CFA Level 1 (2009) - 3

Study S<:ssiolJ 7

Cross-Rdcrcnc<: (0 CIA Instltul<: Assigned Reading #30 - Financial Reporting Mechanics

H.If a firm raises $10 million by issuing new common srock, which or irs financial starcmenrs willlcflecr d~e uansaClion?

A.Income SLllemCIll and stJtcmclH oC owners' equity.

B.Balance shcct, incomc sratcmc[]r, and cash How StalCmcnt.

A.general ledger.

B.general journal.

C.financial staremellls.

10.Paul Schmidt, a reprcsclllativc for \X!eslby Investments, is explaining how security ;lnalysts use thc results of the accouming process. He Slates. "Analysts do not han' access to all the clllrics that wcnl into lTcating a company's linancial SI;lle111UllS. If the analyst card'lIlly rninvs thc auditor's rl'j)ort for 0111\'

instances whcre the financial S[;llel11ClllS dcviate Cronl the aplJr0I)riatc accollilling principles, he un then he confldelll illal managel1lt'1ll is not manipulJting earnings." Schmidt is:

A.correct.

B. incorrect, hecause the entries that went illlo creating :l company's nnanci:d

sratements arc puhlicly available.

C.incorrect, because managemenr can manipulate earnings even within the confines or gcnerally accepted accoullling principles.

Study Session 7

Cross-Reference to CI;A Institute Assigned Reading #30 - Financial Reporting Mechanics

For each account listed, indicate whether the account should be classified as ASSClS (A), Liabilities (L), Owners' Equity (0), Revenues (R), or Expenses (X).

Study Session 7 rrnss-Reference to CFA Institute Assigned Reading #30 - Financial Reponing Mechanics

3.A Accounts receivable are an asset and accounts payable are a liability.

4, B Annual depreciation is an expense. Accumulated depreciation is a contra asset account that typically offsets the historical cost of property, plant, and equipment.

5.A Owners' equity is equal to assets minus liabilities.

6, C The expanded accounting equation shows th;ll assets ~ liabilities + contributed capital

+ beginning retained earnings + revenue - ,'xpens,'s- dividends. A decrease in assets is consistent with an increase in expenses or ~l decrease in revenues but not with an increase in contributed capital.

7.A The service is performed before cash is paid. This rransaction represents accrued revenue to the electrician and an accrued expense to the retail shop, Since the invoice has not been sent as of the statement date, it is not shown in accounts receivable or accounts payable,

8.C The $10 million raised appears on the cash Aow statement as a cash inflow from financing and on the statemelll of owners' equity as an increase in contributed capital. Both assets (cash) and equity (common stock) increase on the balance sheer. The income statement is unaffected by srock issuance.

9, B The general journal lists all of the company's transactions by date. The general ledger

lists them by account.

10.C Schmidt is correct in stating that analysts do not have access to the detailed accounting entries that went into a company's financial statements. However, he is incorreCl in stating that an analyst can be sure management is not manipulating earnings if the audit report does not list deviations from accounting principles. Because accruals and many valuations tequire management's judgment, there is considerable room within the

accounting standards for management to manipulate earnings.

Study Scssion 7

Cross-Reference 10 eFA Instirute Assigned Re,uling tnn - Financial RqlOrting Mechanics

])olh def'Trcl/ IIIX tI.,.'cls allrl rI,j/'rrcIII'IX fi,i/Ji/llics Ilr!' r('«(Irr/N!.

The following is a review of the Financial Reporting and Analysis principles designcd to address the Ie.lrning o\ltCOllle statcments sct forth by CFA InstituteQi). This topic is also covered in:

FINANCIAL REPORTING STANDARDS

Study Session 7

EXAM FoCUS

LOS .1 l.a: Explain the objective of rinancial statements and the importance of reporting standards in security analysis and valuation.

The objective of financial statements is to provide economic decision makers with useful information about a firm's financial performance and changes in financial position.

Given the variety and complexity of possible transactions and the estimates and assumptions a Erm must make when presenting its performance, hn;mcial statements could potentially take any form if reporting standards didn't exist. Reporting standards ensure that the information is "useful to a wide range of users," including security analysts, by making financial statements comparable to one another and narrowing the range of management's "reasonable" estimates.

