International Financial Statement Analysis
Description
Better analysis for more accurate international financial valuation International Financial Statement Analysis, 4th Edition provides the most up-to-date detail for the successful assessment of company performance and financial position regardless of country of origin. The seasoned experts at the CFA Institute offer readers a rich, clear reference, covering all aspects from financial reporting mechanics and standards to understanding income and balance sheets. Comprehensive guidance toward effective analysis techniques helps readers make real-world use of the knowledge presented, with this new third edition containing the most current standards and methods for the post-crisis world. Coverage includes the complete statement analysis process, plus information on income tax accounting, employee compensation, and the impact of foreign exchange rates on the statements of multinational corporations.
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Content
Preface xv
Acknowledgments xvii
About the CFA Institute Investment Series xix
Chapter 1 Introduction to Financial Statement Analysis 1
Learning Outcomes 1
1. Introduction 1
2. Roles of Financial Reporting and Financial Statement Analysis 2
3. Primary Financial Statements and Other Information Sources 8
3.1. Financial Statements and Supplementary Information 9
3.2. Other Sources of Information 28
4. Financial Statement Analysis Framework 28
4.1. Articulate the Purpose and Context of Analysis 30
4.2. Collect Data 30
4.3. Process Data 31
4.4. Analyze/Interpret the Processed Data 31
4.5. Develop and Communicate Conclusions/Recommendations 32
4.6. Follow-Up 32
5. Summary 32
References 34
Practice Problems 34
Chapter 2 Financial Reporting Standards 37
Learning Outcomes 37
1. Introduction 37
2. The Objective of Financial Reporting 38
3. Standard-Setting Bodies and Regulatory Authorities 39
3.1. Accounting Standards Boards 39
3.2. Regulatory Authorities 41
4. The International Financial Reporting Standards Framework 46
4.1. Qualitative Characteristics of Financial Reports 46
4.2. Constraints on Financial Reports 48
4.3. The Elements of Financial Statements 49
4.4. General Requirements for Financial Statements 50
5. Comparison of IFRS with Alternative Reporting Systems 53
6. Monitoring Developments in Financial Reporting Standards 55
6.1. New Products or Types of Transactions 55
6.2. Evolving Standards and the Role of CFA Institute 55
7. Summary 57
Practice Problems 58
Chapter 3 Understanding Income Statements 61
Learning Outcomes 61
1. Introduction 62
2. Components and Format of the Income Statement 62
3. Revenue Recognition 68
3.1. General Principles 69
3.2. Accounting Standards for Revenue Recognition 70
4. Expense Recognition 73
4.1. General Principles 74
4.2. Issues in Expense Recognition 78
4.3. Implications for Financial Analysis 83
5. Non-Recurring Items and Non-Operating Items 84
5.1. Discontinued Operations 84
5.2. Unusual or Infrequent Items 85
5.3. Changes in Accounting Policies 86
5.4. Non-Operating Items 89
6. Earnings per Share 90
6.1. Simple versus Complex Capital Structure 90
6.2. Basic EPS 91
6.3. Diluted EPS 92
6.4. Changes in EPS 98
7. Analysis of the Income Statement 99
7.1. Common-Size Analysis of the Income Statement 99
7.2. Income Statement Ratios 101
8. Comprehensive Income 103
9. Summary 106
Practice Problems 108
Chapter 4 Understanding Balance Sheets 113
Learning Outcomes 113
1. Introduction 113
2. Components and Format of the Balance Sheet 114
2.1. Balance Sheet Components 115
2.2. Current and Non-Current Classification 116
2.3. Liquidity-Based Presentation 117
3. Current Assets and Current Liabilities 118
3.1. Current Assets 118
3.2. Current Liabilities 123
4. Non-Current Assets 127
4.1. Property, Plant, and Equipment 128
4.2. Investment Property 129
4.3. Intangible Assets 129
4.4. Goodwill 132
4.5. Financial Assets 135
4.6. Deferred Tax Assets 138
5. Non-Current Liabilities 139
