1. Chapter 1 Financial Statement Analysis: An Introduction
Learning Outcomes
Describe the roles of financial reporting and financial statement analysis.
Describe the roles of the key financial statements (statement of financial position, statement of comprehensive income, statement of changes in equity, and statement of cash flows) in evaluating a company’s performance and financial position.
Describe the importance of financial statement notes and supplementary information—including disclosures of accounting policies, methods and estimates—and management’s commentary.
Describe the objective of audits of financial statements, the types of audit reports, and the importance of effective internal controls.
Identify and explain information sources that analysts use in financial statement analysis besides annual financial statements and supplementary information.
Describe the steps in the financial statement analysis framework.

2. financial reporting and financial statement analysis
Providing financial information about an entity to enable users to make decisions
Financial information includes financial statements and other types of reports
Financial Statement Analysis
Using financial information to assess prior performance and likely future performance to make decisions
Typical decision: capital allocation
LOS. Describe the roles of financial reporting and financial statement analysis.
Pages 1–6
Financial reporting focuses on external users. Internal users (i.e., managers within a company) can obtain the specific information in the specific format that they need for their specific purposes (budgeting, planning).
Examples of types of financial reports other than financial statements:
President’s letter and supplementary schedules in the annual report
Reports filed with government agencies
News releases and management forecasts
Social or environmental impact statements
Examples of capital allocation decisions:
For an equity investor, deciding whether to include a company’s stock in a portfolio (or whether to short a stock) and at what price.
For a creditor (such as a bond/fixed-income investor) deciding whether to include a company’s bonds in a portfolio and at what price
For a creditor, such as a banker, deciding whether to lend money to a company and on what terms (price, maturity, covenants)
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3. FINANCIAL REPORTING what the company reported (excerpt)
Apple Reports Second Quarter Results
Record March Quarter Sales of iPhones, iPads and Macs
Net Profit Increases 94% Year-over-Year
CUPERTINO, California—April 24, 2012—Apple® today announced financial results for its fiscal 2012 second quarter ended March 31, The Company posted quarterly revenue of $39.2 billion and quarterly net profit of $11.6 billion, or $12.30 per diluted share. These results compare to revenue of $24.7 billion and net profit of $6.0 billion, or $6.40 per diluted share, in the year-ago quarter. Gross margin was 47.4 percent compared to 41.4 percent in the year-ago quarter. International sales accounted for 64 percent of the quarter’s revenue.
LOS. Describe the roles of financial reporting and financial statement analysis.
Pages 1–6
Headline and first paragraph of Apple’s 2Q2012 earnings announcement (obtained from Form 8-K on the SEC website, or from
Companies typically issue press releases announcing their earnings—interim and annual.
Earnings announcements are an example of a financial report other than the financial statements.
Earnings announcements also include financial statements for the period (typically at least the balance sheet and income statement, often the statement of cash flows) although the financial statements in the earnings announcements are often unaudited either because they are preliminary or because they are for a quarterly period. (In many markets, only annual financial statements are required to be audited.)
The headline and first paragraph of this announcement contain items typically relevant to investors, such as growth in net profits and profitability and, here, gross margin (gross profit divided by sales, which is a measure of profitability).
Information about international sales also speaks to diversification and growth.
Customization possibility: Replace this slide and the next with a different company.
Excerpt from Apple’s earnings announcement (2Q2012)
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4. Financial analysis Analysts’ response (excerpt)
On April 24, 2012, Apple (AAPL) reported results that blew past everyone's expectations, including our expectations. Apple reported quarterly revenue of $39.2B and quarterly profit of $11.6B, or $12.30 EPS. This surpassed the $10.07 consensus estimates from the analyst community. Apple saw growth due to strong sales growth from all of its product lines. Revenue enjoyed a mammoth 59% increase versus Q and EPS grew by over 92%. EPS Growth was also aided by a higher gross margin, which was aided by lower commodity input costs associated with Apple's products.
Saibus Research , Seeking Alpha (25 April 2012)
LOS. Describe the roles of financial reporting and financial statement analysis.
Pages 1–6
First sentences from a research company’s longer comments on Apple’s results (obtained from Seeking Alpha website:
Analysts
Compare results to expectations (consensus estimates from the analyst community).
Focus on growth in both revenue and EPS (recall that EPS = earnings per share = earnings available to common shareholders divided by the weighted average number of common shares). EPS is an important metric to equity investors; it is the “E” in P/E, which is a common valuation metric.
Focus on profitability (higher gross margin).
Excerpt refers to lower commodity input costs as being a contributing cause of Apple’s higher profitability. This is important because it is an example of an analyst explaining the reasons for a company’s financial performance. Of course, it is only an example of the reasons for Apple’s profitability (the reasons include all aspects of a company’s strategy, including its products, technology, marketing, etc.).
General comment: Analysis aims not only to describe what happened in a company’s financial performance but to explain the underlying reasons why it happened, to evaluate the performance relative to expectations, historical trends, and competitors, and to form expectations about the company’s future performance.
Optional discussion point: Some suggest that Apple (and some other companies) sometimes purposefully manage down analysts’ expectations so that it can then exceed them.
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5. FINANCIAL STATEMENTS Statement of Financial Position
Statement of Comprehensive Income
Statement of Changes in Equity
Statement of Cash Flows
Notes
LOS. Describe the roles of the key financial statements (statement of financial position, statement of comprehensive income, statement of changes in equity, statement of cash flows) in evaluating a company’s performance and profitability.
Pages 7–8
The relevant standards are shown below for reference only.
