CONTENTS

How to Use the CFA Program Curriculum   xi

CFA Institute Learning Ecosystem (LES)   xi
Designing Your Personal Study Program   xi
Errata   xii
Other Feedback   xii

Financial Statement Analysis

Learning Module 1 Introduction to Financial Statement Analysis   3

Introduction   4
Financial Statement Analysis Framework   5
Articulate the Purpose and Context of the Analysis   6
Collect Data   7
Process Data   7
Analyze/Interpret the Data   8
Develop and Communicate Conclusions and Recommendations   8
Follow-Up   9
Scope of Financial Statement Analysis   9
Regulated Sources of Information   13
International Organization of Securities Commissions   13
US Securities and Exchange Commission   14
Capital Markets Regulation in Europe   17
Financial Notes and Supplementary Schedules   18
Business and Geographic Segment Reporting   19
Management Commentary or Management’s Discussion and Analysis   21
Auditor's Reports   22
Comparison of IFRS with Alternative Financial Reporting Systems   27
Monitoring Developments in Financial Reporting Standards   28
New Products or Types of Transactions   28
Evolving Standards and the Role of CFA Institute   28
Other Sources of Information   30
Practice Problems   32
Solutions   35

Learning Module 2 Analyzing Income Statements   37

Introduction   38
Revenue Recognition   39
General Principles   39
Accounting Standards for Revenue Recognition   40
Expense Recognition   45
General Principles   45
Capitalization versus Expensing   47
Capitalization of Interest Costs   55
Capitalization of Internal Development Costs   58
iv Contents

Implications for Financial Analysts: Expense Recognition   62

Non-Recurring Items   63
Unusual or Infrequent Items   63
Discontinued Operations   65
Changes in Accounting Policy   65
Changes in Scope and Exchange Rates   68
Earnings per Share   69
Simple versus Complex Capital Structure   69
Basic EPS   70
Diluted EPS: The If-Converted Method   72
Diluted EPS When a Company Has Convertible Preferred Stock
Outstanding   72
Diluted EPS When a Company Has Convertible Debt Outstanding   73
Diluted EPS: The Treasury Stock Method   74
Other Issues with Diluted EPS and Changes in EPS   77
Changes in EPS   78
Income Statement Ratios and Common-Size Analysis   78
Common-Size Analysis of the Income Statement   78
Income Statement Ratios   81
Practice Problems   84
Solutions   88

Learning Module 3 Analyzing Balance Sheets   91

Introduction   91
Intangible Assets   92
Identifiable Intangibles   93
Goodwill   97
Financial Instruments   99
Non-Current Liabilities   104
Long-Term Financial Liabilities   105
Deferred Tax Liabilities   106
Ratios and Common-Size Analysis   106
Common-Size Analysis of the Balance Sheet   107
Some interesting general observations can be made from these data:   109
Balance Sheet Ratios   114
Practice Problems   117
Solutions   120

Learning Module 4 Analyzing Statements of Cash Flows I   123

Introduction   124
Linkages between the Financial Statements   125
Primary Financial Statements   125
Relationship between Financial Statements   125
Linkages Between Current Assets and Current Liabilities   127
The Direct Method for Cash Flows from Operating Activities   131
Operating Activities: Direct Method   132
The Indirect Method for Cash Flows from Operating Activities   137
Operating Activities: Indirect Method   138
Contents v

Conversion from the Indirect to Direct Method   140

Method to Convert Cash Flow from Indirect to Direct   140
Cash Flows from Investing Activities   141
Cash Flows from Investing Activities   142
Cash Flows from Financing Activities   144
Cash Flow from Financing activities: Long-Term Debt and Common
Stock   145
Computing Dividends Paid   145
Differences in Cash Flow Statements Prepared under US GAAP versus IFRS   146
Practice Problems   149
Solutions   153

Learning Module 5 Analyzing Statements of Cash Flows II   155

Introduction   155
Evaluating Sources and Uses of Cash   156
Ratios and Common-Size Analysis   160
Free Cash Flow Measures   166
Cash Flow Statement Analysis: Cash Flow Ratios   168
Practice Problems   171
Solutions   172

Learning Module 6 Analysis of Inventories   173

Introduction   173
Inventory Valuation   174
The Effects of Inflation and Deflation on Inventories, Costs of Sales, and
Gross Margin   181
Presentation and Disclosure   184
Presentation and Disclosure   184
Inventory Ratios   185
Practice Problems   192
Solutions   205

Learning Module 7 Analysis of Long-Term Assets   211

Introduction   211
Acquisition of Intangible Assets   212
Intangible Assets Purchased in Situations Other Than Business
Combinations   213
Intangible Assets Developed Internally   213
Intangible Assets Acquired in a Business Combination   215
Impairment and Derecognition of Assets   217
Impairment of Property, Plant, and Equipment   217
Impairment of Intangible Assets with a Finite Life   219
Impairment of Intangibles with Indefinite Lives   219
Impairment of Long-Lived Assets Held for Sale   219
Reversals of Impairments of Long-Lived Assets   220
Derecognition   220
Presentation and Disclosure   222
Using Disclosures in Analysis   229
vi Contents

Practice Problems   233

Solutions   241

Learning Module 8 Topics in Long-Term Liabilities and Equity   245

Introduction   245
Leases   247
Requirements for Lease Accounting   247
Examples of Leases   247
Advantages of Leasing   248
Lease Classification as Finance or Operating   248
Financial Reporting of Leases   250
Lessee Accounting—IFRS   250
Lessee Accounting—US GAAP   252
Lessor Accounting   254
Financial Reporting for Postemployment and Share-Based Compensation
Plans   256
Employee Compensation   256
Deferred Compensation   257
Defined-Benefit Pension Plans   257
Accounting for Defined-Benefit Plans under IFRS   258
Accounting for Defined-Benefit Plan under US GAAP   258
Pension-Related Disclosures   259
Share-Based Compensation   260
Stock Grants   263
Stock Options   263
Accounting for Stock Options   265
Other Types of Share-Based Compensation   266
Presentation and Disclosure   267
Presentation and Disclosure of Leases   267
Lessee Disclosure   267
Lessor Disclosure   269
Presentation and Disclosure of Postemployment Plans   270
Presentation and Disclosure of Share-Based Compensation   273
Practice Problems   276
Solutions   279

Learning Module 9 Analysis of Income Taxes   281

Introduction   282
Differences between Accounting Profit and Taxable Income   283
Taxable Temporary Differences   284
Deductible Temporary Differences   284
Taxable and Deductible Temporary Differences   284
Permanent Differences   286
Tax Expense   287
Deferred Tax Assets and Liabilities   287
Realizability of Deferred Tax Assets   288
Corporate Income Tax Rates   294
Presentation and Disclosure   301
Contents vii

Practice Problems   311

Solutions   314

Learning Module 10 Financial Reporting Quality   317

Introduction   318
Conceptual Overview   319
Conceptual Overview   320
GAAP, Decision Useful Financial Reporting   321
GAAP, Decision-Useful, but Sustainable?   322
Biased Accounting Choices   323
Within GAAP, but “Earnings Management”   331
Departures from GAAP   332
Differentiate between Conservative and Aggressive Accounting   333
Conservatism in Accounting Standards   334
Bias in the Application of Accounting Standards   336
Context for Assessing Financial Reporting Quality   337
Motivations   337
Conditions Conducive to Issuing Low-Quality Financial Reports   338
Mechanisms That Discipline Financial Reporting Quality   339
Market Regulatory Authorities   339
Auditors   341
Private Contracting   345
Detection of Financial Reporting Quality Issues: Introduction and
Presentation Choices   346
Presentation Choices   347
Accounting Choices and Estimates   353
How Accounting Choices and Estimates Affect Earnings and Balance
Sheets   354
Accounting Choices That Affect the Cash Flow Statement   365
Accounting Choices that Affect Financial Reporting   368
Warning Signs   372
Pay Attention to Revenue   372
Pay Attention to Signals from Inventories   373
Pay Attention to Capitalization Policies and Deferred Costs   374
Pay Attention to the Relationship between Cash Flow and Net
Income   374
Look for Other Potential Warnings Signs   374
References   378
Practice Problems   379
Solutions   383

Learning Module 11 Financial Analysis Techniques   387

Introduction   388
The Financial Analysis Process   389
The Objectives of the Financial Analysis Process   390
Distinguishing between Computations and Analysis   391
Analytical Tools and Techniques   393
Financial Ratio Analysis   396
viii Contents

