THOMAS R. ROBINSON, PHD, CFA, is Managing Director of the Americas at CFA Institute.

ELAINE HENRY, PHD, CFA, is a Clinical Associate Professor of Accounting at Fordham University.

WENDY L. PIRIE, PHD, CFA, is Director, Cur-riculum Projects, in the Education Division at CFA Institute and served as editor for this book.

MICHAEL A. BROIHAHN, CFA, is Associate Professor of Accounting at Barry University in Miami Shores, Florida.

Preface xix

Acknowledgments xxi

About the CFA Investment Series xxiii

CHAPTER 1

Financial Statement Analysis: An Introduction 1

Learning Outcomes 1

1. Introduction 1

2. Scope of Financial Statement Analysis 2

3. Major Financial Statements and Other Information Sources 7

3.1. Financial Statements and Supplementary Information 8

3.2. Other Sources of Information 27

4. Financial Statement Analysis Framework 28

4.1. Articulate the Purpose and Context of Analysis 30

4.2. Collect Data 30

4.3. Process Data 31

4.4. Analyze/Interpret the Processed Data 31

4.5. Develop and Communicate Conclusions/Recommendations 32

4.6. Follow-Up 32

5. Summary 32

References 34

Problems 34

CHAPTER 2

Financial Reporting Mechanics 37

Learning Outcomes 37

1. Introduction 38

2. The Classification of Business Activities 38

3. Accounts and Financial Statements 39

3.1. Financial Statement Elements and Accounts 40

3.2. Accounting Equations 42

4. The Accounting Process 47

4.1. An Illustration 47

4.2. The Accounting Records 49

4.3. Financial Statements 62

5. Accruals and Valuation Adjustments 65

5.1. Accruals 65

5.2. Valuation Adjustments 67

6. Accounting Systems 67

6.1. Flow of Information in an Accounting System 68

6.2. Debits and Credits 69

7. Using Financial Statements in Security Analysis 69

7.1. The Use of Judgment in Accounts and Entries 69

7.2. Misrepresentations 70

8. Summary 71

Appendix: A Debit/Credit Accounting System 71

Problems 87

CHAPTER 3

Financial Reporting Standards 91

Learning Outcomes 91

1. Introduction 92

2. The Objective of Financial Reporting 92

3. Standard-Setting Bodies and Regulatory Authorities 95

3.1. Accounting Standards Boards 96

3.2. Regulatory Authorities 99

4. Convergence of Global Financial Reporting Standards 104

5. The International Financial Reporting Standards Framework 107

5.1. Objective of Financial Reports 109

5.2. Qualitative Characteristics of Financial Reports 109

5.3. Constraints on Financial Reports 110

5.4. The Elements of Financial Statements 112

5.5. General Requirements for Financial Statements 114

5.6. Convergence of Conceptual Framework 118

6. Effective Financial Reporting 119

6.1. Characteristics of an Effective Financial Reporting Framework 119

6.2. Barriers to a Single Coherent Framework 120

7. Comparison of IFRS with Alternative Reporting Systems 121

8. Monitoring Developments in Financial Reporting Standards 123

8.1. New Products or Types of Transactions 123

8.2. Evolving Standards and the Role of CFA Institute 124

8.3. Company Disclosures 125

9. Summary 128

Problems 130

CHAPTER 4

Understanding Income Statements 133

Learning Outcomes 133

1. Introduction 134

2. Components and Format of the Income Statement 135

3. Revenue Recognition 139

3.1. General Principles 140

3.2. Revenue Recognition in Special Cases 143

3.3. Implications for Financial Analysis 150

4. Expense Recognition 152

4.1. General Principles 152

4.2. Issues in Expense Recognition 156

4.3. Implications for Financial Analysis 161

5. Non-Recurring Items and Non-Operating Items 162

5.1. Discontinued Operations 163

5.2. Extraordinary Items 163

5.3. Unusual or Infrequent Items 164

