CFA L1 R29

Discuss the roles of financial reporting and financial statement analysis

The role of financial reporting is described by the IASB in its “Framework for the Preparation and Presentation of Financial Statements”:

• The objective of financial statements is to provide information about the financial position, performance and changes in financial position of an entity that is useful to a wide range of users in making economic decisions.
• The role of financial statement analysis is to use the information in a company’s financial statements, along with other relevant information, to make economic decisions. Examples of such decisions include whether to invest in the company’s securities or recommend them to other investors, or to extend trade or bank credit to the company. Analysts use financial statement data to evaluate a company’s past performance and current financial position in order to form opinions about the company’s ability to earn profits and generate cash flow in the future.

Discuss the role of key financial statements (income statement, balance sheet, statement of cash flows, and statement of changes in owners’ equity) in evaluating a company’s performance and financial position

• The income statement reports on the financial performance of the firm over a period of time. The elements of the income statement include revenues, expenses, and gains and losses.
• The balance sheet reports the firm’s financial position at a point in time. The balance sheet consists of assets, liabilities, and owners' equity. Transactions are measured so that the fundamental accounting equation holds: assets = liabilities + owners’ equity.
• The cash flow statement reports the company’s cash receipts and outflows. These cash flows are classified as either operating, investing, or financing.
• The statement of changes in owners’ equity reports the amounts and sources of changes in equity investors’ investment in the firm in a period of time.

Discuss the importance of financial statement notes and supplementary information, including disclosures of accounting methods, estimates, assumptions, and management’s discussion and analysis.

• Financial statement notes (footnotes) include disclosures that offer further detail about the information summarized in the financial statements. Footnotes allow users to improve their assessments of the amount, timing, and uncertainty of the estimates reported in the financial statements.
• Supplementary schedules contain additional information. Examples of such disclosures include operating income or sales by region or business segment, reserves for an oil and gas company, and information about hedging activities and financial instruments.
• Management’s Discussion and Analysis (MD&A) provides an assessment of the financial performance and condition of a company from the perspective of its management. For publicly held companies in the U.S., the MD&A is required to discuss results from operations (with a discussion of trends in sales and expenses), capital resources and liquidity (with a discussion of trends in cash flows), and a general business overview based on known trends.

Discuss the objective of audits of financial statements, the types of audit reports, and the importance of effective internal controls.

• An audit is an independent review of an entity’s financial statements. The objective of an audit is to enable the auditor to provide an opinion on the fairness and reliability of the financial statements.
• The auditor’s opinion gives evidence of an independent review of the financial statements that verifies appropriate accounting principles were used, standard auditing procedures were used, and management’s report on the company’s internal controls has been reviewed. An unqualified opinion indicates that the auditor believes the statements are free from material omissions and errors. If the statements make any exceptions to the accounting principles, the auditor may issue a qualified opinion and explain these exceptions. The auditor can issue an adverse opinion if the statements are not presented fairly or are materially nonconforming with accounting standards.
• Under U.S. GAAP, the auditor must state an opinion on the company’s internal controls, the processes by which the company ensures that it presents accurate financial statements. The Sarbanes-Oxley Act requires management to provide a report on the company's internal control system.

Identify and explain information sources other than annual financial statements and supplementary information that analysts use in financial statement analysis.


Besides the annual financial statements, an analyst should examine a company's:

• Quarterly or semiannual reports: These reports update the major financial statements and footnotes, but may not be audited.
• SEC filings: These include Form 8-K, which is used to report acquisitions and disposals of major assets or changes in management or corporate governance. Companies’ annual and quarterly financial statements are also filed (Forms 10-K and 10-Q).
• Proxy statements, which are issued to shareholders when there are matters that require a shareholder vote. These statements are a good source of information about the election of (and qualifications of) board members, compensation, management qualifications, and the issuance of stock options.
• Corporate reports and press releases, which are written by management and are often viewed as public relations or sales materials. Not all of the material is independently audited.

An analyst should also review information on the economy and the company’s industry and compare the company to its competitors.

Describe the steps in the financial statement analysis framework.

• 1) State the objective and context: Determine what questions the analysis is meant to answer, the form it needs to be presented in, and what resources are available to perform the analysis.
• 2) Gather data: Acquire the firm’s financial statements and other relevant data on its industry and the economy. Ask questions of the firm's management, suppliers, and customers, and visit firm sites.
• 3) Process the data: Make any appropriate adjustments to the financial statements, calculate ratios, and prepare exhibits such as graphs and common-size balance sheets.
• 4) Analyze and interpret the data: Use the data to answer the questions stated in the first step. Decide what conclusions or recommendations the information supports.
• 5) Report the conclusions or recommendations: Prepare a report and communicate it to its intended audience. Be sure the report and its dissemination comply with the Code and Standards that relate to investment analysis and recommendations.
• 6) Update the analysis: Repeat these steps periodically and change the conclusions or recommendations when necessary.