Level 1 CFA® Exam:
Financial Statements - Advanced
The balance sheet is also called the statement of financial position or the statement of financial condition.
The balance sheet shows the current financial situation of the company. In other words, it shows the company’s assets and sources of financing these assets, that is liabilities and owner's equity.
According to the IFRS framework, an asset is defined as a resource controlled by the company as a result of past events and which is expected to bring future economic benefits to the company.
Examples of assets include:
- property, plant, and equipment,
- investment properties,
- intangible assets,
- financial assets,
- inventories,
- accounts receivable,
- cash and cash equivalents.
According to the IFRS framework, a liability is a present obligation of the company arising from past events, the settlement of which is expected to result in an outflow from the company of resources embodying economic benefits.
Examples of liabilities are:
- long-term debt,
- accounts payable, or
- accrued income taxes.
Owners’ equity represents the excess of assets over liabilities of the company. The basic accounting equation states that assets equal liabilities plus owners’ equity:
Mild, Co., whose total assets and liabilities plus owners’ equity are equal to USD 10 million, wants to buy a car for USD 100,000 and has to choose the source of financing the purchase.
The company is considering two sources of financing:
- cash or
- loan.
Consider the impact on the balance sheet of these sources of financing.
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Also, owner’s equity can be presented as follows:
Definitions & Formulas
Comprehensive income includes all items that affect owners’ equity apart from the items that result from transactions with shareholders.
Under the IFRS, a comprehensive income statement may be presented as:
- a single statement of comprehensive income, or
- in two statements, namely: (1) the income statement, and (2) the statement of comprehensive income that begins with profit or loss from the income statement.
The income statement shows items that are used to calculate net income.
Other comprehensive income includes items that affect owners’ equity but are not included in net income and don’t result from transactions with shareowners.
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The net income of Find-it, Inc. is equal to USD 20 million and its income is equal to USD 120 million. What is the value of expenses?
Income minus expenses is equal to net profit. So, expenses are equal to income minus net profit. Expenses are USD 120 million minus USD 20 million and amount to USD 100 million.
It’s worth knowing that net income is also referred to as:
- net earnings,
- net profit,
- profit or loss, or
- bottom line.
If the expenses exceed the revenue and the other income, we say that the company incurred a net loss.
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Shares outstanding at the beginning of 2022 were 100 million shares. 1 July the company issued another 100 million shares. What is the weighted average number of shares outstanding in 2022?
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For diluted earnings per share, we use the diluted number of shares in the denominator.
This means that we take into account the number of shares that would be outstanding if all hypothetical claims to ordinary shares resulting in the dilution, for example, stock options or warrants, were exercised or converted into shares. Note that the net profit or loss attributable to ordinary shareholders which is the nominator should be also properly adjusted.
Comprehensive income includes all items that affect owners’ equity apart from items that result from transactions with shareholders. Some of these items are included in net profit and are presented in the income statement. However, some of them are not.
These items constitute a part of other comprehensive income. If the company reporting under IFRS prepares the comprehensive income statement using both:
- the income statement, and
- the statement of comprehensive income,
then the statement of comprehensive income starts with net profit or loss from the income statement and is adjusted for items included in other comprehensive income.
The income of Find-it, Inc. is equal to USD 200 million and expenses are equal to USD 120 million. What will be the value of other comprehensive income, if the total comprehensive income is USD 90 million?
First of all, note that income equal to USD 200 million is a different thing than the total comprehensive income. Income equal to USD 200 million is the sum of revenue and other income.
Now we can try to solve the problem. We know that:
Net income plus other comprehensive income is equal to total comprehensive income. So, other comprehensive income is equal to total comprehensive income minus net income.
Additionally, we know that net income is equal to income minus expenses, so it is equal to USD 200 million minus USD 120 million and amounts to USD 80 million.
Because total comprehensive income equals USD 90 million, the other comprehensive income equals USD 90 million minus USD 80 million of net income equals USD 10 million.
Cash Flow Statements - Definitions
Note that the statement of comprehensive income tells us how much a company earned in a given period on paper, and the cash flow statement tells us how much money in reality flows in and out of the company as a result of different activities.
Cash flows are divided into cash flows from:
- operating activities,
- investing activities, and
- financial activities.
In the exam, you should be able to classify each cash flow into a specific category of activities. The difficulty you may have in doing this may arise from the differences between IFRS and U.S. GAAP for different cash flows, as well as from the differences between cash flow classifications for different types of companies.
For example, for the bank interest is included among operating cash flows, and for the company producing footwear, it is classified as a financial cash flow.
The role of the statement of cash flows is to determine the sources of money and exact amounts that come from every category of activities.
Remember, in the short term the company may have a negative cash flow from operating activities, but in the long term no company can function properly when operating cash flows are constantly negative.
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Operating Activities vs Investing Activities vs Financial Activities
star content check off when doneAs we’ve already mentioned, the cash flow statement classifies all cash flows of the company into three categories: operating, investing, and financing.
Cash flows from operating activities are the cash flows not included in investing or financing activities. Cash flows from operating activities are related to transactions that influence the value of net income, so are related to everyday business operations.
Cash flows from investing activities are cash flows from operations related to the acquisition or disposal of long-term assets.