International Financial Reporting Standards (IFRS)
International Accounting Standard 1
Presentation of Financial Statements
Complete set of financial statements
10. A complete set of financial statements comprises:
a statement of financial position as at the end of the period;
a statement of profit or loss and other comprehensive income for the period;
a statement of changes in equity for the period;
a statement of cash flows for the period;
notes, comprising a summary of significant accounting policies and other explanatory information; and
a statement of financial position as at the beginning of the earliest comparative period when an entity applies an accounting policy retrospectively or makes a retrospective restatement of items in its financial statements, or when it reclassifies items in its financial statements. An entity may use titles for the statements other than those used in this Standard. For example, an entity may use the title “statement of comprehensive income” instead of “statement of profit or loss and other comprehensive income.”
U.S. GAAP Codification
A full set of financial statements for a period should show: financial position at the end of the period, earnings (net income) for the period, comprehensive income (total nonowner changes in equity) for the period, cash flows during the period, and investments by and distributions to owners during the period.
U.S. SEC (Securities and Exchange Commission)
Division of Corporation Finance
Financial Reporting Manual
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6. FINANCIAL STATEMENTS Statement of financial position
Statement of Financial Position (the Balance Sheet)
Assets = Liabilities + Owners’ equity
Assets − Liabilities = Owners’ equity
Point in Time
LOS. Describe the roles of the key financial statements (statement of financial position, statement of comprehensive income, statement of changes in equity, statement of cash flows) in evaluating a company’s performance and profitability.
Pages 8–12
The balance sheet is a listing of what a company owns (assets), what it owes (liabilities,) and the amount of its ownership (equity).
Assets = Liabilities + Owners’ equity is referred to as the basic accounting equation. The amount of a company’s assets is equal to the amount of the claims on those assets. The two sides of the equation are always in balance, thus the term “balance sheet.”
The accounting equation can also be written as Assets − Liabilities = Owners’ equity. This form emphasizes the residual claim of equity.
Optional discussion points, depending on sophistication of audience:
If you list the value of everything you own and then subtract the amount of everything you owe, the result is your net worth. Equity is equivalent to a company’s net worth.
Assume you buy a house (or car) for $100 thousand by putting a down payment of $20 thousand and borrowing the rest. You would say that you have an asset of $100 thousand, a liability of $80 thousand, and the difference of $20 thousand represents the amount of equity you have in the asset.
The balance sheet is prepared as of a point in time. It is like a snapshot. For example, a company with a fiscal year-end equal to the calendar year-end lists the amount of its assets, liabilities, and equity as of 31 December.
Using the balance sheet and applying financial statement analysis, the analyst can answer such questions as the following:
Has the company’s liquidity (ability to meet short-term obligations) improved?
Is the company solvent (does it have sufficient resources to cover its obligations)?
What is the company’s financial position relative to the industry?
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7. The Hershey Company’s Balance Sheet as of 31 December 2011
LOS. Describe the roles of the key financial statements (statement of financial position, statement of comprehensive income, statement of changes in equity, statement of cash flows) in evaluating a company’s performance and profitability.
Pages 8–12
The Hershey Company’s Balance Sheet as of 31 December 2011
The heading shows the name of the company, the name of the financial statement, and the time period (31 December 2011).
Consolidated means that the balance sheet is for Hershey and all of its subsidiary companies where it has controlling ownership.
Note currency denomination. This balance sheet is presented in thousands of dollars. Total assets = $4.4 billion.
Total assets = Total liabilities and stockholders’ equity.
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8. Assets of Lindt & Sprüngli Group
LOS. Describe the roles of the key financial statements (statement of financial position, statement of comprehensive income, statement of changes in equity, statement of cash flows) in evaluating a company’s performance and profitability.
Pages 8–12
Lindt & Sprügli Group, a Swiss chocolate maker, prepares its financial statements in accordance with International Financial Reporting Standards (IFRS). IFRS require companies to present classified balance sheets that show current and noncurrent assets and current and noncurrent liabilities as separate classifications. However, IFRS do not prescribe a particular ordering or format, and the order in which companies present their balance sheet items is largely a function of tradition. As shown, Lindt presents noncurrent assets before current assets.
The balance sheet is denominated in millions of Swiss francs (CHF million).
Lindt also presents certain line items as a percent of total assets (a common-size balance sheet, which will be covered in a later reading).
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9. Liabilities and Equity of Lindt & Sprüngli Group
LOS. Describe the roles of the key financial statements (statement of financial position, statement of comprehensive income, statement of changes in equity, statement of cash flows) in evaluating a company’s performance and profitability.
Pages 8–12
Lindt also presents owners’ equity before liabilities and, within liabilities, noncurrent liabilities before current liabilities. This method generally reflects a presentation from least liquid to most liquid.
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10. FINANCIAL STATEMENTS: statement of comprehensive income
Also known as the income statement, statement of earnings, or profit and loss statement
Comprehensive income: All items that affect owners’ equity but are not the result of transactions with shareholders
Comprehensive income = Net income + Other comprehensive income
Presentation permitted
Single statement of comprehensive income
Two consecutive statements
Net Income = Income – Expenses
Period of time
LOS: Describe the roles of the key financial statements (statement of financial position, statement of comprehensive income, statement of changes in equity, statement of cash flows) in evaluating a company’s performance and profitability.
Pages 12–15
The basic equation underlying the income statement is
Revenue + Other income – Expenses = Income – Expenses = Net income
Comprehensive income: All items that impact owners’ equity but are not the result of transactions with shareholders.
Comprehensive income = Net income + Other comprehensive income
One way to think about other comprehensive income (OCI) is that it includes items of income that bypass the income statement.
An example is the gains or losses on available for sale securities.
If a company owns securities that are classified as available for sale, accounting rules require that these securities be shown on the balance sheet at their fair value, but changes in the fair value are shown as OCI.
Further elaboration, if needed, depending on sophistication of the audience:
Assume a company has available-for-sale (AFS) securities (an asset) valued on its balance sheet at $100. At the end of the period, the fair value of those securities has increased to $150. The company will make an accounting entry to increase the value of its asset by $50 with a corresponding increase in OCI, not net income.
