CFA Level 1: Financial Statement Analysis

2 Elements of Financial Reporting Quality (L8)

• Faithful representation (Absence of material, Completeness & Neutrality)

• Relevance

Auditors (L8)

A discipling mechanism that focuses on checking accounts and see if there is any mistreatment.

Regulators (SEC) (L8)

A discipling mechanism that focus on revenue recognition as a big area of interest.

Audit Report (L1)

An independent review of a company’s financial statements that must be presented as true & fair. Under US GAAP they must provide an opinion on company’s internal controls.

Qualified Auditor Opinion (L1)

A type of auditor opinion that states exceptions to accounting principles, due to a company's financial statements are generally fair, but contain material misstatements or limitations that are not pervasive.

Unqualified Auditor Opinions (L1)

A type of auditor opinion that states a unmodified or clean opinion, due to indications that a company’s financial statements are presented fairly, in all material respects, and in accordance with GAAP or IFRS and no significant misstatements and that the financial records are reliable.. Considered the best type of auditor opinion.

Adverse Opinion (L1)

A type of auditor opinion that states that the financial statements are not presented fairly, due to a company's financial statements are materially misstated, not prepared according to GAAP, and do not accurately represent its financial position. Considered the most serious type of opinion.

Disclaimer of Opinion (L1)

A type of auditor opinion that states the inability to form an opinion, due to sufficient evidence.

Footnotes (L1)

Additional information presented in primary financial statements. It is used as the basis of representation, and describing accounting methods, and estimates.

Lessee (L6)

The party who directs how the asset is used, and receives benefits from the asset over a contract.

• Makes standard periodic payments.

• Avoid ownership risks such as obsolesce, low up front payments, & effective interest rates lower than unsecured borrowing.

Lessor (L6)

Legal owner of said asset, who grants the rights to use in exchange for periodic payments.

• Increase market for products & interest incomes.

Finance Lease (L6)

Transfers substantially all the risks and rewards of ownership to the lessee (the person renting)

Considered if lease meets any of the requirements:

• Transfer ownership to the lessee

• Lessee has an option to buy & is “reasonably sure” they will exercise it.

• Lease is for most of the asset’s useful life.

• Present Value (PV) of lease payments ≥ fair value of the asset.

• Lessor has no alternative use for the asset.

Operating Lease (L6)

A lease allows for the use of an asset without transferring ownership rights. Short-term & low value treated as rental exposure.

Lessor Accounting for Finance Leases (L6)

• Initiation: Present Value of lease receipts = Lease Receivable Asset

• Derecognition of lease assets

• Difference in present value of lease receipts & carry value of asset = Income Statement gain or loss.

• Effective interest is reported as revenue if leasing assets is a primary business activity.

Lessor Accounting for Operating Leases (L6)

• Treats contract as rental agreement.

• Asset remains in lessor’s balance sheet and is depreciated.

• Not treated as a financing activity = no interest receivable.

• Lease revenue recognized on a straight-line basis.

Lessee Classification for Finance Leases for PV of Lease Payments (L6)

• Right to use asset (ROU) in Balance Sheet

• Lease liability in Balance Sheet

• ROU amortized over contract (straight-line)

Lessee Classification for Finance Leases for Fixed Payments (L6)

• Interest to Income Statement Cash Flow Operations (CFO)

• Principal reduces the Balance Sheet Liability in Cash Flow form Financing.

Lessee Classification for Operating Leases IFRS (L6)

Same treatment as financial leases for lessee classification.

Lessee Classification for Operating Leases for USGAAP (L6)

Has a different treatment for lessee classification, mainly for amortization in which payment less interest.

• Reduce both liability and Right to Use in Balance Sheet

• Lease Expense = payment

• Interest and amortization is not reported separately in Income Statement

Vest (L6)

An employee compensation process in earning the right to consideration or an asset.

Time Based Vesting (L6)

A vesting process that involves the right is earned over time such as salaries and pension payments.

Milestone Based Vesting (L6)

Also known as a performance based compensation that involves the right is earned when certain criteria (task, objectives, and targets) are met.