The Universe of Ratios   397

Value, Purposes, and Limitations of Ratio Analysis   399
Sources of Ratios   400
Common Size Balance Sheets and Income Statements    401
Common-Size Analysis of the Income Statement   402
Cross-Sectional, Trend Analysis, and Relationships in Financial Statements   403
Trend Analysis   404
Relationships Among Financial Statements   406
The Use of Graphs and Regression Analysis   407
Regression Analysis   409
Common Ratio Categories, Interpretation, and Context   409
Interpretation and Context   410
Activity Ratios   411
Calculation of Activity Ratios   411
Interpretation of Activity Ratios   413
Liquidity Ratios   417
Calculation of Liquidity Ratios   418
Interpretation of Liquidity Ratios   418
Solvency Ratios   422
Calculation of Solvency Ratios   422
Interpretation of Solvency Ratios   423
Profitability Ratios   426
Calculation of Profitability Ratios   426
Interpretation of Profitability Ratios   427
Integrated Financial Ratio Analysis   430
The Overall Ratio Picture: Examples   430
DuPont Analysis—The Decomposition of ROE   432
Industry-Specific Financial Ratios   438
Model Building and Forecasting   439
References   441
Practice Problems   442
Solutions   449

Learning Module 12 Introduction to Financial Statement Modeling   453

Introduction   454
Building a Financial Statement Model   455
Company Overview   455
Revenue Forecast   457
COGS   458
SG&A Expenses and Other Operating Expenses   458
Operating Profit by Segment   459
Non-Operating Items   460
Corporate Income Tax Forecast   461
Shares Outstanding   461
Pro Forma Income Statement   462
Pro Forma Statement of Cash Flows   464
Capital Investments and Depreciation Forecasts   464
Working Capital Forecasts   465
Contents ix

Forecasted Cash Flow Statement   466

Forecasted Balance Sheet   467
Valuation Model Inputs   467
Behavioral Finance and Analyst Forecasts   468
Overconfidence in Forecasting   468
Illusion of Control   469
Conservatism Bias   470
Representativeness Bias   472
Confirmation Bias   473
The Impact of Competitive Factors in Prices and Costs   474
Cognac Industry Overview   474
Modeling Inflation and Deflation   484
Sales Projections with Inflation and Deflation   484
Cost Projections with Inflation and Deflation   489
The Forecast Horizon and Long-Term Forecasting   492
Case Study: Estimating Normalized Revenue   493
References   498
Practice Problems   499
Solutions   506

Glossary   G-1
 xi

How to Use the CFA

Program Curriculum
The CFA® Program exams measure your mastery of the core knowledge, skills, and
abilities required to succeed as an investment professional. These core competencies
are the basis for the Candidate Body of Knowledge (CBOK™). The CBOK consists of
four components:
A broad outline that lists the major CFA Program topic areas (www​
.cfainstitute​.org/​programs/​cfa/​curriculum/​cbok/​cbok)
Topic area weights that indicate the relative exam weightings of the top-level
topic areas (www​.cfainstitute​.org/​en/​programs/​cfa/​curriculum)
Learning outcome statements (LOS) that advise candidates about the
specific knowledge, skills, and abilities they should acquire from curricu-
lum content covering a topic area: LOS are provided at the beginning of
each block of related content and the specific lesson that covers them. We
encourage you to review the information about the LOS on our website
(www​.cfainstitute​.org/​programs/​cfa/​curriculum/​study​-sessions), including
the descriptions of LOS “command words” on the candidate resources page
at www​.cfainstitute​.org/​-/​media/​documents/​support/​programs/​cfa​-and​
-cipm​-los​-command​-words​.ashx.
The CFA Program curriculum that candidates receive access to upon exam
registration
Therefore, the key to your success on the CFA exams is studying and understanding
the CBOK. You can learn more about the CBOK on our website: www​.cfainstitute​
.org/​programs/​cfa/​curriculum/​cbok.
The curriculum, including the practice questions, is the basis for all exam questions.
The curriculum is selected or developed specifically to provide candidates with the
knowledge, skills, and abilities reflected in the CBOK.

CFA INSTITUTE LEARNING ECOSYSTEM (LES)

Your exam registration fee includes access to the CFA Institute Learning Ecosystem
(LES). This digital learning platform provides access, even offline, to all the curriculum
content and practice questions. The LES is organized as a series of learning modules
consisting of short online lessons and associated practice questions. This tool is your
source for all study materials, including practice questions and mock exams. The LES
is the primary method by which CFA Institute delivers your curriculum experience.
Here, candidates will find additional practice questions to test their knowledge. Some
questions in the LES provide a unique interactive experience.

DESIGNING YOUR PERSONAL STUDY PROGRAM

An orderly, systematic approach to exam preparation is critical. You should dedicate
a consistent block of time every week to reading and studying. Review the LOS both
before and after you study curriculum content to ensure you can demonstrate the
xii How to Use the CFA Program Curriculum

knowledge, skills, and abilities described by the LOS and the assigned reading. Use
the LOS as a self-check to track your progress and highlight areas of weakness for
later review.
Successful candidates report an average of more than 300 hours preparing for each
exam. Your preparation time will vary based on your prior education and experience,
and you will likely spend more time on some topics than on others.

ERRATA
The curriculum development process is rigorous and involves multiple rounds of
reviews by content experts. Despite our efforts to produce a curriculum that is free of
errors, in some instances, we must make corrections. Curriculum errata are periodically
updated and posted by exam level and test date on the Curriculum Errata webpage
(www​.cfainstitute​.org/​en/​programs/​submit​-errata). If you believe you have found an
error in the curriculum, you can submit your concerns through our curriculum errata
reporting process found at the bottom of the Curriculum Errata webpage.

OTHER FEEDBACK
Please send any comments or suggestions to info@​cfainstitute​.org, and we will review
your feedback thoughtfully.
Financial Statement
Analysis
LEARNING MODULE

1
Introduction to Financial
Statement Analysis
by Elaine Henry, PhD, CFA, J. Hennie van Greuning, DCom, CFA, and
Thomas R Robinson, PhD, CFA, CAIA.
Elaine Henry, PhD, CFA, is at Stevens Institute of Technology (USA). J. Hennie van
Greuning, DCom, CFA, is at BIBD (Brunei). Thomas R. Robinson, PhD, CFA, CAIA,
Robinson Global Investment Management LLC, (USA).

LEARNING OUTCOMES
Mastery The candidate should be able to:

describe the steps in the financial statement analysis framework

describe the roles of financial statement analysis
describe the importance of regulatory filings, financial statement
notes and supplementary information, management’s commentary,
and audit reports
describe implications for financial analysis of alternative financial
reporting systems and the importance of monitoring developments
in financial reporting standards
describe information sources that analysts use in financial statement
analysis besides annual and interim financial reports
The two major accounting
standard setters are as follows:
1) the International Accounting
Standards Board (IASB) who
establishes International
Financial Reporting Standards
(IFRS) and 2) the Financial
Accounting Standards Board
(FASB) who establishes US GAAP.
Throughout this learning module
both standards are referred to
and many, but not all, of these
two sets of accounting rules
are identified. Note: changes
in accounting standards as
well as new rulings and/or
pronouncements issued after
the publication of this learning
module may cause some of the
information to become dated.
4 Learning Module 1 Introduction to Financial Statement Analysis

1 INTRODUCTION
Financial analysis is the process of interpreting and evaluating a company’s performance
and position in the context of its economic environment. Financial analysis is used
by analysts to make decisions and recommendations such as whether to invest in a
company’s debt or equity securities and at what price. A debt investor is concerned
about a company’s ability to pay interest and to repay the principal lent, while an
equity investor is interested in a company’s profitability and per-share value. Overall,
a central focus of financial analysis is evaluating the company’s ability to earn a return
on its capital that is at least equal to the cost of that capital, to profitably grow its
operations, and to generate enough cash to meet obligations and pursue opportunities.
Financial analysis starts with the information found in a company’s financial reports.
These financial reports include audited financial statements, additional disclosures
required by regulatory authorities, and any accompanying (unaudited) commentary by
management. Analysts supplement their analysis of a company’s financial statements
with industry and company research.