Presentation permitted:
Single statement of comprehensive income
Two consecutive statements
The income statement shows net income, which equals revenues minus expenses.
The income statement pertains to a period of time.
Optional discussion point under presentation permitted. U.S. GAAP (but not IFRS) previously allowed OCI to be presented within the statement of changes in equity. In June 2011, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No , “Presentation of Comprehensive Income.” ASU No eliminates the current option to disclose other comprehensive income and its components in the statement of changes in equity. For public entities, the amendments are effective for fiscal years, and interim periods within those years, beginning after 15 December 2011.
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11. Top line is net sales, which were around $6 billion in 2011.
LOS. Describe the roles of the key financial statements (statement of financial position, statement of comprehensive income, statement of changes in equity, statement of cash flows) in evaluating a company’s performance and profitability.
Pages 12–15
Hershey Company Consolidated Statements of Income: Presented on a consolidated basis, meaning that it includes the income and expenses of Hershey and all of its subsidiary companies for which it has controlling ownership.
Top line is net sales, which were around $6 billion in 2011.
After subtracting all expenses, net income was around $629 million in 2011.
Hershey presents a subtotal for income before interest and income taxes. Presentation of this subtotal is fairly typical. This item is also referred to as operating income or as EBIT (earnings before interest and taxes).
Income statement shows earnings per share—here, net income per share.
Companies present both basic and diluted earnings per share on the face of the income statement. Earnings per share numbers represent net income attributable to the class of shareholders divided by the relevant number of shares of stock outstanding during the period.
Basic earnings per share is calculated using the weighted-average number of common (ordinary) shares that were actually outstanding during the period and the profit or loss attributable to the common shareowners.
Diluted earnings per share uses diluted shares—the number of shares that would hypothetically be outstanding if potentially dilutive claims on common shares (e.g., stock options or convertible bonds) were exercised or converted by their holders, and an appropriately adjusted profit or loss attributable to the common shareowners.
Hershey has two classes of common stock. The footnotes to the financial statements (not shown) disclose that holders of the two classes of common stock have different voting rights and different dividend amounts. (Hershey’s common stock holders have 1 vote per share and the holders of Class B stock have 10 votes per share. The common stock holders are entitled to cash dividends 10% higher than those declared and paid on the Class B stock. Also, Class B stock can be converted into common stock on a share-for-share basis at any time.)
Note: For the year 2011, Hershey presented its other comprehensive income on its statement of shareholders’ equity, which will be shown later. Because that presentation format is no longer allowed under U.S. GAAP, it is not displayed here.
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12. Lindt & Sprüngli Group Income Statement
LOS. Describe the roles of the key financial statements (statement of financial position, statement of comprehensive income, statement of changes in equity, statement of cash flows) in evaluating a company’s performance and profitability.
Pages 12–15
Lindt had two sources of income: sales of CHF million and other income of CHF10.3 million.
After subtracting operating expenses, Lindt had 2011 “operating profit” of CHF328.7 million. Note that this item is income before interest and taxes.
Lindt’s 2011 net income was CHF246.5 million.
Lindt shows certain items as a percentage of total sales (a common-size income statement, which will be discussed in a later reading).
Reference notes, if needed:
Note 22 discloses that other income includes fees from third parties (composed mainly of the reimbursement of freight charges), insurance reimbursements, license fees, rental income, and company-produced additions involving investments in fixed assets.
PC means “participation certificate.” Lindt’s ordinary capital is composed of two types of securities: registered shares with a par value of CHF100 and bearer participation certificates with a par value of CHF10. The registered share has a voting right at the general meeting, whereas the bearer participation certificates have no voting rights. Both types of shares have the same rights to dividends and proceeds of liquidation in proportion to their par value. All shares are fully paid in.
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13. Statement of Comprehensive Income
Lindt & Sprüngli Group
Statement of Comprehensive Income
LOS. Describe the roles of the key financial statements (statement of financial position, statement of comprehensive income, statement of changes in equity, statement of cash flows) in evaluating a company’s performance and profitability.
Pages 12–15
Lindt presents comprehensive income as two consecutive statements.
The statement of comprehensive income begins with net income from the income statement and then presents components of other comprehensive income. One of the components of Lindt’s comprehensive income, as previously mentioned, is unrealized gains (losses) on available-for-sale securities. The other components are discussed in subsequent readings.
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14. FINANCIAL STATEMENTS: statement of changes in equity
Also known as statement of changes in owners’ equity or statement of shareholders’ equity
Period of time
Beginning equity + Changes in equity = Ending equity
Basic components of owners’ equity are paid-in capital and retained earnings.
Beginning common stock + Issuances – Repurchases = Ending common stock
Beginning retained earnings + Net Income – Dividends = Ending retained earnings
Beginning AOCI + OCI = Ending AOCI
LOS: Describe the roles of the key financial statements (statement of financial position, statement of comprehensive income, statement of changes in equity, statement of cash flows) in evaluating a company’s performance and profitability.
Pages 15–18
This statement primarily serves to report changes in the owners’ investment in the business over time.
The basic components of owners’ equity are paid-in capital and retained earnings.
Retained earnings include the cumulative amount of the company’s profits that have been retained in the company.
AOCI = accumulated other comprehensive income, and OCI = other comprehensive income for the period.
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15. Comments on some of the items:
LOS. Describe the roles of the key financial statements (statement of financial position, statement of comprehensive income, statement of changes in equity, statement of cash flows) in evaluating a company’s performance and profitability.
Pages 15–18
Hershey’s Statement of Stockholders’ Equity (excerpt showing only 2011 information)
The columns show each line item of shareholders’ equity that is included on the company’s balance sheet, and the far right column displays the total.
The first line shows the beginning balance of total stockholders’ equity. The balance at the end of 2010 is the balance at the beginning of (These numbers can be seen on the company’s balance sheet.)
