FSA Section 1

Financial Statement Analysis Framework 

1. State the objective and context 

2. Gather data 

3. Process the data 

4. Analyze and interpret the data 

5. Report the conclusions or recommendations 

6. Update the analysis 

Standard-setting bodies 

• Professional organizations of accountants and auditors that establish financial reporting standards 

• FASB 

• International accounting standards board (IASB) 

Regulatory Authorities 

• Government agencies that have the legal authority to enforce compliance with financial reporting standards 

• SEC 

• Financial Conduct Authority 

International Organization of Securities Commissions 

• Members work together to improve cross-border cooperation and make regulations enforcement uniform around the world 

• 3 objectives 

• Protecting investors 

• Ensuring markets are fair, efficient, transparent 

• Reducing systemic risk 

Form S-1 

Registration statement filed before the sale of new securities to the public

Form DEF-14A 

Filed when company prepares a proxy statement for its shareholders before annual meeting or other shareholder vote 

Form 8-K 

• Discloses material events including significant asset acquisition and disposal 

• Changes in management 

• Corporate governance 

• Matters related to accountants or financial statements or markets it’s securities trade on 

Form 144 

Company can issue securities to certain qualified buyers without registering the securities with the SEC 

Forms 3,4,5 

Involve the beneficial ownership of securities by a company's officers and directors 

Proxy Statements 

Issued to shareholders when there are matters that require a shareholder vote 

Standard Auditors Opinion 

• The financial statement are prepared by management and are its responsibility 

• Generally accepted auditing standards were followed, providing reasonable assurance that the financial statement contain no material errors 

• Auditor is satisfied that the statements were prepared in accordance with accepted accounting principles and that the principles and estimated are reasonable 

Unqualified Opinion 

Indicates auditor believes the statements are free from material omissions and errors 

Qualified Opinion 

Issued by auditor if statements make any exceptions to the accounting principles 

Adverse Opinion 

Statements are not presented fairly or are materially nonconforming with accounting standards 

Disclaimer of Opinion 

Auditor is unable to express an opinion 

Internal Controls 

Processes by which company ensures that it presents accurate financial statements 

5 Step Process for recognizing revenue 

1. Identify the contract with a customer 

2. Identify the separate or distinct performance obligations in the contract 

3. Determine the transaction price 

4. Allocate the transaction price to the performance obligations in the contract 

5. Recognize revenue when the entity satisfies the performance obligation 

Contract 

• Agreement between two or more parties that specifies their obligations and rights 

• Collectability must be probable for a contract to exist 

Performance obligation 

Promise to deliver a distinct good or service 

Distinct Good or Service 

• Customer can benefit from the good or service on its own or combined with other resources that are readily available 

• Promise to transfer the good or service can be identified separately from any other promises 

Costs to secure long-term contract

must be capitalized over the life of the contract 

Required disclosure under the converged standards

• Contracts with customer by category 

• Assets and liabilities related to contracts, including balances and changes 

• Outstanding performance obligations and the transaction prices allocated to them 

• Management judgments used to determine the amount and timing of revenue recognition 

Expense Recognition 

Recognized in the period in which economic benefits of expenditure are consumed 

Matching Principle 

Expenses to generate revenue are recognized in the same period as the revenue 

Capitalization 

Costs are initially capitalized as assets on the balance sheet and then expensed using depreciation to the income statement over the assets life as its benefits are consumed 

Period Costs 

• Expenses not tied to revenue generation 

• Ex: Administrative costs 

• Expensed in the period incurred 

Aggressive Expense Recognition 

Recognizes expenses later rather than sooner 

Conservative Expense Recognition 

• Recognizes expenses earlier 

• Expensing is more conservative than capitalization 

Total Asset Turnover 

• Sales / Avg Total Assets 

• Lower if costs are capitalized due to higher balance sheet assets 

Capitalized Interest 

• Interest that accrues during construction period is capitalized as part of the asset’s cost 