5.1. Long-term Financial Liabilities 140
5.2. Deferred Tax Liabilities 140
6. Equity 141
6.1. Components of Equity 141
6.2. Statement of Changes in Equity 144
7. Analysis of the Balance Sheet 145
7.1. Common-Size Analysis of the Balance Sheet 146
7.2. Balance Sheet Ratios 153
8. Summary 156
Practice Problems 158
Chapter 5 Understanding Cash Flow Statements 163
Learning Outcomes 163
1. Introduction 163
2. Components and Format of the Cash Flow Statement 164
2.1. Classification of Cash Flows and Non-Cash Activities 165
2.2. A Summary of Differences between IFRS and US GAAP 167
2.3. Direct and Indirect Methods for Reporting Cash Flow from Operating Activities 168
3. The Cash Flow Statement: Linkages and Preparation 177
3.1. Linkages of the Cash Flow Statement with the Income Statement and Balance Sheet 178
3.2. Steps in Preparing the Cash Flow Statement 179
3.3. Conversion of Cash Flows from the Indirect to the Direct Method 191
4. Cash Flow Statement Analysis 192
4.1. Evaluation of the Sources and Uses of Cash 193
4.2. Common-Size Analysis of the Statement of Cash Flows 197
4.3. Free Cash Flow to the Firm and Free Cash Flow to Equity 202
4.4. Cash Flow Ratios 204
5. Summary 205
Practice Problems 206
Chapter 6 Financial Analysis Techniques 213
Learning Outcomes 213
1. Introduction 213
2. The Financial Analysis Process 214
2.1. The Objectives of the Financial Analysis Process 215
2.2. Distinguishing between Computations and Analysis 216
3. Analytical Tools and Techniques 218
3.1. Ratios 221
3.2. Common-Size Analysis 226
3.3. The Use of Graphs as an Analytical Tool 232
3.4. Regression Analysis 233
4. Common Ratios Used in Financial Analysis 234
4.1. Interpretation and Context 234
4.2. Activity Ratios 235
4.3. Liquidity Ratios 241
4.4. Solvency Ratios 246
4.5. Profitability Ratios 250
4.6. Integrated Financial Ratio Analysis 254
5. Equity Analysis 262
5.1. Valuation Ratios 262
5.2. Industry-Specific Ratios 265
5.3. Historical Research on Ratios in Equity Analysis 267
6. Credit Analysis 268
6.1. The Credit Rating Process 268
6.2. Historical Research on Ratios in Credit Analysis 269
7. Business and Geographic Segments 270
7.1. Segment Reporting Requirements 270
7.2. Segment Ratios 271
8. Model Building and Forecasting 274
9. Summary 275
References 275
Practice Problems 276
Chapter 7 Inventories 283
Learning Outcomes 283
1. Introduction 283
2. Cost of Inventories 285
3. Inventory Valuation Methods 286
3.1. Specific Identification 287
3.2. First-In, First-Out (FIFO) 287
3.3. Weighted Average Cost 287
3.4. Last-In, First-Out (LIFO) 288
3.5. Calculation of Cost of Sales, Gross Profit, and Ending Inventory 288
3.6. Periodic versus Perpetual Inventory Systems 290
3.7. Comparison of Inventory Valuation Methods 293
4. The LIFO Method 295
4.1. LIFO Reserve 295
4.2. LIFO Liquidations 296
5. Inventory Method Changes 303
6. Inventory Adjustments 304
7. Evaluation of Inventory Management 311
7.1. Presentation and Disclosure 312
7.2. Inventory Ratios 312
7.3. Financial Analysis Illustrations 313
8. Summary 323
Practice Problems 325
Chapter 8 Long-Lived Assets 339
Learning Outcomes 339
1. Introduction 340
2. Acquisition of Long-Lived Assets 340
2.1. Property, Plant, and Equipment 341
2.2. Intangible Assets 343
2.3. Capitalizing versus Expensing: Impact on Financial Statements and Ratios 348
2.4. Capitalization of Interest Costs 353
2.5. Capitalization of Internal Development Costs 355
3. Depreciation and Amortization of Long-Lived Assets 359
3.1. Depreciation Methods and Calculation of Depreciation Expense 360
3.2. Amortization Methods and Calculation of Amortization Expense 368
4. The Revaluation Model 369
5. Impairment of Assets 373
5.1. Impairment of Property, Plant, and Equipment 373
5.2. Impairment of Intangible Assets with a Finite Life 375
5.3. Impairment of Intangibles with Indefinite Lives 376
5.4. Impairment of Long-Lived Assets Held for Sale 376
5.5. Reversals of Impairments of Long-Lived Assets 376
6. Derecognition 376
