Financial Statement Analysis

 Financial Statements

Financial statements are a snapshot of a company's well being at a specific point in

time. The length of time (the accounting period) that these financial statements
represent varies; they can be annual (fiscal) or quarterly (every three months),
among others. Fiscal year-end is normally defined as 12 months of operations. 
The timing and the methodology used to record revenues and expenses may also
impact the analysis and comparability of financial statements across companies.
Accounting statements are prepared in most cases on the basis of these three basic
premises:
1.      The company will continue to operate (going-concern assumptions).

2.      Revenues are reported as they are earned within the specified accounting
period (revenues-recognition principle).

3.      Expenses should match generated revenues within the specified accounting

period (matching principle).
Basic Accounting Methods:

1.      Cash-basis accounting – This method consists of recognizing revenue

(income) and expenses when payments are made (checks issued) or cash is
received (deposited in the bank).

2.      Accrual accounting – This method consists of recognizing revenue in the

accounting period in which it is earned (revenue is recognized when the
company provides a product or service to a customer, regardless of when the
company gets paid). Expenses are recorded when they are incurred instead of
when they are paid.
  Cash Vs. Accrual Accounting

• A. ACCRUAL ACCOUNTING
Within this section, we will review cash vs. accrual accounting methodologies.
Note that the material set forth in this section is intended as a review and CFA
Institute will most likely not ask a question directly based on this material.
However, we recommend a read of this section is you are unfamiliar with
accounting as you will need this knowledge in order to succeed in future
sections.

I. Cash vs. Accrual Accounting 

Within this section we will explain how income measurement issues are
resolved, accrual accounting, and why the accrual basis of accounting produces
more useful income statements and balance sheets than the cash basis. 
• Benefits of Cash Accounting

Benefits
It is easy to use and implement because the company records income only
when it gets paid and records expenses only when it pays them.
• If accepted by the IRS (limited cases only), the company is taxed when it has
money in the bank.
• On average, fewer transactions will be recorded (bookkeeping).
• Biggest Drawback
Cash accounting can distort a company's actual income and expenses,
especially if it extends credit to its customers, purchases raw materials on
credit from its suppliers or keeps inventory.  
Benefits of Accrual Accounting
• Generally, it provides a clearer picture of the financial performance (income
statement) and financial health (balance sheet).
• It allows management to keep track of accounts receivables and payables more
efficiently.
• It is more representative of the economic reality of the business. A service
provider may not require upfront payment for an annual service; this revenue
will be recorded as it is performed, not when it is paid. Similarly, expenses that
are paid in advance - such as property taxes, which are paid semiannually - will
be recognized on a monthly basis.
• It enhances comparability of performance (income statement) and financial
stability (balance sheet) from one period to the next.
• There is a smoother earning stream.
• There is enhanced predictability of future cash flow.
Let's consider a practical example to fully understand the impact of Cash versus
Accrual Accounting on XYZ Corporation's Income Statement and Balance Sheet.

Cash Basis Accounting

Taken as is, the financial statements in below indicate that XYZ Corporation is
not doing well, with a net loss of $43,200, and may not be a good investment
opportunity. 

XYZ Corporation's Financial Statements using Cash Basis Accounting

Accrual Basis Accounting
Armed with some additional information, let's see what the income statement would
look like if the accrual-basis accounting method was used. 

Additional Information:
A1. June 12, 2005 – The company received a rush order for $80,000 of wood panels.
The order was delivered to the customer five days later. The customer was given 30
days to pay. (With the cash-basis method, sales are not recorded in the income
statement and not recorded in accounts receivables: no cash, no record).

A2. June 13, 2003 – The company received $60,000 worth of wood panels to replenish
their inventory, and $40,000 was related to the rush order. The company paid the
invoice in full to take advantage of a 2% early-payment discount. (With the cash-basis
method, this is recorded in full on the income statement, and there is no record of
inventory on hand).
 
A3. June 1, 2005 – The company launched an advertising campaign that will run
until the end of August. The total cost of the advertising campaign was $15,000
and was paid on June 1, 2005.

