Module 1: Introduction to Financial Statement Analysis

What are the six phases of the financial statement analysis framework?

1. Articulate the purpose and context. 2. Collect data. 3. Process data. 4. Analyse and interpret the processed data. 5. Develop and communicate conclusions/recommendations. 6. Follow up. Memory: Purpose → Collect → Process → Analyse → Communicate → Follow-up.

What happens during the "articulate purpose and context" phase?

The analyst determines the objective of the analysis, questions to be answered, intended audience, required report format, timetable, and available resources. The analysis should be designed around the economic decision being made.

What is typically produced during the purpose/context phase?

A statement of the objective, specific questions to answer, required report format, and timetable.

What happens during the data collection phase?

The analyst gathers relevant financial statements plus macroeconomic, industry, competitor, management, customer, supplier, and other relevant information.

What is the common top-down approach to collecting information?

Macroeconomy → Industry → Company. The analyst first understands the broad economic environment, then the industry's prospects, and finally the individual company.

What happens during the data processing phase?

Raw information is transformed into forms useful for analysis, including adjusted financial statements, common-size statements, ratios, graphs, forecasts, sensitivity analyses, statistical models, and valuation outputs.

In which phase are financial ratios calculated?

Processing the data. CFA trap: Ratios are an output of processing and then become an input into analysis and interpretation.

What is the difference between processing and analysing data?

Processing means calculating or transforming the data. Analysing means interpreting what those calculations actually tell you. Example: calculating debt-to-equity = processing; concluding that rising debt-to-equity indicates increasing financial risk = analysis.

What happens during the analyse and interpret phase?

The analyst converts processed information into meaningful conclusions about the company's performance, financial position, risks, forecasts, or valuation. A number by itself is rarely the final answer; its interpretation matters.

What happens during the develop and communicate conclusions phase?

The analyst produces the required report and recommendation based on the analysis. This may include an investment conclusion, industry analysis, financial forecasts, valuation, risks, and recommendation.

What CFA ethical requirement is particularly relevant when communicating analysis?

CFA Institute Standard V(B) requires analysts to distinguish fact from opinion and communicate relevant risks and limitations.

What happens during the follow-up phase?

New information is incorporated, actual performance is compared with expectations, forecasts are revised, valuations are updated, and recommendations may be changed.

Which phase most likely involves producing an updated report or revised recommendation?

Follow-up. Words such as "updated," "revised," "new information," or "actual versus expected" should point toward follow-up.

What is a simple way to remember the six phases of financial statement analysis?

What am I trying to answer? → Get the information → Work with the information → Understand it → Communicate it → Update it.

What is the overall role of financial statement analysis?

To use a company's financial reports together with other relevant information to evaluate past/current performance and financial position, form expectations about the future, and support investment, credit, and other economic decisions.

Why do analysts study historical financial statements if investment decisions concern the future?

Historical performance provides the foundation for forming expectations about future profitability, cash flows, financial position, and risks.

What types of decisions commonly use financial statement analysis?

Equity investment selection and valuation, creditworthiness and loan pricing, debt ratings, private equity/venture capital investments, and evaluating merger or acquisition targets.

Why are both profitability and cash flow important to an analyst?

Profitability shows the company's ability to generate accounting earnings from its business. Cash flow shows its ability to convert business performance into spendable cash. Strong earnings accompanied by weak cash generation can be a warning sign.

Why is risk assessment important in financial statement analysis?

Future returns cannot be evaluated independently of the risks threatening those returns. Analysts consider factors such as leverage, customer concentration, regulation, supply risk, and other threats to future performance.

What is the primary perspective of a debt investor?

Whether the company can service interest and repay principal. Memory: Debt investor = "Can I get my money back?"

What is the primary perspective of an equity investor?

The company's ability to generate profitability, growth, cash flow, and per-share value. Memory: Equity investor = "How much value can this company create?"

How does financial analysis performed by management differ from analysis performed by external analysts?

Management uses financial analysis for operating, investing, and financing decisions but has access to internal information that external analysts generally cannot access.

Is providing reasonable assurance that financial statements are free of material misstatement a role of financial statement analysis?

No. That is the role of the independent auditor. The analyst uses financial statements to form conclusions; the auditor expresses an opinion on whether they are fairly presented.