Comments on some of the items:
Note, for example, that the column labeled retained earnings increases by the amount of net income ($628,962 thousand) and decreases by the dividends paid to the common stockholders.
Hershey presented its other comprehensive income (for 2011, a loss of $227,264 thousand) on its statement of shareholders’ equity. After 2011, that presentation format is no longer allowed under U.S. GAAP.
During 2011, shares of Class B stock were converted into common stock.
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16. Statement of Changes in Equity
Lindt & Sprüngli Group
Statement of Changes in Equity
LOS: Describe the roles of the key financial statements (statement of financial position, statement of comprehensive income, statement of changes in equity, statement of cash flows) in evaluating a company’s performance and profitability.
Pages 15–18
Lindt’s Statement of Changes in Equity
The first column shows the amount of share and participation-certificate capital—that is, paid-in capital (CHF23.3 million at the end of 2011)—and the far right column displays the total (CHF1,619.1 million at the end of 2011). Other items are summarized on the balance sheet.
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17. FINANCIAL STATEMENTS statement of CASH FLOWS
Period of time
Beginning Cash + Changes in cash = Ending cash
Changes in cash from
Operating
Investing
Financing
LOS. Describe the roles of the key financial statements (statement of financial position, statement of comprehensive income, statement of changes in equity, statement of cash flows) in evaluating a company’s performance and profitability.
Pages 18–22
Although the income statement and balance sheet provide measures of a company’s success in terms of performance and financial position, cash flow is also vital to a company’s long-term success.
Disclosing the sources and uses of cash helps creditors, investors, and other statement users evaluate a company’s liquidity, solvency, and financial flexibility. Financial flexibility is the ability of a company to react and adapt to financial adversities and opportunities.
The cash flow statement classifies all cash flows of a company into three categories: operating, investing, and financing.
Cash flows from operating activities are those cash flows not classified as investing or financing and generally involve the cash effects of transactions that enter into the determination of net income and, hence, make up the day-to-day operations of the company.
Cash flows from investing activities are those cash flows from activities associated with the acquisition and disposal of long-term assets, such as property and equipment.
Cash flows from financing activities are those cash flows from activities related to obtaining or repaying capital to be used in the business.
IFRS permit more flexibility than U.S. GAAP in classifying dividend and interest receipts and payments within these categories.
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18. Portions omitted
LOS. Describe the roles of the key financial statements (statement of financial position, statement of comprehensive income, statement of changes in equity, statement of cash flows) in evaluating a company’s performance and profitability.
Pages 18–22
Begin at the bottom of the slide. The overall change in Hershey’s cash was a decrease of $190,956 thousand. Beginning cash was $884,642 thousand, so the change leaves an ending balance of $693,686 thousand. Both the beginning and ending cash balances can be seen on the balance sheet.
Next, look at the components of cash flow. Ideally, for an established company, the analyst would like to see that the primary source of cash flow is from operating activities as opposed to investing or financing activities. This is the case with Hershey. In 2011, the company generated $580,867 thousand from operating activities, used $333,005 thousand for investing activities (mainly capital additions), and used $438,818 thousand in financing activities (mainly for dividends and repurchases of common stock).
The operating activities section of Hershey’s cash flow statement begins with net income $628,962 thousand and makes adjustments to reconcile net income to the amount of cash generated from operating activities of $580,867 thousand. (Detail of the adjustments is not shown here for presentation purposes.) This approach to reporting cash flow from operating activities is termed the indirect method.
The direct method of reporting cash flows from operating activities (not illustrated) discloses major classes of gross cash receipts and gross cash payments. Examples of such classes are cash received from customers and cash paid to suppliers and employees.
The indirect method emphasizes the different perspectives of the income statement and cash flow statement. On the income statement, income is reported when earned, not necessarily when cash is received, and expenses are reported when incurred, not necessarily when paid. The cash flow statement presents another aspect of performance: the ability of a company to generate cash flow from running its business.
Lindt’s statement of cash flows is similar.
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19. ACCOMPANYING NOTES
The notes (also sometimes referred to as footnotes) that accompany the four financial statements are required and form an integral part of the statements.
Notes include information on
Significant accounting choices (policies, methods, and estimates).
Explanatory detail about line items on the face of the financial statements.
Other disclosures, such as commitments and contingencies.
Based on notes disclosures, analysts can understand whether accounting choices are similar for the companies being compared. If the policies differ, an analyst can often make necessary adjustments so that the financial statement data used are more comparable.
LOS. Describe the importance of financial statement notes and supplementary information—including disclosures of accounting policies, methods, and estimates—and management’s commentary.
Pages 20–22
The notes provide information that is essential to understanding the information provided in the primary statements.
A company’s significant accounting choices (policies, methods, and estimates) must be discussed in the notes to the financial statements.
Also, the financial notes and supplemental schedules provide explanatory information about almost every line item on the balance sheet and income statement.
In addition, note disclosures include information about the following (this list is not exhaustive):
financial instruments and risks arising from financial instruments
commitments and contingencies
legal proceedings
related-party transactions
subsequent events (i.e., events that occur after the balance sheet date)
business acquisitions and disposals
operating segments’ performance
Analysts must understand the accounting choices a company makes and determine whether they are similar to those of other companies identified and used as benchmarks or comparables. If the policies of the companies being compared are different, the analyst who understands accounting and financial reporting can often make necessary adjustments so that the financial statement data used are more comparable.