Deferred Compensation (L6)

Employees earn the right to compensation in the current period but receive consideration in future period.

Defined Benefit Pension Plans (L6)

A pension plan that is deferred compensation offers fixed payments on retirement to death.

Employee entitlements to future benefits on retirement are based on predetermined also known as a formula such as accrual rate, service history, and expected final salary.

Risk of funding payments on retirement lies sole within the employer and are typically prefunded.

Tax Base of Asset (L7)

Amount deductible for tax purposes in future period as economic benefits are realized.

6 Stages of Financial Analysis

I. Articulate

II. Collect Data

III. Process Data

IV. Analyze Data

V. Draw Conclusion

VI. Follow Up

Articulate (L1)

A stage of financial statement analysis that states what is trying to be achieved and what is the general output.

Collect Data (L1)

A stage of financial statement analysis in which company visits, look at trade journals, and collect data from financial statements.

Process Data (L1)

A stage of financial statement analysis that focuses on creating data visualization and computing ratios.

Analyze Data (L1)

A stage of financial statement analysis that describes data and interpretations.

Draw Conclusion (L1)

A stage of financial statement analysis that lists recommendations and draw conclusions from the data.

Follow Up (L1)

A stage of financial statement analysis that focuses on updating analysis and conduct a follow up.

Restricted Stock Grant (L6)

Employees must return the shares to the company if specific requirements are not met.

Typical Restriction (L6)

Employees must be employed for a specific period of time.

Stock Grants with Restriction (L6)

• Measures fair value at the grant rate with the spread value over the service period.

• Reduce net income and increase common stock at par & APIC

• 2 Types: Restricted Stock Grant & Typical Restriction

Share-Based Compensation Compromised of (L6)

Stock Grants and Stock Option

Share-Based Compensation Benefits (L6)

• Aligns management & shareholder interests.

• Potentially no cash outlay.

Share-Based Compensation Costs (L6)

• Dilution (ownership % and Earnings Per Share)

• Managers may have limited or no influence over share price.

• Potential risk aversion or increased risk taking.

Stock Options Key Components (L6)

Fair value at grant data established using a valuation model with key assumption of volatility of stock price.

Stock Option Compensation (L6)

Spread over service period (vesting) = time to first exercise

Stock Options Over vesting Period (L6)

• Reduce net income (additional compensation expense).

• Increase Additional Paid in Capital (APIC).

Stock Options on Exercise (L6)

• Increase common stock for the par value of shares issued.

• Increase Additional Paid Capital (APIC) by the difference between fair value at grant date.

Types of Stock Grants given to employees (L6)

• Outright

• With restrictions

• Contingent on performance

Stock Grant Outright (L6)

• Measured at first fair value of shares on grant date.

• Allocated over service period.

• Service period assumed to be current period unless there are restrictions.

• Reduce net incomes (additional compensation expense) by fair value.

• Increase common stock at par and Additional Paid in Capital (APIC).

Presentation and Disclosure for Leases (L6)

IFRS and US GAPP disclose designed to give information to assess amounts, timings, and uncertainties of cash flows.

Presentation and Disclosure for Pensions (L6)

IFRS and US GAAP disclosure designed to explain characteristics and risks, identify amounts in the financial statements, and describe the impact on amounts, timings, and uncertainty of future cash flows.

Presentation and Disclosure for Share Based Compensation (L6)

Disclosure designed to enable users to understand the nature & extent of share-based compensation arrangements.

Balance Sheet Asset / Liabilities (L6)

• Funded Status in Balance Sheet

• Fair Value of Plan Assets (Asset) < Present Value of Defined Benefit Obligation (PVSBO).

Fair Value of Plan Assets (L6)

• Market value of assets held.

• Employer makes contributions into a pension trust fund.

Present Value of Defined Benefit Obligation (PVDBO) (L6)

• Present Value of payments expected to be made post retirement, based on entitlements earned to date.

Assumptions for Present Value of Defined Benefit Obligation (PVDBO) (L6)

Final salary, post-retirement life expectancy, inflation, employee turnover, retirement age, discount rate, etc.