LEARNING MODULE OVERVIEW

■ Financial analysis for a company often includes obtaining an

understanding of the target company’s business model, finan-
cial performance, financial position, and broader information about
the economic environment and the industry in which the company
operates. When analytical tasks are not well defined, the analyst
may need to make decisions about the approach, the tools, the data
sources, the format for reporting the results, and the relative impor-
tance of different aspects of the analysis.
■ Financial analysis will include evaluating financial results, and struc-
turing and scaling data to facilitate comparisons by calculating
percentages, changes, and ratios. Answers to analytical questions
often rely not just on numerical results but also on the analyst’s
interpretation of the numerical results to support a conclusion or
recommendation.
■ The role of financial statement analysis is to form expectations about
a company’s future performance, financial position, and risk factors
for the purpose of making investment, credit, and other economic
decisions.
■ · Regulatory authorities require publicly traded companies to prepare
financial reports in accordance with specified accounting standards
and other securities laws and regulations. An example of such a reg-
ulatory authority is the Securities and Exchange Commission in the
United States.
■ Other organizations exist without explicit regulatory authority and
develop reporting standards, facilitate cooperation, and advise govern-
ments. Examples include the International Organization of Securities
Commissions, the European Securities Committee, and the European
Securities and Market Authority.
■ Sources of information for analysts and investors include standard-
ized forms that are filed with regulatory authorities, disclosures made
in notes, supplementary schedules, and management commentary
that accompany financial statements, and audit reports. In an audit
report, an independent auditor expresses an opinion on whether the
Financial Statement Analysis Framework 5

information in the audited financial statements fairly presents the

financial position, performance, and cash flows of the company in
accordance with a specified set of accounting standards.
■ Despite increasing convergence over time, differences still exist
between IFRS (International Financial Reporting Standards) and US
GAAP (Generally Accepted Accounting Principles) that affect financial
reporting. Analysts must be aware of areas where accounting stan-
dards have not converged.
■ In addition to information required by regulatory authorities, issuers
also communicate through earnings calls, investor day events, press
releases, company websites, and company visits. Analysts may also
get information by speaking with management, investor relations, and
other company personnel.
■ Third-party sources for additional information include industry white-
papers, analyst reports, economic information from governments,
general and industry-specific news outlets, and electronic data plat-
forms. Analysts also use surveys, conversations, and product evalua-
tions to generate their own information.

FINANCIAL STATEMENT ANALYSIS FRAMEWORK

2
describe the steps in the financial statement analysis framework

Analysts work in a variety of positions within the investment management industry.

Some are equity analysts whose main objective is to evaluate potential investments
in a company’s equity securities as a basis for deciding whether a prospective invest-
ment is attractive and what an appropriate purchase price might be. Others are credit
analysts who evaluate the creditworthiness of a company to decide whether (and
on what terms) a debt investment should be made or what credit rating should be
assigned. Analysts may also be involved in a variety of other tasks, such as evaluating
the performance of a subsidiary company, evaluating a private equity investment, or
finding stocks that are overvalued for purposes of taking a short position.
Exhibit 1 presents a generic framework for financial statement analysis used in
these various roles.
6 Learning Module 1 Introduction to Financial Statement Analysis

Exhibit 1: Financial Statement Analysis Framework

Phase Sources of Information Output

Articulate the purpose and ■ The nature of the analyst’s function, such as ■ Statement of the purpose or objective of
context of the analysis. evaluating an equity or debt investment or analysis.
issuing a credit rating. ■ A list (written or unwritten) of specific ques-
■ Communication with client or supervisor on tions to be answered by the analysis.
specific needs and concerns. ■ Nature and content of report to be provided.
■ Institutional guidelines related to developing ■ Timetable and budgeted resources for
specific work product. completion.
Collect data. ■ Financial statements, other financial data, ■ Financial statements and other quantitative
questionnaires, and industry/economic data. data in a usable form, such as a spreadsheet.
■ Discussions with issuer investor relations, ■ Completed questionnaires, if applicable.
management, suppliers, customers, competi-
tors, and company or industry experts.
■ Company site visits (e.g., to production facili-
ties or retail stores).
Process data. Data from the previous phase. ■ Adjusted financial statements.
■ Common-size statements.
■ Ratios and graphs.
Analyze/interpret the data. Input data as well as processed data. ■ Analytical results.
■ Forecasts.
■ Valuations.
Develop and communicate ■ Analytical results and previous reports. ■ Analytical report answering questions posed
conclusions and recom- ■ Institutional guidelines for published reports. in Phase 1.
mendations (e.g., with an ■ Recommendation regarding the purpose of
analysis report). the analysis, such as whether to make an
investment or extend credit.
Follow-up. Information gathered by periodically repeating ■ Comparison of actual to expected results
the previous steps as necessary to determine ■ Revised forecasts
whether changes to holdings or recommenda-
■ Updated reports and recommendations.
tions are necessary.

The following sections discuss the individual phases of financial statement analysis.

Articulate the Purpose and Context of the Analysis

Before undertaking any analysis, it is essential to understand the purpose of the analysis.
An understanding of the purpose is particularly important in financial statement anal-
ysis because of the numerous available techniques and the substantial amount of data.
Some analytical tasks are well defined, in which case articulating the purpose of
the analysis requires little decision making by the analyst. For example, a periodic
credit review of an investment-grade debt portfolio or an equity analyst’s quarterly
report on a particular company may be guided by institutional norms such that the
purpose of the analysis is given. Furthermore, the format, procedures, or sources of
information may also be given.
For other analytical tasks, articulating the purpose of the analysis requires the
analyst to make decisions about the approach, the tools, the data sources, the format
in which to report the results of the analysis, and the relative importance of different
aspects of the analysis.
Financial Statement Analysis Framework 7

When facing a substantial amount of data, a less experienced analyst may be

tempted to start calculating ratios without considering what is relevant for the decision
at hand. It is generally advisable to resist this temptation and thus avoid unnecessary
or pointless efforts. Consider the questions: If you could have all the calculations and
ratios completed instantly, what question would you be able to answer? What decision
would your answer support?
The analyst should also define the context at this stage. Who is the intended
audience? What is the deliverable—for example, a final report explaining conclusions
and recommendations? What is the time frame (i.e., when is the report due)? What
resources and resource constraints are relevant to completion of the analysis? Again,
the context may be predefined (i.e., standard and guided by institutional norms).
Having clarified the purpose and context of the financial statement analysis, the
analyst should next compile the specific questions to be answered by the analysis. For
example, if the purpose of the financial statement analysis (or, more likely, a stage of a
larger analysis) is to compare the historical performance of three companies operating
in a particular industry, specific questions would include the following: What has been
the relative growth rate of the companies, and what has been their relative profitability?

Collect Data
Next, the analyst obtains information required to answer the specific questions. A
key part of this step is obtaining an understanding of the target company’s business
model, financial performance, and financial position (including trends over time and
relative to peer companies). Financial statement data alone may be adequate in some
cases. For example, to screen a large number of companies to find those with a min-
imum level of historical profitability or sales growth, financial statement data alone
would be adequate. But to address more in-depth questions, such as why and how
one company performed better or worse than its competitors, additional information
would be required.
Furthermore, information on the economy and industry is necessary to understand
the environment in which the company operates. Analysts often take a top-down
approach whereby they (1) gain an understanding of an issuer’s macroeconomic
environment, such as prospects for growth in the economy and inflation; (2) analyze
the prospects of the industry in which the company operates, based on the expected
macroeconomic environment; and (3) determine the prospects for the company given
the expected industry and macroeconomic environments. For example, an analyst
may need to forecast future growth in earnings for a company. Past company data
provide the platform for statistical forecasting; however, an understanding of economic
and industry conditions and an outlook for them can improve the analyst’s ability to
make forecasts.

Process Data
After obtaining the requisite financial and other information, the analyst processes
these data using appropriate analytical tools. For example, processing the data may
involve computing ratios or growth rates; preparing common-size financial state-
ments; creating charts; performing statistical analyses, such as regressions or Monte
Carlo simulations; making forecasts; performing valuations; performing sensitivity
8 Learning Module 1 Introduction to Financial Statement Analysis

analyses; or using any other analytical tools or combination of tools that are available
and appropriate for the task. A comprehensive financial analysis at this stage may
include the following:
■ Reading and evaluating financial results for each company being analyzed.
This includes understanding any factors that may affect comparability
between companies, such as differences in business models, operating deci-
sions (e.g., leasing versus purchasing fixed assets), accounting policies (e.g.,
when to report revenue on the income statement), and tax jurisdictions.
■ Making any needed adjustments to the financial statements or using alterna-
tive measures to facilitate comparison. Note that commonly used databases
do not always make such analyst adjustments.
■ Preparing or collecting common-size financial statement data (which scale
data to directly reflect percentages [e.g., of sales] or changes [e.g., from the
prior year]) and financial ratios (which are measures of various aspects of
corporate performance based on financial statement elements. Analysts can
use these to evaluate a company’s relative profitability, liquidity, leverage,
efficiency, and valuation in relation to past results or peers.