5.4. Changes in Accounting Policies 165

5.5. Non-Operating Items 168

6. Earnings per Share 169

6.1. Simple versus Complex Capital Structure 169

6.2. Basic EPS 170

6.3. Diluted EPS 171

6.4. Changes in EPS 178

7. Analysis of the Income Statement 178

7.1. Common-Size Analysis of the Income Statement 178

7.2. Income Statement Ratios 181

8. Comprehensive Income 183

9. Summary 186

Problems 188

CHAPTER 5

Understanding Balance Sheets 193

Learning Outcomes 193

1. Introduction 193

2. Components and Format of the Balance Sheet 194

2.1. Balance Sheet Components 195

2.2. Current and Non-Current Classification 197

2.3. Liquidity-Based Presentation 198

3. Current Assets and Current Liabilities 199

3.1. Current Assets 199

3.2. Current Liabilities 206

4. Non-Current Assets 209

4.1. Property, Plant, and Equipment 211

4.2. Investment Property 212

4.3. Intangible Assets 212

4.4. Goodwill 215

4.5. Financial Assets 217

5. Non-Current Liabilities 220

5.1. Long-term Financial Liabilities 222

5.2. Deferred Tax Liabilities 222

6. Equity 223

6.1. Components of Equity 223

6.2. Statement of Changes in Equity 225

7. Analysis of the Balance Sheet 227

7.1. Common-Size Analysis of the Balance Sheet 227

7.2. Balance Sheet Ratios 235

8. Summary 237

Problems 239

CHAPTER 6

Understanding Cash Flow Statements 243

Learning Outcomes 243

1. Introduction 243

2. Components and Format of the Cash Flow Statement 244

2.1. Classification of Cash Flows and Non-Cash Activities 245

2.2. A Summary of Diff erences between IFRS and US GAAP 247

2.3. Direct and Indirect Methods for Reporting Cash Flow from

Operating Activities 248

3. The Cash Flow Statement: Linkages and Preparation 258

3.1. Linkages of the Cash Flow Statement with the Income Statement and Balance Sheet 258

3.2. Steps in Preparing the Cash Flow Statement 260

3.3. Conversion of Cash Flows from the Indirect to the Direct Method 272

4. Cash Flow Statement Analysis 273

4.1. Evaluation of the Sources and Uses of Cash 274

4.2. Common-Size Analysis of the Statement of Cash Flows 277

4.3. Free Cash Flow to the Firm and Free Cash Flow to Equity 282

4.4. Cash Flow Ratios 283

5. Summary 285

Reference 286

Problems 286

CHAPTER 7

Financial Analysis Techniques 291

Learning Outcomes 291

1. Introduction 291

2. The Financial Analysis Process 292

2.1. The Objectives of the Financial Analysis Process 293

2.2. Distinguishing between Computations and Analysis 294

3. Analytical Tools and Techniques 296

3.1. Ratios 300

3.2. Common-Size Analysis 304

3.3. The Use of Graphs as an Analytical Tool 311

3.4. Regression Analysis 312

4. Common Ratios Used in Financial Analysis 313

4.1. Interpretation and Context 313

4.2. Activity Ratios 314

4.3. Liquidity Ratios 320

4.4. Solvency Ratios 325

4.5. Profi tability Ratios 329

4.6. Integrated Financial Ratio Analysis 333

5. Equity Analysis 341

5.1. Valuation Ratios 341

5.2. Industry-Specifi c Ratios 344

5.3. Research on Ratios in Equity Analysis 346

6. Credit Analysis 347

6.1. The Credit Rating Process 347

6.2. Research on Ratios in Credit Analysis 349

7. Business and Geographic Segments 350

7.1. Segment Reporting Requirements 350

7.2. Segment Ratios 351

8. Model Building and Forecasting 353

9. Summary 353

References 354

Problems 355

CHAPTER 8

Inventories 363

Learning Outcomes 363

1. Introduction 363

2. Cost of Inventories 365

3. Inventory Valuation Methods 366

3.1. Specific Identification 367

3.2. First-In, First-Out (FIFO) 367

3.3. Weighted Average Cost 367

3.4. Last-In, First-Out (LIFO) 368

3.5. Calculation of Cost of Sales, Gross Profit, and Ending Inventory 368