 
XYZ Corporation's Restated Financial Statements using Accrual Basis
Accounting.
Adjustments:
To obtain the figures in the restated financial statements in figure 6.2 above, the
following adjusting entries were made:

A1. Product sales and Accounts receivable – Even though the client has not paid this
invoice, the company still made a sale and delivered the products. As a result, sales for
the accounting period should increase by $80,000. Account s receivables (reported
sales made but awaiting payment) should also increase by $80,000. 

Adjusting entries: 

 
A2. June 13, 2003 – Since the entire $60,000 order was paid during the accounting
period, the full amount was included in production costs under the cash-basis
method. Only $40,000 of the order was related to product sales during that
accounting period, and the rest was stored as inventory for future product
sales. 

Adjusting entries: 

 
A3. June 1, 2005 – Marketing expenses included in the income statement totaled
$15,000 for a three-month advertising campaign because it was paid in full at
initiation (cash-basis accounting). The reality is that this campaign will last for
three months and will generate a benefit for the company every month. As a
result, under accrual-basis accounting, the company should record in this
accounting period only one-third of the cost. The remainder should be
allocated to the next period and recoded as prepaid expenses on the assets side
of the balance sheet. 

Adjusting entries:

 
  Income Statement Basics

I. Basics
Within this basics section, we will define each component of a multi-step
income statement, and prepare a multi-step income statement.

Multi-Step Income Statement

A multi-step income statement is a condensed statement of income as opposed
to a single-step format, which is the more detailed format. Both single and
multi-step formats conform to GAAP standards. Both yield the same net
income figure. 

The main difference is how they are formatted, not how figures are calculated. 
Multi-Step Income Statement
• Sales – These are defined as total sales (revenues) during the accounting
period. Remember these sales are net of returns, allowances and discounts 

• Cost of goods sold (COGS) – These are all the direct costs related to the
product or rendered service sold and recorded during the accounting period.
(Reminder: matching principle.)  

• Operating expenses – These include all other expenses that are not included
in COGS but are related to the operation of the business during the specified
accounting period. This account is most commonly referred to as "SG&A" (sales
general and administrative) and includes expenses such as selling, marketing,
administrative salaries, sales salaries, maintenance, administrative office
expenses (rent, computers, accounting fees, legal fees), research and
development (R&D), depreciation and amortization, etc.  
• Other revenues & expenses – These are all non-operating expenses such as
interest earned on cash or interest paid on loans.

• Income taxes – This account is a provision for income taxes for reporting
purposes.
  Income Statement Components

Income Statement Format

The following figure demonstrates which components are used to calculate a
company's net income, which is the income available to shareholders.
The Components of Net Income:
• Operating income from continuing operations – This comprises all revenues net
of returns, allowances and discounts, less the cost and expenses related to the
generation of these revenues. The costs deducted from revenues are typically the
COGS and SG&A expenses.
 
• Recurring income before interest and taxes from continuing operations – This
component includes, in addition to operating income from continuing operations,
all other income, such as investment income from unconsolidated subsidiaries
and/or other investments and gains (or losses) from the sale of assets. To be
included in this category, these items must be recurring in nature. This component
is generally considered to be the best predictor of future earning. That said, it does
assume that noncash expenses such as depreciation and amortization are a good
indicator of future capital expenditures. Since this component does not take into
account the capital structure of the company (use of debt), it is also used to value
similar companies.
• Recurring (pre-tax) income from continuing operations – This component
takes the company's financial structure into consideration as it deducts
interest expenses. 

• Pre-tax earning from continuing operations – This component considers all

unusual or infrequent items. Included in this category are items that are either
unusual or infrequent in nature but cannot be both. Examples are an
employee-separation cost, plant shutdown, impairments, write-offs, write-
downs, integration expenses, etc.

• Net income from continuing operations – This component takes into

account the impact of taxes from continuing operations.
Non-Recurring Items
Discontinued operations, extraordinary items and accounting changes are all
reported as separate items in the income statement. They are all reported net
of taxes and below the tax line, and are not included in income from continuing
operations. In some cases, earlier income statements and balance sheets have
to be adjusted to reflect changes.
Income (or expense) from discontinued operations – This component is
related to income (or expense) generated due to the shutdown of one or more
divisions or operations (plants). These events need to be isolated so they do
not inflate or deflate the company's future earning potential. This type of
nonrecurring occurrence also has a nonrecurring tax implication and, as a
result of the tax implication, should not be included in the income tax expense
used to calculate net income from continuing operations. That is why this
income (or expense) is always reported net of taxes. The same is true for
extraordinary items and cumulative effect of accounting changes (see below).
• Extraordinary items - This component relates to items that are both unusual
and infrequent in nature. That means it is a one-time gain or loss that is not
expected to occur in the future. An example is environmental remediation.