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20. Example of disclosure of Accounting principles in notes
Property, plant, and equipment — Property, plant, and equipment are valued at historical cost, less the accumulated depreciation. The assets are depreciated using the straight-line method over the period of their expected useful economic life. Historical cost includes all costs associated with the acquisition. Subsequent costs increasing the value of an asset are, depending on the case, either recorded in the book value of the asset or as a separate asset, to the extent that it can be assumed that it is likely that the Group will benefit from it in the future and that its costs can be calculated in a reliable manner. All other repair or maintenance costs are reflected in the income statement in the year of their occurrence. Land is not depreciated. Depreciation on other assets is calculated using the straight-line method to write down their cost to their residual values. The following useful lives have been applied: − Buildings (incl. installations): 5 – 40 years − Machinery: 10 – 15 years − Other fixed assets: 3 – 8 years Profits and losses from disposals are recorded in the income statement. Excerpt from Lindt & Sprüngli Group, Annual Report (2011)
LOS. Describe the importance of financial statement notes and supplementary information—including disclosures of accounting policies, methods, and estimates—and management’s commentary.
Pages 20–22
This excerpt from the Lindt & Sprüngli Group, Annual Report (2011) illustrates typical disclosure about accounting principles, here for property, plant, and equipment (PP&E).
The company:
Values its PP&E at historical cost less accumulated depreciation.
Uses the straight-line method for depreciation.
Capitalizes expenditures that will provide future benefits and that can be reliably calculated and expenses all other expenditures in the year incurred.
For comparison…. Hershey’s principles are similar.
“Property, Plant and Equipment
Property, plant and equipment are stated at cost and depreciated on a straight-line basis over the estimated useful lives of
the assets, as follows: 3 to 15 years for machinery and equipment; and 25 to 40 years for buildings and related improvements.
Maintenance and repairs are expensed as incurred. We capitalize applicable interest charges incurred during the construction
of new facilities and production lines and amortize these costs over the assets’ estimated useful lives.”
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21. Example of disclosure of line item detail in notes
LOS. Describe the importance of financial statement notes and supplementary information—including disclosures of accounting policies, methods, and estimates—and management’s commentary.
Pages 20–22
This excerpt from Note 7 of Lindt’s Annual Report (2011) illustrates a disclosure providing detail about a line item on the balance sheet. The PP&E line item on the 2011 balance sheet shows a total of CHF742.1 million.
This note discloses acquisition cost of CHF1,758.8 and total accumulated depreciation of CHF1,016.7 million, which nets to the CHF742.1 million shown on the balance sheet.
The footnote also discloses the composition of PP&E. Reading across each column, we see that net PP&E comprised CHF336.2 million land and buildings, CHF322.3 million machinery, CHF34.8 million other fixed assets, and CHF48.8 million construction in process.
The footnote also discloses detail about additions, retirements, impairments, transfers, and the effect of currency translation.
Excerpt from Lindt & Sprüngli Group, Annual Report (2011)
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22. Example of disclosure in notes
LOS. Describe the importance of financial statement notes and supplementary information—including disclosures of accounting policies, methods, and estimates—and management’s commentary.
Pages 20–22
This excerpt from Note 30 of Lindt’s 2011 annual report shows that the company has contracted for—but not yet incurred—CHF24.7 million capital expenditures as of the balance sheet date.
Excerpt from Lindt & Sprüngli Group, Annual Report (2011)
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23. Management Commentary or MD&A
Is a narrative report that provides a context within which to interpret the financial position, financial performance, and cash flows of an entity.
Provides explanations of the amounts in the financial statements.
Provides information on a company’s prospects.
Provides management with an opportunity to explain its objectives and its strategies for achieving those objectives.
Encompasses reporting that jurisdictions may describe as management’s discussion and analysis (MD&A), operating and financial review (OFR), or management’s report.
LOS. Describe the importance of financial statement notes and supplementary information—including disclosures of accounting policies, methods, and estimates—and management’s commentary.
Page 23
Publicly held companies typically include a section in their annual reports where management discusses a variety of issues of concern, including the nature of the business, past results, and future outlook. This section is referred to by a variety of names, including management report(ing), management commentary, operating and financial review, and management’s discussion and analysis.
Inclusion of a management report is recommended by the International Organization of Securities Commissions and frequently required by regulatory authorities, such as the U.S. SEC or the U.K. Financial Services Authority. In Germany, management reporting has been required since 1931 and is audited. The discussion by management is arguably one of the most useful parts of a company’s annual report besides the financial statements themselves; however, other than excerpts from the financial statements, information included in the management commentary is typically unaudited. When using information from the management report, an analyst should be aware of whether the information is audited or unaudited.
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24. Contents of Management Commentary
The IFRS practice statement Management Commentary states that the management commentary should include information that is essential to an understanding of:
the nature of the business;
management’s objectives and its strategies for meeting those objectives;
the entity’s most significant resources, risks, and relationships;
the results of operations and prospects; and
the critical performance measures and indicators that management uses to evaluate the entity’s performance against stated objectives.
In the United States, the SEC requires listed companies to provide an MD&A and specifies the content. Management must highlight any favorable or unfavorable trends and identify significant events and uncertainties that affect the company’s liquidity, capital resources, and results of operations.
LOS. Describe the importance of financial statement notes and supplementary information—including disclosures of accounting policies, methods, and estimates—and management’s commentary.
Page 23
To help improve the quality of the discussion by management, the International Accounting Standards Board (IASB) issued (on 8 December 2010) the IFRS practice statement Management Commentary. The practice statement provides a broad, nonbinding framework for the presentation of management commentary that relates to financial statements prepared in accordance with IFRS.
The practice statement is not an IFRS. Consequently, entities are not required to comply with the practice statement, unless specifically required by their jurisdiction.
The particular focus of management commentary will depend on the facts and circumstances of the entity, but the practice statement provides guidance on the contents of the commentary.
The management commentary or MD&A is a good starting place for understanding information in the financial statements. In particular, the forward-looking disclosures in an MD&A, such as those about planned capital expenditures, new store openings, or divestitures, can be useful in projecting a company’s future performance. However, the commentary is only one input for the analyst seeking an objective and independent perspective on a company’s performance and prospects.
