CERTIFIED INVESTMENT AND FINANCIAL ANALYSTS

(CIFA)

 

PART II SECTION 3

 

FINANCIAL STATEMENT ANALYSIS

 

 

STUDY TEXT

 

FINANCIAL STATEMENT ANALYSIS GENERAL OBJECTIVES

This paper is intended to equip candidate with knowledge, skills and attitude that will enable him/her to analyse and interpret the financial statements of a firm

 

9.0  LEARNING OUTCOMES

 On successful completion of this paper, the candidate should be able to:

• Evaluate the various alternative sources of financial information
• Apply the various financial statement analytical tools and techniques in analyzing financial statements
• Demonstrate an understanding of accounting measurements and recognition
• Compare the financial reporting and accounting treatments of assets and liabilities
• Comply with the requirements of IASs, IFRSs and IPSASs
• Evaluate the financial performance of a firm

CONTENT

• Overview of financial statement analysis……………………………………………………………………. 5

• Definition of financial statement analysis
• Different reporting environment frameworks
• Steps in analyzing financial statements
• Importance and challenges of financial statement analysis
• Sources of information for analysis (Financial Statements, Auditors report, Management commentary, Filing with regulatory authorities and press reports)
• Approaches to analyzing financial statements (Macro, industry and Firm-Either to down or bottom up)

9.2  Financial reporting on assets and liabilities………………………………………………………………. 15

• Investment properties; presentation and disclosure
• Accounting policies, changes in accounting estimates and errors (prior period errors)
• Events after the reporting period
• Non-current items and non operating items; discounted operations (Exclude disposal of subsidiaries), extraordinary items, unusual or infrequent items, changes in recognition and disclosures and impairment)
• Non-current assets held for sale
• Intangible assets
• Leases (finance and operating, presentation disclosure, recognition), off balance sheet leverage from operating
• Income taxes: accounting profit and taxable income, deferred tax assets and liabilities tax base of assets and liabilities, temporary and permanent differences, recognition and measurement of current and deferred tax, presentation and disclosure
• Employee benefits (Post-employment benefits): types of post employment benefits; impact of the assumption used such as discount rates, return on plan assets and salary growth on the defined benefit obligation and periodic expense; pension plan footnote disclosure, effect on underlying economic liability (assets) of a company’s pension and other post employment benefits; share based compensation
• Multinational operations: foreign currency transactions; translation of foreign currency in the financial statements, effects of changing prices and inflation

9.3  Quality of earnings and earnings management………………………………………………………… 72

•  Categories of earnings: earnings before interest, tax depreciation and armotization (EBITDA), operating earnings, net income among others
• Measures of the accrual components of earnings and earnings quality
• Earnings Per Share (EPS); Basic EPS, diluted EPS, using EPS to value firms, criticism of EPS
• Segment reporting; disclosure requirements, geographical segments, segment ratios

9.4  Other Inter-corporate Investments…………………………………………………………………………… 86

• Subsidiaries
• Associate companies
• Jointly controlled entities
• Evaluating the effect of the inter-corporate investments on financial statements given the different accounting treatment

9.5  Analysing the financial statements…………………………………………………………………………. 132

• Income statement: components and format of the income statement, revenue recognition and expenses recognition; analysis of the income statement; common size analysis, ratio analysis
• Statement of financial position; components and format of statement of financial position (assets, liabilities and equity), off balance sheet items; analysis of the statement of financial position; common size analysis, cross sectional analysis, ratio analysis
• Statement of changes in equity; components of equity, equity valuation ratios
• Cash flow statements; components and format of the cash flow statement, categories of cash flow items, direct and indirect methods for preparing cash flow statements; cash flow statement analysis; evaluation and uses of cash, common size analysis, free cash flow to the firm and free cash flow to equity, cash flow ratios, quality of