• Accurately measures the cost of the asset  

• Not reported on the income statement as interest expense 

• Allocated to depreciation expense (if asset held for use) or COGS (if asset held for sale) 

• Reported on cash flow statement as an outflow from investing activities  

Interest Coverage 

EBIT/interest expense 

R&D Costs (GAAP)

Research and development costs generally expensed as incurred excluding creation of software for sale to others 

R&D Costs (IFRS)

• Research costs are expensed as incurred 

• Development costs may be capitalized 

Bad Debt and Warranty Expenses 

• Matching principle requires firms to estimate bad debt expense or warranty expense 

• Firm recognizes the expense in the period of the sale 

Unusual/Infrequent Items 

Unusual in nature or infrequent in occurrence and are material 

• Examples: 

• Gains or losses from the sale of assets or part of a business 

• Impairments, write offs, write downs 

• Restructuring costs 

Included in income from continuing operations and reported before tax 

Discontinued Operations 

Operation that management has decided to dispose of but has not done so or has disposed of it in the current year after operation had generated income or losses 

Income or loss from discontinued operations is reported separately in the income statement, net of tax, after income from continuing operations 

Measurement Date 

Date when a company develops a formal plan for disposing of an operation 

Phaseout Period 

Time between the measurement period and the actual disposal date 

Retrospective Application 

Any prior-period financial statements presented in firm’s current financial statements must be rested applying the new policy 

Prospective application 

Prior statements are not restated, new policies applied only to future financial statements 

Change in Accounting Estimate 

Result of a change in managements judgement 

Typically do not affect cash flow 

Reported prospectively 

Prior-period adjustment 

Required for a correction of an accounting error made in previous financial statements 

Prior-period results are restated 

Disclosure of significant prior period adjustment and its effect on net income also required 

Earnings Per Share (EPS) 

Reported only for share of common stock (ordinary stock) 

Firms with complex capital structures must report both basic and diluted EPS 

Firms with simple capital structure only report basic EPS 

Simple Capital Structure 

Contains no potentially dilutive securities 

• Contains only: 

• Common stock 

• Nonconvertible debt 

• Nonconvertible preferred stock

Complex Capital Structure 

• Contains potentially dilutive securities such as: 

• Employee stock options 

• Warrants 

• Convertible securities 

Basic EPS 

Refers to the per-share earnings available to common shareholders 

 = Net income – preferred dividends / weighted average number of common shares outstanding 

Common stock dividends are not subtracted because they are factored into net income available to common shareholders 

Weighted Average Number of Common Shares 

Number of share outstanding during the year, weighted by the portion of the year they were outstanding 

Stock Split 

• Division of each “old” share into a specific number of “new” (post-split) shares 

• Holder of 100 shares will have 200 shares after a 2-for-1 split or 150 shares after a 3-for-2 split 

Tips for Calculating Weighted Avg Shares Outstanding 

• The weighting system is days outstanding divided by the number of days in a year, but on the exam, the monthly approximation method will probably be used. 

• Shares issued enter into the computation from the date of issuance. 

• Reacquired shares are excluded from the computation from the date of reacquisition. 

• Shares sold or issued in a purchase of assets are included from the date of issuance. 

• A stock split or stock dividend is applied to all shares outstanding before the split or dividend and to the beginning-of-period weighted average shares. A stock split or stock dividend adjustment is not applied to any shares issued or repurchased after the split or dividend date. 

Dilutive Securities 

• Stock options, warrants, convertible debt, convertible preferred stock that would decrease EPS if exercised or converted to common stock 

• Only dilutive when exercise prices are less than the avg market price of the stock over the year 

Antidilutive Securities 

Stock options, warrants, convertible debt, convertible preferred stock that would increase EPS if exercised or converted to common stock 

Calculating basic EPS for Dilutive Securities 

• If convertible preferred stock is dilutive (meaning EPS will decrease if it is converted to common stock), the convertible preferred dividends must be added to earnings available to common shareholders. 