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25. Example of MD&A explanation of amounts in financial statements
Net Sales 2011 compared with 2010 Net sales increased 7.2% in 2011 compared with 2010 due to net price realization and sales volume increases in the U.S. and for our international businesses. Net price realization contributed approximately 3.5% to the net sales increase primarily due to the impact of list price increases, offset somewhat by higher promotional rates. Sales volume increased net sales by approximately 3.4% due primarily to sales of new products in the U.S. The favorable impact of foreign currency exchange rates increased net sales by approximately 0.3%. Excerpt from Hershey’s MD&A, Annual Report (2011)
LOS. Describe the importance of financial statement notes and supplementary information—including disclosures of accounting policies, methods, and estimates—and management’s commentary.
Page 23
This excerpt from Hershey’s MD&A illustrates an explanation of the components of the company’s 2011 sales growth of 7.2%. Sales growth attributable to price increases was 3.5%, to volume was 3.4%, and to favorable impact of foreign currency exchange rates was 0.3%.
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26. Example of MD&A information on the company’s prospects
OUTLOOK The outlook section contains a number of forward-looking statements, all of which are based on current expectations. Actual results may differ materially..... Excluding the Brookside acquisition, we expect volume to be slightly up for the full year 2012, resulting in net sales growth of about 5% to 7%, including the impact of foreign currency exchange rates…. We expect reported gross margin to increase approximately 90 basis points in 2012…. We expect full-year adjusted earnings per share-diluted, including the adjustment for non-service related pension expenses, to increase 9% to 11%.... Cash Flows from Investing Activities …We anticipate total capital expenditures, including capitalized software, of approximately $280 million to $295 million in 2012… Excerpt from Hershey’s MD&A, Annual Report (2011)
LOS. Describe the importance of financial statement notes and supplementary information—including disclosures of accounting policies, methods, and estimates—and management’s commentary.
Page 23
This excerpt from Hershey’s MD&A illustrates information on a company’s prospects.
An analyst can use prospective information as one input in preparing his or her own forecasts of the company’s performance.
The information shown here was found in different sections of Hershey’s MD&A. The sales and earnings information was found in a section labeled “Outlook,” whereas the anticipated capital expenditure information was found in a section discussing cash flows.
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27. Auditor’s reports
Financial statements presented in companies’ annual reports are generally required to be audited (examined) by an independent accounting firm in accordance with specified auditing standards.
An audit report is a written opinion on the financial statements prepared by the independent auditor.
Objectives of the independent auditor in conducting an audit:
To obtain reasonable assurance about whether the financial statements as a whole are free from material misstatement (whether due to fraud or error), enabling the auditor to opine on whether the statements are prepared in accordance with applicable financial reporting framework
To report on the financial statements
LOS. Describe the objective of audits of financial statements, the types of audit reports, and the importance of effective internal controls.
Pages 24–26
Audit reports take slightly different forms in different jurisdictions, but the basic components, including a specific statement of the auditor’s opinion, are similar.
Audits of financial statements may be required by contractual arrangement, law, or regulation.
International standards for auditing have been developed by the International Auditing and Assurance Standards Board of the International Federation of Accountants. These standards have been adopted by many countries and are referenced in audit reports issued in those countries. Other countries, such as the United States, specify their own auditing standards. With the enactment of the Sarbanes–Oxley Act of 2002 in the United States, auditing standards for public companies are promulgated by the Public Company Accounting Oversight Board.
Under international standards for auditing (ISAs), the objectives of an auditor in conducting an audit of financial statements are
To obtain reasonable assurance about whether the financial statements as a whole are free from material misstatement, whether due to fraud or error, thereby enabling the auditor to express an opinion on whether the financial statements are prepared, in all material respects, in accordance with an applicable financial reporting framework and
To report on the financial statements and communicate as required by the ISAs, in accordance with the auditor’s findings.
Publicly traded companies may also have requirements set by regulators or stock exchanges, such as appointing an independent audit committee within its board of directors to oversee the audit process. The audit process provides a basis for the independent auditor to express an audit opinion on whether the information presented in the audited financial statements present fairly the financial position, performance, and cash flows of the company in accordance with a specified set of accounting standards.
Because audits are designed and conducted using audit sampling techniques and financial statement line items may be based on estimates and assumptions, independent auditors cannot express an opinion that provides absolute assurance about the accuracy or precision of the financial statements. Instead, the independent audit report provides reasonable assurance that the financial statements are fairly presented, meaning that there is a high probability that the audited financial statements are free from material error, fraud, or illegal acts that have a direct effect on the financial statements.
See the International Auditing and Assurance Standards Board (IAASB) Handbook of International Quality Control, Auditing, Review, Other Assurance, and Related Services Pronouncements.
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28. Types of Auditor’s reports
Unqualified audit opinion: “Clean” opinion. States that the financial statements give a “true and fair view” (international) or are “fairly presented” (international and U.S.) in accordance with applicable accounting standards. This opinion is the one that analysts would like to see in a financial report.
Other types of opinions:
Qualified audit opinion: One in which there is some scope limitation or exception to accounting standards. Exceptions are described in the audit report with additional explanatory paragraphs so that the analyst can determine the importance of the exception.
Adverse audit opinion: Issued when an auditor determines that the financial statements materially depart from accounting standards and are not fairly presented. Generally, an analyst would not bother analyzing these statements.
Disclaimer of opinion: Issued when the auditors are unable to issue an opinion for some reason, such as a scope limitation.
LOS. Describe the objective of audits of financial statements, the types of audit reports, and the importance of effective internal controls.
Pages 24–26
An unqualified audit opinion states that the financial statements give a “true and fair view” (international) or are “fairly presented” (international and U.S.) in accordance with applicable accounting standards. This is often referred to as a “clean” opinion and is the one that analysts would like to see in a financial report. There are several other types of opinions.
A qualified audit opinion is one in which there is some scope limitation or exception to accounting standards. Exceptions are described in the audit report with additional explanatory paragraphs so that the analyst can determine the importance of the exception.