LOS 31.b: Explain the role of standard-setting bodies, such as the International Accounting Standards Board and the U.S. Financial Accounting Standards Board, and regulatory authorities such as the International Organization of Securities Commissions, the U.K. Financial Services Authority, and the U.S. Securities and Exchange Commission in establishing and enforcing financial reporting standards.

Standard-setting bodies are professional organizations of accounranrs and audirors that establish financial reporting standards. Regulatory authorities are government agencies that have the legal authority to enforce compliance with financial reporting standards.

The two primary standard-setting bodies are the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB). In (he United States, the FASE sets forth Generally Accepted Accounting Principles (GAAP). Outside the United States, the lASE establishes International Financial Reporting Standards (IFRS).

Study Session 7

Cross-Refercnce to CI~A Institute Assigncd Reading #31 - Financial Reporting Standards

Other national standard-scteing bodies cxisr as well. Many of them (including rhe FASB) arc working toward convergence with I l;RS. Some of rhe older IASB standards are referred to as Inrernational AccoulHing Standards (lAS).

The IASB has four stated goals: I

I.Develop glohal accounring slandards requiring transparcncy, comparability, and high quality in hnancial statcmenrs.

2.Promote the use of global accounting standards.

3.ACCOlllH [or the needs of emerging markers and smalllinl1s when implementing global accounting srandards.

4.Achieve convergence bcrween various national accounting srandards and global

accounti,w sundards.

,0

Regulalory :lur!]()rilics, such as the Sccllritin IIIIr.l Fxchange COff/mission (SEC) in the U.S. and the Financial Semicc.f Authority (FSA) in the United Kingdom, arc esrablished by national governmenrs. Figure 1 summarizes the SEC's flling rcquiremenrs for publicly [faded companies in the Unired Srates. These filings, which are available fr0111 rhe SEC web sire (www.scc.gov), are atguably the 1110Sr imporranr source of informarion for rhe analysis of publicly rraded firms.

Mosr national authoriries belong to rhe International Organization o/Securities Commissions (lOSCO). The three objectives of financial market regulation according ro

IOSC0 2 are to (1) protect investors, (2) ensure the faillless, efficiency, and transparency of markets, and (3) red uce sysrcmic risk. Because of the increasing globaliz:ltion of securities markets, the IOSCO has a goal of uniform financial regularions across countrIes.

Figure 1: Securities and Exchange Commission Required f'ilings

Form $-1. Regisrra tion staremellt filed prior to the sale of new securities to the

public.

Form 10-K. Required annual filing that includes information about the business and irs management, audired financial st3rements and disclosures, and disclosures about legal matters involving the firm. Information required in Form 10-K is similar to that which a firm typically provides in its annual report to shareholders. However, a hrm's annual report is not a substitute for the required I O-K filing. Equivalent SEC forms for foreign issuers in the U.S. markets are Form 4o-F for Canadian companies and Form 20- F for other foreign issuers.

Form IO-Q. U.S. firms are required ro file this form quarterly, with updated financial statements (unlike Form IO-K, these statements do not have to be

audited) and disclosures about certain events such as significant legal proceedings or

1.International Accounting; Standards Commirtce Foundation Consritutioll, July 2005.

2.Inrernational Organi1.arion of Securiries Commissions, "Objectives and Principles of Securjries Regularion," May 2003.

StlIdy Session 7

Cross-Reference to CIA Institute Assigned Reading #31 - Financial Reporting Standards

c11anges in accounring policy. Non-U.S. companies are typically required to file the equivale'H Form G-K semiannually. I

Form DEF-14A. When a company prepares a proxy statement for its shareholders prior to the annual meeting or other shareholder vote, it also files the statement with the SEC as form DEF-I4A.

Form 8-K. Companies must hIe this form to disclose material events including signihcanr asset acquisitions and disposals, changes in management or corporate governance, or matters related to its accountants, its hnancial statements, or the markets in which its securities trade.

Form 144. A com pan)' can issue secu ri tics to certain qual if1ed bu )'ers withou t registering the securities with the SEC but must notify the SEC that it intends to do so.

Forms 3, 4, and 5 involve the benehcial ownership o( securities by a company's officers and directors. Analysts can use these filings to learn about purchases and sales of company securities by corporate insiders.

