Financial Reporting and Analysis

© EduPristine For [CFA-I – Financial Reporting and Analysis-] (Confidential)

 Mind Map
Financial Statements Framework

International Standards
FS Reporting Reporting Standards Reporting Quality
Convergence

© EduPristine For [CFA-I – Financial Reporting and Analysis-] (Confidential) 2

 Mind Map
Financial Statements Framework

International Standards
FS Reporting Reporting Standards Reporting Quality
Convergence

Balance sheet: Income Cash flow Management

Financial health of statement: statement: Cash Discussion &
The way
a firm in terms of Financial inflow & outflow for Footnotes: Analysis: Auditor's opinion:
companies depict
assets and performance in a period of time Disclosures to Assessment of Unqualified opinion
their financial
liabilities as on terms of Cash flow = provide detailed financial by auditor indicates
performance and
date. operational gains / operating + information like performance statements are free
health to investors
Owners' equity = losses over a investing + accounting discussion on from material
Assets - Liabilities period of time financing cash flow methods, industry trends, omissions & errors
assumptions, legal capital resources,
actions, general business
contingencies, overview
sales to related discussion on
parties accounting policies
requiring significant
judgments

3
© EduPristine For [CFA-I – Financial Reporting and Analysis-] (Confidential)
 Mind Map
Financial Statements Framework

International Standards
FS Reporting Reporting Standards Reporting Quality
Convergence

Principles for preparing FS:

▪ Substance over form: True nature of item instead of its legal form. Fair representation
▪ Going concern: Based on the assumption that firm will continue to exist
▪ Accrual basis: Transactions are recorded when they occur irrespective of cash flow
▪ Conservatism: Expenses immediately, gains on accrual basis. Consistency
▪ Materiality: Free of misstatements or omissions

IFRS framework US GAAP framework Regulatory Bodies

International Accounting Standard Board (IASB) goals: ▪ International Organisation of

▪ Global accounting standards with transparency, compatibility, & higher reporting quality Securities Commission (IOSCO)
▪ Promote the use of global accounting standards ▪ European Securities Committee (ESC)
▪ Convergence between national GAAP standards and global accounting standards ▪ Committee of European Securities
▪ Needs of emerging nations & small firms in implementation of global accounting standards Regulators (CESR)
Q: ▪ Securities and Exchange Commission
Which of the following is least likely to be true IFRS is a largely principle based approach with following characteristics: (SEC)
in case of a company which report its earnings ▪ Understandability: Easy to comprehend and
according to IFRS? ▪ Comparability: Comparable among firms and across time periods
CF Operations CF Financing ▪ Relevance: Sufficiently detailed & relevant information
A. Interest received ▪ Reliability: Should reflect economic reality
Interest paid
B. Dividends paid Interest paid Q:
C. Dividend received Which of the following characteristics least likely to contribute to the relevance?
Dividend paid A. Detailed footnotes
Ans: B. Qualified opinion by auditor
In case of IFRS dividend paid cannot be C. Annual report available on request
classified under cash flow from financing and Ans:
hence answer is B. Annual report available on request act as a barrier in information dissipation and hence does not contribute towards relevance.

© EduPristine For [CFA-I – Financial Reporting and Analysis-] (Confidential) 4

 Mind Map
Financial Statements Framework

International Standards
FS Reporting Reporting Standards Reporting Quality
Convergence

Principles for preparing FS:

▪ Substance over form: True nature of item instead of its legal form. Fair representation
▪ Going concern: Based on the assumption that firm will continue to exist
▪ Accrual basis: Transactions are recorded when they occur irrespective of cash flow
▪ Conservatism: Expenses immediately, gains on accrual basis. Consistency
▪ Materiality: Free of misstatements or omissions

IFRS framework US GAAP framework Regulatory Bodies

Financial Accounting Standards Board (FASB) has similar framework, but

its rule based approach and differ in some aspects:
▪ FASB defines assets as a future economic benefit, IASB defines it as a
resource for future economic benefit
▪ FASB does not allow upward revision of asset prices

Q:
Which of the following is least likely to be true in case of a company which
report its earnings according to US GAAP?
CF Operations CF Financing
A. Interest paid Dividends paid
B. Dividends received Interest paid
C. Interest received Dividend paid
Ans:
In case of US GAAP interest paid cannot be classified under Cash flow from
financing and hence answer is B.