An adverse audit opinion is issued when an auditor determines that the financial statements materially depart from accounting standards and are not fairly presented. An adverse opinion makes analysis of the financial statements easy: Do not bother analyzing these statements because the company’s financial statements cannot be relied on.
Finally, a disclaimer of opinion occurs when, for some reason, such as a scope limitation, the auditors are unable to issue an opinion.
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29. internal control system
The internal control system is the company’s internal system that is designed, among other things, to ensure that the company’s process for generating financial reports is sound.
Some countries (e.g., the United States) require an additional audit opinion on the company’s internal control systems.
LOS. Describe the objective of audits of financial statements, the types of audit reports, and the importance of effective internal controls.
Pages 24–26
In the United States, under the Sarbanes–Oxley Act, the auditors must also express an opinion on the company’s internal control systems. This information may be provided in a separate opinion or incorporated as a paragraph in the opinion related to the financial statements.
Although management has always been responsible for maintaining effective internal control, the Sarbanes–Oxley Act greatly increases management’s responsibility for demonstrating that the company’s internal controls are effective.
Management of publicly traded companies in the United States are now required by securities regulators to explicitly accept responsibility for the effectiveness of internal control, evaluate the effectiveness of internal control using suitable control criteria, support the evaluation with sufficient competent evidence, and provide a report on internal control. Although these reports and attestations provide some assurances to analysts, they are not infallible. The analyst must always use a degree of healthy skepticism when analyzing financial statements.
Examples of situations that might raise questions about a company’s internal control systems:
Restatements to correct an error in previously issued financial statements can indicate problems.
Rapid growth and/or numerous acquisitions can create challenges.
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30. information sources besides annual financial statements
Annual report or proxy statement: Management compensation and governance information
Interim reports: (Unaudited) financial statements with updated information on a company’s performance and financial position since the last annual period
Press releases, particularly earnings announcements, and conference calls
Presentations to analysts
External data sources for information on
the economy
the industry
the company and peer (comparable) companies
Regulatory context, where applicable
Direct experience of the company’s products and services
LOS. Identify and explain information sources that analysts use in financial statement analysis besides annual financial statements and supplementary information.
Pages 26–27
Annual report or proxy statements are statements distributed to shareholders about matters that are to be put to a vote at the company’s annual (or special) meeting of shareholders.
They include information on management and director compensation, company stock performance, and any potential conflicts of interest that may exist between management, the board, and shareholders.
Interim reports are also provided by the company either semiannually or quarterly, depending on the applicable regulatory requirements.
Interim reports generally present financial statements and condensed notes but are not audited.
Companies also provide relevant current information on their websites, in press releases, and in conference calls with analysts and investors.
One type of press release, which analysts often consider to be particularly important, is the periodic earnings announcement. The earnings announcement often happens well before the company files its formal financial statements.
Such earnings announcements are often followed by a conference call in which the company’s senior executives describe the company’s performance and answer questions posed by conference call participants.
Following the earnings conference call, the investor relations portion of the company’s website may post a recording of the call accompanied by slides and supplemental information discussed during the call.
Analysts should also review information from external sources regarding the economy, the industry, the company, and peer (comparable) companies.
Information on the economy, industry, and peer companies is useful in putting the company’s financial performance and position in perspective and in assessing the company’s future.
In most cases, information from sources apart from the company is crucial to an analyst’s effectiveness.
For example, an analyst studying a consumer-oriented company will typically seek direct experience with the products (taste the food or drink, use the shampoo or soap, visit the stores or hotels).
An analyst following a highly regulated industry will study the existing and expected relevant regulations.
An analyst following a highly technical industry will gain relevant expertise personally or seek input from a technical specialist.
In sum, thorough research goes beyond financial reports.
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31. steps in financial statement analysis
Phase
1. Articulate the Purpose and Context of the Analysis
2. Collect Data
3. Process Data
4. Analyze/Interpret the Processed Data
5. Develop and Communicate Conclusions and Recommendations
6. Follow-Up
LOS. Describe the steps in the financial statement analysis framework.
Pages 27–31
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32. Articulate the Purpose and Context of Analysis
Purpose of analysis: evaluate the historical performance of a company (trend and cross sectional), prepare a forecast of future performance, value a company’s equity or debt securities, prepare rating or recommendation
Define the context
Intended audience
End product
Time frame
Resources and resource constraints
Based on purpose and context, formulate questions to be answered
LOS Describe the steps in the financial statement analysis framework.
Pages 27–29
Prior to undertaking any analysis, it is essential to understand the purpose of the analysis. An understanding of the purpose is particularly important in financial statement analysis because of the numerous available techniques and the substantial amount of data.
Some analytical tasks are well defined, in which case articulating the purpose of the analysis requires little decision making by the analyst.
For example, a periodic credit review of an investment-grade debt portfolio or an equity analyst’s report on a particular company may be guided by institutional norms such that the purpose of the analysis is given.
Furthermore, the format, procedures, and/or sources of information may also be given.
For other analytical tasks, articulating the purpose of the analysis requires the analyst to make decisions.
The purpose of an analysis guides further decisions about the approach, the tools, the data sources, the format in which to report the results of the analysis, and the relative importance of different aspects of the analysis.
When facing a substantial amount of data, a less experienced analyst may be tempted to just start making calculations and generating financial ratios without considering what is relevant for the decision at hand. It is generally advisable to resist this temptation and thus avoid unnecessary or pointless efforts.
Consider the questions, If you could have all the calculations and ratios completed instantly, what conclusion would you be able to draw? What question would you be able to answer? What decision would your answer support?
The analyst should also define the context at this stage.
Who is the intended audience? What is the end product—for example, a final report explaining conclusions and recommendations? What is the time frame (i.e., when is the report due)? What resources and resource constraints are relevant to completion of the analysis?