6.1. Sale of Long-Lived Assets 377
6.2. Long-Lived Assets Disposed of Other than by a Sale 378
7. Presentation and Disclosures 379
8. Investment Property 389
9. Summary 393
Practice Problems 395
Chapter 9 Income Taxes 407
Learning Outcomes 407
1. Introduction 408
2. Differences between Accounting Profit and Taxable Income 408
2.1. Current Tax Assets and Liabilities 409
2.2. Deferred Tax Assets and Liabilities 410
3. Determining the Tax Base of Assets and Liabilities 413
3.1. Determining the Tax Base of an Asset 414
3.2. Determining the Tax Base of a Liability 415
3.3. Changes in Income Tax Rates 417
4. Temporary and Permanent Differences Between Taxable and Accounting Profit 418
4.1. Taxable Temporary Differences 419
4.2. Deductible Temporary Differences 419
4.3. Examples of Taxable and Deductible Temporary Differences 420
4.4. Temporary Differences at Initial Recognition of Assets and Liabilities 422
4.5. Business Combinations and Deferred Taxes 423
4.6. Investments in Subsidiaries, Branches, Associates, and Interests in Joint Ventures 423
5. Unused Tax Losses and Tax Credits 423
6. Recognition and Measurement of Current and Deferred Tax 424
6.1. Recognition of a Valuation Allowance 425
6.2. Recognition of Current and Deferred Tax Charged Directly to Equity 425
7. Presentation and Disclosure 428
8. Comparison of IFRS and US GAAP 433
9. Summary 436
Practice Problems 437
Chapter 10 Non-Current (Long-Term) Liabilities 443
Learning Outcomes 443
1. Introduction 443
2. Bonds Payable 444
2.1. Accounting for Bond Issuance 444
2.2. Accounting for Bond Amortization, Interest Expense, and Interest Payments 448
2.3. Current Market Rates and Fair Value Reporting Option 453
2.4. Derecognition of Debt 457
2.5. Debt Covenants 459
2.6. Presentation and Disclosure of Long-Term Debt 461
3. Leases 464
3.1. Lessee accounting 465
3.2. Lessor accounting 466
4. Introduction to Pensions and Other Post- Employment Benefits 468
5. Evaluating Solvency: Leverage and Coverage Ratios 472
6. Summary 475
Practice Problems 477
Chapter 11 Financial Reporting Quality 483
Learning Outcomes 483
1. Introduction 484
2. Conceptual Overview 484
2.1. GAAP, Decision-Useful, Sustainable, and Adequate Returns 486
2.2. GAAP, Decision-Useful, but Sustainable? 486
2.3. Biased Accounting Choices 487
2.4. Departures from GAAP 496
2.5. Differentiate between Conservative and Aggressive Accounting 498
3. Context for Assessing Financial Reporting Quality 501
3.1. Motivations 501
3.2. Conditions Conducive to Issuing Low-Quality Financial Reports 501
3.3. Mechanisms That Discipline Financial Reporting Quality 502
4. Detection of Financial Reporting Quality Issues 510
4.1. Presentation Choices 510
4.2. Accounting Choices and Estimates 516
4.3. Warning Signs 533
5. Summary 538
References 539
Practice Problems 540
Chapter 12 Applications of Financial Statement Analysis 545
Learning Outcomes 545
1. Introduction 545
2. Application: Evaluating Past Financial Performance 546
3. Application: Projecting Future Financial Performance 550
3.1. Projecting Performance: An Input to Market-Based Valuation 551
3.2. Projecting Multiple-Period Performance 555
4. Application: Assessing Credit Risk 559
5. Application: Screening for Potential Equity Investments 561
6. Analyst Adjustments to Reported Financials 565
6.1. A Framework for Analyst Adjustments 565
6.2. Analyst Adjustments Related to Investments 565
6.3. Analyst Adjustments Related to Inventory 566
6.4. Analyst Adjustments Related to Property, Plant, and Equipment 569
6.5. Analyst Adjustments Related to Goodwill 571
7. Summary 573
References 574
Practice Problems 574
Chapter 13 Intercorporate Investments 577
Learning Outcomes 577
1. Introduction 577
2. Basic Corporate Investment Categories 578
3. Investments in Financial Assets: IFRS 9 579
3.1. Classification and Measurement 580
3.2. Reclassification of Investments 582
4. Investments in Associates and Joint Ventures 583
4.1. Equity Method of Accounting: Basic Principles 584