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 Mind Map
Financial Statements Framework

International Standards
FS Reporting Reporting Standards Reporting Quality
Convergence

Relationship Low quality financial report exits Warning signs

▪ Attention to revenue: It may

▪ Opportunity: Result of internal
Financial reporting quality. Earning Quality. manipulate by recognition policies.
conditions.
High: Enables assessment. High: Company value increases. ▪ Attention to inventories: Must check
▪ Motivations: To meet certain
Low: Delays assessment. Low; Company value decreases. cost flow method and inventory turnover
reporting level.
ratios.
▪ Rationalization: Concerned about
Conservatism in standards ▪ Attention to capitalization policies:
choice.
Analyst must not for it’s long term assets
Impairment change under different standards capitalization policies including interest
Mechanisms cost and deferred cost.
▪ Attention on cash flows: Must be
IFRS: recoverable amount GAAP: sum of aware if net income is higher or lower
< carrying value undiscounted future cash ▪ Marketing regulatory
then CFO.
flows < carrying value authorities: Helps to minimize
▪ Other signs: Useful lives of assets and
the cost of capital and maximize
depreciation methods,.
the reporting quality.
Overachievement in fourth quarter,
▪ Auditors: It assures that
Related party transactions, Expenses
accounting standards and
classification as “non recurring”,
company information is relevant.
Gross/operating margins in comparison
▪ Private contracting: They
with industry or competitors.
monitor to ensure the reports are
of high quality.

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 Mind Map
Financial Statements Framework

International Standards
FS Reporting Reporting Standards Reporting Quality
Convergence

Qualitative Characteristics of Financial FSA Applications for potential debt

Reports: investment
▪ Relevance. ▪ Scale and Diversification
▪ Faithful presentation. ▪ Operational Efficiency
Characteristics that enhance faithful ▪ Margin Stability
presentation :. ▪ Leverage
▪ Compatibility.
▪ Verifiability.
▪ Timeliness. FSA Applications for potential
▪ Understandability. equity investment
▪ Price-Earnings Ratio
▪ Back-Testing
Conclusion

▪ Reporting quality should pertains high quality reporting. Analysts' adjustments for
▪ Earning quality should be cash, economic reality and financial comparison
condition basis of the company. ▪ Investment in securities
▪ Financial report can assess whether the accounting is ▪ Inventory accounting differences
conservative or aggressive. ▪ Differences in depreciation
▪ May motivated to issue low quality reports. methods and estimates
▪ Report should be transparent. ▪ Off-balance sheet financing
▪ Disclosure if presenting any non IFRS or non GAAP item.
▪ Management may stretch payables.
▪ Flexibility may lead to aggressive accounting.

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 Mind Map
Financial Statements Framework

International Standards
FS Reporting Reporting Standards Reporting Quality
Convergence

Convergence of IFRS & US GAAP is

ongoing process, but material
differences in their accounting standards
are listed below:
▪ LIFO method is allowed under US GAAP
but not allowed under IFRS
▪ IFRS allows upward revaluation of PP&E,
but US GAAP does not allow upward
revision
▪ US GAAP recommends equity method of
accounting for joint ventures, whereas
IFRS uses proportionate consolidation
▪ US GAAP doesn't permit upward
revaluation of intangible assets like
goodwill
▪ US GAAP allows capitalization of
construction interest, IFRS allows
capitalization of acquisition, construction
interest
▪ US GAAP – interest received & paid –
CFO
▪ IFRS flexible in terms of classification

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 Mind Map
Financial Statements Framework

Generally Accepted
Financial Statement
Accounting Principles Critical Ratios Inventory Accounting DuPont Analysis Basic & Diluted EPS
Impacts
(GAAP)