What is the difference between a standard-setting body and a regulatory authority?

Standard-setting bodies develop financial reporting standards. Regulatory authorities enforce financial reporting and securities requirements within their jurisdictions.

Who develops IFRS?

The International Accounting Standards Board (IASB).

Who develops US GAAP?

The Financial Accounting Standards Board (FASB).

Does the SEC develop US GAAP?

No. FASB develops US GAAP. The SEC regulates US securities markets and enforces reporting requirements. Memory: FASB writes; SEC enforces.

What is IOSCO?

The International Organization of Securities Commissions. It is an international body whose members include securities regulators from many jurisdictions; it is not itself a national securities regulator.

What are IOSCO's three core objectives?

1. Protect investors. 2. Ensure markets are fair, efficient, and transparent. 3. Reduce systemic risk.

What are two common CFA traps regarding IOSCO's objectives?

IOSCO aims to REDUCE, not eliminate, systemic risk. Its objective is to protect INVESTORS specifically, rather than the broader phrase "protect users of financial statements."

What is Form 10-K?

The major annual SEC filing for US issuers. It includes audited financial statements, notes, MD&A, business information, risk factors, and the auditor's report. Memory: 10-K = annual.

What is Form 10-Q?

A quarterly/interim SEC filing containing financial statements and interim MD&A. The interim statements are generally unaudited. Memory: Q = Quarter.

What is Form 8-K?

A current report used to disclose material events such as acquisitions, disposals, management changes, accountant changes, and other important developments. Memory: 8-K = something important just happened.

What information is found in a proxy statement/Form DEF-14A?

Information relating to shareholder meetings, including director biographies/elections, executive compensation, management and significant-owner shareholdings, and matters requiring shareholder votes. Memory: Proxy = People + Pay + Votes.

Where should an analyst look for executive compensation information?

The proxy statement/Form DEF-14A.

What are Forms 3, 4, and 5 used for?

Beneficial-ownership disclosures involving directors, officers, and significant (>10%) owners. Analysts can use them to track insider transactions.

What is Form 144?

A notice of the proposed sale of certain restricted or affiliate-held securities.

What is Form 11-K?

An annual report relating to certain employee stock purchase, savings, and similar plans.

What are Forms 20-F and 40-F?

Annual SEC filings used by certain foreign issuers: 20-F for many non-US issuers and 40-F for certain Canadian issuers.

Is a company's annual report necessarily the same as its 10-K?

No. An annual report is distributed to shareholders and may be a more polished/marketing-oriented document. It often overlaps substantially with the 10-K, but the 10-K is the SEC regulatory filing.

Why are financial statement notes important to analysts?

The primary financial statements summarize financial information; the notes disaggregate, explain, and provide context necessary to properly interpret the numbers.

What information is commonly found in financial statement notes?

Basis of preparation, accounting policies and estimates, detailed breakdowns of financial-statement items, segment information, acquisitions/disposals, contractual obligations, financial instruments and risks, legal proceedings, related-party transactions, and subsequent events.

Why are accounting policy disclosures particularly important for comparability?

Accounting standards permit judgment and alternative methods in certain areas. Two companies can therefore report different numbers partly because of accounting choices rather than economic differences. Analysts should identify important differences and adjust when appropriate.

What is an operating segment?

A component of a company that may generate revenues and expenses, whose results are regularly reviewed by senior management, and for which discrete financial information is available.

What is the basic 10% rule for reportable operating segments?

Separate disclosure is generally required when a segment represents at least 10% of the relevant combined measure of revenue, assets, or profit/loss.

How is the 10% profit/loss segment test determined?

The segment's absolute profit or loss is compared with 10% of the greater of: (1) combined profits of profitable segments or (2) the absolute value of combined losses of loss-making segments.

How does the 75% external-revenue rule work?

If reportable segments do not collectively represent at least 75% of total external revenue, additional segments must be separately reported until at least 75% is covered.

What is the major-customer 10% disclosure rule?

If a single customer generates at least 10% of total company revenue, the concentration must be disclosed. The customer's identity does not have to be disclosed.

Does segment reporting require a complete income statement and balance sheet for each segment?

No. Segment disclosures provide selected information, not complete standalone financial statements for every segment. For example, cost of goods sold is not necessarily a required segment disclosure.