4.2. Investment Costs That Exceed the Book Value of the Investee 587
4.3. Amortization of Excess Purchase Price 588
4.4 Fair Value Option 590
4.5. Impairment 591
4.6. Transactions with Associates 591
4.7. Disclosure 594
4.8. Issues for Analysts 595
5. Business Combinations 595
5.1. Acquisition Method 597
5.2. Impact of the Acquisition Method on Financial Statements, Post-Acquisition 599
5.3. Th e Consolidation Process 601
5.4. Financial Statement Presentation Subsequent to the Business Combination 607
5.5. Variable Interest and Special Purpose Entities 610
5.6. Additional Issues in Business Combinations That Impair Comparability 613
6. Summary 614
Practice Problems 615
Chapter 14 Employee Compensation: Post-Employment and Share-Based 627
Learning Outcomes 627
1. Introduction 627
2. Pensions and Other Post-Employment Benefits 628
2.1. Types of Post-Employment Benefit Plans 628
2.2. Measuring a Defined Benefit Pension Plan's Obligations 631
2.3. Financial Statement Reporting of Pension Plans and Other Post-Employment Benefits 632
2.4. Disclosures of Pension and Other Post-Employment Benefits 645
3. Share-Based Compensation 656
3.1. Stock Grants 658
3.2. Stock Options 659
3.3. Other Types of Share-Based Compensation 662
4. Summary 662
Reference 663
Practice Problems 663
Chapter 15 Multinational Operations 673
Learning Outcomes 673
1. Introduction 674
2. Foreign Currency Transactions 675
2.1. Foreign Currency Transaction Exposure to Foreign Exchange Risk 676
2.2. Analytical Issues 680
2.3. Disclosures Related to Foreign Currency Transaction Gains and Losses 682
3. Translation of Foreign Currency Financial Statements 688
3.1. Translation Conceptual Issues 688
3.2. Translation Methods 693
3.3. Illustration of Translation Methods (Excluding Hyperinflationary Economies) 701
3.4. Translation Analytical Issues 704
3.5. Translation when a Foreign Subsidiary Operates in a Hyperinflationary Economy 716
3.6. Companies Use Both Translation Methods at the Same Time 720
3.7. Disclosures Related to Translation Methods 721
4. Multinational Operations and a Company's Effective Tax Rate 727
5. Additional Disclosures on the Effects of Foreign Currency 730
5.1. Disclosures Related to Sales Growth 730
5.2. Disclosures Related to Major Sources of Foreign Exchange Risk 733
6. Summary 734
Practice Problems 736
Chapter 16 Analysis of Financial Institutions 749
Learning Outcomes 749
1. Introduction 749
2. What Makes Financial Institutions Different? 750
2.1. Global Organizations 753
2.2. Individual Jurisdictions' Regulatory Authorities 755
3. Analyzing a Bank 756
3.1. The CAMELS Approach 756
3.2. Other Factors Relevant to Analysis of a Bank 773
3.3. An Illustration of the CAMELS Approach to Analysis of a Bank 777
4. Analyzing an Insurance Company 800
4.1. Property and Casualty Insurance Companies 800
4.2. Life and Health Insurance Companies 809
5. Summary 816
Practice Problems 817
Chapter 17 Evaluating Quality of Financial Reports 825
Learning Outcomes 825
1. Introduction 825
2. Quality of Financial Reports 827
2.1. Conceptual Framework for Assessing the Quality of Financial Reports 827
2.2. Potential Problems that Affect the Quality of Financial Reports 829
3. Evaluating the Quality of Financial Reports 840
3.1. General Steps to Evaluate the Quality of Financial Reports 841
3.2. Quantitative Tools to Assess the Likelihood of Misreporting 842
4. Earnings Quality 845
4.1. Indicators of Earnings Quality 845
4.2. Evaluating the Earnings Quality of a Company (Cases) 855
4.3. Bankruptcy Prediction Models 866
5. Cash Flow Quality 867
5.1. Indicators of Cash Flow Quality 867
5.2. Evaluating Cash Flow Quality 868
6. Balance Sheet Quality 876
7. Sources of Information about Risk 880
7.1. Limited Usefulness of Auditor's Opinion as a Source of Information about Risk 880
7.2. Risk-Related Disclosures in the Notes 884
7.3. Management Commentary (Management Discussion and Analysis, or MD&A) 888
7.4. Other Required Disclosures 891