3.6. Periodic versus Perpetual Inventory Systems 370

3.7. Comparison of Inventory Valuation Methods 373

4. The LIFO Method 375

4.1. LIFO Reserve 375

4.2. LIFO Liquidations 382

5. Inventory Method Changes 386

6. Inventory Adjustments 386

7. Evaluation of Inventory Management 393

7.1. Presentation and Disclosure 394

7.2. Inventory Ratios 394

7.3. Financial Analysis Illustrations 395

8. Summary 406

Problems 408

CHAPTER 9

Long-Lived Assets 421

Learning Outcomes 421

1. Introduction 422

2. Acquisition of Long-Lived Assets 423

2.1. Property, Plant, and Equipment 423

2.2. Intangible Assets 426

2.3. Capitalizing versus Expensing—Impact on Financial Statements and Ratios 429

2.4. Capitalization of Interest Costs 434

2.5. Capitalization of Internal Development Costs 437

3. Depreciation and Amortization of Long-Lived Assets 440

3.1. Depreciation Methods and Calculation of Depreciation Expense 441

3.2. Amortization Methods and Calculation of Amortization Expense 449

4. The Revaluation Model 450

5. Impairment of Assets 453

5.1. Impairment of Property, Plant, and Equipment 454

5.2. Impairment of Intangible Assets with a Finite Life 455

5.3. Impairment of Intangibles with Indefinite Lives 455

5.4. Impairment of Long-Lived Assets Held for Sale 455

5.5. Reversals of Impairments of Long-Lived Assets 455

6. Derecognition 456

6.1. Sale of Long-Lived Assets 456

6.2. Long-Lived Assets Disposed of Other Th an by a Sale 457

7. Presentation and Disclosures 458

8. Investment Property 469

9. Leasing 471

9.1. The Lease versus Buy Decision 472

9.2. Finance versus Operating Leases 472

10. Summary 493

Problems 495

CHAPTER 10

Non-Current (Long-Term) Liabilities 505

Learning Outcomes 505

1. Introduction 506

2. Bonds Payable 506

2.1. Accounting for Bond Issuance 506

2.2. Accounting for Bond Amortisation, Interest Expense, and Interest Payments 510

2.3. Current Market Rates and Fair Value Reporting Option 515

2.4. Derecognition of Debt 517

2.5. Debt Covenants 520

2.6. Presentation and Disclosure of Long-Term Debt 522

3. Leases 525

3.1. Advantages of Leasing 526

3.2. Finance (or Capital) Leases versus Operating Leases 526

4. Introduction to Pensions and Other Post-Employment Benefits 544

5. Evaluating Solvency: Leverage and Coverage Ratios 547

6. Summary 551

Problems 552

CHAPTER 11

Financial Reporting Quality 555

Learning Outcomes 555

1. Introduction 556

2. Conceptual Overview 557

2.1. GAAP, Decision-Useful, Sustainable, and Adequate Returns 558

2.2. GAAP, Decision-Useful, but Sustainable? 559

2.3. Biased Accounting Choices 560

2.4. Departures from GAAP 567

2.5. Diff erentiate between Conservative and Aggressive Accounting 569

3. Context for Assessing Financial Reporting Quality 573

3.1. Motivations 573

3.2. Conditions Conducive to Issuing Low-Quality Financial Reports 574

3.3. Mechanisms Th at Discipline Financial Reporting Quality 575

4. Detection of Financial Reporting Quality Issues 581

4.1. Presentation Choices 581

4.2. Accounting Choices and Estimates 586

4.3. Warning Signs 603

5. Summary 609

References 610

Problems 611

CHAPTER 12

Financial Statement Analysis: Applications 613

Learning Outcomes 613

1. Introduction 614

2. Application: Evaluating Past Financial Performance 614

3. Application: Projecting Future Financial Performance 623

3.1. Projecting Performance: An Input to Market-Based Valuation 624

3.2. Projecting Multiple-Period Performance 629

4. Application: Assessing Credit Risk 633

5. Application: Screening for Potential Equity Investments 637

6. Analyst Adjustments to Reported Financials 640