Analyze/Interpret the Data

Once the data have been processed, the next step—critical to any analysis—is to inter-
pret the output. The answer to a specific question is seldom the numerical answer alone.
Rather, the answer relies on the analyst’s interpretation of the output, and the use of
this interpreted output to support a conclusion or recommendation. The answers to
the specific analytical questions may themselves achieve the underlying purpose of
the analysis, but usually, a conclusion or recommendation is required. For example,
an equity analysis may involve forecasts of earnings, free cash flow, and a range of
fair value estimates that would be used to issue a buy, hold, or sell recommendation.
A credit analyst may also create forecasts of free cash flow, interest coverage, and
leverage in support of an investment decision.

Develop and Communicate Conclusions and

Recommendations
Communicating the conclusion or recommendation in an appropriate format is the
next step. The appropriate format will vary by analytical task, by institution, or by
audience. For example, an equity analyst’s report for external distribution would
typically include the following components:
■ summary and investment conclusion;
■ industry overview and competitive analysis;
■ financial statement model, potentially with several scenarios;
■ valuation; and
■ investment risks.
The contents of reports may also be specified by regulatory agencies or profes-
sional standards. For example, the CFA Institute Standards of Practice Handbook
(Handbook) dictates standards that must be followed in communicating recommen-
dations. According to the Handbook:
Standard V(B) states that members and candidates should communicate
in a recommendation the factors that were instrumental in making the
investment recommendation. A critical part of this requirement is to
Scope of Financial Statement Analysis 9

distinguish clearly between opinions and facts. In preparing a research

report, the member or candidate must present the basic characteristics
of the security(ies) being analyzed, which will allow the reader to evaluate
the report and incorporate information the reader deems relevant to his
or her investment decision making process.1
The Handbook requires that limitations to the analysis and any risks inherent to
the investment be disclosed. Furthermore, it requires that any report include elements
important to the analysis and conclusions so that readers can evaluate the conclusions
themselves.

Follow-Up
The process does not end with the report. If an equity investment is made or a credit
rating is assigned, periodic review is required to revise forecasts and recommenda-
tions based on the receipt of new information. In the case of a rejected investment,
subsequent analyses may still be required should the security price or business con-
ditions change. Follow-up may involve repeating all the previous steps in the process
on a periodic basis.

SCOPE OF FINANCIAL STATEMENT ANALYSIS

3
describe the roles of financial statement analysis

The role of financial statement analysis is to use financial reports prepared by com-
panies, combined with other information, to evaluate the past, current, and potential
performance and financial position of a company for the purpose of making investment,
credit, and other economic decisions. Managers within a company perform financial
analysis to make operating, investing, and financing decisions but do not exclusively
rely on analysis of related financial statements because they have access to nonpublic
financial information.
In evaluating financial reports, analysts typically have a specific economic decision
in mind. Examples of these decisions include the following:
■ Evaluating an equity investment for inclusion in a portfolio.
■ Valuing a security for making an investment recommendation to others.
■ Determining the creditworthiness of a company to decide whether to extend
a loan to the company and if so, what terms to offer.
■ Assigning a debt rating to a company or bond issue.
■ Deciding whether to make a venture capital or other private equity
investment.
■ Evaluating a merger or acquisition candidate.
These decisions demonstrate certain themes in financial analysis. In general,
analysts seek to examine the past and current performance and financial position of
a company to form expectations about its future performance and financial position.
Analysts are also concerned about factors that affect the risks to a company’s future
performance and financial position. An examination of performance can include an

1 Standards of Practice Handbook, 11th ed. (Charlottesville, VA: CFA Institute, 2014), p. 169.
10 Learning Module 1 Introduction to Financial Statement Analysis

assessment of a company’s profitability (the ability to earn a profit from delivering

goods and services) and its ability to generate positive cash flows (cash receipts in
excess of cash disbursements).
Exhibit 2 shows how news coverage of corporate earnings announcements places
corporate results in the context of analysts’ expectations. Panel A shows the earnings
announcement, and Panel B shows a sample of the news coverage of the announcement.
Earnings are also frequently used by analysts in valuation. For example, an analyst
may value shares of a company by comparing its price-to-earnings ratio (P/E) to the
P/Es of peer companies or may use forecasted future earnings as direct or indirect
inputs into discounted cash flow models of valuation.

Exhibit 2: An Earnings Release and News Media Comparison with Analysts’

Expectations
Panel A: Excerpt from Sea Limited’s Earnings Release
Singapore, August 16, 2022 – Sea Limited (NYSE: SE) (“Sea” or the “Company”)
today announced its financial results for the second quarter ended June 30, 2022.

“As we navigate the current environment of increased macro uncertainty

with that same nimble and decisive approach, we believe it is vital to be
thoughtful, prudent, and disciplined. While we have strong resources and
are well on-track to achieve our self-sufficiency targets, we are nevertheless
rapidly prioritizing profitability and cash flow management. We are con-
fident that this focus, combined with our demonstrated ability to execute,
our scale and leadership, and our proven business models, will position us
for long-term sustained success.”

Second Quarter 2022 Highlights:

■ Total GAAP revenue was US$2.9 billion, up 29.0% year-on-year.

■ Total gross profit was US$1.1 billion, up 17.1% year-on-year.
■ Total net income (loss) was US$(931.2) million compared to
US$(433.7) million for the second quarter of 2021. Total net loss
excluding share-based compensation and impairment of goodwill was
US$(569.8) million compared to US$(321.2) million for the second
quarter of 2021.
■ Total adjusted EBITDA was US$(506.3) million compared to US$(24.1)
million for the second quarter of 2021.
■ E-commerce Segment:
■ GAAP revenue was US$1.7 billion, up 51.4% year-on-year. Based
on constant currency assumptions, GAAP revenue was up 56.2%
year-on-year.
■ Gross orders totaled 2.0 billion, an increase of 41.6% year-on-year.
■ Gross profit margin for e-commerce continued to improve sequentially
quarter-on-quarter, as we have seen faster growth of transaction-based
fees and advertising income, which have higher profit margin com-
pared to product revenue and revenue generated from other val-
ue-added services.
E-commerce Full Year 2022 Guidance Update:

In our efforts to adapt to increasing macro uncertainties, we are proactively

shifting our strategies to further focus on efficiency and optimization for the
long-term strength and profitability of the e-commerce business. Given this
Scope of Financial Statement Analysis 11

strategic shift, we will be suspending e-commerce GAAP revenue guidance

for the full year 2022. We believe such efforts will further strengthen our
ability to better capture the long-term growth opportunities in our markets,
which we remain highly positive about.

Source: Sea Limited, “Sea Limited Reports Second Quarter 2022 Results,” accessed
16 August 2022, https://​cdn​.sea​.com/​webmain/​static/​resource/​seagroup/​website/​
investornews/​2Q2022/​u​XxGiCr8oTG​xOFTPhBUB/​2022​.08​.16​%20Sea​%20Second​
%20Quarter​%202022​%20Results​.pdf.

Panel B: Excerpt from News Article: Sea Limited Reports

Mixed Results, Suspends Revenue Guidance
Singapore-based Sea Limited (SE) reported second-quarter results early Tuesday
that missed on revenue but beat on earnings. The company, however, said it
will suspend guidance for its e-commerce unit, which accounts for about 60%
of company revenue.
The company reported revenue of $2.9 billion, missing estimates of $2.98
billion. It lost 61 cents a share, better than the estimated loss of $1.14 a share,
according to FactSet.
SE stock plunged 14.3% during afternoon action on the stock market today.
Sea has one of the largest e-commerce and digital entertainment platforms
in the Southeast Asia region. It also provides financial services.
The company said its decision to suspend revenue guidance was driven by
a highly volatile and unpredictable macro environment.
"We think the right thing to do in this time of continuing heightened macro
volatility is to prioritize efficiency and self-sufficiency," Chief Executive Forrest
Li said in written remarks in the Sea Limited earnings report.
Sea's gaming unit, called Garena, accounts for about 31% of revenue.
"We are in an environment of increased macro uncertainty, with rising infla-
tion, rising interest rates, local currency depreciations against the U.S. dollar,
and ongoing reopening trends," said Li. "In this environment, being agile and
adaptable is even more crucial to the long-term success of our business."
SE stock is down about 62% this year.
Source: Brian Deagon, “Sea Limited Reports Mixed Results, Suspends Revenue Guidance,” 16
August 2022, https://​www​.investors​.com/​news/​technology/​se​-stock​-drops​-on​-second​-quarter​
-results​-earnings/​.

