LESSON 2: Financial Reporting and Analysis

What is the end product of financial reporting?

Financial statements

Factors affecting financial reporting

accounting rules, manager motivations, and enforcement mechanisms

Match the statutory financial report with its description

SEC Form 17-A ↔ Annual report with audited financials

SEC Form 17-Q ↔ Quarterly report with financials

SEC Form 17-C ↔ Earnings announcement for traders

Seasonality

is a crucial factor when analyzing quarterly trends

On which day does the immediate stock price reaction to quarterly earnings information occur?

Earnings announcement day

A prospectus accompanies

an application for an equity offering.

Order the factors affecting statutory financial reports

1️⃣ Generally Accepted Accounting Principles (GAAP)

2️⃣ Managers

3️⃣ Monitoring and Enforcement Mechanisms

4️⃣ Alternative Information Sources

What is the purpose of GAAP?

Standardize accounting practices

Managers

have primary responsibility for fair financial reporting.

Who audits the financial statements of public companies?

Independent CPAs

An independent audit committee

is a crucial corporate governance feature.

Match the information source with its effect

Economic Information ↔️ Updates company forecasts Industry Information ↔️ Changes competitive position Company

What is voluntary disclosure in financial reporting?

Sharing non

Information intermediaries

include security analysts and investment advisers

Relevance

is a primary quality of accounting information.

What are the three components of reliability in accounting information?

Verifiability, faithfulness, neutrality

Accounting information

often demands a trade

Match the secondary quality of accounting information with its meaning

Comparability ↔️ Similar measurement across companies Consistency ↔️ Same method over time

Under accrual accounting, when are revenues recognized?

When earned

Historical cost

records an asset at its original cost

Fair value

estimates the current economic value of an asset.

What trade

off often arises in accounting information between relevance and reliability?

Analysts’ forecasts

are relevant but less reliable

Standard setters

often struggle with the trade

What does comparability imply in accounting information?

Similar measurement across companies

Consistency

in accounting means using the same method for similar transactions

Accrual accounting

recognizes revenues when earned and expenses when incurred, regardless of cash flow.

What is historical cost in accounting?

Original cost when acquired

Fair value

estimates the current economic value of an asset or liability

Materiality

refers to the magnitude of a misstatement that could influence a reasonable person’s judgment.

What does conservatism involve in accounting measurement?

Reporting the least optimistic view

Conservatism

understates both net assets and net income

Accrual accounting

aims to inform users about future cash flow consequences as soon as possible with reasonable certainty.

What are accruals in accounting terms?

Adjustments to net income

Steps to calculate net income using accruals

1️⃣ Operating cash flow 2️⃣ Add accruals 3️⃣ Equals net income

What are short

term accruals primarily related to?

Long

term accruals

Operating cash flow

refers to cash from a company’s ongoing operating activities.

What does free cash flow to the firm (FCFF) represent?

Cash available for distribution

Free cash flow to equity (FCFE)

measures cash available to shareholders

Accrual accounting

is more relevant than cash flow for determining company value.

Which is more reliable, cash flows or accruals?

Cash flows

Income

also called earnings or profit, summarizes the net effects of business operations. Income provides a measure of change in stockholders’ wealth and an estimate of current profitability.

What does economic income typically measure?

Change in net asset market value

Permanent income

is the stable average income expected over a business’s life

Operating income

excludes expenses from financing activities.

What is another term for accounting income?

Net income

Fair value accounting

uses fair values on the measurement date.

The historical cost model

uses prices from past transactions to determine asset values.

Hierarchy of fair value inputs

1️⃣ Level 1: Market prices for identical assets 2️⃣ Level 2: Observable inputs for similar assets 3️⃣ Level 3: Unobservable inputs

What is the market approach to fair value measurement?

Uses prices from market transactions

Income approach

measures fair value by discounting future cash flows.

Cost approach

determines the current replacement cost of an asset’s remaining service capacity.

What is an advantage of fair value accounting?

Reflects current information

Fair value accounting

is more useful for equity analysis. May result in excessive income volatility due to market fluctuations.