Unusual or Infrequent Extraordinary Items Compute Cash Flows

Revenue Recognition Discontinued Operations Free Cash Flow
Items (U.S. GAAP) From Operations (CFO)
▪ Gains/losses from disposal ▪ Similar to unusual/infrequent
Conditions necessary for Revenue
of a business segment. items, extraordinary items are
recognition as per IFRS:
▪ Gains/losses from sale of both unusual & infrequent in
▪ Risk and reward should be
assets or investments in occurrence, and material in
transferred
subsidiaries. nature (e.g., losses from
▪ The cost can be reliably measured
▪ Impairments, write-offs, expropriation of assets). IFRS
▪ There is a probable flow of
write-downs, & does not allow extraordinary
economic benefits
restructuring costs. items to be separated from
▪ Revenue can be reliably measured
▪ Integration expenses operating results.
▪ There is no continuing control or
associated with
management over goods sold
businesses recently
The conditions of Revenue
acquired.
recognition under US GAAP are
same
Exception to accrual method of Q:
revenue recognition in special cases: Contract to build a ship for $1,000 and a reliable estimate of the total cost
▪ Long term contracts is $800. Find Net Income using % of completion method?
• Revenue is booked in advance Ans:
as per Year 2010 2011 2012 Total
− Percentage of completion Cost $400 $300 $100 $800
method
− Completed contract method Year 2010 2011 2012 Total
• Revenue is booked with lag as Rev 500 375 125 1,000
per
− Installment method NI 100 75 25 200
− Cost of recovery method

© EduPristine For [CFA-I – Financial Reporting and Analysis-] (Confidential) 9

 Mind Map
Financial Statements Framework

Generally Accepted
Financial Statement
Accounting Principles Critical Ratios Inventory Accounting DuPont Analysis Basic & Diluted EPS
Impacts
(GAAP)

Unusual or Infrequent Extraordinary Items Compute Cash Flows

Revenue Recognition Discontinued Operations Free Cash Flow
Items (U.S. GAAP) From Operations (CFO)

▪ Interest and Dividend – ▪ Free cash flow (FCF) measures cash

▪ To be accounted for as a
USG GAAP IFRS discontinued operation, a business available for discretionary purposes.
assets, operations have been It is equal to operating cash flow less
Paid Received Paid Received decided to sell off by mgmt but not net capital expenditures.
yet disposed off. Income / losses are ▪ Free Cash Flow to Equity (FCFE) is
Interest CFO CFO Interest CFO CFO or reported net of tax after net income the cash available for distribution to
or CFI from continuing operations. shareholders
Dividend
Dividend CFF CFO CFF

▪ Taxes – ▪ Indirect Method- Start with net

• US GAAP: Taxes on all types of incomes is shown as an outflow from ▪ Direct Method- Start with cash income, subtracting back gains &
CFO. collections (cash equivalent of adding back losses resulting from
• IFRS: Taxes on different types of activities are shown under sales); cash inputs (cash financing or investment cash flows,
respective heads. equivalent of COGS); cash adding back all noncash charges,
▪ Passive Investment – operating expenses; cash interest and adding / subtracting asset &
• Trading securities: Under CFO; expense; cash taxes. liability a/c that result from
• Other than Trading securities: Under CFI. operations

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 Mind Map
Financial Statements Framework

Generally Accepted
Financial Statement
Accounting Principles Critical Ratios Inventory Accounting DuPont Analysis Basic & Diluted EPS
Impacts
(GAAP)

▪ Common-size balance sheet expresses all balance sheet items as a percentage of total assets.
▪ Common-size income statement expresses all income statement items as percentage of sales.
▪ Common-size cash flow statement expresses each cash inflow/outflow as a percentage of total cash
inflow/outflow, or as a percentage of revenue.
▪ Horizontal Common-size financial statement analysis: Expresses each line item relative to its value in a common
base period.

Receivable, Inventory, Total Asset,

Liquidity Profitability Solvency Interest & Performance
Payables Turnover Fixed Asset, & Working
Ratios Ratios Ratios Fixed Charge Coverage Ratios
Ratios Capital Turnover Ratios

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 Mind Map
Financial Statements Framework

Generally Accepted
Financial Statement
Accounting Principles Critical Ratios Inventory Accounting DuPont Analysis Basic & Diluted EPS
Impacts
(GAAP)

Receivable, Inventory, Total Asset,

Liquidity Profitability Solvency Interest & Performance
Payables Turnover Fixed Asset, & Working
Ratios Ratios Ratios Fixed Charge Coverage Ratios
Ratios Capital Turnover Ratios

Defensive Interval = (Cash + Q:

Current Ratio = Current Asset / Quick Ratio = (Current Asset – Cash Ratio = (Cash + Mktable Assuming current assets are
Mkt. Sec. + Receivables) / Daily
Current Liabilities (CL) Inventory) / CL Securities) / CL $160,000 and current liabilities
Cash Expenditures
are $40,000 the current ratio is?
Ans:
4

