Ah, level I candidacy for the CFA exam. How naïve, many of you do not yet realize how intimate you need to get with corporate financial statements. Financial Reporting & Analysis (FRA) is worth around 20% of your first two CFA exams and you won’t be able to complete much of the material in equity investments without a good understanding of financial statements.
Embrace the horror! You need to be masters of those quarterly and annual reports, the sooner you realize that and work to it, the better.
While some topic areas seem mostly conceptual, like corporate finance and economics, and others are mostly quantitatively focused (quantitative methods, duh), financial reporting and analysis runs the spectrum between the three exams. At the first level of the CFA exams much of the FRA material is conceptual but you’re still going to have to learn some key formulas so you’ll need to spend a good amount of time on reading as well as practice problems.
We’ll cover the three key statements, important relationships and some of the formulas you need to know over this and the next post.
The income statement measures the company’s performance over a period of time (as opposed to the balance sheet which is a snapshot of one particular moment). The main point is that revenues and related expenses are matched during the period in which they occur. This is supposed to give a better measure of performance than cash accounting. The problem is that management often has a strong incentive to manipulate the revenues, expenses and other items to show earnings in a different light.
It’s important to understand the basic structure of the statement and what each line item represents:
- Net Sales is gross revenue minus any allowances for returns
- Cost of goods sold is really what it sounds like and is the inventory cost, here it is important to understand inventory accounting procedures like LIFO, FIFO, or average cost to understand how management is expensing it
- Gross Profit is the difference between net revenue and COGS (also used to find Gross Margin) and is your first measure of profitability
- Selling, General & Administrative is all direct and indirect expenses that can be linked to operations (salaries, rent, utilities, marketing, pretty much everything that is not associated with the cost of inventory itself)
- Operating income (profit) is the result of operations and your second measure of profitability (profit margin = operating income/ net revenue)
- Interest expense is just the interest on debt for the period
- Nonrecurring items- discussed below
- Provision for income taxes represents the estimated tax liability and gives an indication of the effective tax rate
- Net income is your final measure of profitability (net margin = net income/net revenue)
A theme throughout the curriculum is the preference for conservative accounting principles, as opposed to aggressive practices. Conservative principles are those that take the ‘safe’ bet when recognizing revenues or expenses (and usually less favorable to short-term reporting).
Understand how to calculate the two methods for revenue recognition of long-term projects and the SEC’s four criteria for revenue recognition:
- Legitimate arrangement between buyer and seller
- Delivered or rendered the product or service
- Price is or can be determined
- The seller can be reasonably assured of collection
Nonrecurring items that are unusual or infrequent (but not both) are reported as part of earnings from continuing operations and are often a way for management to take large expenses up front instead of in the future. Examples are: restructuring costs, asset impairment charges, gains or losses on sale of long-lived assets.
Those nonrecurring items that are unusual and infrequent (extraordinary) or discontinued operations are reported net of taxes below income from continued operations. Because these are so out of the ordinary, analysts do not normally consider them against performance. As with those nonrecurring items included in continuing operations, analysts must decide whether they are appropriately reported.
Remember that some items are not reported on the income statement but go “direct to equity” as other comprehensive income. Here I’ll borrow from the great Peter Olinto of Stalla (Schweser definitely needs to pick this guy up in the purchase) and recommend PUFE for:
- Pensions or additional minimum pension liability
- Unrealized gains or losses on available for sale securities
- Foreign currency exchange translations on hedging
- Effective portion of cash flow hedges
You are not asked to do much with the Statement of Comprehensive Income at level I but just understand the basic relationship and what each of the four items represents.
Understand which changes to accounting standards must be reported retrospectively (changes to accounting principles) and which must be treated prospectively with no adjustments to prior periods (changes to estimates) and that corrections of prior period errors require a restatement of financial statements.
Be able to calculate earnings per share for both a simple (just NI minus preferred dividends over weighted average common shares) and complex capital structure (basic EPS adjusted for After-tax interest on convertible and common share adjustments for assumed conversions).
Income Statement Analysis and Ratios
Common-sized analysis will be used with the other statements and is simply dividing each line item by a ‘common’ denominator to find the relative proportion. In the income statement, each line is divided by Net Sales. This helps to see two things, where the largest proportional expenses are coming from and do those proportions change over time.
As mentioned earlier, the three measures of profitability (gross, operating, and net profit margins) are your basic ratios for the income statement. All fairly easy to calculate and remember.
Don’t expect to find everything you need to know about financial statements in a blog post or two. I’ve tried to cover a recap of the stuff I found important for the first exam. Reading other posts you know how important this topic is throughout the curriculum. Spend as much time as possible getting a good base in the material to be able to tackle the curriculum at level II.
We’ll finish up with the balance sheet and statement of cash flows and hit on some other important topics in the next post.
Let me know if you’ve got any questions or want to see anything covered in a future post,
Joseph Hogue, CFA