9.6  Financial statement analytical tools…………………………………………………………………….. 193

• Financial analysis techniques; financial analysis framework/process; computation and analysis
• Profitability analysis: desegregation and interpreting return on assets (ROA), return on capital employed (ROCE), relating ROA to ROCE, DuPont
• Analysis of growth and sustainable earning: growth analysis, analysis of changes in profitability and sustainable earnings, analysis of growth in shareholder’s equity growth, sustainable earnings and the evaluation of price to book-P/B ratios and price earnings-P/E ratios.
• Analytical tools and techniques; ratio analysis, common size analysis, graphs, regression analysis.
• Model building and forecasting; sensitivity analysis, scenario analysis, simulation,.
• Application of ratio analysis-cross sectional analysis, trend analysis, forecast financial statements, credit analysis and rating

9.7  Qualitative and other current issues in analysis of financial statements……………………. 225

• Qualities of useful financial statements
• Red flag and accounting warning signs that may indicate financial statements are of poor quality
• Accounting scandals
• Accounting shenanigans on the cash flow statement; Creative accounting and manipulating financial statements
• Mispresentation in the financial statements
• Adjustments that may be required to make financial statements comparable

9.8  Emerging issues and trends

 Summaries of IFRS and IAS……………………………………………………………………………………… 234

 

SAMPLE NOTES

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CHAPTER ONE

 OVERVIEW OF FINANCIAL STATEMENT ANALYSIS

INTRODUCTION

Financial statement analysis is defined as the process of identifying financial strengths and weaknesses of the firm by properly establishing relationship between the items of the balance sheet and the profit and loss account.

There are various methods or techniques that are used in analyzing financial statements, such as comparative statements, schedule of changes in working capital, common size percentages, funds analysis, trend analysis, and ratios analysis.

Financial statements are prepared to meet external reporting obligations and also for decision making purposes. They play a dominant role in setting the framework of managerial decisions. But the information provided in the financial statements is not an end in itself as no meaningful conclusions can be drawn from these statements alone. However, the information provided in the financial statements is of immense use in making decisions through analysis and interpretation of financial statements.

 

DIFFERENT REPORTING ENVIRONMENTAL FRAMEWORK

Accounting conceptual framework

An accounting conceptual framework is a coherent system of inter-related objectives and fundamentals that should lead to consistence standards that prescribe the nature, function and limits of financial accounting and financial statements.

The main reason for developing an agreed conceptual framework is that it provides:

• A framework for setting accounting standards
• A basis for solving accounting disputes
• Fundamental principles which then do not have to be repeated in accounting standards

The IFRS framework describes the basic concepts that underlie the preparation and presentation of financial statements for external users. The IFRS framework serves as a guide to the board in developing future IFRSs and as a guide to resolving accounting issues that are not addressed directly in an international Financial Reporting Standard or interpretation.

The IFRS frame work addresses

1. The objectives of financial reporting
2. The qualitative characteristics of useful financial information
3. The reporting entity
4. The definition, recognition and measurement of the elements from which financial statements are constructed
5. Concepts of capital and capital maintenance

SAMPLE NOTES

CHAPTER TWO

 FINANCIAL REPORTING ON ASSETS AND LIABILITIES

  

ACCOUNTING POLICIES, CHANGES IN ACCOUNTING ESTIMATES AND ERRORS

 IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors is applied in selecting and applying accounting policies, accounting for changes in estimates and reflecting corrections of prior period errors.

The standard requires compliance with any specific IFRS applying to a transaction, event or condition, and provides guidance on developing accounting policies for other items that result in relevant and reliable information. Changes in accounting policies and corrections of errors are generally retrospectively accounted for, whereas changes in accounting estimates are generally accounted for on a prospective basis.

IAS 8 was reissued in December 2005 and applies to annual periods beginning on or after 1 January 2005.