Analysts are also interested in the financial position of a company, particularly for
credit analysis, as depicted in Exhibit 3. Panel A of the exhibit is an excerpt from an
August 2022 T-Mobile’s press release highlighting a series of credit rating upgrades
that the company received from the three major rating agencies. Panel B of the exhibit
is an excerpt from a July 2022 announcement from Moody’s Investor Service about
its upgrade of T-Mobile’s credit rating.

Exhibit 3: Credit Rating Upgrade for T-Mobile

Panel A: Excerpt from Announcement by T Mobile
T-Mobile Secures First-Ever Full Investment Grade Rating
BELLEVUE, Wash.--(BUSINESS WIRE)-- T-Mobile US, Inc. (NASDAQ:
TMUS) today announced that following an investment grade issuer rating from
S&P Global Ratings (S&P) – the third it has received from credit rating agen-
cies – the company now has its first-ever full investment grade rating. S&P has
12 Learning Module 1 Introduction to Financial Statement Analysis

assigned the Company a BBB- with positive outlook. This follows the company
securing a Baa3 rating with a stable outlook from Moody’s and a BBB- rating
with a positive outlook from Fitch.
This full investment grade rating comes as a result of T-Mobile’s successful
operational and financial performance, which is consistently demonstrated
through strong subscriber growth and the company’s ability to translate that
into increasing free cash flow.
“Achieving a full investment grade rating is an important milestone for
T-Mobile that reflects the leading credit rating agencies’ positive outlook on
our Un-carrier leadership strategy that is rooted in an unwavering focus on
putting customers first,” said Peter Osvaldik, T-Mobile chief financial officer.
“This ‘clean sweep’ in upgrades provides T-Mobile with the ability to unlock full
access to the deep investment grade debt markets, which will further fuel our
growth and momentum toward our mission of being the very best at connecting
customers to their world.”
Source: “T-Mobile Secures First-Ever Full Investment Grade Rating,” 5 August
2022, https://​investor​.t​-mobile​.com/​events​-and​-presentations/​news/​news​-details/​
2022/​T-​ Mobile​-Secures​-First​-Ever​-Full​-Investment​-Grade​-Rating/​default​.aspx.

Panel B: Excerpt from Moody’s Announcement About

Rating Action on T-Mobile
Rating Action: Moody's upgrades T-Mobile to Baa3; outlook stable
New York, July 20, 2022 -- Moody's Investors Service (Moody's) upgraded
T-Mobile USA, Inc.'s (T-Mobile) senior unsecured debt rating to Baa3 from Ba2
and affirmed the Baa3 rating on the company's existing senior secured notes
and senior secured revolving credit facility.
Moody's has also withdrawn T-Mobile's Ba1 corporate family rating, Ba1-PD
probability of default rating and SGL-1 speculative grade liquidity rating. With
this rating action, Moody's changed T-Mobile's ratings outlook to stable from
positive.
The ratings upgrade reflects T-Mobile's accelerated achievement of higher
than expected operating cost synergies following its April 2020 merger with
Sprint, significant and nearly complete network and operations integration
and high visibility into the company's steady path towards sustained debt lever-
age (Moody's adjusted) below 3.75x. T-Mobile's sizable operating scale, high
speed 5G coverage footprint, substantial upside growth potential in historically
under-indexed rural and enterprise end market segments, solid incremental
revenue growth adjacencies in fixed wireless access, extensive asset base and
solid industry market position support continued subscriber growth, EBITDA
margin expansion and ramping free cash flow over the next 12-18 months. The
company's financial policy, which prudently focuses on network infrastructure
investments to support market share growth, remains an important driver of
the credit profile going forward. Moody's views network investments, including
spectrum investments, as supportive of the business profile.
The stable outlook reflects Moody's expectation for T-Mobile's continued
subscriber and service revenue growth, EBITDA margin expansion, debt leverage
(Moody's adjusted) declining steadily towards and sustained around 3.75x and
rising free cash flow.
Source: “Moody's Upgrades T-Mobile to Baa3; Outlook Stable,” 20 July 2022, https://​www​.moodys​
.com/​research/​Moodys​-upgrades​-T​-Mobile​-to​-Baa3​-outlook​-stable​-​-PR​_468077.
Regulated Sources of Information 13

In conducting financial analysis of a company, the analyst will regularly refer to

the company’s financial statements, financial notes, and supplementary schedules as
well as a variety of other information sources. The next lesson introduces commonly
used information sources.

REGULATED SOURCES OF INFORMATION

4
describe the importance of regulatory filings, financial statement
notes and supplementary information, management’s commentary,
and audit reports

Regulatory authorities require publicly traded issuers to prepare financial reports in

accordance with specified accounting standards and other securities laws and regula-
tions. For example, in Switzerland, Swiss-based companies listed on the main board
of the Swiss Exchange must prepare their financial statements in accordance with
either IFRS (International Financial Reporting Standards) or US GAAP (Generally
Accepted Accounting Principles) if they are multinational. 2 While jurisdictions differ
in their approach to securities regulations and corporate reporting standards, regu-
lators of jurisdictions that oversee more than 95 percent of world’s financial markets
are members of the International Organization of Securities Commissions (IOSCO)
and share objectives and principles, thereby creating a degree of global uniformity.

International Organization of Securities Commissions

Although technically not a regulatory authority, IOSCO regulates a significant portion
of the world’s financial capital markets. This organization was formed in 1983 and
consists of ordinary members, associate members, and affiliate members. Ordinary
members are the securities commission or similar governmental regulatory authority
with primary responsibility for securities regulation in the member country.3 The
members regulate more than 95 percent of the world’s financial capital markets in
more than 115 jurisdictions, and securities regulators in emerging markets account
for 75 percent of its ordinary membership.
IOSCO’s comprehensive set of Objectives and Principles of Securities Regulation is
updated as required and is recognized as an international benchmark for all markets.
The principles of securities regulation are based upon three core objectives:4
■ protecting investors;
■ ensuring that markets are fair, efficient, and transparent; and
■ reducing systemic risk.

2 “Financial Reporting Framework in Switzerland,” Deloitte, https://​www​.iasplus​.com/​en/​jurisdictions/​

europe/​switzerland.
3 Examples include the China Securities Regulatory Commission, Egyptian Financial Supervisory Authority,
Securities and Exchange Board of India, Kingdom of Saudi Arabia Capital Market Authority, and Banco
Central del Uruguay.
4 Objectives and Principles of Securities Regulation, IOSCO, May 2017.
14 Learning Module 1 Introduction to Financial Statement Analysis

IOSCO’s principles are grouped into 10 categories, including principles for reg-
ulators, for enforcement, for auditing, and for issuers, among others. Within the
category “Principles for Issuers,” two principles relate directly to financial reporting:
■ There should be full, accurate, and timely disclosure of financial results, risk,
and other information that is material to investors’ decisions.
■ Accounting standards used by issuers to prepare financial statements should
be of a high and internationally acceptable quality.
Historically, regulation and related financial reporting standards were developed
within individual countries and were often based on the cultural, economic, and
political norms of each country. As financial markets have become more global, it has
become desirable to establish comparable financial reporting standards internationally.
Ultimately, laws and regulations are established by individual jurisdictions, so this also
requires cooperation among regulators. Another IOSCO principle deals with the use
of self-regulatory organizations (SROs), which exercise some direct oversight for their
areas of competence and should be subject to the oversight of the relevant regulator
and observe fairness and confidentiality.5
To ensure consistent application of international financial standards (such as the
Basel Committee on Banking Supervision’s standards and IFRS), it is important to
have uniform regulation and enforcement across national boundaries. IOSCO assists
in attaining this goal of uniform regulation as well as cross-border cooperation in
combating violations of securities and derivatives laws.

