1
Chapter
Framework For Financial Statement
Analysis
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Chapter Objectives
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Explain why Financial Statement Analysis is needed.
Discuss the General Principles of the Financial reporting system
Review the elements of the FASB’s conceptual framework.
Briefly describe the principal financial statement:
Balance Sheet, Income Statement, Statement of Comprehensive
Income, Statement of Cash Flows & Statement of Stockholder’s
Equity.
• Discuss the usefulness of Financial Statement footnotes &
supplementary data.
• Describe the usefulness of the Management Discussion and
Analysis & other sources of financial information.
Need For Financial Statement Analysis
• In an ideal world, the user of financial statements could focus
only on the bottom lines of financial reporting: net income and
stockholders equity.
• The financial reporting system is not perfect. Economic events &
accounting entries do not correspond precisely; they diverge
across the dimensions of timing, recognition & measurement.
• Economic events and accounting recognition of those events
frequently take place at different times.
• Example- the recognition of capital gain and losses only upon sale
in most cases.
• Long - lived assets are written down, most of the time, in the
Fiscal Period of management’s choice.
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Need For Financial Statement Analysis, cont..
• Many Economic events do not receive accounting recognition at
all. Some contracts such as leases and hedging activities.
• Generally Accepted Accounting Principles (GAAP) permit
economic events that do receive accounting recognition to be
recognized in different ways by different financial statement
prepares.
• Financial reports often contain supplementary data that,
although not included in the statements themselves, help the
financial statement users to interpret the statements or to adjust
measures of corporate performance to make them more
comparable.
• Information from outside the financial reporting process can be
used to make financial data more useful.
Classes of Users
External users of financial information encompasses a wide range
of interests but can be classified into three general groups:
1. Credit and equity investors;
2. Government (executive and legislative branches), regulatory
bodies & tax authorities.
3. The general public and special interest groups, labor unions and
consumer groups.
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The Financial Reporting System
The Accounting process or financial reporting system, which
generates financial information for external users, encompasses
five principal financial statements:
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5.
Balance sheet ( statement of financial position)
Income statement ( statement of earnings)
Statement of comprehensive income
Statement of cash flows
Statement of stockholders’ equity
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General Principles & Measurement Rules
Financial statement provide information about the assets (resources),
liabilities (obligations), income & cash flows, and stockholders’
equity of the firm. The effects of transactions and other events are
recorded in the appropriate financial statements.
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The income statement reports revenues, expenses, and gains &
losses.
The balance sheet shows assets, liabilities, & stockholders
equity; the statement of stockholders’ equity reports capital
transaction with owners.
The statement of comprehensive income reports changes in
certain balance sheet accounts that bypass the income statement.
The statement of cash flows includes operating investing, and
financial inflows and outflows. Many transactions are reflected
in more than one statement so that the entire set is required to
evaluate the firm.
Qualitative Characteristics of Accounting
Information
Relevance:
Defined as “the capacity of information to make a difference in a
decision ..” In practice, of course the relevance of information
depends on the decision maker.
Timeliness:
Is an important aspect of relevance. Information loses value rapidly
in the financial world. Market prices are predicted on estimates of the
future; data on the past are helpful in making projections. But, if
future becomes the present, past data become irrelevant.
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Qualitative Characteristics of Accounting
Information, cont..
Reliability:
Encompasses verifiability, representational faithfulness and
neutrality. The first two elements (verifiability & representational
faithfulness) are concerned with whether financial data have been
measured accurately and whether they are what they purport to be.
Neutrality:
Is Concerned with whether financial statement data are biased.
The principle of neutrality states that the board should consider
only the relevance and reliability of the data, not any possible
economic impact.
Qualitative Characteristics of Accounting
Information, cont..
Consistency & Comparability:
Are also key Characteristics of accounting information from the
analyst perspective. Consistency refers to use of the same
accounting principles over time. A broader term, comparability,
refers to comparison among companies.
Materiality:
Is paradoxically the most elusive accounting quality and arguably
the most important. We define information to be material when it
would make a difference in the valuation of the firm.
International Accounting Standards
Growing international trade, multinational industrial and financial
enterprises, and increasingly global capital markets have
significantly expanded investment opportunities. Creditors and
equity investors need to analyze both domestic and foreign
companies. Yet differences in accounting and reporting standards
make it difficult to compare domestic companies with those in
other countries. Furthermore, as accounting standards are
established separately in each country, it is difficult to generalize
about those differences.
International Accounting Standard Board:
The IASB was established in 1973 to harmonize (conform) the
accounting standards of different nations.