6.1. A Framework for Analyst Adjustments 640

6.2. Analyst Adjustments Related to Investments 641

6.3. Analyst Adjustments Related to Inventory 641

6.4. Analyst Adjustments Related to Property, Plant, and Equipment 645

6.5. Analyst Adjustments Related to Goodwill 646

6.6. Analyst Adjustments Related to Off -Balance-Sheet Financing 649

7. Summary 656

References 656

Problems 657

CHAPTER 13

Income Taxes 661

Learning Outcomes 661

1. Introduction 662

2. Differences between Accounting Profi t and Taxable Income 662

2.1. Current Tax Assets and Liabilities 663

2.2. Deferred Tax Assets and Liabilities 664

3. Determining the Tax Base of Assets and Liabilities 667

3.1. Determining the Tax Base of an Asset 668

3.2. Determining the Tax Base of a Liability 669

3.3. Changes in Income Tax Rates 671

4. Temporary and Permanent Diff erences between Taxable and Accounting Profi t 672

4.1. Taxable Temporary Diff erences 673

4.2. Deductible Temporary Diff erences 673

4.3. Examples of Taxable and Deductible Temporary Differences 674

4.4. Temporary Differences at Initial Recognition of Assets and Liabilities 676

4.5. Business Combinations and Deferred Taxes 677

4.6. Investments in Subsidiaries, Branches, Associates and Interests

in Joint Ventures 677

5. Unused Tax Losses and Tax Credits 677

6. Recognition and Measurement of Current and Deferred Tax 678

6.1. Recognition of a Valuation Allowance 679

6.2. Recognition of Current and Deferred Tax Charged Directly to Equity 679

7. Presentation and Disclosure 682

8. Comparison of IFRS and US GAAP 687

9. Summary 690

Problems 691

CHAPTER 14

Employee Compensation: Post-Employment and Share-Based 697

Learning Outcomes 697

1. Introduction 697

2. Pensions and Other Post-Employment Benefits 698

2.1. Types of Post-Employment Benefi t Plans 698

2.2. Measuring a Defined Benefit Pension Plan’s Obligations 701

2.3. Financial Statement Reporting of Pension Plans and Other Post-Employment Benefits 702

2.4. Disclosures of Pension and Other Post-Employment Benefits 715

3. Share-Based Compensation 726

3.1. Stock Grants 728

3.2. Stock Options 729

3.3. Other Types of Share-Based Compensation 732

4. Summary 732

Reference 733

Problems 733

CHAPTER 15

Intercorporate Investments 739

Learning Outcomes 739

1. Introduction 739

2. Basic Corporate Investment Categories 741

3. Investments in Financial Assets: Standard IAS 39 (as of December 2012) 742

3.1. Held-to-Maturity 743

3.2. Fair Value through Profi t or Loss 743

3.3. Available-for-Sale 744

3.4. Loans and Receivables 745

3.5. ReClassification of Investments 746

3.6. Impairments 747

4. Investments in Financial Assets: IFRS 9 (as of December 2012) 752

4.1. Classification and Measurement 752

4.2. ReClassification of Investments 754

5. Investments in Associates and Joint Ventures 755

5.1. Equity Method of Accounting: Basic Principles 756

5.2. Investment Costs Th at Exceed the Book Value of the Investee 759

5.3. Amortization of Excess Purchase Price 761

5.4. Fair Value Option 763

5.5. Impairment 763

5.6. Transactions with Associates 764

5.7. Disclosure 766

5.8. Issues for Analysts 767

6. Business Combinations 767

6.1. Pooling of Interests and Purchase Methods 769

6.2. Acquisition Method 770

6.3. Impact of the Acquisition Method on Financial Statements, Post-Acquisition 772

6.4. The Consolidation Process 775

6.5. Financial Statement Presentation Subsequent to the Business Combination 781

6.6. Variable Interest and Special Purpose Entities 784

6.7. Additional Issues in Business Combinations That Impair Comparability 788

7. Summary 789

Problems 790