• Cumulative effect of accounting changes - This item is generally related to

changes in accounting policies or estimations. In most cases, these are non
cash-related expenses but could have an effect on taxes. 
 
  Income Statement: Non-recurring Items

INCOME STATEMENT: NONRECURRING ITEMS

Within this section we will further our discussion on the non-recurring components of
net income, such as unusual or infrequent items, discontinued operations,
extraordinary items, and prior period adjustments.

Unusual or Infrequent Items

Included in this category are items that are either unusual or infrequent in nature but
cannot be both. 

Examples of unusual or infrequent items:

– Gains (or losses) as a result of the disposition of a company's business segment
including:
• Plant shutdown costs
• Lease-breaking fees
• Employee-separation costs
 – Gains (or losses) as a result of the disposition of a company's assets or investments
(including investments in subsidiary segments) including:
• Plant shut-down costs
• Lease-breaking fees
– Gains (or losses) as a result of a lawsuit
– Losses of operations due to an earthquake
– Impairments, write-offs, write-downs and restructuring costs
– Integration expenses related to the acquisition of a business

Extraordinary Items
Events that are both unusual and infrequent in nature are qualified as extraordinary
expenses.
• Example of extraordinary items:
– Losses from expropriation of assets
– Gain (or losses) from early retirement of debt
Discontinued Operations
Sometimes management decides to dispose of certain business operations but
either has not yet done so or did it in the current year after it had generated
income or losses. To be accounted for as a discontinued operation, the business
must be physically and operationally distinct from the rest of the firm. Basic
definitions:
• Measurement date - The date when the company develops a formal plan for
disposing.
• Phaseout period - Time between the measurement date and the actual
disposal date
The income or loss from discontinued operations is reported separately, and
past income statements must be restated, separating the income or loss from
discontinued operations. 
Accounting Changes
Accounting changes occur for two reasons:
As a result of a change in an accounting principle
As a result of a change in an accounting estimate.
The most common form of a change in accounting principle is the switch from
the LIFO inventory accounting method to another method such FIFO or
average cost basis. 

The most common form of a change in accounting estimates is a change in

depreciation method for new assets or change in depreciable lives/salvage
values, which is considered a change in accounting estimates and not a change
in accounting principle. Note that past income does not need to be restated
from the LIFO inventory accounting method to another method such FIFO or
average cost basis. 
In general, prior years' financial statements do not need to be restated unless it is
a change in:

• Inventory accounting methods (LIFO to FIFO) 

• Change to or from full-cost method (This is used in oil & gas exploration. The
successful-efforts method capitalizes only the costs associated with successful
activities while the full-cost method capitalizes all the costs associated with all
activities.)
• Change from or to percentage-of-completion method (look at revenue-
recognition methods)
• All changes just prior to a company's IPO
Prior Period Adjustments
These adjustments are related to accounting errors. These errors are typically
NOT reported in the income statement but are reported in retained earnings.
(These can be found in changes in retained earnings.) These errors are
disclosed as footnotes explaining the nature of the error and its effect on net
income.
 Balance Sheet Basics

I. Basics
Within this section we'll define each asset and liability category on the
balance sheet, and prepare a classified balance sheet

Balance Sheet Categories

The balance sheet provides information on what the company owns (its
assets), what it owes (its liabilities) and the value of the business to its
stockholders (the shareholders' equity) as of a specific date. 

Total Assets = Total Liabilities + Shareholders' Equity

• Assets are economic resources that are expected to produce economic benefits
for their owner.
• Liabilities are obligations the company has to outside parties. Liabilities
represent others' rights to the company's money or services. Examples include
bank loans, debts to suppliers and debts to employees.
• Shareholders' equity is the value of a business to its owners after all of its
obligations have been met. This net worth belongs to the owners.
Shareholders' equity generally reflects the amount of capital the owners have
invested, plus any profits generated that were subsequently reinvested in the
company.