7.5. Financial Press as a Source of Information about Risk 892
8. Summary 892
References 894
Practice Problems 896
Chapter 18 Integration of Financial Statement Analysis Techniques 901
Learning Outcomes 901
1. Introduction 901
2. Case Study: Long-Term Equity Investment 903
2.1. Phase 1: Define a Purpose for the Analysis 903
2.2. Phase 2: Collect Input Data 903
2.3. Phase 3: Process Data and Phase 4: Analyze/Interpret the Processed Data 904
2.4. Phase 5: Develop and Communicate Conclusions and Recommendations (e.g., with an Analysis Report) 932
2.5. Phase 6: Follow-up 933
3. Summary 933
Practice Problems 933
Glossary 937
About the Editors 947
About the CFA Program 949
Index 951
Chapter 1
Introduction to Financial Statement Analysis
Elaine Henry, PhD, CFA
Thomas R. Robinson, PhD, CFA
Learning Outcomes
After completing this chapter, you will be able to do the following:
- describe the roles of financial reporting and financial statement analysis;
- describe the roles of the 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 describe 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.
1. Introduction
Financial analysis is the process of examining a company's performance in the context of its industry and economic environment in order to arrive at a decision or recommendation. Often, the decisions and recommendations addressed by financial analysts pertain to providing capital to companies-specifically, whether to invest in the company's debt or equity securities and at what price. An investor in debt securities is concerned about the company's ability to pay interest and to repay the principal lent. An investor in equity securities is an owner with a residual interest in the company and is concerned about the company's ability to pay dividends and the likelihood that its share price will increase.
Overall, a central focus of financial analysis is evaluating the company's ability to earn a return on its capital that is at least equal to the cost of that capital, to profitably grow its operations, and to generate enough cash to meet obligations and pursue opportunities.
Fundamental financial analysis starts with the information found in a company's financial reports. These financial reports include audited financial statements, additional disclosures required by regulatory authorities, and any accompanying (unaudited) commentary by management. Basic financial statement analysis-as presented in this chapter-provides a foundation that enables the analyst to better understand other information gathered from research beyond the financial reports.
This chapter is organized as follows: Section 2 discusses the scope of financial statement analysis. Section 3 describes the sources of information used in financial statement analysis, including the primary financial statements (statement of financial position or balance sheet, statement of comprehensive income, statement of changes in equity, and cash flow statement). Section 4 provides a framework for guiding the financial statement analysis process. A summary of the key points concludes the chapter.
2. Roles of Financial Reporting and Financial Statement Analysis
The role of financial statements issued by companies is to provide information about a company's performance, financial position, and changes in financial position that is useful to a wide range of users in making economic decisions. The role of financial statement analysis is to use financial reports prepared by companies, combined with other information, to evaluate the past, current, and potential performance and financial position of a company for the purpose of making investment, credit, and other economic decisions. Managers within a company perform financial analysis to make operating, investing, and financing decisions but do not necessarily rely on analysis of related financial statements. They have access to additional financial information that can be reported in whatever format is most useful to their decision.
