Reading 22 LOS's

Question 1

LOS 22a: Describe the roles of financial reporting and financial statement analysis

Answer 1

Role of financial statement reporting to provide information about a company’s financial performance, financial position, and changes in financial position

Role of Financial Statement Analysis to asses a company’s past performance and evaluate its future prospects using financial reports along with other relevant company information. Assessments are performed prior to making an investment decision, offering any credit facilities, or making other economic decisions related to the company

A company’s performance can be examined through profitability and cash flow. A forecast of the expected amount of future cash flows is important in determining the company’s ability to meet its obligations

• Liquidity refers to a company’s ability to meet its short-term obligations
• Solvency is the ability to meet long-term obligations

Question 2

LOS 22b: Describe the roles of the key financial statements:

• statement of financial position
• statement of comprehensive income
• statement of changes in equity
• statement of cash flows

in evaluating a company’s performance and financial position

Answer 2

Statement of Comprehensive Income

The income statement is known as the statement of operations or profit and loss statement. It presents revenues earned by the company with the corresponding costs, the difference between the two being net income

• Net Income = Revenues - Expenses

Income statements are useful in evaluating a company’s profitability and therefore are an important source of information for financial statement analysis

Balance Sheet

also know as statements of financial position, present a company’s assets, liabilities, and equity at a point in time:

• Assets = Liabilities + Owner’s Equity

Assets are the productive resources that a company owns. Liabilities are amounts the company owes other entities. Owner’s equity is the shareholder’s residual claim on the company’s assets after deducting liabilities.

Cash Flow Statement

A cash flow statement reports the various sources of cash receipts and cash payments. The put the sources and use into 3 categories:

1. Operating activities- refer to the day to day core business activities
2. Investing activities- refer to the acquisition or disposal of long-term assets
3. Financing activities - relate to the injection or repayment of capital

It is better for companies to make most of their money from operating activities. A company’s sources and uses of cash provide valuable insight into its liquidity and solvency levels

Statement of changes in equity this reports any changes in owner’s investment in the business

Question 3

LOS 22c: Describe the importance of financial statement notes and supplementary information - including disclosures of acounting policies, methods, and estimates - and management’s commentary.

Answer 3

Financial Notes and Supplementary Information.

Financial notes are an important part of financial statements because they provide detailed explanatory information about the following:

• Accounting policies. methods, estimates
• Business acquisitions and disposals
• commitments and contingencies
• legal proceedings
• subsequent events
• related-party transactions
• business and geographic segments
• financial instruments and risk arising from them

Footnotes contain important details bout the accounting methods, estimates, and assumptions that have been used by the company in preparing its financial statements

Management’s discussion and Analysis (MD & A)

The management discussion and analysis section ( required under U.S. GAAP) highlights important trends and events that affect a company’s liquidity, capital resources, and operations. Management also discusses prospects for the upcoming year with respect to inflation, future goals, material events, and uncertainties.

Question 4

LOS 22d: Describe the objective of audits of financial statements, the types of audit reports, and the importance of effective internal controls.

Answer 4

Obejective of audits:

1. To obtain a reasonable asurance about whether the financial statements as a whole are free from material misstatement, wheter due to fraud or error, thereby enabling the auditor to express an opinion on whether the financial statements are prepared, in all material respects, in accordance with an applicable financial reporting frame-work
2. To report on the financial statements and communicate as required by the ISAs, in accordance with the auditors findings

Types of Audits:

• An unqualified opinion states that everything is represented fairly in accordance with accounting standards
• A qualified opinion states that everything is presented fairly, but do contain exceptions to the accounting standards, which the auditor reports further details on
• An adverse opinion states that things have not been presented fairly and that their is significant deviation from acceptable accounting standards
• A disclaimer of opinion is issued when the auditor, for whatever reason, is not able to issue an opinion on the financial statements

Internal controls seek to ensure the reliability of processes used by the company in preparing its financial statements

Question 5

LOS 22e: Identify and describe information sources that analysts use to financial statement analysis besides annual financial statements and supplementary information

Answer 5

• Interim reports are prepared semiannually or quarterly and contain the four financial statements and footnotes, but are not audited
• Proxy statements are distributed to shareholders when there are matters that require a shareholder vote. They provide info about management and director compensation, company stock performance, and anything of interest
• Press Releases provide current information about the company
• External Sources provide info about the economy, the industry, and other competition. This info is useful because it helps place the companies performance in perspective

Question 6

LOS 22f: Describe the steps in the financial statement analysis framework

Answer 6

1. Define the purpose and context of the analysis the purpose determines the approach, tools, data sources, and the format used to present results. Here the analyst is also required to define the context of the analysis, which requires understanding the audience, time frame, and resources available for completion of the task
2. Collect Data The analyst requires the necessary info to answer the questions that were defined in the previous stage
3. Process Data the data collected is converted into ratios, growth rates, common size financial statements, charts, and regressions
4. Analyze/interpret the processed data- data is interpreted and a recommendation is reached
5. Develop and Communicate conclusions
6. Follow up