 

SUMMARY OF IAS 8

Key definitions [IAS 8.5]

• Accounting policies are the specific principles, bases, conventions, rules and practices applied by an entity in preparing and presenting financial
• A change in accounting estimate is an adjustment of the carrying amount of an asset or liability, or related expense, resulting from reassessing the expected future benefits and obligations associated with that asset or
• International Financial Reporting Standards are standards and interpretations adopted by the International Accounting Standards Board (IASB). They comprise:
  • International Financial Reporting Standards (IFRSs)
  • International Accounting Standards (IASs)
  • Interpretations developed by the International Financial Reporting Interpretations Committee (IFRIC) or the former Standing Interpretations Committee (SIC) and approved by the
• Omissions or misstatements of items are material if they could, by their size or nature, individually or collectively; influence the economic decisions of users taken on the basis of the financial statements.

SAMPLE NOTES

CHAPTER THREE

 QUALITIES OF EARNINGS AND EARNINGS MANAGEMENT

 

EARNINGS PER SHARE

 EPS is the average of earnings attributed to every individual shareholder by equity holder

Net profit attributable to ordinary olders Number of ordinary s ares in issue

For the purpose of calculating basic EPS, the profit or loss for the period should be the profit or loss attributable to shareholders in the present company less dividends on the irredeemable preference shares and any shares with a prior claim. (Dividends on redeemable/convertible preference shares are classified as part of finance charges and deducted in arriving at the profit before tax)

Earnings should be apportioned over the weighted average equity shares capital (i.e. taking account of the date any new shares are issued during the year)

Bonus issue

A bonus issue (or capitalization issue or scrip issue) does not provide additional resources to the issuer and it means the shareholder owns the same proportion of the business before and after the issue.

In calculating EPS, the bonus shares are deemed to have been issued at the start of the year and comparative figures are restated to allow for the proportional increase in share capital caused by the bonus issue.

Example:

A company makes a bonus issue of one new share for every five existing shares held on 1^st July 2012.

	2012           2011
Profit attributable to ordinary shareholders for year ending 31s December	550,000      460,000
Number of ordinary shares in issue at 31st Calculate EPS in year 2012 accounts?	1,200,000    1,000,000

SAMPLE NOTES

CHAPTER FOUR

OTHER INTER-CORPORATE INVESTMENTS

A strong understanding of accounting rules and treatments is the backbone of quality financial analysis. Whether you’re an established analyst at a large investment bank, working in a corporate finance advisory team, just starting out in the financial industry or still learning the basics in school, understanding how firms account for different investments, liabilities and other such positions is a key in determining the value and future prospects of any business. In this article we will examine the different categories of intercorporate investments and how to account for them on financial statements.

Intercorporate investments are undertaken when companies invest in the equity or debt of other firms. The reasons behind why one company would invest in another are many, but could include:

1. the desire to gain access to another market
2. increase its asset base
3. Gain a competitive advantage or simply increase profitability through an ownership (or creditor) stake in another

A company can have investments in other companies in the form of: ordinary shares, preference shares and loan stock. The investment in ordinary shares leads to ownership and therefore requires further consideration. The investment in the ordinary shares can be summarized diagrammatically as follows;

SAMPLE NOTES

CHAPTER FIVE

 ANALYSING THE FINANCIAL STATEMENTS

 

PRESENTATION OF FINANCIAL STATEMENTS

Sixth schedule to the Companies Act: Accounts

IFRSs Gives the guideline on the content and the accounting statements of certain events and transactions in the financial statements. The following IFRSs are relevant for the purpose of preparing published financial statements;

IAS 1:             – Presentation of Financial Statements IAS 7:                     – Cashflow statements

IAS 8:             – Accounting policies, changes in accounting estimates and errors IAS 10:                   – Events after the balance sheet date

IAS 12:           – Income Tax

IFRS 5            – Non-current assets held for sale and discontinued operations.

 IAS 1 — Presentation of Financial Statements

 

OVERVIEW

 IAS 1 Presentation of Financial Statements sets out the overall requirements for financial statements, including how they should be structured, the minimum requirements for their content and overriding concepts such as going concern, the accrual basis of accounting and the current/non-current distinction. The standard requires a complete set of financial statements to comprise a statement of financial position, a statement of profit or loss and other comprehensive income, a statement of changes in equity and a statement of cash flows.

