve touched on several times already, the basic accounting equation is an extremely
important condition.

The equation is:

𝑨𝒔𝒔𝒆𝒕𝒔 = 𝑳𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔 + 𝒐𝒘𝒏𝒆𝒓𝒔′ 𝒆𝒒𝒖𝒊𝒕𝒚

This is often just written as A = L + E. To help remember it think of drinking ALE 

We can also expand the equation by further breaking down the components of owners’ equity:

𝑂𝑤𝑛𝑒𝑟𝑠 ′ 𝑒𝑞𝑢𝑖𝑡𝑦 = 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑐𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑒𝑑 𝑏𝑦 𝑜𝑤𝑛𝑒𝑟𝑠 + 𝑐𝑢𝑚𝑢𝑙𝑎𝑡𝑖𝑣𝑒 𝑟𝑒𝑡𝑎𝑖𝑛𝑒𝑑 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠

Plugging that in to our basic accounting equation we get:

𝑨𝒔𝒔𝒆𝒕𝒔 = 𝑳𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔 + 𝒄𝒐𝒏𝒕𝒓𝒊𝒃𝒖𝒕𝒆𝒅 𝒄𝒂𝒑𝒊𝒕𝒂𝒍 + 𝒆𝒏𝒅𝒊𝒏𝒈 𝒓𝒆𝒕𝒂𝒊𝒏𝒆𝒅 𝒆𝒂𝒓𝒏𝒊𝒏𝒈𝒔

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Breaking down retained earnings into the amount at the beginning of the period plus revenue
minus expenditures we get:

𝐴𝑠𝑠𝑒𝑡𝑠 = 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑒𝑠 + 𝑐𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑒𝑑 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 + 𝑏𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑝𝑒𝑟𝑖𝑜𝑑 𝑟𝑒𝑡𝑎𝑖𝑛𝑒𝑑 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠

+ 𝑟𝑒𝑣𝑒𝑛𝑢𝑒 − 𝑒𝑥𝑝𝑒𝑛𝑠𝑒𝑠 − 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠

Going deeper on Accrual Accounting

Recall that accrual accounting requires that a firm records revenue when it is earned and
expenses when they are incurred REGARDLESS of whether cash has actually been moved. That
is, accrual accounting works on the basis of the matching principle, where all revenues and
expenses must be matched to the accounting period in which the revenue or expenses relates.

This requires an accounting entry when the event occurs and an offsetting entry when cash
moves and the exchange is completed.

The 4 major categories of accruals:

 Unearned/deferred revenue – This occurs when a firm receives cash before it delivers
the good or service. Because the firm still has to provide the good we recognize unearned
revenue as a liability while increasing cash. Once the firm provides the good or service
this changes to earned revenue.

 Accrued/unbilled revenue – This occurs when a firm provides a good or service before
receiving cash from the customer. Because the company is owed money we recognize
accrued revenue as an asset. On the income statement we increase revenue and accounts
receivable. Once customer pays accounts receivable will decrease.

 Prepaid expenses – This is where a firm pays cash ahead of anticipated expenses. Any
prepaid expenses are recorded as an asset. This decreases cash (asset) and increases
prepaid expenses (also an asset). Most common when manufacturers sell a good to a
retailer but don’t get paid until retailer sells it.

 Accrued expenses – This happens when a firm owes cash for a previously incurred
expense. Because the firm still owes this amount it is recognized as a liability. This
increases expenses and accrued expenses, both of which will decrease when the firm pays
cash. This is common with wages.

As you can see, with unearned revenue & prepaid expenses cash changes hands first and
revenue/expenses are recorded later. With accrued revenue & accrued expenses, however, the
revenue/expense is recorded first and the cash is recorded later.

All of these create potential timing differences between accrual accounting and cash-basis
accounting.4

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In addition to accrual accounting, we may also have to account for different asset costs.

For example, while most assets are recorded on the balance sheet at historical cost, the value of
certain assets is required to be reported at fair market value.

Any accounting entry to update this is called a valuation adjustment. When we make a valuation
adjustment on the balance sheet we need to adjust the owner’s equity via G/L on the income
statement or in other comprehensive income in order to maintain the equality of our accounting
equation (A = L+E).

Relationships between the financial statements

You should look this over now. Then, read each of the sections on the individual statements and
come back and revisit this section. It is that important. You must be able to link statements and
trace a change in one statement through to the relevant line item change on another is a vital
skill that will be extensively tested on the exam.

The balance sheet, or statement of financial position summarizes the company’s financial
position at the end of a current accounting period by listing its assets and liabilities.
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The other major elements—the income statement, statement of cash flows, and owners’ equity—
all show changes that happened throughout the most recent accounting period.