Principal Financial Statements
The Balance Sheet
The balance sheet reports major classes and amounts of assets
(resources owned or controlled by the firm), liabilities (external
claims on those assets), and stockholders’ equity (owners’ capital
contributions and other internally generated sources of capital) and
their interrelationships at specific points of time.
Elements of Balance Sheet:
Assets: Are defined in SFAC 6 as –
Probable future economic benefits obtained or enrolled by a
particular entity as a result of past transaction or events. (Para - 25)
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Principal Financial Statements, cont..
Liabilities: Are defined, similarly, as –
Probable future sacrifices of economic benefits arising from present
obligations of a particular entity to transfer assets provide services to
other entities in the future as a result of past transactions or events.
(Para – 35)
Owners’ equity: As required by the fundamental accounting
equation, stockholders’ equity is therefore –
The residual interest in the net assets of an entity that remains after
deducting its liabilities. (Para – 49)
Principal Financial Statements, cont..
The Income Statement:
The income statement (statement of earnings) reports on the
performance of the firm. The result of its operating activities. It
explains some but not all of the changes in the assets, liabilities, and
the equity of the firm between two consecutive balance sheet dates.
Use of the accrual concept means that income and the balance sheet
are interrelated.
Elements of the Income Statement:
Revenues: Are defined in SFAC 6 as –
Inflows of an entity from delivering or producing goods, rendering
services, or other activities that constitute the entities’ ongoing major
or central operations. (Para -78)
Principal Financial Statements, cont..
Expenses: Are defined as –
Outflows from delivering or producing goods, rendering services, or
carrying out other activities that constitute the entities’ ongoing
major or central operations. (Para -80)
These definitions explicitly exclude gains (and losses) defined as –
Increases (decreases) in equity (net assets) from peripheral or
incidental transactions…(Para – 82)
Principal Financial Statements, cont..
Statement of Cash Flows:
The statement of cash flows reports cash receipts and payments in
the period of their occurrence, classified as to operating, investing
and financing activities. It also provides supplementary disclosures
about noncash investing and financing activities. Defining investing
cash flows as those resulting from:
• Acquisition or sale of property, plant an equipment
• Acquisition or sale of a subsidiary or segment
• Purchase or sale of investments in other firms.
Principal Financial Statements, cont..
Similarly, financing cash flows are those resulting from:
• Issuance or retirement of debt and equity securities
• Dividends paid to stockholders
Cash from operations – This key performance measure includes the
cash effects of all transactions that do not meet the definition of
investing or financing.
Principal Financial Statements, cont..
Statement of Stockholders’ Equity:
This statement reports the amounts and sources of changes in equity
from capital transactions with owners and may include the following
components:
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Preferred shares
common Shares (at par of stated value)
Additional paid-in capital
Retained earnings
Treasury Shares (repurchase equity)
Employee Stock Ownership Plan (ESOP) adjustments
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Footnotes
Footnotes provide information about the accounting method,
assumptions, and estimates used by management to develop the data
reported in the financial statements. They are designed to allow users
to improve assessments of the amounts, timing, and uncertainty of
the estimates reported in the financial statements. Footnotes provide
additional disclosure related to such areas as:
• Fixed assets
• Inventories
• Income taxes
• Pension and other postemployment benefit plans
• Debt (interest rates, maturity schedules, and contractual terms)
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Lawsuits and other loss contingencies
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Footnotes, cont..
• Marketable securities and other investments
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Hedging and other risk management activities
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Business segments
• Significant customers, sales to related parties and export sales.
• In some cases, additional information about the assets and liabilities
of a firm is provided within the financial statement footnotes, or as
supplementary data outside the financial statements. Example
include:
• Oil and gas companies provide additional data on their exploration
activities, quantities and types of reserves and the present value of
cash flows expected from those reserves.
• Disclosure of sales revenue, operating income, and other data for
major business segments and by geographic areas (chap. 13 & 15).
Firms also provide information about export sales.
Other Sources of Financial Information
Management Discussion and Analysis
Companies with publicly traded securities have been required since
1968 to provide a discussion of earnings in the MD & A sections.
The MD & A is required to discuss:
• Results of operations, including discussion of trends in sales and
categories of expense
• Capital resources and liquidity, including discussion of cash flow
trends
• Outlook based on known trends.
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Other Data Sources
Companies that issue securities to the public are required to publish a
registration statement including a prospectus.
Proxy statements, issued in connection with shareholder meetings,
contain information about board members and management,
executive compensation, stock options, and major stockholders.
Many companies prepare periodic “fact books” containing additional
financial and operational data. Corporate press releases also provide
new information on a timely basis.
In addition, many companies hold periodic meetings or conference
telephone calls to keep the financial community appraised of recent
developments regarding the company.
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