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Financial Statement Analysis - Chp01 - Summary Notes

1. The document discusses the key concepts in analyzing financial statements, including the role of financial reporting in capital markets, how capital markets function, and factors that influence accounting quality. 2. It also covers the four main steps of business analysis using financial statements: business strategy analysis, accounting analysis, financial analysis, and prospective analysis. 3. International Financial Reporting Standards and auditing are discussed as important ways to improve the quality and consistency of financial reporting.

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58 views

Financial Statement Analysis - Chp01 - Summary Notes

1. The document discusses the key concepts in analyzing financial statements, including the role of financial reporting in capital markets, how capital markets function, and factors that influence accounting quality. 2. It also covers the four main steps of business analysis using financial statements: business strategy analysis, accounting analysis, financial analysis, and prospective analysis. 3. International Financial Reporting Standards and auditing are discussed as important ways to improve the quality and consistency of financial reporting.

Uploaded by

Brain
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© © All Rights Reserved
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Download as DOCX, PDF, TXT or read online on Scribd
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Financial statement analysis exam notes

Chapter 1:
The structure of state economies - two distinct and broad ideologies for channeling savings into business investments:
1. capitalism and;
The capitalist market model broadly relies on the market mechanism to govern economic activity, and decisions regarding
investments are made privately.
2. central planning.
Centrally planned economies have used central planning and government agencies to pool national savings and to direct
investments in business enterprises.
KEY CONCEPTS IN CHAPTER 1
Financial statements are an important source of information to the capital markets and business analysts.
Analyzing financial statements addresses a number of issues of interest to external stakeholders and company insiders.
THE ROLE OF FINANCIAL REPORTING IN CAPITAL MARKETS
Financial reporting provides much-needed information to capital market participants

 Financial intermediaries depend upon the information in financial statements to evaluate investment opportunities.
 Information intermediaries assure the quality of financial statement representations.
 Relevant and reliable financial information is essential for the functioning of capital markets.
Matching savings to business investment opportunities is complicated for at least three reasons.
First, entrepreneurs typically have better information than savers on the value of business investment opportunities. info
asymmetry (lemons problem),
Second, communication by entrepreneurs to investors is not completely credible because investors know entrepreneurs
have an incentive to inflate the value of their ideas - communication by firms to investors not completely credible
Third, savers generally lack the financial sophistication needed to analyze and differentiate among the various business
opportunities - savers lack the financial sophistication
The emergence of the institutions that make up a fully formed capital market system can prevent such a market
breakdown.
Financial intermediaries such as venture capital and private equity firms, banks, mutual funds, and insurance companies
focus on aggregating funds from individual investors and distributing those funds to businesses seeking sources of capital
Information intermediaries such as auditors and company audit committees serve as credibility enhancers to provide an
independent assessment of business
Information analyzers and advisors such as financial analysts, credit rating agencies and the financial press are another
type of information intermediary that collect and analyze business information used to make business decisions.
Transaction facilitators such as stock exchanges and brokerage houses play a crucial role in capital markets by providing
a platform that facilitates buying and selling in markets
Regulators such as the Securities and Exchange Commission (SEC) and the Financial Accounting Standards Board
(FASB) in the United States create appropriate regulatory policy that establishes the legal framework of the capital market
system
Adjudicators such as the court system resolve disputes that arise between participants.
HOW CAPITAL MARKET’S FUNCTION

Financial reports are influenced both by the firm’s business activities and by its accounting system. Financial statements
measure and summarize the economic consequences of business activities.

A key aspect of financial statement analysis, therefore, involves understanding the influence of the accounting system on
the quality of the financial statement data being used in the analysis.
Feature 1: Accrual Accounting
One of the fundamental features of corporate financial reports is that they are prepared using accrual rather than cash
accounting.
Unlike cash accounting, accrual accounting distinguishes between the recording of costs and benefits associated with
economic activities and the actual payment and receipt of cash. Net income is the primary periodic performance index
under accrual accounting. To compute net income, the effects of economic transactions are recorded on the basis of
expected, not necessarily actual, cash receipts and payments.
IFRS defines the following financial statement elements:
 Assets
 Liabilities
 Equity
 Income or Revenue
 Expenses
Feature 2: Accounting Conventions and Standards
a firm’s managers are entrusted with the task of making the appropriate estimates and assumptions to prepare the financial
statements because they have intimate knowledge of their firm’s business.

Applying accounting principles is the responsibility of management, who has superior knowledge of a firm’s business.

 Incentives exist for management to distort accounting numbers in their favor.


 Contracts
 Reputation
 Mitigating effects of legal liability, auditing, public enforcement.

Feature 3: Managers’ Reporting Strategy


A firm’s reporting strategy, i.e., the manner in which managers use their accounting discretion, has an important influence
on the firm’s financial statements.
INTERNATIONAL FINANCIAL REPORTING STANDARDS (IFRS)
 IFRS allows for consistency in reporting between firms and over different time periods of the same firm.
 Uniform accounting standards minimize manager’s ability to manipulate financial statement information.
 Rigid accounting rules may be dysfunctional; calls for principles-based accounting standards.
Feature 4: Auditing
a verification of the integrity of the reported financial statements by someone other than the preparer, ensures that
managers use accounting rules and conventions consistently over time and that their accounting estimates are reasonable.
Therefore, auditing improves the quality of accounting data.
EXTERNAL AUDITING OF FINANCIAL STATEMENTS
 Required for publicly traded companies; within the EU also required for some private firms.
 Conducted according to standards: – EU: minimum standards set by the Revised Statutory Audit Directive and
Regulation (US: Sarbanes-Oxley Act) – International Standards of Auditing (US: GAAS) - Generally accepted
auditing standards
 Auditing has its limitations; it is backed up by legal liability and public enforcement. (GAAP) - Generally
Accepted Accounting Principles.

FACTORS INFLUENCING ACCOUNTING QUALITY


 It is necessary to allow managers some discretion in applying accounting standards.
 As a result, three potential sources of noise and bias in accounting data include:
1. Noise from accounting rules
2. Forecast errors
3. Manager’s accounting choices
ALTERNATE FORMS OF INVESTOR COMMUNICATION
 Analyst meetings
 Regular meetings with analysts release information to these intermediaries.
 Material information released to analysts must also be publicly disclosed.
 Voluntary disclosure
 Management has the discretion to voluntarily disclose information, though there are constraints on this
type of disclosure.
FROM FINANCIAL STATEMENTS TO BUSINESS ANALYSIS

Figure 1-3 provides a schematic


overview of how business
intermediaries use financial
statements to accomplish four key
steps:
1. business strategy analysis,
2. accounting analysis,
3. financial analysis, and
4. prospective analysis.

Analysis Step 1: Business Strategy Analysis


The purpose of business strategy analysis is to identify key profit drivers and business risks, and to assess the company’s
profit potential at a qualitative level.
Analysis Step 2: Accounting Analysis
The purpose of accounting analysis is to evaluate the degree to which a firm’s accounting captures its underlying business
economics.
Analysis Step 3: Financial Analysis
The goal of financial analysis is to use financial data to evaluate the current and past performance of a firm and to assess
its sustainability. There are two important skills related to financial analysis.
 First, the analysis should be systematic and efficient.
 Second, it should allow the analyst to use financial data to explore business issues
Analysis Step 4: Prospective Analysis Prospective analysis,
which focuses on forecasting a firm’s future, is the final step in business analysis. Two commonly used techniques in
prospective analysis are financial statement forecasting and valuation.

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