Why are segment disclosures useful to analysts?

Consolidated numbers can hide differences between businesses. Segment information helps identify which divisions drive revenue/profit, which are growing or declining, and which may create risks or potential impairment issues.

What is management commentary or MD&A?

Management's discussion of the company's business, strategy, results, financial position, risks, and future outlook. It may also be called management commentary, management report, or operating and financial review.

What are the five content elements of decision-useful management commentary identified in the curriculum?

1. Nature of the business. 2. Management's objectives and strategies. 3. Significant resources, risks, and relationships. 4. Results of operations. 5. Critical performance measures.

Why can MD&A be especially valuable for forecasting?

It can contain forward-looking information about planned capital expenditures, expansion, store openings, divestitures, liquidity needs, trends, and other expected developments.

What is the key limitation of management commentary?

It generally reflects management's perspective and much of it is unaudited. Analysts should therefore use it as one source rather than treating it as an independent assessment.

What is the primary purpose of an independent audit?

To allow the auditor to express an opinion on whether the financial statements are fairly presented, in all material respects, under the applicable financial reporting framework.

What level of assurance does an audit provide?

Reasonable assurance, NOT absolute assurance. Audits involve sampling and estimates, so absolute certainty is impossible.

Who is responsible for preparing the financial statements?

Management. Management is also responsible for maintaining appropriate internal controls relevant to financial reporting.

What is the auditor responsible for?

Conducting the audit under applicable auditing standards and expressing an independent opinion on the financial statements.

What are the three basic responsibility/opinion components of a standard audit report?

1. Management's responsibility: preparation/fair presentation and relevant internal controls. 2. Auditor's responsibility: conduct the audit and obtain reasonable assurance. 3. Opinion: auditor's conclusion regarding fair presentation.

What is an unqualified/unmodified audit opinion?

A clean opinion indicating that the financial statements are fairly presented in accordance with the applicable financial reporting framework. CFA trap: "Unqualified" is GOOD.

What is a qualified audit opinion?

A particular accounting exception or scope limitation exists, but the issue is not so pervasive that the financial statements overall are considered unfairly presented. Think: "fairly presented EXCEPT FOR…"

What is an adverse audit opinion?

The financial statements materially depart from applicable standards such that they are not fairly presented overall.

What is a disclaimer of opinion?

The auditor is unable to express an opinion, often because sufficient appropriate audit evidence could not be obtained.

What is the easiest way to remember the four audit outcomes?

Unqualified = Clean. Qualified = Except for. Adverse = Bad overall. Disclaimer = Can't tell.

If a company's statements comply with accounting standards except for one specific material but non-pervasive inventory-accounting issue, which opinion is most likely?

Qualified opinion. A specific material but non-pervasive exception generally produces a qualified opinion rather than an adverse opinion.

What are Key Audit Matters (KAMs) or Critical Audit Matters (CAMs)?

Matters receiving significant auditor attention, often because they involve high misstatement risk, substantial management judgment, or important/complex transactions.

Does the existence of a Key/Critical Audit Matter automatically mean the audit opinion is modified?

No. It highlights an area receiving significant audit attention but does not by itself change the audit opinion.

Under Sarbanes-Oxley, what additional audit-related requirement applies to US public companies?

Management must accept responsibility for and evaluate internal control over financial reporting, and the external auditor also expresses an opinion on the effectiveness of internal control over financial reporting.

Who sets auditing standards for US public companies?

The Public Company Accounting Oversight Board (PCAOB). CFA trap: PCAOB deals with auditing, not the development of US GAAP.

What eight general features of financial statements are identified under IAS 1?

Fair presentation; going concern; accrual basis; materiality and aggregation; no offsetting; frequency of reporting; comparative information; consistency of presentation.

What does going concern mean?

Financial statements are normally prepared assuming the entity will continue operating for the foreseeable future. Significant doubts about that assumption require appropriate disclosure.

What does accrual accounting mean?

Transactions and events are recognized when they occur, rather than simply when cash is received or paid. The cash flow statement reports actual cash flows and is therefore the major exception.

What does materiality mean?

Information is material when its omission or misstatement could influence users' economic decisions.

What does "no offsetting" mean?

Assets and liabilities, and income and expenses, generally should not be netted against each other unless an accounting standard specifically permits it.