LOS .31.c: Discuss the ongoing barriers to developing Olll' tlnivlTsally accepted Scl of' financial reporting standards.

One barrier to developing one universally accepted set of accounring standards (referred to as "convergence") is simply that different standard-setting bodies and the regulatory authorities of differenr countries can and do disagree on the best treatmenr of a particular item or issue. Other barriers result from the political pressures that regulatory bodies face from business groups and others who will be affected by changes in reporting standards.

LOS 31.d: Describe the International Financial Reporting Slal1(LuJ:, (tnt'")) framework, including tlle objective of financial statcmclllS, [heir quaiil:llivc characteristics, required reporting elements, and the constraints and assumptions in preparing financial statements.

The ideas on which the lASB bases its standards are expressed in the lFRS "Framework for the Preparation and Presentation of Financial Statements" that the organization adopted in 200 1. The lFRS framework details the objective of financial statements, defines the qualitative characteristics necessary to meet that objective, and specifies

the required reporting elements. The framework also notes certain constraints and assumptions that are involved in financial statement preparation.

The objective of financial statements, according to the IFRS framework, is "to provide information about the financial position, performance, and changes in financial position of an entity; this information should be useful to a wide range of users for the purpose of making economic decisions." Stated another way, the objective of financial statements is the fair presentation of a company's financial performance.

Swell' Session 7

Cross-Reference to CFA Institute Assigned Reading #,1\ - Financial Reporting Standards

Qualitative Characteristics

I

To llleet the ohjl'uives of fairness and llSefu!ness, !1n~lncial statellleJ1(S should he understandahlc, releVJIll, reliJhlc, and cOlllp:nahle, The I FRS frJlllework descrihes eJch of these CJu;dities,

lhulerstallrlability, Users wirh J hJsic knowledge of husiness and accouIlling and who make a reasonable effort to study the financi:d statcmcnts should hc able to readily understand the in form:nion the sta temeIllS prescnt.

Comparability, Financial statement prescntation should be consistcnt alllong firms and across time periods,

Relevance, Financial statcmenrs arc relevant if the information in them can influence

IISC'!";' economic decisions or affcl'l lIsers' evaluations of past events or forecasts of fUlllre C\Tnts, Til he !'elevant, information should hl' tilllcly ,In<l suHieiellrl:' dl,tailed (mcaning

nil materiallllllissions or mis'!;llements),

Reliability. Jnformation is reliable if it reflects economic reality, is unbiased, and is free of marerial errors. Specific factors that SUPIJott reliabilit)' include:

•Prud('flcc and conservatism in making estimates,

Co mplctmcss , within the limits of cost and materiality.

Required Reporting Elements

The elements of financial statements arc the by now familiar groupings of assets, liabilities, and owners' equity (for measuting financial position) and income and expenses (for measuring performance), The IH\S framework descrihes each of rhese elements:

•Assets are the resources the entity controls and from which it expects to derive economic benefits in the future.

• Liabilities are obligations that are expected to require an outflow of resources.

•Equity is the owners' residual interest in the assets after deducting the liabilities.

•Income is an increase in economic benefits, either increasing assets or decreasing liabilities in a way that increases owners' equity (but not including contributions by owners). Income includes teven ues and gains.

•Expenses arc decreases in economic benefits, either decreasing assets or increasing liabilities in a way that decreases owners' equity (but not including distributions to owners). Losscs arc included in cxpenses.

An item should be recognized in its financial statement element jf a future economic benefit from the item (flowing to or from the firm) is probable and if the item's value or cost can be measured reliably. The amounts at which items ate reponed in the financial statement clements depend on their measurement base. Bases of measurement used in financial statements include historical cost (the amount originally paid for the asset),

Study Scssion 7

Cross-Refercnce to CFA Institutc Assigned Reading #31 - Financial Reponing Standards

(lI/TOlt cost (lhe amount the firm would have 10 pay tOllay for the same asset), ,.cllliz,//;!r {JIJlm' (the ,lJl1OUIH !()r which the flrm could se~1 lhe asset), prI'H'IJ/ {ildill' (the discounrnl vallie of the assn's expeLled futute cash Hows), and I"',. {M!ill' (the amount ,II which two parries in an arm's-length ttansaLlion would exchange the asset).