US Securities and Exchange Commission

The US SEC has primary responsibility for securities and capital markets regulation in
the United States and is an ordinary member of IOSCO. Any company issuing secu-
rities within the United States (e.g., on the New York Stock Exchange or NASDAQ),
or otherwise involved in US capital markets, is subject to the rules and regulations
of the SEC. The SEC, one of the oldest and most developed regulatory authorities,
was created by reforms after the stock market crash of 1929 that preceded the Great
Depression.
From a financial reporting and analysis perspective, the most significant statutes
enforced by the SEC are the Securities Acts of 1933 and 1934 and the Sarbanes–Oxley
Act of 2002.
■ Securities Act of 1933 (the 1933 Act): This law specifies the financial and
other significant information that investors must receive when securities
are sold, prohibits misrepresentations, and requires initial registration of all
public issuances of securities.
■ Securities Exchange Act of 1934 (the 1934 Act): This law created the
SEC, gave the SEC authority over all aspects of the securities industry, and
empowered the SEC to require periodic reporting by companies with pub-
licly traded securities.
■ Sarbanes–Oxley Act of 2002: This law created the Public Company
Accounting Oversight Board (PCAOB) to oversee auditors. The SEC is
responsible for carrying out the requirements of the act and overseeing
the PCAOB. The act addresses auditor independence (it prohibits auditors
from providing certain non-audit services to the companies they audit);
strengthens corporate responsibility for financial reports (it requires
executive management to certify that the company’s financial reports fairly
present the company’s condition); and requires management to report on

5 Objectives and Principles of Securities Regulation, IOSCO, May 2017.

Regulated Sources of Information 15

the effectiveness of the company’s internal control over financial reporting

(including obtaining external auditor confirmation of the effectiveness of
internal control).
Companies comply with these acts principally through filing standardized forms
created by the SEC and by responding to and complying with specific comments on
their filings by the SEC staff. More than 50 different types of SEC forms are used to
satisfy reporting requirements; the discussion herein is limited to those forms most
relevant for financial analysts.
Most of the SEC filings are required to be made electronically, so filings that an
analyst would be interested in can be retrieved online from one of many websites,
including an issuer’s investor relations website and the SEC’s own website. Some
filings are required on the initial offering of securities, whereas others are required
on a periodic basis thereafter. The following are some of the more common filings
used by analysts.
■ Securities Offerings Registration Statement: The 1933 Act requires
companies offering securities to file a registration statement. New issuers as
well as previously registered companies that are issuing new securities are
required to file these statements. Required information and the precise form
vary depending upon the size and nature of the offering. Typically, required
information includes (1) disclosures about the securities being offered for
sale, (2) the relationship of these new securities to the issuer’s other capi-
tal securities, (3) the information typically provided in the annual filings,
(4) recent audited financial statements, and (5) risk factors involved in the
business. Interim unaudited financial statements are also provided if the
statement is filed three months or more after a fiscal year end.
■ Forms 10-K, 20-F, and 40-F: Companies are required to file these forms
annually. Form 10-K is for US registrants, Form 40-F is for certain Canadian
registrants, and Form 20-F is for all other non-US registrants. These forms
require a comprehensive overview, including information concerning a
company’s business, risk factors, financial disclosures, legal proceedings,
and information related to management. The financial disclosures include
audited financial statements and notes, management discussion and analysis
(MD&A) of the company’s financial condition and results of operations, and
auditors’ reports.
■ Annual Report: In addition to the SEC’s annual filings (e.g., Form 10-K),
most companies prepare an annual report to shareholders. This is not a
requirement of the SEC. The annual report is usually viewed as one of the
most significant opportunities for a company to present itself to share-
holders and other external parties; accordingly, it is often a highly polished
marketing document with photographs, an opening letter from the chief
executive officer, financial data, market segment information, research and
development activities, and future corporate goals. In contrast, the Form
10-K is a more legal type of document with minimal marketing emphasis.
Although the perspectives vary, a company’s annual report and its Form
10-K have considerable overlap. Some companies prepare only Form 10-K
or publish an annual report that consists of a few pages of material and a
copy of the 10-K.
■ Proxy Statement/Form DEF-14A: The SEC requires that shareholders of a
company receive a proxy statement before a shareholder meeting. A proxy is
an authorization from the shareholder giving another party the right to cast
its vote. Shareholder meetings are held at least once a year, but any special
meetings also require a proxy statement. Proxies, especially annual meeting
16 Learning Module 1 Introduction to Financial Statement Analysis

proxies, contain information that is often useful to financial analysts.

Such information typically includes proposals that require a shareholder
vote, details of security ownership by management and principal owners,
biographical information on directors, and disclosure of executive compen-
sation. Proxy statement information is filed with the SEC as Form DEF-14A.
■ Forms 10-Q and 6-K: Companies are required to submit these forms for
interim periods (quarterly for US companies on Form 10-Q, and semiannu-
ally for many non-US companies on Form 6-K). The filing requires certain
financial information, including unaudited financial statements and an
MD&A for the interim period covered by the report. Additionally, if cer-
tain types of non-recurring events—such as the adoption of a significant
accounting policy, commencement of significant litigation, or a material
limitation on the rights of any holders of any class of registered securities—
take place during the period covered by the report, these events must be
included in the Form 10-Q report. Companies may provide the 10-Q report
to shareholders or may prepare a separate, abbreviated, quarterly report to
shareholders.

KNOWLEDGE CHECK

1. In September 2017, Sea Ltd, the Singapore-based technology

company, filed a registration statement with the US SEC to register its initial
public offering of securities (American Depositary Shares, each representing
one Class A Ordinary Share) on the New York Stock Exchange. In addition
to a large amount of financial information, the registration statement pro-
vided over 50 pages of discussion on Sea Ltd.’s business and industry.

Which of the following is most likely to have been included in Sea’s registra-
tion statement?
A. Underwriters’ fairness opinion of the offering
B. Assessment of risk factors involved in the business
C. Projected cash flows and earnings for the business
Solution:
B is correct. Information provided by companies in registration statements
typically includes disclosures about the securities being offered for sale; the
relationship of these new securities to the issuer’s other capital securities;
the information typically provided in the annual filings; recent audited
financial statements; and risk factors involved in the business. Companies
provide information useful in developing projected cash flows and earnings
but do not typically include these in the registration statement, nor do they
provide opinions of the underwriters.

A company or its officers make other SEC filings—either periodically, or, if sig-
nificant events or transactions have occurred, in between the periodic reports noted
previously. By their nature, these forms sometimes contain timely information that
may have significant valuation implications.
■ Form 8-K: In addition to filing annual and interim reports, SEC registrants
must report material corporate events on a more current basis. Form 8-K
(6-K for non-US registrants) is the “current report” companies must file
with the SEC to announce such major events as acquisitions or disposals of
Regulated Sources of Information 17

corporate assets, changes in securities and trading markets, matters related

to accountants and financial statements, corporate governance and manage-
ment changes, and Regulation FD disclosures.6
■ Forms 3, 4, 5, and 144: Forms 3, 4, and 5 are required to report beneficial
ownership of securities. These filings are required for any director or officer
of a registered company as well as beneficial owners of greater than 10 per-
cent of a class of registered equity securities. Form 3 is the initial statement,
Form 4 reports changes, and Form 5 is the annual report. Form 144 is notice
of the proposed sale of restricted securities or securities held by an affili-
ate of the issuer. These forms can be used to examine purchases and sales
of securities by officers, directors, and other affiliates of the company, who
collectively are regarded as corporate insiders.
■ Form 11-K: This is the annual report of employee stock purchase, savings,
and similar plans. It might be of interest to analysts for companies with sig-
nificant employee benefit plans because it contains more information about
these plans than disclosed in the company’s financial statements.
In jurisdictions other than the United States, similar legislation exists for the pur-
pose of regulating securities and capital markets. Regulatory authorities are responsible
for enforcing regulation, and securities regulation is intended to be consistent with
the IOSCO objectives described in the previous section. Within each jurisdiction,
regulators will either establish or, more typically, recognize and adopt a specified
set or sets of accounting standards. The regulators will also establish reporting and
filing requirements. IOSCO members have agreed to cooperate in the development,
implementation, and enforcement of internationally recognized and consistent stan-
dards of regulation.

