A Framework for Financial A Framework for Financial Statement AnalysisStatement Analysis

Lecture 2

Why Financial Statements Are Analyzed

• In order for financial information to be useful, it must be interpreted.

• A comprehensive set of ratios allows the user to make sense of all the financial information reported in the financial statements.

Users of Financial Information • Users of financial information may be current

or future users.

–Investors–Managers–Customers

–Potential suppliers and creditors

– Government regulators

– Employee unions– Public interest and

community groups

• Some of the users of financial information are the following:

Sources of Financial Information• The major source of financial information is a

firm's annual report.• Management discussion and analysis• Independent auditor's report • Primary financial statements• Secondary financial statements• Notes to the financial statements

Other Sources of Information• Reports filed with regulatory agencies (special,

quarterly, and annual)• Business periodicals (magazines, newspapers,

newsletters)• Investment advisory services (Standard &

Poor, Moody's, etc.)

Basis of Comparison• When analyzing financial reports, one of the

first decisions is to identify the basis of comparison.

• Comparability is enhanced when firms' size, capital structure, and product mix are similar.

Data may be compared with the following:

• The firm's own data from prior years• Data from another firm in the same industry• Data from another firm in which the analyst

may invest• Industry averages• Benchmarks or targets

Restatements May Be Necessary• The statements may need to be restated

when significant unusual events have occurred which would distort comparisons.

• Such events include, among others, mergers or acquisitions, discontinued operations, changes in accounting principles, and extraordinary items.

Analysis of Financial Statements steps:1. Review the financial statements, notes, and

audit opinion to identify any unusual events or characteristics and to become familiar with the nature of the firm’s operation.

2. Determine whether any restatements due to mergers, discontinued operations, etc., are necessary to enhance comparability of the firm’s financial statements.

Analysis of Financial Statements steps:3. Determine whether the firm’s size, capital

structure, and product mix are sufficiently comparable (between firms or time

periods) to proceed with the ratio calculations.

Financial Statement Analysis Ratios & Framework

• The analyst usually performs horizontal and vertical analyses of the financial statements.

• Horizontal analysis focuses on changes or growth, year to year, for each major element on the income statement and the balance sheet.

Horizontal Analysis of Balance Sheet

Financial Statement Analysis Ratios & Framework

• Vertical analysis examines the percentage composition of the income statement and the balance sheet: It uses common-size financial statements for this analysis.

• A company financial statement that displays all items as percentages of a common base figure. This type of financial statement allows for easy analysis between companies or between time periods of a company.

Horizontal Analysis of Balance Sheet

First Level = Basic Objectives

Second Level = Qualitative Characteristics and Elements

Third Level = Recognition, Measurement, and Disclosure Concepts.

Conceptual Framework of AccountingOverview of the Conceptual Framework

Conceptual Framework

• Objective of general-purpose financial reporting is:

• To provide financial information about the reporting entity that is useful to present and potential equity investors, lenders, and other creditors in making decisions about providing resources to the entity.

“The FASB identified the Qualitative Characteristics of accounting information that distinguish better (more useful) information from inferior (less useful) information for decision-making purposes.”

Second Level: Fundamental Concepts

Qualitative Characteristics

QUALITATIVE CHARACTERISTICS QUALITATIVE CHARACTERISTICS OF ACCOUNTING INFORMATIONOF ACCOUNTING INFORMATION

• The accounting alternative selected should be one that generates the most useful financial information for decision making.

• To be useful, information should possess the following qualitative characteristics:1. understandability2. relevance3. reliability4. comparability and consistency

Qualitative Characteristics

UNDERSTANDABILITYUNDERSTANDABILITY• Information must be understandable by its

users.• Users are assumed to have a reasonable

comprehension of, and ability to study, the accounting, business, and economic concepts needed to understand the information.

RELEVANCERELEVANCE• Accounting information is relevant if it makes a

difference in a decision.• Relevant information helps users forecast

future events (predictive value), or it confirms or corrects prior expectations (feedback value).

• Information must be available to decision makers before it loses its capacity to influence their decisions (timeliness).

RELIABILITY

• Reliability of information means that the information is free of error and bias – it can be depended on.

• To be reliable, accounting information must be verifiable – there must be proof that it is free of error and bias.

• The information must be a faithful representation of what it purports to be – it must be factual.

COMPARABILITY AND CONSISTENCY COMPARABILITY AND CONSISTENCY

2000 2001 2003

• Comparability means that the information should be comparable with accounting information about other enterprises.

• Consistency means that the same accounting principles and methods should be used from year to year within a company.

Generally Accepted Accounting Principle (GAAP)

• Rules that govern how accountants measure, process and communicate financial information

• Ensures that consistent accounting procedures are followed in recording the events created by business transactions and in preparing financial statements

Generally Accepted Accounting Principle (GAAP)

• The Business Entity Concept

• The going Concern Concept• The Time Period Concept• The Consistency Principle• The Principle of

Conservatism• The Objectivity Principle

• The Materiality Principle• The Monetary-unit

Concept• The Full Disclosure

Principle• The Cost Principle• The Revenue Recognition

Convention• The Matching Principle

• A constraint is a limit, regulation, or confinement within prescribed bounds.

• This term refers to the accounting guidelines that border the Hierarchy of Qualitative Information

• They consist of:– Cost Effectiveness– Materiality– Conservatism

Constraints

• Also called Cost Benefit Constraint• The cost of providing accounting information

should not exceed the benefit of the information it is reporting.