What does frequency of reporting mean under IAS 1?

Financial statements are presented at least annually. If the reporting period changes, the company should explain the change and limitations on comparability.

What does comparative information mean?

Prior-period figures are presented alongside current-period figures so users can compare performance and financial position over time.

What does consistency of presentation mean?

Presentation and classification should generally remain consistent from period to period unless a change is required by a standard or a different presentation becomes more appropriate.

What are the two dominant financial reporting systems covered in CFA Level I?

IFRS and US GAAP.

Which bodies set IFRS and US GAAP?

IASB → IFRS. FASB → US GAAP.

How are IFRS and US GAAP commonly characterized in terms of orientation?

IFRS is generally described as more principles-based, whereas US GAAP is generally described as more rules-based.

How does the classification of interest paid differ between IFRS and US GAAP?

US GAAP: interest paid is operating cash flow. IFRS: interest paid may be classified as operating or financing, subject to the applicable accounting policy requirements.

How does LIFO differ under IFRS and US GAAP?

US GAAP permits LIFO; IFRS prohibits LIFO. Memory: LIFO → US yes, IFRS no.

How do development costs generally differ under IFRS and US GAAP?

Under the curriculum comparison, US GAAP generally expenses development costs, whereas IFRS capitalizes qualifying development costs when specified criteria are satisfied.

How do inventory write-down reversals differ under IFRS and US GAAP?

US GAAP generally prohibits reversal of an inventory write-down. IFRS may permit reversal when specified conditions are met, up to the amount of the original write-down.

Why can different accounting standards reduce comparability between companies?

Similar economic transactions can produce different reported assets, liabilities, income, expenses, and cash-flow classifications depending on the reporting framework. Differences in ratios may therefore reflect accounting rules rather than underlying economics.

Are companies required to provide analysts with a complete reconciliation between IFRS and US GAAP?

No. Analysts may therefore lack sufficient information to make perfect comparability adjustments.

What should an analyst do when comparing companies using different reporting systems?

Identify important accounting differences, adjust where sufficient information exists, interpret cross-company comparisons cautiously, and disclose significant limitations on comparability.

Why should analysts monitor developments in financial reporting standards?

Because new standards, new transactions, and changes in accounting policies or estimates can change what is recognized, how it is measured, where it is reported, and therefore the ratios and conclusions analysts derive.

What three broad developments should analysts monitor?

1. New products and transactions that may not fit existing guidance cleanly. 2. Standard-setter actions that change recognition, measurement, or disclosure. 3. Company-specific accounting policies, estimates, and changes in them.

From what perspective should an analyst monitor changes in accounting standards?

From the perspective of a financial-statement USER: "How will this change the financial statements and my analysis?" rather than focusing primarily on how to prepare the accounting entry.

Why is movement from note disclosure to financial-statement recognition potentially important?

Recognition directly on the face of the financial statements can affect reported earnings, assets, liabilities, ratios, and investor attention more directly than disclosure alone.

Besides annual and interim financial reports, what four broad sources of information can analysts use?

1. Issuer sources. 2. Public third-party sources. 3. Proprietary third-party sources. 4. Proprietary primary research.

What are issuer information sources?

Information originating directly from the company, such as earnings calls, investor presentations, investor days, press releases, management/IR conversations, company websites, and direct experience with the company's products or services.

What is an earnings call?

A management presentation and Q&A discussing financial results, important developments, variances from expectations, corporate actions, and often forward-looking targets or guidance.

What is an investor day?

An issuer-hosted event that typically provides deeper information about strategy, individual business segments, products, long-term plans, or other topics.

What is the major limitation of issuer-generated information such as earnings calls and presentations?

It is generally unaudited and reflects management's perspective, creating the possibility of bias.

What are public third-party sources?

Publicly available information produced by parties other than the company, including government statistics, economic indicators, general news, industry publications/trade journals, public industry research, and social media.

What are proprietary third-party sources?

Non-public or restricted information produced by outside organizations, including sell-side research, credit-rating reports, commercial data platforms, and specialized consultancy research.

How is a sell-side analyst report classified?

Proprietary third-party. It comes from someone other than the issuer and is generally not freely available to the public.

How is a government economic statistics release classified?

Public third-party.