Reading 27: Introduction to Financial Statement Analysis

Book 2: Financial Statement Analysis

Financial Statement Analysis Framework

1.) State the objective and context

2.) Gather data

3.) Process data

4.) Analyze and interpret data

5.) Report conclusions or recommendations

6.) Update the analysis

Role of Financial Statement Analysis

use financial statements and other relevant information to make economic decisions

Standard-Setting Bodies

professional organizations of accountants and auditors that establish financial reporting standards

What are the standard-setting bodies?

Financial Account Standards Board (FASB)

International Accounting Standards Board (IASB)

Which standard-setting bodies created US GAAP and IFRS?

GAAP —> FASB

IFRS —> IASB

Do standard-setting bodies enforce GAAP and IFRS?

No

Regulatory bodies enforce these

European Securities Commission (ESC)

advises the European Commission on issuances

European Securities and Market Authority (ESMA)

coordinates the regulation of markets within the EU

Conceptually, what is GAAP and IFRS?

They are frameworks for accounting principles and standards for financial statements and filings

TRUE or FALSE: Only GAAP requires companies to report segment data.

False

Both GAAP and IFRS require segment data to be reported

Regulatory Authorities

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

What are examples of Regulatory Authorities?

Securities Exchange Commission (SEC) —> US

Financial Conduct Authority (FCA) —> UK

Sarbanes-Oxley Act of 2002

created by the SEC

prohibits a company’s external auditor from providing additional paid services to companies to avoid conflicts of interest

the auditor has to provide a statement about the company’s internal controls

What else does the SEC require a firm to include in their financial statements?

• ID trends in MD&A that affect a firm’s liquidity, capital resources, and results of operation

• Effects of inflation if material

• Impacts of off-balance sheet items such as purchase commitments

• Accounting policies that require significant judgment

• Forward-looking expenditures or divestitures

International Organization of Securities Commissions (IOSCO)

attempt to improve cross-border cooperation and make national regulations and enforcement more uniform around the world

How much of the world’s financial markets are governed under IOSCO?

95%

Is IOSCO a regulatory body?

no

it is a global association of securities regulators

not all police officers are from Boston, but all police officers around the world can be considered to govern authority

What are the objectives of IOSCO?

protect investors

ensure markets are fair, efficient, and transparent

reducing systematic risk

What are the required SEC filings?

S-1

10-K

10-K

DEF-14A

Form 8-K

Form 144

Forms 3, 4, and 5

S-1 Filing

registration of public securities issuance; if a company wants to go public, they file an S-1

Includes disclosures of securities offered, audited financial statements, risk assessment, underwriter identification, and the estimated amount and use of the offering proceeds

In an S-1 filing, what else has to be included if the S-1 is filed more than three months after the year-end?

Interim financial statements for the most recent quarter

Form 10-K

the annual financial statement

TRUE or FALSE: the annual report is not a a substitute for the required 10-K.

TRUE

the annual report is meant for shareholders and will not go into as much detail and may not be audited

What is the foreign equivalent of a 10-K?

Canada: 40-F

International: 20-F

Form 10-Q

quarterly financial statements

TRUE or FALSE: the 10-Q is required to be audited.

FALSE

What is the foreign equivalent of the 10-Q and how is it different?

6-K

It is required to be filed semiannually, not quarterly

Form DEF-14A

proxy statement

filed separately with the SEC and then distributed to shareholders

Form 8-K

announces important material events that happen between periodic filings

discloses material events such as asset acquisitions/disposals, changes in management or corporate governance, etc.

Form 144

announces when insiders or affiliates intend to sell securities in the public market

important wording: must notify, not register, with the SEC

Forms 3, 4, and 5

Form 3 – when an insider first acquires ownership

Form 4 – when an insider changes ownership by buying or selling

Form 5 – filed once a year for changes in ownership that weren’t reported on Form 4

Proxy Statements

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

• Election of board members, renumeration, or issuance of stock options

Financial Statement Notes

disclosures that provide further detail about the information summarized in the financial statements

• basis of presentation (fiscal year, GAAP or IFRS)

• accounting methods, assumptions, estimates by management

• acquisitions, legal actions, employee benefit plans, contingencies and commitments, significant customers

Business Segment

a portion of a company that accounts for more than 10% of revenues, income, or assets

Business segments reported should account for a minimum of __ of external sales

75%

Management Discussion and Analysis (MD&A)

addresses the nature of the business, management objectives, past performance, performance measures used, key relationships and resources

Audit

independent review of the firm’s financial statements

What is the objective of an audit?

an auditor can provide an opinion on the fairness and reliability of financial statements

Who is responsible for making sure the financial statements conform to the applicable accounting standards and ensuring there are no material errors?

The auditor, not the firm

What are the components of a Standard Auditor Opinion?

1.) auditor has performed an independent review

2.) Reasonable assurance —> accepted auditing standards were followed and financial statements contain no material errors

3.) a statement that the auditor is satisfied with the statements that were prepared and estimates are reasonable. Must contain additional explanation when accounting methods have not been used consistency between periods

Unqualified Opinion

indicates the auditor believes that statements are free from material omissions or errors

Qualified Opinion

exceptions to the accounting principles, the auditor has to explain why

Adverse Opinion

if the statements are not presented fairly or are materially nonconforming with accounting standards

Difference between a qualified and adverse opinion?

Qualified —> kinda disagree

Adverse —> statement’s are really materially misstated

Disclaimer of Opinion

when the auditor is unable to express an opinion

When should an explanatory paragraph be included in the going concern assumptions?

when a material is probable but the amount is not calculated

Going Concern Assumptions

the assumption that the firm will continue to operate for the foreseeable future

Internal Controls

the processes by which the company ensures that it presents accurate financial statements

TRUE or FALSE: the auditor must express an opinion on internal controls

TRUE

however, this only applies to companies in the United States

Critical Audit Matters

highlights accounting choices that are of greatest significance to the users of financial statements

highlights areas that are highly subjective or challenging in interpretation or other areas that are likely to be misstated

Significant Differences Between IFRS and US GAAP: US GAAP

US GAAP

• Developed by: FASB

• Based on: Rules

• Inventory Valuation: FIFO, LIFO, or Weighted Average

• Product Development Costs: Expensed

• Interest Paid: CFO

• Reversal of Inventory Writedowns: Prohibited

Significant Differences Between IFRS and US GAAP: IFRS

IFRS

• Developed by: IFRS

• Based on: Principles

• Inventory Valuation: LIFO Prohibited

• Product Development Costs: can be capitalized

• Interest Paid: CFO or CFF

• Reversal of Inventory Writedowns: Allowed

Issuer Sources of Information

Earnings Calls

Ad Hoc Presentations

Press Releases

Communications with Management

Public Third-Party Sources

Free industry reports

Government agency-produced economic and industry statistics

Generalized media sources

Social Media

Proprietary Third-Party Sources

Analyst Reports

Reports from Data Platforms

Reports for industry-specific agencies

Proprietary Primary Research

Studies commissioned by an analyst

Hands-on experience with company products or services

Technical specialists employed by the analyst