The income statement shows the revenues and expenditures of a firm over a specific period of
time (which is why it used to be called the profit and loss account). At the bottom of the income
statement we get net income which is added (or subtracted) on the balance sheet.
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The statement of cash flows is the most explicit document showing the sources and utilization
of a firm’s cash. Think of it as a statement which adjusts net income for any non-cash expenses
and changes to net working capital. The statement of cash flows will also show the cash coming
in or going out from financing and investing activities.

Finally the statement of owner’s equity will show any changes in the company’s equity over
the accounting period. It will include any transactions with shareholders such as issuing new
shares, paying dividends as well as any changes in equity value resulting from the changes in a
company’s comprehensive income (from net income, revaluation of assets etc.)

Now let’s link these statements together.

1. First, the income statement will show net income for a period.
2. Net income, the last line item on the income statement, will flow through to the cash flow
statement as CF from operating activities
3. Net income less dividends will also flow directly through to retained owner’s equity.5

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4. The Cash Flow statement takes net income and makes any adjustments to non-cash
charges and then adds in CF from investing and financing activities which do not show
up on the income statement
5. Finally, the ending cash balance will flow through as an asset (cash) on the balance sheet.

It may also be helpful to think of two balance sheets, one from last year and one from this current
year being linked by the activities captured in the income statement, statement of cash flows, and
statement of retained earnings.6

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In other words, the income/revenue we generate in the income statement is done by using the
assets in the balance sheet which we can then issue to shareholders or reinvest in the business
(asset accumulation) in order to generate more future earnings. Here’s one more view of how it’s
all linked:

Financial Reporting Standards – R25

Before diving deeper into the mechanics of how we build a balance sheet let’s take a quick break
and come up for air and summarize the point of all of this.

First, financial statements are critical to understanding a company’s position. Without

understanding a firm’s finances (and how it got there) investing becomes much riskier.

Second, because analysts spend so much time within the financial statements it’s important to
step outside them to understand that preparing these statements doesn’t just happen in a
vacuum—they are impacted by countless assumptions and decisions.

Finally, because financial statements are (1) incredibly importance and simultaneously (2) rely
on management’s integrity and ability to make sensible assumptions the industry has created a
set of common accounting rules and standards that are then enforced by various reporting
authorities (see IFRS and GAAP). It’s this last point that Reading 25 tackles.

Why have Reporting Standards?

Reporting standards help provide consistency when evaluating the broad range and complexities
of a firm’s transactions as well as the assumptions that go into presenting their financial
performance. The fact that they help standardize reporting across companies also means that
reporting standards let us more easily compare different firms to one another.
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Basically, reporting standards exist to make sure that the financial information we actually see is
useful. In this context useful means the information has:

 Relevance – Information should have predictive value, confirmatory value, or both

 Faithful representation – Information should be complete, free of bias, & free of errors

The four qualities that enhance relevance and faithful representation are:

1. Comparability – Across firms and across time

2. Verifiability – Independent observers using the same methods should obtain similar
results
3. Timeliness – Info available while it still has importance to decision-making
4. Understandability – Analysts with basic accounting training should be able to readily
understand presented information while useful information should not be omitted because
it is complicated

This is inline with the main objectives of financial market regulation as well. These are to:

a. Protect investors
b. Ensure fairness, accuracy, and transparency of markets
c. Reduce systemic risk

Standard Setting Bodies

The differences between accounting standards between GAAP and IFRS is as frustrating to most
Candidates as it is guaranteed to be tested. Understand that most test questions will focus on (1)
how the reporting standards are different from one another and (2) what those differences mean
for how you need to adjust the financial statements between firms reporting under IFRS and
GAAP.

Consider this section a summary, but rest assured that throughout the rest of the FSA readings
we will be explicit in highlighting the differences and how they might be tested.

Anytime there are standards there needs to be organizations to enforce them. Standard setting
bodies are private sector organizations that help establish financial reporting standards. An
effective standard-setting organization has the following characteristics. They:

 Adhere to high professional standards

 Have adequate authority, resources, and competency to achieve mission
 Use clear and consistent processes to set standards
 Are guided by a well-articulated framework
 Operate independently but are willing to accept guidance from stakeholders
 Make decisions in the public interest so that the standards will be adopted by the
regulatory authorities
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Globally, the two main standard-setting bodies are:

- The Financial Accounting Standards Board (FASB)

- Within the USA, FASB sets forth the set of rules that form GAAP, or the Generally
Accepted Accounting Principles

- International Accounting Standards Board (IASB)

- Outside the USA, IASB sets forth IFRS – the International Financial Reporting
Standards

Regulatory authorities on the other hand, are the government agencies that legally enforce
compliance with the standards set by the standard setting bodies. If needed, a regulatory
authority can overrule the standard setting bodies. In the U.S. this main regulatory authority is
the SEC and in the U.K. it is the FSA.