IJrol;'J.w,.~ Nlltl': III thl' Ill'xt Stlirly Sc'JSilllJ, wc {(Jil! rliJCWS /hl'.\( /lICII.\J(/'{'/l11'1It Ih/.ll'.i dlJd thl' Ji/lIIl/ilJllJ ill /i'hich Ctlc/; is appruprilltc.

Constraints and Assumptions

Some of the qualitative characteristics of flnancial st:llements can be at cross-purposes. One of the constraints on financial st;1teI11ent preparation is the need 10 lJalance reliability, in the sense of being free of error, with the limeliness that makes the illr()['mation relcv'llll. (:OSI is alsu a constLlilH: the lJcndlt that users gain from tht' inf(HllLllion should l1L' greatcr th,\I1 lhe cml of prt'st'llling il. A third conslLlinl is lhe htl that inLlngihk ;lI1d non-quaIHili;lblc informatioll ;IlJOlIl :1 comp:lny (its repul:ltion, hr.\I1d [oy:dty, capacilY for innov:1tion, ClC.) Cll1llOt he Clplllrcd directly in hn;\Ilci;1! statemcnlS.

The two primary assumptions that llnderlie financial statements arc the tlCCI'lIa! basis and the L~oil1K (Ollal'll tlHmnptiolJ. The accrual basis means that financial statemenlS should refleer transaerions at thc time they actually occur, not necessarily when cash is paid. The going concern assumption means there is an assumption that the company will continue to exist for rhe foreseeable futlJ['c. If this is not the case, then presenting the company's financial posirion fairly requires a number of adjusrments (for example, its inventory or other assets may only hc worrh their liquidation valucs).

LOS .11.e: Explain the gencral requircmcnts For financial statcments.

International Accounting Standard (lAS) No.1 defines which financial statements ate requited and how they must be prescl1ted. The required financial statements arc:

•Balance sheet.

•Income statement.

•Cash flow statement.

Statement of changes in owners' equity.

•Explanatory notes, including a summary of accounting policies.

The fundamental principles for preparing financial statements are stated in lAS

No. I:

Fair presentation, defined as fai thfully representing the effects of the en ti ty's transactions and events according to the standards for recognizing assets, liabilities, reven ues, and expenses.

Going concern baJis, meaning the financial statemel1ts arc based on the assumption that the firm will continue to exist unless its management intends to (or must) liquidate it.

Accru.a! baJis of accounting is used to ptepare the financial statemcnts other than the statemen t of cash flows.

SnIcly Session 7

Cross-Reference to CFA Institute Assigned Reading #31 - Financial Reporting Standards

Consistency between periods in how items are presen ted and classified, wi th prio r- period amounts disclosed for comparison.

Materiality, meaning the financial statements should be free of misstatements or omissions that could influence the decisions of users of financial statements.

Also stated in lAS No.1 Jrc principles for presenting financial statements:

Aggregation of similar items and separation of dissimilar items.

No ofJsetting of assets against liabilities or income against expenses unless a specific standard permits or requires it.

Most entities should present a classified balance sheet showing current and noncurrent assets and liabilities.

Minimum information is required on the face of each financial statement and in the nares. For example, the face of the balance sheet must show specific items such as cash and cash equivalents, plant, property and equipment, and inventories. Items listed on the face of the income statement must include revenue, profit or loss, tax expense, and finance costs, among others.

Comparatilie information for prior periods should be included unless a specific standard states otherwise.

.,/ GMF

U.S. GAAP consists of standards issued by the FASB, along with numerous other pronouncements and interpretations. Like the lASB, the FASB has a framework for preparing and presenting financial statements. The two organizations are working toward a common framework, but at present the two frameworks differ in several respects.

PU7pose ofthe framework. Both frameworks are meant to help develop and revise standards, but the FASB framework, unlike the IASB framework, is not at the top of the "GAAP hierarchy." The IASB requires management to consider the framework if no explicit standard exists on an issue, but the FASB does not.

Objectives offinancial statements. The FASB framework presents different objectives for business and non-business financial statement reporting; the IASB framework has one objective for both.

•Assumptions. The IASB framework places more emphasis on the going concern assumption.

Qualitative characteristics. In the FASB framework, relevance and reliability are the primary characteristics, while the IASB framework also lists comparability and understandability as primary characteristics.