IAS 1 was reissued in September 2007 and applies to annual periods beginning on or after 1 January 2009.

SUMMARY OF IAS 1

Objective of IAS 1

 The objective of IAS 1 (2007) is to prescribe the basis for presentation of general purpose financial statements, to ensure comparability both with the entity’s financial statements of previous periods and with the financial statements of other entities. IAS 1 sets out the overall requirements for the presentation of financial statements, guidelines for their structure and minimum requirements for their content. Standards for recognizing, measuring, and disclosing specific transactions are addressed in other Standards and Interpretations.

SAMPLE NOTES

CHAPTER SIX

 FINANCIAL STATEMENT ANALYTICAL TOOLS

 

Introduction

Financial statement analysis is the application of analytical tools and techniques to ‘general purpose ‘financial statements and related data to derive estimates and be useful in business analysis.

Financial statement analysis is an integral part of business analysis. Business analysis is the process of evaluating a company’s economic prospect and risk.

Components of business analysis

1. Business environmental strategy/analysis

-analysis of business environment seeks to identify and asses a company economic and industry circumstances. This includes analysis of capital, labour and capital markets, Economic and regulatory setting. It also assesses its strengths, weaknesses, opportunities and threats. Business environment and strategy analysis consists of:-

1. Industry analysis

It assesses industry prospect and degree of actual and potential competition facing a company.

1. Strategy analysis

Its evaluation of both a company’s business decision and its success at establishing a competitive advantage

A)  Accounting analysis

This is the process of evaluating the extent to which a company’s accounting reflects economic reality.

b) Financial analysis

 It’s the Use of financial statements to analyze a company’s financial position in performance and to assess future financial performance. Financial statement analysis consists of three broad areas.

• Profitability analysis

This is the evaluation of a company’s return on investment. It focuses on a company’s sources and level of profits and involves identifying and measuring impact of various profitability avenues.

• Risk analysis

This is the evaluation of a company’s ability to meet its commitments. Risk analysis involves assessing solvency and liquidity of a company along with its earnings variability.

SAMPLE NOTES

CHAPTER SEVEN

 

QUALITATIVE AND OTHER CURRENT ISSUES IN THE ANALYSIS OF FINANCIAL STATEMENTS

 

Qualities of useful financial information

For financial information to be useful, it should possess the fundamental decision-specific qualities of:

RELEVANCE

Relevance in the context of financial reporting means that the information must possess predictive value confirmation of investor expectations about future cash-generating ability.

It should be both predictive and confirmative. For example, if net income and its components confirm investor expectations about a company’s future cash-generating ability, then net income has confirmatory value for investors. This confirmation also can be useful in predicting the company’s future cash-generating ability as expectations are revised.

FAITHFUL REPRESENTATION

 Faithful representation exists when there is agreement between a measure or description and the phenomenon it purports to represent. For example, assume that the term inventory in the balance sheet of a retail company is understood by external users to represent items that are intended for sale in the ordinary course of business. If inventory includes, say, machines used to produce inventory, then it lacks faithful representation.

To break it down further, faithful representation requires that information be complete, neutral, and free from material error. A depiction of an economic phenomenon is complete if it includes all information that is necessary for faithful representation of the economic phenomena that it purports to represent. Omitting a portion of that information can cause the depiction to be false or misleading and thus not helpful to the users of the information.

NEUTRALITY

The information being relied on should be free from bias. In that regard, neutral with respect to parties potentially affected. It is highly related to the establishment of accounting standards.

Changes in accounting standards can lead to adverse economic consequences for certain companies, their investors and creditors, and other interest groups. Accounting standards should be established with overall societal goals and specific objectives in mind and should try not to achieve particular social outcomes or favor particular groups or companies.

 

SAMPLE NOTES