© EduPristine For [CFA-I – Financial Reporting and Analysis-] (Confidential) 12

 Mind Map
Financial Statements Framework

Generally Accepted
Financial Statement
Accounting Principles Critical Ratios Inventory Accounting DuPont Analysis Basic & Diluted EPS
Impacts
(GAAP)

Receivable, Inventory, Total Asset,

Liquidity Profitability Solvency Interest & Performance
Payables Turnover Fixed Asset, & Working
Ratios Ratios Ratios Fixed Charge Coverage Ratios
Ratios Capital Turnover Ratios

All of which are used in the cash conversion cycle

Receivables turnover = Net annual sales / avg. receivables Inventory turnover = Cost of goods sold / avg. Inventory

Payables turnover ratio = Purchases / avg. trade payables Days of sales outstanding = 365 / Receivables turnover

Days of inventory in hand = 365 / Inventory turnover No. of days of payables = 365 / Payables turnover

Cash conversion cycle = Days of inventory on hold + Day Q:

of sales outstanding – Days of payables If Neev, Inc. has annual sales of $1,000,000, average
accounts payable of $400,000, and average accounts
receivable of $350,000, Neev's receivables turnover and
average collection period are closest to
Ans:
2.85, 127.75

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 Mind Map
Financial Statements Framework

Generally Accepted
Financial Statement
Accounting Principles Critical Ratios Inventory Accounting DuPont Analysis Basic & Diluted EPS
Impacts
(GAAP)

Receivable, Inventory, Total Asset,

Liquidity Profitability Solvency Interest & Performance
Payables Turnover Fixed Asset, & Working
Ratios Ratios Ratios Fixed Charge Coverage Ratios
Ratios Capital Turnover Ratios

Total Asset Turnover = Revenue / Avg. Fixed Asset Turnover = Revenue / Working Capital Turnover = Revenue /
Total Net Asset Avg. Net Fixed Asset Avg. Working Capital

Q:
Find the Total Asset Turnover Ratio given:
Net Sales = $32,500
Net Assets (current year) = $11,400
Net Assets (previous year) = $9,800
Ans:
Average Net Assets = ($11,400 + $9,800) / 2
= $10,650
Total Asset Turnover ratio = 32,500 / 10,650
= 3.05

© EduPristine For [CFA-I – Financial Reporting and Analysis-] (Confidential) 14

 Mind Map
Financial Statements Framework

Generally Accepted
Financial Statement
Accounting Principles Critical Ratios Inventory Accounting DuPont Analysis Basic & Diluted EPS
Impacts
(GAAP)

Receivable, Inventory, Total Asset,

Liquidity Profitability Solvency Interest & Performance
Payables Turnover Fixed Asset, & Working
Ratios Ratios Ratios Fixed Charge Coverage Ratios
Ratios Capital Turnover Ratios

Gross, Operating & Net Profit Margins Return on Total Capital: (ROTC)

Operating Profit Margin Neev Corp. earned Return on Capital = EBIT/ Avg. Total Capital
Gross Profit Margin = = Operating Profit / $10mn in revenue from
Net Profit Margin = Net
Gross Profit / Revenue Revenue = EBIT / producing widgets and Q:
Income / Revenue
Revenue incurred Neev Corp. earned $20mn in revenue from
$5mn in COGS-related producing widgets and ABC's operating profit
expense. ABC's gross margin would be 30%.
profit margin would be For the financial year 2005 & 2006 total capital
50%. was $55mn & $75mn. Calculate the return on
capital of Neev Corp for the FY2006?
Ans:
ROC = (20 * 30%) / [(55 + 75)/2] = 9.23%

© EduPristine For [CFA-I – Financial Reporting and Analysis-] (Confidential) 15

 Mind Map
Financial Statements Framework

Generally Accepted
Financial Statement
Accounting Principles Critical Ratios Inventory Accounting DuPont Analysis Basic & Diluted EPS
Impacts
(GAAP)

Receivable, Inventory, Total Asset,

Liquidity Profitability Solvency Interest & Performance
Payables Turnover Fixed Asset, & Working
Ratios Ratios Ratios Fixed Charge Coverage Ratios
Ratios Capital Turnover Ratios

Total Debt Ratio = Total debt/ Total asset Debt to Equity Ratio = Total debt / Total equity