Convergence and the Barriers to Convergence

It’s important to understand that there is an increasing trend towards convergence between
GAAP and IFRS. In fact, this movement has evolved to the point where the SEC no longer
requires firm’s using IFRS to reconcile their statements. However the integration is far from
complete, and this is a result of two main factors.

First, the different standard-setting bodies and regulatory agencies often disagree on the best
treatment method for a given issue (due to institutional, regulatory, economic, or cultural
differences). Second, political pressure from businesses and lobbyists that would be affected by
changes in stnadards can impact or slow down the process.

General Requirements and Concerns under IAS

The International Accounting Standards (IAS) under IFRS, have requirements about which
financial statements need to be included and how they must be presented. The five required
financial statements are the:

 Balance sheet
 Statement of comprehensive income
 Cash flow statement
 Statement of changes in owner’s equity
 Explanatory notes (footnotes), including summary of accounting policies

As we mentioned previously a firm’s financial reporting framework needs to be:

1. Transparent – Full disclosure & fair presentation reveal accurate picture of the firm
2. Comprehensive – Include all material transactions that have financial significance
3. Consistent – Similar transactions should be treated consistently across companies,
geographies, and time periods
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Barriers to Creating a Single Financial Statement Framework

But achieving transparent, comprehensive, and consistent financial statements is easier said than
done. In addition to the cost of preparing these statements and the difficulty of capturing
intangible aspects of a business such as the value of a company’s reputation or brand there are
also numerous tradeoffs and measurement questions involved in the construction of each
statement. Namely a company has to deal with tradeoffs around:

1. Valuation – Tradeoff between using a more relevant measurement basis (like fair value)
which may require significant judgement versus a less relevant basis like historical cost
which is easier to establish
2. Standard-setting – Is it more “principals based” like IFRS or “rules-based” like GAAP?
Convergence is moving towards an “objective-based” approach that combines the two
3. Measurement – Tradeoff between emphasizing a balance sheet assessment (looking at
assets/liabilities at a single point in time) versus an income statement approach that looks
more at changes in values between periods. The Balance sheet approach is an
asset/liability approach whereas the income statement approach is a revenue/expense
approach that tracks changes in the value of an element over a period of time. There is
now a preference for the balance sheet approach.

In order to address some of these concerns the standard setting bodies have established a set of
general features required when preparing financial statements.

The general features/requirements of preparing financial statements under IAS are:

 Fair presentation – Transactions must be faithful representations of value and

transactions in compliance with the relevant standards
 Going-concern basis – Statements should be prepared as if the firm will continue unless
liquidation is the specific concern
 Accrual basis – Other than the cash flow statement all statements should use the accrual
method
 Materiality – Statements should be free from omissions and misrepresentations
 Aggregation – Similar items should be grouped & dissimilar items separated to facilitate
interpretation
 No offsetting - Assets may not be offset against liabilities or income against expenses
unless specifically permitted by a standard
 Frequency – Reporting should occur at least annually
 Comparative information for past periods must be included
 Consistent – Items should be grouped and classified in the same manner every period

Comparing IFRS and GAAP

We will continue to articulate the specific differences between IFRS and GAAP as we dive
deeper into each financial statement, however, this is a good introduction to some key testable
differences.

There are a few key differences between IFRS and GAAP including in the way they classify and
display various financial metrics within the statements. You should know these cold, although
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rest assured the nuances and impacts of each are unpacked in much greater detail in the next
few chapters.

In general the IFRS follows a principles-based approach whereas GAAP is usually more of a
rules-based approach. Greater convergence has seen GAAP move towards more of an objectives
approach however.

IASB standards (Responsible for IFRS)

 Income & Expenses are related to performance
 Defines an asset as a resource from which future economic benefits expected to flow
 More emphasis on going-concern assumption
 Emphasizes comparability and understandability in addition to relevance and reliability

FASB standards (Responsible for GAAP)

 In addition to the IFRS elements listed above, GAAP also includes revenues, expenses, and
gains and losses in comprehensive income
 Defines an asset as its future economic benefit rather than a resource
 Does not allow upward valuation of assets unless they are required to be reported at fair
value
 Less emphasis on going-concern assumption
 Emphasizes relevance and reliability
 Deemphasizes the ‘probable” portion of revenue recognition compared to IFRS

When all is said and done the importance and complexity of financial statement analysis means
analysts should keep a close eye on new developments in reporting standards. Specifically
analysts should track:

 Company disclosures in the footnotes and MD&A section

 Actions of the standard-setting bodies
 New products and transactions in capital markets

Summary
In the first three introductory readings we introduced why we look at financial statements, what
elements they include, how different standards evolved, and even spent some time diving into the
links between the major statements themselves. All of this is testable, and more importantly, is
woven into the next set of readings.

We turn now to constructing and linking the various financial statements so we can (1)
understand the financial position of a firm and (2) make any necessary adjustments to the
statements to compare firms using different methods or assumptions.
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