• If convertible bonds are dilutive, then the bonds' after-tax interest expense is not considered an interest expense for diluted EPS. Hence, interest expense multiplied by (1 – the tax rate) must be added back to the numerator. 

Diluted EPS Equation 

= adjusted income available for common shares / weighted avg common and potential common shares outstanding 

Adjusted income available for common shares  

= net income – preferred dividends + dividends on convertible preferred stock + after tax interest on convertible debt 

Treasury Stock Method 

= (avg share price – exercise price)/avg share price x # of exercisable shares 

• Funds received by the company from the exercise of the options would be used to hypothetically purchase shares of the company’s common stock in the market at the avg market price 

• Net increase in the number of share outstanding is the number of shares created by exercising the options less the number of shares hypothetically repurchased with proceeds of exercise 

Vertical Common Size Income Statement 

• Expresses each category of the income statement as a percentage of revenue 

• Standardizes income statement by eliminating the effects of size 

• Allows for comparison of income statement items over time and across firms 

Effective tax rate 

Tax expense expressed as a percentage of pretax income 

Pretax margin 

= pretax accounting profit / revenue 

Gross profit margin 

= gross profit / revenue 

Net profit margin 

= net income / revenue 

Intangible Assets 

Nonmonetary assets that lack physical substance 

Identifiable Intangibles 

Can be acquired separately or are the result of rights or privileges conveyed to their owner 

Unidentifiable Intangibles 

• Cannot be acquired separately and may have an unlimited life 

• Ex: goodwill 

Following intangible costs Should be expensed as incurred 

• start up and training costs 

• Administrative overhead 

• Advertising and promotion costs 

• Relocation and reorganization costs 

• Termination costs 

If project is not yet feasible – expense all costs 

Goodwill 

• Results from acquiring another business 

• Amount by which the purchase price is greater than the fair value of the acquired company’s assets 

• Internal goodwill expensed as incurred 

Economic Goodwill 

Derives from the expected future performance of the firm 

Financial Instruments 

Contracts that give rise to both a financial asset of one entity and a financial liability or equity instrument of another entity 

Debt securities acquired with intent to hold until maturity are classified as held to maturity securities and measured at amortized cost

Financial Instrument Examples

• Securities (stocks and bonds) 

• Derivates 

• Loans 

• Receivables 

Trading securities 

• Debt securities acquired with the intent to sell them in the near term 

• Reported at fair value with unrealized gains or losses reported on the income stmt 

Available for Sale Securities 

• Debt securities that are not expected to be held to maturity or traded in the near term 

• Reported at fair value 

• Unrealized gains or losses not reported on the income statement but reported in other comprehensive income as part of shareholders equity 

IFRS Treatment of Marketable Securities (3 Classifications) 

• Securites measured at amortized cost 

• Securities measured at fair value through other comprehensive income 

• Securities measured at fair value through profit and loss 

Long-Term Financial Liabilities 

• Bank loans, notes payable, bonds payable, some derivatives 

• If not issued at face value, reported on the balance sheet at amortized cost 

• If issuance value differs from face value, difference is amortized through interest expense over life of the liability  

Deferred tax liabilities 

• Income taxes payable in future periods as a result of timing differences between financial accounting and tax accounting 

• Amount of income tax expense recognized in the income statement is greater than taxes payable using tax accounting 

• Can occur when expenses or losses are tax deductible before they are recognized on the income statement 

Vertical Common Size balance sheet 

• Express each item of the balance sheet as a percentage of total assets 

• Eliminates the effects of size 

• Better comparison performance across time and firms 

Solvency Ratios 

Debt Ratio

Financial Leverage Ratio

Debt Ratio

total debt/total assets

Financial Leverage Ratio

total assets/total equity

High Quality Earnings 

When operating cash flows (CFO) are close to or higher than reported earnings 

Preparation of Cash Flow Statement 

• Increase in an asset account is a use of cash 

• Increase in a liability account is a source of cash  

Direct Method for Cash from Operations 

• Shows only cash payments and cash receipts over the period 

• Sum of these inflows and outflows is CFO 

• Common Components 

• Cash collected from customers (typically the main component of CFO) 