Capital Markets Regulation in Europe

Each individual member state of the European Union (EU) regulates capital markets
in its jurisdiction. Certain regulations, however, have been adopted at the EU level.
Importantly, the EU agreed that from 2005 consolidated accounts of EU-listed compa-
nies would use International Financial Reporting Standards. The endorsement process
by which newly issued IFRS are adopted by the EU reflects the balance between the
individual member state’s autonomy and the need for cooperation and convergence.
When the IASB issues a new standard, the European Financial Reporting Advisory
Group advises the European Commission on the standard, and the Standards Advice
Review Group provides the Commission with an opinion about that advice. Based
on the input from these two entities, the Commission prepares a draft endorsement
regulation. The Accounting Regulatory Committee votes on the proposal; and if the
vote is favorable, the proposal proceeds to the European Parliament and the Council
of the European Union for approval.7
Two bodies related to securities regulation established by the European Commission
are the European Securities Committee (ESC) and the European Securities and Market
Authority (ESMA). The ESC consists of high-level representatives of member states
and advises the European Commission on securities policy issues. ESMA is an EU
cross-border supervisor established to coordinate supervision of the EU market. As
noted earlier, regulation still rests with the individual member states and, therefore,

6 Regulation Fair Disclosure (FD) provides that when an issuer discloses material non-public information
to certain individuals or entities—generally, securities market professionals such as stock analysts or hold-
ers of the issuer’s securities who may trade on the basis of the information—the issuer must make public
disclosure of that information. In this way, the rule aims to promote full and fair disclosure.
7 European Commission, https://​www​.esma​.europa​.eu/​convergence/​ias​-regulation​#:​~:​text​=Th
​ e​%20objective​
%20of​%20the​%20International​,the​%20European​%20Union​%20(EU).
18 Learning Module 1 Introduction to Financial Statement Analysis

requirements for registering shares and filing periodic financial reports vary from
country to country. ESMA is one of three European supervisory authorities; the two
others supervise the banking and insurance industries.

Financial Notes and Supplementary Schedules

The notes (also sometimes referred to as footnotes) that accompany the financial
statements are required and often account for a large percentage of the financial dis-
closures made in regulatory filings. The notes provide information that is essential to
understanding the information provided in the statements. Sea Ltd.’s 2021 financial
statements, for example, include more than 60 pages of notes.
The notes disclose the basis of preparation for the financial statements. For exam-
ple, Sea Ltd. discloses that its fiscal year corresponds to the calendar year; its financial
statements are prepared in accordance with US GAAP; the statements are thousands
of US dollars unless otherwise specified; and the figures have been rounded, which
might give rise to minor discrepancies when they are added. Sea Ltd. also states that
its financial statements are on a consolidated basis—that is, aggregating the financial
records of all its subsidiaries it controls, after eliminating intercompany balances and
transactions.
The notes also disclose information about the accounting policies, methods, and
estimates used to prepare the financial statements. Both IFRS and US GAAP allow some
flexibility in choosing among alternative policies and methods when accounting for
certain items. This flexibility aims to meet the divergent needs of many businesses for
reporting a variety of economic transactions. In addition to differences in accounting
policies and methods, differences arise as a result of estimates needed to record and
measure transactions, events, and financial statement line items.
Overall, flexibility in accounting choices is necessary because, ideally, a company
will select those policies, methods, and estimates that are allowable and most relevant
and that fairly reflect the unique economic environment of the company’s business
and industry. Flexibility can, however, create challenges for the analyst because the use
of different policies, methods, and estimates reduces comparability across different
companies’ financial statements.
For example, if a company acquires a piece of equipment to use in its operations,
accounting standards require that the cost of the equipment be reported as an expense
(depreciation) by allocating its cost, less any residual value, in a systematic manner
over the equipment’s useful life. Accounting standards permit flexibility, however, in
determining the way each year’s expense is determined. Two companies may acquire
similar equipment but use different methods and assumptions to record the expense
over time. An analyst’s ability to compare the companies’ performance is hindered
by the difference. Analysts must understand reporting choices to make appropriate
adjustments when comparing companies’ financial positions and performance.
For many companies, the financial notes and supplemental schedules provide
explanatory information about every line item (or almost every line item) on the bal-
ance sheet and income statement. In addition, note disclosures include information
about the following (this is not an exhaustive list):
■ segment reporting;
■ business acquisitions and disposals;
■ contractual obligations, including both on- and off-balance sheet debt;
■ financial instruments and risks arising from financial instruments;
■ legal proceedings;
■ related-party transactions; and
■ subsequent events (i.e., events that occur after the balance sheet date).
Regulated Sources of Information 19

Experience using the disclosures made by a company and its competitors typically
enhances an analyst’s judgment about the relative importance of different disclosures
and the ways in which they can be helpful.

Business and Geographic Segment Reporting

Many companies are composed of several businesses. Although companies are not
required to provide disaggregated full financial statements for all of its businesses or
subsidiaries, they are required to provide some disaggregated information under both
IFRS and US GAAP in the notes to financial statements by operating segment. An
operating segment is defined as a component of a company that
■ engages in activities that may generate revenue and create expenses, includ-
ing a start-up segment that has yet to earn revenues;
■ whose results are regularly reviewed by the company’s senior management;
and
■ for which discrete financial information is available.
A company must disclose separate information about any operating segment that
meets certain quantitative criteria—namely, the segment constitutes 10 percent or
more of the combined operating segments’ revenue, assets, or profit. (For purposes
of determining whether a segment constitutes 10 percent or more of combined prof-
its or losses, the criteria is expressed in terms of the absolute value of the segment’s
profit or loss as a percentage of the greater of (1) the combined profits of all profit-
able segments and (2) the absolute amount of the combined losses of all loss-making
segments.) If, after applying these quantitative criteria, the combined revenue from
external customers for all reportable segments combined is less than 75 percent of
the total company revenue, the company must identify additional reportable segments
until the 75 percent level is reached. Small segments might be combined as one if they
share a substantial number of factors that define a business or geographical segment,
or they might be combined with a similar significant reportable segment. Information
about operating segments and businesses that are not reportable is combined in an
“all other segments” category.
Companies must disclose the factors used to identify reportable segments and the
types of products and services sold by each reportable segment.
For each reportable segment, the following should also be disclosed in the notes
to financial statements:
■ revenue, distinguishing between revenue to external customers and revenue
from other segments;
■ a measure of profit or loss;
■ a measure of assets and liabilities (if these amounts are regularly reviewed
by the company’s chief decision-making officer);
■ interest revenue and interest expense;
■ cost of property, plant, and equipment, and intangible assets acquired;
■ depreciation and amortization expense;
■ other non-cash expenses;
■ income tax expense or income; and
■ share of the net profit or loss of an investment accounted for under the
equity method.
Companies also must provide a reconciliation between the information of report-
able segments and the consolidated financial statements in terms of segment revenue,
profit or loss, assets, and liabilities.
20 Learning Module 1 Introduction to Financial Statement Analysis

A company’s reporting segments can be useful as a means of quickly understanding

what a company does and how and where it earns money. The segment data shown
in Exhibit 4 appear in the notes to the financial statements for Sea Ltd.

Exhibit 4: Segment Reporting

Excerpts from Note 22 (Segment Reporting) of Sea Ltd.’s
2021 Annual Report on Form 20-F
The Company has three reportable segments, namely digital entertainment,
e-commerce and digital financial services. The Chief Operating Decision Maker
(CODM) reviews the performance of each segment based on revenue and certain
key operating metrics of the operations and uses these results for the purposes
of allocating resources to and evaluating financial performance of each segment.
Description of Reportable Segments:

Digital entertainment – Garena’s platform offers mobile and PC online

games and develops mobile games for the global market. Garena is the
global leader in eSports, it also provides access to other entertainment
content and social features, such as live streaming of gameplay, user chat
and online forums.

E-commerce – Shopee’s platform is a mobile-centric, social-focused mar-

ketplace. It provides users with a convenient, safe, and trusted shopping
environment with integrated payment, logistics infrastructure and com-
prehensive seller services. Products from manufacturers and third parties
are also purchased and sold directly to buyers on Shopee platform.