• Example: Your checkbook register and bank statement differs by $0.10. Rather than waste time to find the $0.10, the accountant should record the amount as miscellaneous expense or income.

Cost Effectiveness Constraint

• Material means big enough to make a difference in the user’s decision-making process.

• States that the requirements of any accounting principle may be ignored when there is no effect on the decisions of the user of financial information.

• Example: A company purchases a Trashcan for $10. Per GAAP, this amount should be capitalized as an asset and depreciated. Because the amount is immaterial, the $10 can be recorded as an expense.

Materiality Constraint

• Accountants use their judgment to record transactions that require estimation.

• Conservatism helps the accountant choose between 2 equally likely alternatives.

• Requires the accountant to record the transaction using the less optimistic choice.

• Example: There is the potential for a customer to sue the company. Although, the customer may choose not to sue, the accountant will disclose this potential lawsuit to investors.

Conservatism Constraint

• Concepts are the ground rules of accounting that should be followed when preparing financial statements.

• These are:– Recognition Concept– Measurement Concept

Concepts

• States that an item should be recognized (recorded) in the financial statements when:– It can be defined by GAAP assumptions and

principles– It can be measured– It is relevant to decision-making by users– It is reliable

Recognition Concept

• States that every transaction is measured by the stated unit of measurement, such as the dollar

• The stated procedure of valuing assets, liabilities, equity, revenue, and expenses as defined by GAAP

Measurement Concept

• Assumptions are agreed upon rules of accounting, and are basic, understood beliefs.

• There are Four Basic Assumptions of Accounting:– Economic Business Entity– Going Concern– Monetary Unit– Time Period

Assumptions

• All of the business transactions should be separate from the business owner’s personal transactions

• There should be no co-mingling of personal funds with business funds.

Economic Business Entity Assumption

• Financial statements are prepared under the assumption that the company will remain in business indefinitely unless there is sufficient evidence otherwise.

• If there is evidence that a company may possibly have a going concern issue, this must be disclosed in the financial statements.

Going Concern Assumption

• Assumes a stable currency is going to be the unit of record.

• FASB accepts the nominal value of the US Dollar as the monetary unit of record unadjusted for inflation.

Monetary Unit Assumption

• The entity’s activities are separated into periods of time such as months, quarters or years.

• Transactions must be accounted for within the time period they occur regardless of when cash is exchanged.

Time Period Assumption

• Principles are accounting rules used to prepare, present, and report financial statements.

• Principles dictate how events should be recorded and reported.

Principles of Accounting

• Assets are recorded at historical cost, not fair market value.

• For example, if a company purchases a building for $500,000 it should be recorded as such, and should remain on the books for that amount until disposed of.

• If the building appreciates to $700,000 in the next few years, no adjustment should be made.

Cost Principle

• All information pertaining to the operations and financial position of the entity must be reported within the period of time in question.

• Circumstances and events that make a difference to financial statement users should be disclosed.

• For Example: • Accounting policies need to be disclosed because

they help understand the basis of accounting.• Significant events occurring after the date of the

financial statements but before the issue of financial statements (i.e. events after the balance sheet date) need to be disclosed.

Full Disclosure Principle

• Revenue is earned and recognized upon product delivery or service completion, without regard to when cash is actually received.

• Also called accrual basis accounting• Example: • A customer purchases inventory from a

company on credit. Even though no cash has yet been received, the sale is recorded.

Revenue Recognition Principle

• The costs of doing business are recorded in the same period as the revenue they help generate, regardless of when the money is actually paid.

• Also called accrual basis accounting• Example: • A company orders merchandise on credit and

has 30 days in which to pay. This purchase is recorded immediately, even though no cash has been paid.

Matching Principle

Accounting cycleActivities performed in an accounting period that help the business keep its records in an

orderly fashion.

The Steps of the Accounting Cycle

The Accounting Cycle

The Steps of the Accounting Cycle1. TransactionsFinancial transactions start the process. Transactions can

include the sale or return of a product, the purchase of supplies for business activities, or any other financial activity that involves the exchange of the company’s assets, the establishment or payoff of a debt, or the deposit from or payout of money to the company’s owners.

2. Journal entriesThe transaction is listed in the appropriate journal,

maintaining the journal’s chronological order of transactions. The journal is also known as the “book of original entry” and is the first place a transaction is listed.

3. PostingThe transactions are posted to the account that it impacts. These accounts are part of the General Ledger, where you can find a summary of all the business’s accounts.4.Trial balanceAt the end of the accounting period (which may be a month, quarter, or year depending on a business’s practices), you calculate a trial balance.

The Steps of the Accounting Cycle

The Steps of the Accounting Cycle5. WorksheetMany times your first calculation of the trial balance shows that the books aren’t in balance. If that’s the case, you look for errors and make corrections called adjustments, which are tracked on a worksheet.

Adjustments are also made to account for the depreciation of assets and to adjust for one-time payments (such as insurance) that should be allocated on a monthly basis to more accurately match monthly expenses with monthly revenues. After you make and record adjustments, you take another trial balance to be sure the accounts are in balance.

The Steps of the Accounting Cycle6. Adjusting journal entriesYou post any corrections needed to the affected accounts once your trial balance shows the accounts will be balanced once the adjustments needed are made to the accounts. You don’t need to make adjusting entries until the trial balance process is completed and all needed corrections and adjustments have been identified.7. Financial statementsYou prepare the balance sheet and income statement using the corrected account balances.8. Closing the booksYou close the books for the revenue and expense accounts and begin the entire cycle again with zero balances in those accounts.