• Cash used in the production of goods and services (cash inputs) 

• Cash operating expenses, such as salaries 

• Cash paid for interest 

• Cash paid for taxes 

Indirect Method of Presenting CFO 

• Begin with net income and adjust it for differences between accounting items and actual cash inflows and outflows 

• Depreciation expense – non cash item add back to Net Inc 

• Sale of Fixed Assets – investing cash flow not operating – remove from net income 

Investment in Working Capital 

Net change in a company’s total operating assets and liabilities 

CFO 

• Net income adjusted for noncash charges and the investment in working capital  

• CFO = NI + NCC - WCINV 

 

Non-Cash Charges 

Gains and losses that have passed through the income statement but are not cash flows 

Typical Noncash Gains 

Add Back to Net Income: 

• Depreciation and amortization 

• Loss on asset disposal 

• Losses on early retirement of debt 

• Amortization of bond discounts 

• Increases in deferred tax liabilities 

• Decreases in deferred tax assets 

• Losses of equity accounted associates 

Typical Noncash charges

Subtract from Net Income: 

• Gains on asset disposals 

• Gains on early retirement of debt 

• Reversals of impairment and write-downs 

• Amortization of bond premiums 

• Decreases in deferred tax liabilities 

• Increases in deferred tax assets 

Steps for Calculating CFO under the Indirect Method 

1. Begin with Net Income 

2. Add back noncash charges to income and subtract noncash components of revenue 

3. Adjust for working capital by adding or subtracting changes to balance sheet operating accounts 

1. Subtract increases in operating asset accounts (add decreases) 

2. Add increases in operating liability accounts (subtract decreases)

IFRS and US GAAP Preferred CFO Method

Direct method of calculating CFO 

Cash Flow from Investing Activities (CFI) 

Consists of the cash inflow and outflows that result from acquiring or disposing of long-term assets and certain investments 

Cash Flow from Financing Activities (CFF) 

Consists of the cash inflows and outflows that result from transactions affecting a firm’s capital structure, such as borrowing, repaying debt, and issuing or redeeming equity securities 

Contributed Capital 

• Sum of common stock at par value and additional paid in capital 

• Reflects the price at which the company issued shares  

Bonds issued at a premium or discount 

• Difference from par is amortized over life of the bond 

• Coupon + amortized discount – amortized premium = interest expense 

Amortization of Discount Bond 

Amortization will increase the interest expense and carrying value 

Amortization of a Premium Bond 

Amortization will decrease the interest expense and carrying value 

Steps for Converting from indirect cash flow statements to direct cash flow statements 

• Aggregate all revenues and gains and all expenses and losses 

• Remove all noncash charges and disaggregate the remaining items 

• Convert from accruals to cash flows by adjusting for the change in working capital  

Free Cash Flow 

Measure of cash available for discretionary use, after a firm has covered its capital expenditures 

Free Cash Flow to the Firm (FCFF) 

Cash available to all investors, both equity owners and debtholders 

Free Cash Flow to the Firm (FCFF) Formula (Net Income)

• FCFF = NI + NCC + [Int x (1-tax rate)] - FC Inv – WC Inv 

• NCC – Noncash charges (depreciation and amortization) 

• Int – cash interest paid 

• FC Inv – fixed capital investment (net capex) 

Free Cash Flow to the Firm (FCFF) Formula (CFO)

FCFF = CFO + [Int x (1 – tax rate)] - FC Inv 

Free Cash Flow to Equity (FCFE) 

Cash flow available for distribution to common shareholders