Digital financial services – SeaMoney provides a variety of payment

services and loans to individuals and businesses. It is an important
payment infrastructure supporting the Company’s digital entertainment
and e-commerce businesses. In addition, SeaMoney also integrates with
third party merchant partners and covers a broad set of consumption use
cases.
A combination of multiple business activities that does not meet the quan-
titative thresholds to qualify as reportable segments are grouped together as
“Other services”.
Segment Results for Year Ended 31 December 2021 (000s of USD)
Digital
Digital Financial Other Unallocated
Entertainment E-Commerce Services Services Expenses Consolidated

Revenue 4,320,013 5,122,959 469,774 42,444 0 9,955,190

Operating income (loss) 2,500,081 (2,766,566) (640,422) (177,633) (498,520) (1,583,060)
Non-operating loss, net (132,124)
Income tax expense (332,865)
Regulated Sources of Information 21

Segment Results for Year Ended 31 December 2021 (000s of USD)

Digital
Digital Financial Other Unallocated
Entertainment E-Commerce Services Services Expenses Consolidated
Share of results of equity
investees 5,019
Net loss (2,043,030)

Revenue by Geography (000s of USD)

Year Ended 31 December

Revenue: 2019 2020 2021

Southeast Asia 1,378,141 2,791,894 6,316,782

Latin America 282,618 790,308 1,850,861
Rest of Asia 489,291 655,007 1,394,342
Rest of the World 25,328 138,455 393,205
Consolidated
revenue 2,175,378 4,375,664 9,955,190

From the data in Exhibit 4, an analyst can quickly see that the e-commerce seg-
ment accounted for just over 50 percent of total revenues in 2021 but generated a
large operating loss, while the digital entertainment segment accounted for most of
the remaining revenues and was the only profitable segment. An analyst would likely
spend a majority of their time on examining the past and present, and forecasting
the future results of these two segments. Similarly, an analyst would use these disclo-
sures to understand that Southeast Asia and Latin America are the company’s most
important geographies.
Identifying segments requires significant judgment by management, and companies
often change the definition of segments and related disclosures.
Another required disclosure is the company’s reliance on any single customer. If
any single customer represents 10 percent or more of the company’s total revenues,
the company must disclose that fact, though not the identity of that customer. From
an analysts’ perspective, information about a concentrated customer base can be
useful in assessing the risks faced by the company.

Management Commentary or Management’s Discussion and

Analysis
Regulatory filings such as Form 10-K and 10-Q include a section in which manage-
ment discusses a variety of issues, including the nature of the business, past results,
and outlook. This section is referred to by a variety of names, including management
report(ing), management commentary, operating and financial review, and MD&A.
The discussion by management is arguably one of the most useful parts of a
company’s annual report besides the financial statements themselves; however, other
than excerpts from the financial statements, information included in the management
commentary is typically unaudited. In Germany, management reporting has been
required since 1931 and is audited.
To help improve the quality of the discussion by management, the International
Accounting Standards Board (IASB) issued an IFRS Practice Statement “Management
Commentary” includes a framework for the preparation and presentation of man-
agement commentary. The framework provides guidance rather than sets forth
22 Learning Module 1 Introduction to Financial Statement Analysis

requirements in a standard. The framework identifies five content elements of a

“decision-useful management commentary”: (1) the nature of the business; (2) man-
agement’s objectives and strategies; (3) the company’s significant resources, risks,
and relationships; (4) results of operations; and (5) critical performance measures.
In the United States, the SEC requires listed companies to provide an MD&A
and specifies the content.8 Management must highlight any favorable or unfavorable
trends and identify significant events and uncertainties that affect the company’s
liquidity, capital resources, and results of operations. The MD&A must also provide
information about the effects of inflation, changing prices, or other material events
and uncertainties that may cause the future operating results and financial condition
to materially depart from the current reported financial information. In addition, the
MD&A must provide information about off-balance-sheet obligations and about con-
tractual commitments, such as purchase obligations. Management should also discuss
the critical accounting policies that require them to make subjective judgments and
that have a significant impact on reported financial results.
The management commentary, or MD&A, is a good starting place for under-
standing information in the financial statements. In particular, the forward-looking
disclosures, such as those about planned capital expenditures, new store openings, or
divestitures, can be useful in projecting a company’s future performance. However, the
commentary is only one input for the analyst seeking an objective and independent
perspective on a company’s performance and prospects.
Sea Ltd.’s 2021 annual report on Form 20-F includes much information of potential
interest to an analyst. The lengthy report contains sections such as “Information on
the Company” and “Operating and Financial Review and Prospects” that discuss the
company’s history, business model, strategies, key performance indicators, risk factors,
relevant laws and regulations, recent financial performance and position, cash flows
and working capital, capital expenditures, and key accounting policies.

Auditor's Reports
Financial statements presented in companies’ annual reports are generally required to
be audited by an independent accounting firm in accordance with specified auditing
standards. The independent auditor then provides a written opinion on the financial
statements. This opinion is referred to as the audit report. Audit reports may vary in
different jurisdictions, but the minimum components, including a specific statement
of the auditor’s opinion, are similar. Audits of financial statements may be required
by contractual arrangement, law, or regulation.
International standards on auditing (ISAs) have been developed by the International
Auditing and Assurance Standards Board (IAASB). This body has emerged from the
International Federation of Accountants. ISAs have been adopted by many countries
and are referenced in audit reports issued in those countries. Other countries, such
as the United States, specify their own auditing standards. With the enactment of
the Sarbanes–Oxley Act of 2002 in the United States, auditing standards for public
companies are promulgated by the PCAOB.

8 Relevant sections of SEC requirements are included for reference in the FASB Accounting Standards
Codification (ASC). The FASB ASC does not include sections of SEC requirements that deal with matters
outside the basic financial statements, such as the MD&A.
Regulated Sources of Information 23

Under ISAs, the overall objectives of an auditor in conducting an audit of financial

statements are
■ to obtain reasonable assurance about whether the financial statements as a
whole are free from material misstatement, whether due to fraud or error,
thereby enabling the auditor to express an opinion on whether the finan-
cial statements are prepared, in all material respects, in accordance with an
applicable financial reporting framework; and
■ to report on the financial statements, and communicate as required by the
ISAs, in accordance with the auditor’s findings.9
Publicly traded companies may also have requirements set by regulators or stock
exchanges, such as appointing an independent audit committee within its board of
directors to oversee the audit process. The audit process provides a basis for the
independent auditor to express an opinion on whether the information in the audited
financial statements presents fairly the financial position, performance, and cash flows
of the company in accordance with a specified set of accounting standards.
Audits are designed and conducted using sampling techniques, and financial
statement line items may be based on estimates and assumptions. This means that the
auditors cannot express an opinion that provides absolute assurance about the accuracy
or precision of the financial statements. Instead, the independent audit report provides
reasonable assurance that the financial statements are fairly presented, meaning that
there is a high probability that the audited financial statements are free from material
error, fraud, or illegal acts that have a direct effect on the financial statements.
The independent audit report expresses the auditor’s opinion on the fairness of the
audited financial statements, and specifies which financial statements were audited, the
reporting entity, and the date. An unqualified audit opinion states that the financial
statements give a “true and fair view” (international) or are “fairly presented” (inter-
national and United States) in accordance with applicable accounting standards. This
is also referred to as an “unmodified” or a “clean” opinion and is the one that analysts
would like to see in a financial report. There are several other types of modified
opinions. A qualified audit opinion is one in which there is some scope limitation or
exception to accounting standards. Exceptions are described in the audit report with
additional explanatory paragraphs so that the analyst can determine the importance
of the exception. An adverse audit opinion is issued when an auditor determines that
the financial statements materially depart from accounting standards and are not
fairly presented. Finally, a disclaimer of opinion occurs when, for some reason, such
as a scope limitation, the auditors are unable to issue an opinion.
The audit report also describes the basis for the auditor’s opinion and, for listed
companies, includes a discussion of Key Audit Matters (international) and Critical
Audit Matters (United States).10 Key Audit Matters are defined as issues that the
auditor considers to be most important, such as those that have a higher risk of
misstatement, involve significant management judgment, or report the effects of sig-
nificant transactions during the period. Critical Audit Matters are defined as issues
that involve “especially challenging, subjective, or complex auditor judgment” and
similarly include areas with higher risk of misstatement or that involve significant
management judgment and estimates. However, Key and Critical Audit Matters are
not necessarily the most important factors for analysts and investors.

9 See the International Auditing and Assurance Standards Board (IAASB), Handbook of International
Quality Control, Auditing, Review, Other Assurance, and Related Services Pronouncements (New York:
International Federation of Accountants, 2020).
10 Discussion of Key Audit Matters in the auditor’s report is required by the International Standard on
Auditing (ISA) ISA 701, effective in 2017, issued by the International Audit and Assurance Standards Board.
Discussion of Critical Audit Matters in the auditor’s report is required by the Auditor Reporting Standard
AS 3101, effective for large filers’ fiscal years ending on or after 30 June 2019, issued by the PCAOB.