If a company has $10 in debt and $20 in

equity, it has a debt to equity ratio of 0.5
($10M/$20M)

© EduPristine For [CFA-I – Financial Reporting and Analysis-] (Confidential) 16

 Mind Map
Financial Statements Framework

Generally Accepted
Financial Statement
Accounting Principles Critical Ratios Inventory Accounting DuPont Analysis Basic & Diluted EPS
Impacts
(GAAP)

Receivable, Inventory, Total Asset,

Liquidity Profitability Solvency Interest & Performance
Payables Turnover Fixed Asset, & Working
Ratios Ratios Ratios Fixed Charge Coverage Ratios
Ratios Capital Turnover Ratios

Interest & Fixed Charge Coverage Growth Rate g = RR x ROE Retention Rate = 1 – Dividend Payout Ratio

Fixed Charge Coverage = (EBIT + Lease Year Company Company SPK

Interest Coverage = EBIT/ Interest
payments)/ (Interest + Lease payments) XYZ

Net Income 30,000,000 80,000,000

Q:
Neev Inc.'s income statement shows sales of No. of Stock Holders 3,000,000 5,000,000
$100,000, cost of goods sold of $40,000 pre-
interest operating expense of $30,000, and Net Income per Share $10.00 $16.00
interest expense of $10,000. Neev's interest
Dividend Declared $4.00 $6.00
coverage ratio is approx
Ans: Dividend Yield 40.00% 37.5%
3 times
RR 60% 62.5%

ROE 25% 35%

G 15.00% 21.88%

© EduPristine For [CFA-I – Financial Reporting and Analysis-] (Confidential) 17

 Mind Map
Financial Statements Framework

Generally Accepted
Financial Statement
Accounting Principles Critical Ratios Inventory Accounting DuPont Analysis Basic & Diluted EPS
Impacts
(GAAP)

Receivable, Inventory, Total Asset,

Liquidity Profitability Solvency Interest & Performance
Payables Turnover Fixed Asset, & Working
Ratios Ratios Ratios Fixed Charge Coverage Ratios
Ratios Capital Turnover Ratios

▪ Cash Flow to Revenue = CFO/ Net Revenue

▪ Cash Return on Assets = CFO / Average Total Assets
▪ Cash Return on Equity= CFO/ Average Total Equity
▪ Cash to Income Ratio = CFO / Operating Income
▪ Cash Flow per Share = (CFO – Preferred Dividends)/
weighted average number of common shares

© EduPristine For [CFA-I – Financial Reporting and Analysis-] (Confidential) 18

 Mind Map
Financial Statements Framework

Generally Accepted
Financial Statement
Accounting Principles Critical Ratios Inventory Accounting DuPont Analysis Basic & Diluted EPS
Impacts
(GAAP)

In periods of rising prices

& stable or increasing
inventory quantities

LIFO results in: FIFO results in:

▪ High COGS ▪ Lower COGS

▪ Lower taxes ▪ Higher taxes
▪ Lower net income (EBT & EAT) ▪ Higher net income (EBT & EAT)
▪ Lower inventory balances ▪ Higher inventory balances
▪ Lower working capital ▪ Higher working capital
▪ Higher inventory turnover ▪ Lower inventory turnover

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 Mind Map
Financial Statements Framework

Generally Accepted
Financial Statement
Accounting Principles Critical Ratios Inventory Accounting DuPont Analysis Basic & Diluted EPS
Impacts
(GAAP)

Extended DuPont equation:

DuPont equation:
Return on Equity = (Net Income/EBT) * (EBT/EBIT) *
Return on Equity = (Net Income/Sales) *
(EBIT/ Revenue) * (Revenue/ Avg. Total Asset) *
(Sales/Assets) * (Asset/Equity)
(Avg. Total Asset/ Avg. Equity)
You may also see ROE = (Net Profit Margin) *
ROE = Tax Burden * Interest Burden * EBIT Margin *
(Asset Turnover) * (Equity Multiplier)
Asset Turnover * Leverage

Q:
Q:
Firm has o/p profit margin of 10%; asset turnover of
Firm has net profit margin of 10%; asset turnover
1.5; a financial leverage of 1.2 times; tax rate of
of1.5; a financial leverage of 1.2 times
25%; and interest burden rate of 15%.
Ans:
Ans:
Return on equity = (10)(1.5)(1.2) = 18%
Return on equity = (75/25)*15%*10%*1.5*1.2 = 8.1%

