INTERNATIONAL FINANCIAL STATEMENT ANALYSIS CFA Institute is the premier association for investment professionals around the world, with over 124,000 members in 145 countries. Since 1963 the organization has developed and ad- ministered the renowned Chartered Financial Analyst® Program. With a rich history of leading the investment profession, CFA Institute has set the highest standards in ethics, education, and professional excellence within the global investment community and is the foremost authority on investment profession conduct and practice. Each book in the CFA Institute Investment Series is geared toward industry practitioners along with graduate-level fi nance students and covers the most important topics in the industry. Th e authors of these cutting-edge books are themselves industry professionals and academics and bring their wealth of knowledge and expertise to this series. INTERNATIONAL FINANCIAL STATEMENT ANALYSIS Th ird Edition Th omas R. Robinson, CFA Elaine Henry, CFA Wendy L. Pirie, CFA Michael A. Broihahn, CFA Cover image: © iStock.com / BreatheFitness Cover design: Wiley Copyright © 2015 by CFA Institute. All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Th e First and Second Editions of this book were published by Wiley in 20XX and 20XX respectively. Published simultaneously in Canada. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the Web at www .copyright.com. 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ISBN 9781118999479 (Hardcover) ISBN 9781119029748 (ePDF) ISBN 9781119029755 (ePub) Printed in the United States of America. 10 9 8 7 6 5 4 3 2 1 CONTENTS Foreword xvii Preface xix Acknowledgments xxi About the CFA Investment Series xxiii CHAPTER 1 Financial Statement Analysis: An Introduction 1 Learning Outcomes 1 1. Introduction 1 2. Scope of Financial Statement Analysis 2 3. Major Financial Statements and Other Information Sources 7 3.1. Financial Statements and Supplementary Information 8 3.2. Other Sources of Information 27 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 Problems 34 CHAPTER 2 Financial Reporting Mechanics 37 Learning Outcomes 37 1. Introduction 38 2. Th e Classifi cation of Business Activities 38 3. Accounts and Financial Statements 39 v vi Contents 3.1. Financial Statement Elements and Accounts 40 3.2. Accounting Equations 42 4. Th e Accounting Process 47 4.1. An Illustration 47 4.2. Th e Accounting Records 49 4.3. Financial Statements 62 5. Accruals and Valuation Adjustments 65 5.1. Accruals 65 5.2. Valuation Adjustments 67 6. Accounting Systems 67 6.1. Flow of Information in an Accounting System 68 6.2. Debits and Credits 69 7. Using Financial Statements in Security Analysis 69 7.1. Th e Use of Judgment in Accounts and Entries 69 7.2. Misrepresentations 70 8. Summary 71 Appendix: A Debit/Credit Accounting System 71 Problems 87 CHAPTER 3 Financial Reporting Standards 91 Learning Outcomes 91 1. Introduction 92 2. Th e Objective of Financial Reporting 92 3. Standard-Setting Bodies and Regulatory Authorities 95 3.1. Accounting Standards Boards 96 3.2. Regulatory Authorities 99 4. Convergence of Global Financial Reporting Standards 104 5. Th e International Financial Reporting Standards Framework 107 5.1. Objective of Financial Reports 109 5.2. Qualitative Characteristics of Financial Reports 109 5.3. Constraints on Financial Reports 110 5.4. Th e Elements of Financial Statements 112 5.5. General Requirements for Financial Statements 114 5.6. Convergence of Conceptual Framework 118 6. Eff ective Financial Reporting 119 6.1. Characteristics of an Eff ective Financial Reporting Framework 119 6.2. Barriers to a Single Coherent Framework 120 7. Comparison of IFRS with Alternative Reporting Systems 121 8. Monitoring Developments in Financial Reporting Standards 123 8.1. New Products or Types of Transactions 123 8.2. Evolving Standards and the Role of CFA Institute 124 8.3. Company Disclosures 125 9. Summary 128 Problems 130 Contents vii CHAPTER 4 Understanding Income Statements 133 Learning Outcomes 133 1. Introduction 134 2. Components and Format of the Income Statement 135 3. Revenue Recognition 139 3.1. General Principles 140 3.2. Revenue Recognition in Special Cases 143 3.3. Implications for Financial Analysis 150 4. Expense Recognition 152 4.1. General Principles 152 4.2. Issues in Expense Recognition 156 4.3. Implications for Financial Analysis 161 5. Non-Recurring Items and Non-Operating Items 162 5.1. Discontinued Operations 163 5.2. Extraordinary Items 163 5.3. Unusual or Infrequent Items 164 5.4. Changes in Accounting Policies 165 5.5. Non-Operating Items 168 6. Earnings per Share 169 6.1. Simple versus Complex Capital Structure 169 6.2. Basic EPS 170 6.3. Diluted EPS 171 6.4. Changes in EPS 178 7. Analysis of the Income Statement 178 7.1. Common-Size Analysis of the Income Statement 178 7.2. Income Statement Ratios 181 8. Comprehensive Income 183 9. Summary 186 Problems 188 CHAPTER 5 Understanding Balance Sheets 193 Learning Outcomes 193 1. Introduction 193 2. Components and Format of the Balance Sheet 194 2.1. Balance Sheet Components 195 2.2. Current and Non-Current Classifi cation 197 2.3. Liquidity-Based Presentation 198 3. Current Assets and Current Liabilities 199 3.1. Current Assets 199 3.2. Current Liabilities 206 4. Non-Current Assets 209 4.1. Property, Plant, and Equipment 211 4.2. Investment Property 212 4.3. Intangible Assets 212 viii Contents 4.4. Goodwill 215 4.5. Financial Assets 217 5. Non-Current Liabilities 220 5.1. Long-term Financial Liabilities 222 5.2. Deferred Tax Liabilities 222 6. Equity 223 6.1. Components of Equity 223 6.2. Statement of Changes in Equity 225 7. Analysis of the Balance Sheet 227 7.1. Common-Size Analysis of the Balance Sheet 227 7.2. Balance Sheet Ratios 235 8. Summary 237 Problems 239 CHAPTER 6 Understanding Cash Flow Statements 243 Learning Outcomes 243 1. Introduction 243 2. Components and Format of the Cash Flow Statement 244 2.1. Classifi cation of Cash Flows and Non-Cash Activities 245 2.2. A Summary of Diff erences between IFRS and US GAAP 247 2.3. Direct and Indirect Methods for Reporting Cash Flow from Operating Activities 248 3. Th e Cash Flow Statement: Linkages and Preparation 258 3.1. Linkages of the Cash Flow Statement with the Income Statement and Balance Sheet 258 3.2. Steps in Preparing the Cash Flow Statement 260 3.3. Conversion of Cash Flows from the Indirect to the Direct Method 272 4. Cash Flow Statement Analysis 273 4.1. Evaluation of the Sources and Uses of Cash 274 4.2. Common-Size Analysis of the Statement of Cash Flows 277 4.3. Free Cash Flow to the Firm and Free Cash Flow to Equity 282 4.4. Cash Flow Ratios 283 5. Summary 285 Reference 286 Problems 286 CHAPTER 7 Financial Analysis Techniques 291 Learning Outcomes 291 1. Introduction 291 2. Th e Financial Analysis Process 292 2.1. Th e Objectives of the Financial Analysis Process 293 2.2. Distinguishing between Computations and Analysis 294 3. Analytical Tools and Techniques 296