Again, the context may be predefined (i.e., standard and guided by institutional norms).
Having clarified the purpose and context of the financial statement analysis, the analyst should next compile the specific questions to be answered by the analysis.
For example, if the purpose of the financial statement analysis (or, more likely, the particular stage of a larger analysis) is to compare the historical performance of three companies operating in a particular industry, specific questions would include the following:
What has been the relative growth rate of the companies, and what has been the relative profitability of the companies?
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33. Collect data, process data, analyze data
Collect data required to answer questions.
Use analytical tools to process data:
Ratio analysis
Common-size financial statements
Analyze data:
Use financial ratios to assess a company’s profitability, liquidity, leverage, and efficiency relative to its own past (trend analysis) and relative to peer/benchmark companies.
Synthesize all available information to develop expectations about a company’s likely future performance.
Develop forecasts and use as input to valuation.
LOS Describe the steps in the financial statement analysis framework.
Pages 29–30
Collect Data
A key part of this step is obtaining an understanding of the company’s business, financial performance, and financial position (including trends over time and in comparison with peer companies).
For historical analyses, financial statement data alone are adequate in some cases.
For example, to screen a large number of alternative companies to find those with a minimum level of profitability, financial statement data alone would be adequate. But to address more in-depth questions, such as why and how one company performed better or worse than its competitors, additional information would be required.
As another example, to compare the historical performance of two companies in a particular industry, the historical financial statements would be sufficient to determine which had faster-growing sales or earnings and which was more profitable. However, a broader comparison with overall industry growth and profitability would obviously require industry data.
Furthermore, information on the economy and industry is necessary to understand the environment in which the company operates.
Analysts often take a top-down approach whereby they
gain an understanding of the macroeconomic environment, such as prospects for growth in the economy and inflation,
analyze the prospects of the industry in which the subject company operates based on the expected macroeconomic environment, and
determine the prospects for the company in the expected industry and macroeconomic environments. For example, an analyst may need to forecast future growth in earnings for a company.
Process Data
Process data using appropriate analytical tools:
computing ratios or growth rates
preparing common-size financial statements
creating charts
performing statistical analyses, such as regressions or Monte Carlo simulations
performing equity valuation
performing sensitivity analyses
A comprehensive financial analysis at this stage would include
reading and evaluating financial statements (and notes and other disclosures) for each company being analyzed.
making any needed adjustments to the financial statements to facilitate comparison when the unadjusted statements of the subject companies reflect differences in accounting standards, accounting choices, or operating decisions (note that commonly used databases do not make such analyst adjustments).
preparing or collecting common-size financial statement data (which scale data to directly reflect percentages [e.g., of sales] or changes [e.g., from the prior year]) and financial ratios (which are measures of various aspects of corporate performance based on financial statement elements).
On the basis of common-size financial statements and financial ratios, analysts can evaluate a company’s relative profitability, liquidity, leverage, efficiency, and valuation in relation to past results and/or peers’ results.
Analyze/Interpret the Processed Data
Once the data have been processed, the next step—critical to any analysis—is to interpret the output.
The answer to a specific financial analysis question is seldom the numerical answer alone. Rather, the answer to the analytical question relies on the analyst’s interpretation of the output and the use of this interpreted output to support a conclusion or recommendation.
Financial statement analysis typically involves assessing a company’s profitability, liquidity, leverage, efficiency, and valuation relative to its own past (trend analysis) and relative to peer/benchmark companies.
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34. Develop and Communicate Conclusions/Recommendations
Communicate the conclusion or recommendation in an appropriate format.
Appropriate format will vary by analytical task, by institution, and/or by audience.
An equity analyst’s report would typically include the following components:
Summary and investment conclusion
Earnings projections
Valuation
Business summary
Risk, industry, and competitive analysis
Historical performance
Forecasts
LOS Describe the steps in the financial statement analysis framework.
Pages 30–31
Develop and Communicate Conclusions/Recommendations
Compliance standards may require specific disclosures.
The contents of reports may also be specified by regulatory agencies or professional standards. For example, the CFA Institute Standards of Practice Handbook (SOPH) dictates standards that must be followed in communicating recommendations. According to the SOPH:
Standard V(B) states that members and candidates should communicate in a recommendation the factors that were instrumental in making the investment recommendation.
A critical part of this requirement is to distinguish clearly between opinions and facts.
In preparing a research report, the member or candidate must present the basic characteristics of the security(ies) being analyzed, which will allow the reader to evaluate the report and incorporate information the reader deems relevant to his or her investment decision making process.
The SOPH requires that limitations to the analysis and any risks inherent to the investment be disclosed.
Furthermore, the SOPH requires that any report include elements important to the analysis and conclusions so that readers can evaluate the conclusions themselves.
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35. Follow-Up
If an equity investment is made or a credit rating is assigned, periodic review is required to determine whether the original conclusions and recommendations are still valid.
Follow-up may involve repeating all the previous steps in the process on a periodic basis.
LOS Describe the steps in the financial statement analysis framework.
Page 31
Follow-Up
The process does not end with the report.
If an equity investment is made or a credit rating is assigned, periodic review is required to determine whether the original conclusions and recommendations are still valid.
In the case of a rejected investment, follow-up may not be necessary but may be useful in determining whether the analysis process is adequate or should be refined (for example, if a rejected investment turns out to be successful in the market, perhaps the rejection was due to inadequate analysis).
Follow-up may involve repeating all the previous steps in the process on a periodic basis.
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36. summary Financial statements include
statement of financial position (balance sheet);
statement of comprehensive income;
statement of changes in equity;
statement of cash flows; and
notes.
Analysts use various information sources in financial statement analysis besides annual financial statements.
For example, MD&A, earnings announcements, external data sources, and direct experience.
Steps in financial analysis:
articulate purpose and context,
collect data,
process data,
analyze data,
develop and communicate conclusions and recommendations, and
follow-up.
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