© EduPristine For [CFA-I – Financial Reporting and Analysis-] (Confidential) 20

 Mind Map
Financial Statements Framework

Generally Accepted
Financial Statement
Accounting Principles Critical Ratios Inventory Accounting DuPont Analysis Basic & Diluted EPS
Impacts
(GAAP)

Basic EPS calculation does not consider effects of any dilutive securities:
Basic EPS = (Net income – Preferred dividends) / Wtd. Avg. No. of Common Shares
Outstanding

Diluted EPS = Available income for common shareholders / (Wtd. Avg. Common shares
plus potential common shares outstanding)

Therefore, diluted EPS = [(Net Income – PFD Div) + (Convertible preferred Dividends) +
(Convertible Debt Interest) * (1–t) ] / [Wtd. Avg. Sh's + Shares from conversion of conv.
pfd. shares + Shares from conversion of conv. debt + Shares issuable due to stock option]

Q:
Reported net income of $555,600 and 150,000 shares of common stock outstanding for
the entire year. 10,000 shares of 6%, $100par, preferred stock outstanding during 2006.
During 2005, issued 1000, $1,000 par, 9% of bonds for $1,000,000 (issued at par),
convertible to 100 shares of common stock. The tax rate is 40%. Compute the 2006 basic
and diluted EPS.
Ans:
Basic EPS = (555,600 – 60,000) / 150,000 = $3.31
Diluted EPS = (555,600 – 60,000 + 1,000 * 1,000 * 9% (1–0.4)) /
(150,000 + 100,000) = $2.20

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 Mind Map
Financial Statements Framework

Generally Accepted
Financial Statement
Accounting Principles Critical Ratios Inventory Accounting DuPont Analysis Basic & Diluted EPS
Impacts
(GAAP)

Capitalizing Marketable Screening

Depreciation Deferred Financing
vs. Pension Leases Security Equity
& Impairment Taxes Liabilities
Expensing Classifications Investments

© EduPristine For [CFA-I – Financial Reporting and Analysis-] (Confidential) 22

 Mind Map
Financial Statements Framework

Generally Accepted
Financial Statement
Accounting Principles Critical Ratios Inventory Accounting DuPont Analysis Basic & Diluted EPS
Impacts
(GAAP)

Capitalizing Marketable Screening

Depreciation Deferred Financing
vs. Pension Leases Security Equity
& Impairment Taxes Liabilities
Expensing Classifications Investments

Capitalizing: Depreciation Impairment

Lowers income
variability &
increases near-term Calculation: Straight line and SYD methods Calculation: Straight line and SYD methods
profits. Increase total subtract salvage value, the double-declining subtract salvage value, the double-declining
assets & equity. balance method does not. Assuming continued balance method does not. Assuming continued
Expensing: investment in new assets. Relative to a firm that investment in new assets. Relative to a firm that
Opposite effect. uses accelerated depreciation. A company that uses accelerated depreciation. A company that
uses straight line depreciation will have: uses straight line depreciation will have:
Lower: Depreciation expense, turnover ratios. Lower: Depreciation expense, turnover ratios.
Higher: Net income, assets, equity, ROA, ROE Higher: Net income, assets, equity, ROA, ROE
Same: Cash flows. Same: Cash flows.

Q:
Company purchased machine at $6,000. Residual value = $1,000 after 5 years.
Ans:
Double declining balance method is:
Year 1: (2/5) ($6,000) = $2,400
Year 2: (2/5) ($6,000 – $2,400) = $1,440
Year 3: (2/5) ($6,000 – $3,840) = $864
Year 4: $296,
Year 5: Depreciation expense is $0

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 Mind Map
Financial Statements Framework

Generally Accepted
Financial Statement
Accounting Principles Critical Ratios Inventory Accounting DuPont Analysis Basic & Diluted EPS
Impacts
(GAAP)

Capitalizing Marketable Screening

Depreciation Deferred Financing
vs. Pension Leases Security Equity
& Impairment Taxes Liabilities
Expensing Classifications Investments

▪ Created when taxable income (on tax return) differs

from pretax income (financial statement)
▪ Deferred tax liabilities (DTR) are created by the use of
accelerated depreciation methods for tax purposes
(resulting in lower taxable income) & straight line for
financial reporting (lower depreciation expense results
in higher net income)
▪ If DTL are not expected to reverse, treat it as equity
for analysis.