Cash flows from financing activities are cash flows from the activities related to the acquisition or repayment of capital used to finance the company’s operations.
You should remember that at different stages of a business life cycle, companies are characterized by different optimal cash flow patterns.
For instance, the best situation for a growing company which is not a startup anymore is as follows:
- cash flow from operating activities is positive,
- cash flow from investing activities is negative, and
- cash flow from financing activities is positive.
What does this cash flow pattern indicate?
The company generates positive cash flows from operating activities, which is desirable. Additionally, the company raises capital because there is a positive cash flow from financing activities and uses this capital for investments, which is indicated by negative cash flows from investing activities.
Total net cash flows from operating, investing, and financing activities and the impact of exchange rates on cash and cash equivalents are equal to the net change over the period.
Remember, the cash flow statement is important because as they say cash is king.
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Statement of changes in equity shows how equity was changing over time. It is a statement useful especially for owners of equity, for example, shareholders of a listed company.
Equity is divided into:
- paid-in capital,
- retained earnings, and
- minority interests and reserves.
In the case of a listed company, paid-in capital is money raised from the issuance of equity.
Retained earnings are the company's profits that were not distributed by the company. In other words, they have not been paid out to shareholders as dividends.
How do we present the statement of changes in equity?
If we want to show a change, then we need to have data on individual items at the beginning of the period and at the end of the period. Then, we can calculate changes in every position and sum it up to show the value and the structure of equity at the end of the period.
The amount of equity at the end of the period can be affected for example by the issuance of shares, the redemption of shares, retained earnings of the period, the loss of the period, the value of dividends, etc.
Let’s now go back for a second to retained earnings. Remember that if the company earns profit over the period, it can do two things:
- pay out as dividends, or
- retain it.
Factors affecting the shareholders' equity:
- The issuance of new shares increases the equity.
- The redemption of shares decreases the equity.
- If the company has a profit in a given period, the equity will increase. If the company incurs a loss, the equity will be reduced.
- Paying dividends reduces retained earnings, which results in lower equity.
Any additional notes (aka. footnotes) provided in a financial report constitute an essential and integral part of a complete set of financial statements and are the source of important and detailed information left out from the core statements for the sake of clarity.
The financial statements themselves are only sets of numbers. It is crucial to understand where these numbers come from and to know their source. This is the information you can find in the footnotes.
In other words, footnotes contain the real essence of financial statements and the core of information for analysts. A good understanding of footnotes can help draw reasonable conclusions related to the numbers and amounts included in the 4 statements that we’ve discussed above.
The notes include copious information. Some basic information includes:
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Public companies are very often required (depending on the country) to include in the annual financial report a section with management commentary about the company, its performance, prospects, etc.
Different countries and jurisdictions may require different disclosures in the management commentary.
According to the Securities and Exchange Commission (SEC), management commentary should at least include and disclose:
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It is required that the annual financial report of a company be audited by an independent auditor.
The role of an audit report is to provide a reasonable assurance that financial statements are fairly presented and the financial condition of the company, its performance, and cash flows are prepared in accordance with an applicable set of accounting standards.
After conducting the audit, the auditor prepares a written opinion on the company’s financial statements. The opinion is one of the three generally required paragraphs of an audit report:
- Introductory paragraph: describes the financial statements and responsibilities of both the company’s management and the auditor itself.
- Scope paragraph: describes the nature of an audit process and gives the basis for reasonable assurance that the financial statements are fairly presented.
- Opinion paragraph: includes the auditor’s opinion on the fairness of the financial statements.
In the USA (under the Sarbanes-Oxley Act), auditors are also obliged to express an opinion about the company’s internal control systems.
Auditor: Types of Opinion
There are 3 types of opinions that an auditor can give:
- Unqualified audit opinion means that the financial statements give a true and fair view of the company and are prepared in accordance with accounting standards.
- Qualified audit opinion means that there are some limitations and exceptions to accounting standards in the company’s financial statements. These limitations and exceptions are then described in detail to help analysts, etc. evaluate them and their impact.
- Adverse audit opinion means that the financial statements don’t give a true and fair view of the company and materially depart from accounting standards.
There is also a possibility that for some rational reasons no opinion will be expressed by the auditor. In such a case, we talk about a disclaimer of opinion.
Apart from the annual report, analysts use lots of different sources of information to prepare their analyses:
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- The balance sheet shows the financial situation of the company at a given point in time.
- The income statement provides us with information about how much money the company earned or lost over a period of time.
- Comprehensive income includes all items that affect owners’ equity apart from the items that result from transactions with shareholders.
- The cash flow statement shows if the profit is accompanied by cash inflows.
- The statement of changes in equity shows how equity has changed over a period of time.
- Cash flows are divided into cash flows from: operating activities, investing activities, and financial activities.
- Any additional notes (aka. footnotes) provided in a financial report constitute an essential and integral part of a complete set of financial statements and are the source of important and detailed information left out from the core statements for the sake of clarity.
- Public companies are very often required (depending on the country) to include in the annual financial report a section with management commentary about the company, its performance, prospects, etc.
- The role of an audit report is to provide a reasonable assurance that financial statements are fairly presented and the financial condition of the company, its performance, and cash flows are prepared in accordance with an applicable set of accounting standards.