CHAPTER 16

Multinational Operations 799

Learning Outcomes 799

1. Introduction 800

2. Foreign Currency Transactions 801

2.1. Foreign Currency Transaction Exposure to Foreign Exchange Risk 802

2.2. Analytical Issues 805

2.3. Disclosures Related to Foreign Currency Transaction Gains and Losses 808

3. Translation of Foreign Currency Financial Statements 814

3.1. Translation Conceptual Issues 814

3.2. Translation Methods 819

3.3. Illustration of Translation Methods (Excluding Hyperinflationary Economies) 827

3.4. Translation Analytical Issues 830

3.5. Translation when a Foreign Subsidiary Operates in a Hyperinflationary Economy 842

3.6. Companies Use Both Translation Methods at the Same Time 846

3.7. Disclosures Related to Translation Methods 847

4. Multinational Operations and a Company’s Effective Tax Rate 853

5. Additional Disclosures on the Eff ects of Foreign Currency 856

5.1. Disclosures Related to Sales Growth 856

5.2. Disclosures Related to Major Sources of Foreign Exchange Risk 859

6. Summary 860

Problems 862

CHAPTER 17

Evaluating Quality of Financial Reports 869

Learning Outcomes 869

1. Introduction 869

2. Quality of Financial Reports 871

2.1. Conceptual Framework for Assessing the Quality of Financial Reports 871

2.2. Potential Problems Th at Aff ect the Quality of Financial Reports 873

3. Evaluating the Quality of Financial Reports 884

3.1. General Steps to Evaluate the Quality of Financial Reports 885

3.2. Quantitative Tools to Assess the Likelihood of Misreporting 886

4. Earnings Quality 889

4.1. Indicators of Earnings Quality 889

4.2. Evaluating the Earnings Quality of a Company (Cases) 899

4.3. Bankruptcy Prediction Models 910

5. Cash Flow Quality 911

5.1. Indicators of Cash Flow Quality 912

5.2. Evaluating Cash Flow Quality 913

6. Balance Sheet Quality 921

7. Sources of Information about Risk 925

7.1. Limited Usefulness of Auditor’s Opinion as a Source of Information about Risk 925

7.2. Risk-Related Disclosures in the Notes 929

7.3. Management Commentary (Management Discussion and Analysis, or MD&A) 933

7.4. Other Required Disclosures 936

7.5. Financial Press as a Source of Information about Risk 937

8. Summary 937

References 939

Problems 940

CHAPTER 18

Integration of Financial Statement Analysis Techniques 943

Learning Outcomes 943

1. Introduction 944

2. Case Study 1: Long-Term Equity Investment 945

2.1. Phase 1: Define a Purpose for the Analysis 945

2.2. Phase 2: Collect Input Data 945

2.3. Phase 3: Process Data/Phase 4: Analyze/Interpret the Processed Data 946

2.4. Phase 5: Develop and Communicate Conclusions and Recommendations (e.g., with an Analysis Report) 971

2.5. Phase 6: Follow-up 972

3. Case Study 2: Off -Balance Sheet Leverage from Operating Leases 972

3.1. Phase 1: Define a Purpose for the Analysis 973

3.2. Phase 2: Collect Input Data 973

3.3. Phase 3: Process Data/Phase 4: Analyze/Interpret the Processed Data 973

3.4. Phase 5: Develop and Communicate Conclusions and Recommendations (e.g., with an Analysis Report) 975

3.5. Phase 6: Follow-up 976

4. Case Study 3: Anticipating Eff ects of Changes in Accounting Standards 976

4.1. Phase 1: Define a Purpose for the Analysis 977

4.2. Phase 2: Collect Input Data 977

4.3. Phase 3: Process Data/Phase 4: Analyze/Interpret the Processed Data 977

4.4. Phase 5: Develop and Communicate Conclusions and Recommendations (e.g., with an Analysis Report) 980

4.5. Phase 6: Follow-up 980

5. Summary 980

Problems 981

Glossary 987

About the Authors 999

About the CFA Program 1003

Index 1005

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