Reading 27

The financial statement analysis framework sets out a generic set of steps for analysts to apply to a multitude of objectives when analyzing debt issues, equity securities, and corporate actions. The framework consists of six steps:

1. Step 1:State the objective and context. Determine what questions the analysis seeks to answer, the form in which this information needs to be presented, and what resources and how much time are available to perform the analysis.
2. Step 2:Gather data. Acquire the company's financial statements and other relevant data on its industry and the economy. Ask questions of the company's management, suppliers, and customers, and visit company sites.
3. Step 3:Process the data. Make any appropriate adjustments to the financial statements. Calculate ratios and perform statistical analysis. Prepare exhibits such as graphs and common-size balance sheets.
4. Step 4:Analyze and interpret the data. Use the data to answer the questions stated in the first step. Decide what conclusions or recommendations the information supports.
5. Step 5:Report the conclusions or recommendations. Prepare a report and communicate it to its intended audience. Be sure the report and its dissemination comply with the Code and Standards that relate to investment analysis and recommendations.
6. Step 6:Update the analysis. Repeat these steps periodically, and change the conclusions or recommendations when necessary.

Financial reporting refers to the way companies show their financial performance to investors, creditors, and other interested parties by preparing and presenting financial statements.

The role of financial statement analysis is to use the information in a company's financial statements, along with other relevant information, to make economic decisions. Examples of such decisions include whether to invest in the company's securities or recommend them to investors, whether to extend trade or bank credit to the company, and assigning credit ratings to a company's debt. Analysts use financial statement data to evaluate a company's past performance and current financial position to form opinions about the company's ability to earn profits and generate cash flow in the future. As part of this process, analysts will identify risk factors that affect the company's future profitability and position.

Standard-setting bodies are professional organizations of accountants and auditors 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 the United States, the FASB sets forth the U.S. Generally Accepted Accounting Principles (U.S. GAAP). Outside the United States, the IASB establishes the International Financial Reporting Standards (IFRS). Some of the older IASB standards are referred to as the International Accounting Standards (IAS).

Most national authorities belong to the International Organization of Securities Commissions (IOSCO), which regulates more than 95% of the world's financial markets. IOSCO is not a regulatory body itself, but its members work together to improve cross-border cooperation. IOSCO's three main objectives based on its Objectives and Principles of Securities Regulation:

1. Protecting investors
2. Ensuring markets are fair, efficient, and transparent
3. Reducing systemic risk

Financial statement notes (footnotes) include disclosures that provide further details about the information summarized in the financial statements. Footnotes allow users to improve their assessments of the amount, timing, and uncertainty of the estimates reported. They:

• Discuss the basis of presentation (fiscal period, IFRS or U.S. GAAP, consolidated entities)
• Provide information about accounting methods, assumptions, and estimates used by management
• Provide additional detail on acquisitions/disposals, legal actions, employee benefit plans, contingencies, segment performance, and post balance sheet events
• Are audited along with the primary financial statements

Management commentary (also known as MD&A — Management Discussion and Analysis) is one of the most useful sections of an annual report. For U.S. publicly held firms, the SEC requires management commentary to discuss trends, significant events, and uncertainties affecting liquidity, capital resources, and results of operations. Management must also discuss:

• Effects of inflation and changing prices (if material)
• Impact of off-balance-sheet obligations and contractual obligations
• Accounting policies requiring significant management judgment
• Forward-looking expenditures and divestitures

An audit is an independent review of an entity's financial statements. The standard auditor's opinion contains three parts:

1. The financial statements are prepared by management and are its responsibility; the auditor has performed an independent review.
2. Generally accepted auditing standards were followed, providing reasonable assurance that the statements contain no material errors.
3. The statements were prepared in accordance with accepted accounting principles and the principles chosen and estimates made are reasonable.

Types of auditor opinions:

• Unqualified (clean) opinion — statements are free from material omissions and errors
• Qualified opinion — statements make exceptions to accounting principles; exceptions explained in the report
• Adverse opinion — statements are not presented fairly or are materially nonconforming
• Disclaimer of opinion — auditor is unable to express an opinion (e.g., scope limitation)

Any opinion other than unqualified is sometimes referred to as a modified opinion.

An audit report must also contain a section communicating key audit matters (international) or critical audit matters (U.S.), highlighting accounting choices that require significant management judgment and have a significant likelihood of being misstated.

Segment data: Both U.S. GAAP and IFRS require segment data. A business segment is a portion of a larger company that accounts for more than 10% of revenues, assets, or income. Segments reported should account for a minimum of 75% of the firm's external sales. Required disclosures per segment include: revenue, a measure of profit or loss, assets and liabilities, interest income/expense, acquisitions of PP&E and intangibles, depreciation and amortization, other noncash expenses, income tax expense, and share of equity-accounted investment results.

The existence of differences between the two sets of standards requires the analyst to exercise caution when making comparisons between firms operating in different jurisdictions. Analysts need to monitor evolving standards and be aware of new products and innovations that generate new types of transactions. Key resources include the IASB (www.ifrs.org) and FASB (www.fasb.org) websites.

Additional information sources beyond regulated filings:

• Issuer sources: earnings calls, ad hoc presentations, press releases, communications with management and investor relations. Note: these sources are unlikely to have been audited.
• Public third-party sources: free industry reports, whitepapers, trade journals, government economic and industry statistics, generalized and industry-specific media, social media
• Proprietary third-party sources: analyst reports, reports from data platforms (Bloomberg, Wind, FactSet), reports from industry-specific agencies and consultancies
• Proprietary primary research: commissioned studies, hands-on experience with the company's products or services, technical specialists employed by the analyst