© EduPristine For [CFA-I – Financial Reporting and Analysis-] (Confidential) 24

 Mind Map
Financial Statements Framework

Generally Accepted
Financial Statement
Accounting Principles Critical Ratios Inventory Accounting DuPont Analysis Basic & Diluted EPS
Impacts
(GAAP)

Capitalizing Marketable Screening

Depreciation Deferred Financing
vs. Pension Leases Security Equity
& Impairment Taxes Liabilities
Expensing Classifications Investments

Premium bond: Coupon rate > market rate at

issuance.
Discount bond: Coupon rate < market rate at
issuance.
Interest expense equals book value at the beginning of
the year multiplied by the market rate of interest at the
time the bonds were issued.
For premium bonds, CFF is overstated & CFO is
understated relative to par bonds.

Q:
year, 10% coupon, FV $100,000 trading at $105,221
issued on 31 Dec 2002 when market rate = 6%.
Ans:
Annual interest payment = $100,000*10% = $10,000
interest expense in I/S = 105,221*6% = 6313.26
Amortized value of bond = $105,221 – (10,000 –
6313.26) = $101,534.3

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 Mind Map
Financial Statements Framework

Generally Accepted
Financial Statement
Accounting Principles Critical Ratios Inventory Accounting DuPont Analysis Basic & Diluted EPS
Impacts
(GAAP)

Capitalizing Marketable Screening

Depreciation Deferred Financing
vs. Pension Leases Security Equity
& Impairment Taxes Liabilities
Expensing Classifications Investments

Defined Contribution Plan Pension Expense under IFRS Pension Expense under US GAAP
▪ Company contributes on a defined amount
into the plan
▪ Defined amount = pension expense ▪ Employees' service cost
Defined Benefit Plan ▪ Employees' service cost ▪ Interest Expense accrued
▪ Company makes promises of future ▪ Net Interest Expense ▪ Expected Return on Planned Asset
benefits to be paid to its employees ▪ Re-measurements ▪ Past Service Costs
▪ Example: 80% of final salary to be paid ▪ Actuarial Gains and Losses
each year until death

© EduPristine For [CFA-I – Financial Reporting and Analysis-] (Confidential) 26

 Mind Map
Financial Statements Framework

Generally Accepted
Financial Statement
Accounting Principles Critical Ratios Inventory Accounting DuPont Analysis Basic & Diluted EPS
Impacts
(GAAP)

Capitalizing Marketable Screening

Depreciation Deferred Financing
vs. Pension Leases Security Equity
& Impairment Taxes Liabilities
Expensing Classifications Investments

Capital /Finance leases result in: Balance Sheet Income

▪ Higher: assets, liabilities, CFO, Statement
Debt / Equity. Held for ▪ Fair value ▪ Dividends,
▪ Lower: Net income (early trading interest
years), FCFF, current ratio,
▪ Realized G/L
working capital, asset turnover,
ROA, ROE. ▪ Unrealized G/L
▪ Same: Total cash flow. Available ▪ Fair value ▪ Realized G/L
▪ Compared to Operating Leases for sale ▪ Unrealized ▪ Interest,
G/L part of Dividends
comprehensiv
e income
under
shareholder's
equity
Held-to- ▪ Amortized ▪ Interest
maturity cost ▪ Realized G/L

© EduPristine For [CFA-I – Financial Reporting and Analysis-] (Confidential) 27

 Mind Map
Financial Statements Framework

Generally Accepted
Financial Statement
Accounting Principles Critical Ratios Inventory Accounting DuPont Analysis Basic & Diluted EPS
Impacts
(GAAP)

Capitalizing Marketable Screening

Depreciation Deferred Financing
vs. Pension Leases Security Equity
& Impairment Taxes Liabilities
Expensing Classifications Investments

Limitations of Back-testing:
▪ Survivorship Bias: No longer existing companies
would be excluded from the data sample. Upward Bias.
▪ Look-Ahead Bias: Some Errors are corrected in
Restatements. If corrected data is used in back-testing,
there is an information mis-match about what investors
knew and what is actually true.
▪ Data-Snooping Bias: Occurs when back-testing
results on a set of data is successful, but when applied
elsewhere does not give favorable results.

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