🏷️Financial Statement Analysis Unit 2 – Accounting Principles & Standards

Key Accounting Concepts

• Accrual basis accounting recognizes revenue when earned and expenses when incurred, regardless of when cash is received or paid out
• Going concern assumption presumes that a business will continue operating for the foreseeable future and not face liquidation
  • Allows for the deferral of recognition for certain expenses and revenues
  • Provides a basis for using historical cost for asset valuation
• Conservatism principle requires accounting for potential losses and expenses immediately, while revenues and gains are recognized only when realized
• Materiality concept states that an item is considered significant when it would affect the decisions of users of financial statements
  • Allows for the omission of insignificant items that would not impact decision-making
• Matching principle requires expenses to be reported in the same period as the revenues they helped generate (rent expense matched with rental income)
• Full disclosure principle necessitates the disclosure of all relevant information about a company's financial performance and position
  • Includes notes to the financial statements, which provide additional context and explanations
• Consistency principle requires the use of the same accounting methods and policies from one period to the next for comparability

Financial Statements Overview

• Balance sheet provides a snapshot of a company's financial position at a specific point in time
  • Reports assets, liabilities, and equity
  • Assets = Liabilities + Equity (fundamental accounting equation)
• Income statement presents a company's financial performance over a specific period (quarterly or annually)
  • Displays revenues, expenses, and net income or loss
  • Net Income = Revenues - Expenses
• Statement of cash flows shows the inflows and outflows of cash during a specific period
  • Categorizes cash flows into operating, investing, and financing activities
  • Helps assess a company's liquidity and ability to generate cash
• Statement of changes in equity reports the changes in a company's equity accounts over a specific period
  • Includes net income, dividends, and other comprehensive income
• Notes to the financial statements provide additional information and disclosures
  • Accounting policies, segment information, and contingent liabilities
• Management discussion and analysis (MD&A) offers insights into a company's financial performance, risks, and future prospects

Generally Accepted Accounting Principles (GAAP)

• GAAP is a set of accounting standards, rules, and procedures used to prepare and report financial statements in the United States
• Developed by the Financial Accounting Standards Board (FASB) and the Securities and Exchange Commission (SEC)
• Objectives of GAAP include relevance, reliability, comparability, and consistency of financial information
• Key principles include revenue recognition, expense matching, full disclosure, and going concern
• GAAP is based on a rules-based approach, providing specific guidance and detailed rules for various transactions and events
• Hierarchy of GAAP sources: FASB Statements, FASB Interpretations, FASB Technical Bulletins, and AICPA Accounting Research Bulletins
• Compliance with GAAP is mandatory for publicly traded companies in the United States
  • Ensures a high degree of standardization and comparability among financial statements

International Financial Reporting Standards (IFRS)

• IFRS is a set of accounting standards developed by the International Accounting Standards Board (IASB) for global financial reporting
• Aims to provide a common language for financial reporting and enhance comparability across countries
• IFRS is based on a principles-based approach, focusing on broad guidelines and professional judgment
  • Allows for more flexibility in applying the standards to specific situations
• Key differences between IFRS and GAAP include the treatment of inventory valuation (LIFO not permitted under IFRS), and the presentation of financial statements
• Over 120 countries have adopted IFRS or have converged their national standards with IFRS
  • Facilitates cross-border investments and comparisons of financial performance
• Convergence efforts between FASB and IASB aim to minimize differences between GAAP and IFRS
  • Joint projects on revenue recognition, leases, and financial instruments

Accounting Methods and Conventions

• Historical cost principle records assets and liabilities at their original acquisition cost
  • Provides reliable and verifiable information
  • May not reflect current market values
• Fair value accounting measures assets and liabilities at their current market value
  • Relevant for financial instruments and investment properties
  • Can introduce volatility in financial statements
• LIFO (Last-In, First-Out) and FIFO (First-In, First-Out) are inventory valuation methods
  • LIFO assumes the most recently purchased items are sold first
  • FIFO assumes the oldest inventory items are sold first
• Straight-line and accelerated depreciation methods allocate the cost of long-term assets over their useful lives
  • Straight-line method spreads the cost evenly over the asset's life
  • Accelerated methods (double-declining balance) allocate more depreciation expense in early years
• Accrual basis and cash basis are two main accounting methods
  • Accrual basis recognizes revenues and expenses when earned or incurred
  • Cash basis recognizes transactions only when cash is received or paid

Financial Statement Components

• Assets are resources owned by a company that provide future economic benefits
  • Current assets (cash, accounts receivable, inventory) are expected to be converted to cash within one year
  • Non-current assets (property, plant, and equipment, intangible assets) provide benefits beyond one year
• Liabilities are obligations that a company owes to others
  • Current liabilities (accounts payable, short-term debt) are due within one year
  • Non-current liabilities (long-term debt, deferred tax liabilities) are due beyond one year
• Equity represents the residual interest in the assets after deducting liabilities
  • Consists of contributed capital (common stock, additional paid-in capital) and retained earnings
• Revenues are inflows of assets or settlements of liabilities from delivering goods or services
  • Recognized when earned, not necessarily when cash is received
• Expenses are outflows of assets or incurrences of liabilities from generating revenues
  • Recognized when incurred, not necessarily when cash is paid
• Gains and losses are increases or decreases in equity from peripheral transactions
  • Gains from the sale of investments or foreign currency translations
  • Losses from the disposal of assets or settlement of liabilities

Regulatory Bodies and Compliance

• Securities and Exchange Commission (SEC) oversees financial reporting for publicly traded companies in the United States
  • Requires the filing of annual (10-K) and quarterly (10-Q) reports
  • Enforces compliance with GAAP and other disclosure requirements
• Public Company Accounting Oversight Board (PCAOB) regulates audits of public companies
  • Sets auditing standards and conducts inspections of accounting firms
  • Aims to protect investors and enhance audit quality
• International Organization of Securities Commissions (IOSCO) is a global association of securities regulators
  • Promotes the adoption of IFRS and cross-border cooperation
  • Facilitates the exchange of information and best practices among regulators
• Sarbanes-Oxley Act (SOX) was enacted in 2002 to improve corporate governance and financial reporting
  • Requires management certification of financial statements
  • Mandates internal control assessments and auditor attestations
• Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) was passed in 2010 to enhance financial stability and consumer protection
  • Established the Consumer Financial Protection Bureau (CFPB)
  • Introduced the Volcker Rule to restrict proprietary trading by banks

Practical Applications in Financial Analysis

• Ratio analysis uses financial statement data to evaluate a company's performance and financial health
  • Liquidity ratios (current ratio, quick ratio) assess a company's ability to meet short-term obligations
  • Profitability ratios (gross margin, return on equity) measure a company's ability to generate profits
• Trend analysis compares a company's financial performance over time
  • Horizontal analysis calculates percentage changes in financial statement items across periods
  • Vertical analysis expresses each item as a percentage of a base amount (total assets, total revenues)
• Comparative analysis benchmarks a company's performance against its peers or industry averages
  • Helps identify strengths, weaknesses, and competitive positioning
• Valuation models use financial statement data to estimate a company's intrinsic value
  • Discounted cash flow (DCF) model projects future cash flows and discounts them to present value
  • Relative valuation multiples (P/E, EV/EBITDA) compare a company's valuation to its peers
• Credit analysis assesses a company's creditworthiness and ability to repay debt
  • Debt ratios (debt-to-equity, interest coverage) measure leverage and debt servicing capacity
  • Cash flow analysis evaluates a company's ability to generate cash to meet debt obligations