In evaluating financial reports, analysts typically have a specific economic decision in mind. Examples of these decisions include the following:
- Evaluating an equity investment for inclusion in a portfolio.
- Evaluating a merger or acquisition candidate.
- Evaluating a subsidiary or operating division of a parent company.
- Deciding whether to make a venture capital or other private equity investment.
- Determining the creditworthiness of a company in order to decide whether to extend a loan to the company and if so, what terms to offer.
- Extending credit to a customer.
- Examining compliance with debt covenants or other contractual arrangements.
- Assigning a debt rating to a company or bond issue.
- Valuing a security for making an investment recommendation to others.
- Forecasting future net income and cash flow.
These decisions demonstrate certain themes in financial analysis. In general, analysts seek to examine the past and current performance and financial position of a company in order to form expectations about its future performance and financial position. Analysts are also concerned about factors that affect risks to a company's future performance and financial position. An examination of performance can include an assessment of a company's profitability (the ability to earn a profit from delivering goods and services) and its ability to generate positive cash flows (cash receipts in excess of cash disbursements). Profit and cash flow are not equivalent. Profit (or loss) represents the difference between the prices at which goods or services are provided to customers and the expenses incurred to provide those goods and services.
In addition, profit (or loss) includes other income (such as investing income or income from the sale of items other than goods and services) minus the expenses incurred to earn that income. Overall, profit (or loss) equals income minus expenses, and its recognition is mostly independent from when cash is received or paid. Example 1 illustrates the distinction between profit and cash flow.
Example 1 Profit versus Cash Flow
Sennett Designs (SD) sells furniture on a retail basis. SD began operations during December 2017 and sold furniture for ?250,000 in cash. The furniture sold by SD was purchased on credit for ?150,000 and delivered by the supplier during December. The credit terms granted by the supplier required SD to pay the ?150,000 in January for the furniture it received during December. In addition to the purchase and sale of furniture, in December, SD paid ?20,000 in cash for rent and salaries.
- How much is SD's profit for December 2017 if no other transactions occurred?
- How much is SD's cash flow for December 2017?
- If SD purchases and sells exactly the same amount in January 2018 as it did in December and under the same terms (receiving cash for the sales and making purchases on credit that will be due in February), how much will the company's profit and cash flow be for the month of January?
Solution to 1: SD's profit for December 2017 is the excess of the sales price (?250,000) over the cost of the goods that were sold (?150,000) and rent and salaries (?20,000), or ?80,000.
Solution to 2: The December 2017 cash flow is ?230,000, the amount of cash received from the customer (?250,000) less the cash paid for rent and salaries (?20,000).
Solution to 3: SD's profit for January 2018 will be identical to its profit in December: ?80,000, calculated as the sales price (?250,000) minus the cost of the goods that were sold (?150,000) and minus rent and salaries (?20,000). SD's cash flow in January 2018 will also equal ?80,000, calculated as the amount of cash received from the customer (?250,000) minus the cash paid for rent and salaries (?20,000) and minus the ?150,000 that SD owes for the goods it had purchased on credit in the prior month.
Although profitability is important, so is a company's ability to generate positive cash flow. Cash flow is important because, ultimately, the company needs cash to pay employees, suppliers, and others in order to continue as a going concern. A company that generates positive cash flow from operations has more flexibility in funding needed for investments and taking advantage of attractive business opportunities than an otherwise comparable company without positive operating cash flow. Additionally, a company needs cash to pay returns (interest and dividends) to providers of debt and equity capital.
The expected magnitude of future cash flows is important in valuing corporate securities and in determining the company's ability to meet its obligations. The ability to meet short-term obligations is generally referred to as liquidity, and the ability to meet long-term obligations is generally referred to as solvency. Cash flow in any given period is not, however, a complete measure of performance for that period because, as shown in Example 1, a company may be obligated to make future cash payments as a result of a transaction that generates positive cash flow in the current period.
Profits may provide useful information about cash flows, past and future. If the transaction of Example 1 were repeated month after month, the long-term average monthly cash flow of SD would equal...
