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Academy of Professional Finance

CFA Level I
Financial Reporting and Analysis
(FRA)
CFA Lecturer: Juyun Lu

Contents

Brief introduction of FRA part in CFA exam

Reading 22. FRA: An Introduction (LOS a. & b)

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Brief introduction of FRA part in CFA exam

FRA is 20% of Level I


36/180 each session
4 sessions/14 readings/109 LOSs
Study Session 7: An Introduction
Study Session 8: Income Statements, Balance Sheets, and
Cash Flow Statements
Study Session 9: Inventories, Long-lived Assets, Income Taxes,
and Non-current Liabilities
Study Session 10: Evaluating Financial Reporting Quality and
Other Applications

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Reading 22. FRA: An Introduction

LOS 22 .a: describe the roles of financial


reporting and financial statement analysis .

Financial Reporting - to provide a variety of users with


useful information about a company's performance and
financial position.
Financial Statement Analysis - to use the data from
financial statements to support economic decisions.

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Learning Outcome Statement 1

LOS 22 .a: describe the roles of financial


reporting and financial statement analysis .
Providing information about the performance of a company, its financial
position, and changes in financial position that is useful to a wide range
of users is most accurately described as the role of:
A. financial reporting.
B. the auditors report.
C. financial statement analysis.
A is correct. The role of financial reporting is to provide information about the performance of a company, its
financial position, and changes in financial position that is useful to a wide range of users in making economic
decisions.
B is incorrect. The role of the auditors report is to provide reasonable assurance that the financial statements
are free of material mistakes.
C is incorrect. The role of financial statement analysis is to help analysts or investors to make a wide array of
economic decisions, including evaluating potential equity or venture capital investments, evaluating corporate
division or subsidiaries and forecasting future financial performance.

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Learning Outcome Statement 1

LOS 22 .a: describe the roles of financial


reporting and financial statement analysis .
Which of the following statements least accurately describes a role of
financial statement analysis?
A. Use the information in financial statements to make economic
decisions.
B . Provide reasonable assurance that the financial statements are free
o f material errors.
C. Evaluate an entity's financial position and past performance to form
opinions about its future ability to earn profits and generate cash flow.
B is correct. This statement describes the role of an auditor, rather than the role of an analyst. The
other responses describe the role of financial statement analysis.

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Reading 22. FRA: An Introduction

LOS 22 .b: describe the roles of the key financial statements (statement of
financial position, statement of comprehensive income, statement of
changes in equity, and statement of cash flows) in evaluating a companys
performance and financial position .

Balance sheet/statement of financial position/ statement of


financial condition reports the firm's financial position at a
point in time.
The balance sheet consists of three elements:
1. Assets are the resources controlled by the firm.
2. Liabilities are amounts owed to lenders and other creditors.
3. Owners' equity is the residual interest in the net assets of an entity
that remains after deducting its liabilities.
assets = liabilities + owners' equity
(A = L + E)
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Reading 22. FRA: An Introduction

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Reading 22. FRA: An Introduction

LOS 22 .b: describe the roles of the key financial statements (statement of
financial position, statement of comprehensive income, statement of
changes in equity, and statement of cash flows) in evaluating a companys
performance and financial position .

Income statement/ statement of operations/profit and loss


statement reports on the financial performance of the firm
over a period of time.
The income statement consists of:
1.
2.
3.

Revenues are inflows from delivering or producing goods, rendering services


that constitute the entity's ongoing major or central operations.
Expenses are outflows from delivering or producing goods or services that
constitute the entity's ongoing major or central operations.
Other income includes gains that may or may not arise in the ordinary course
of business.

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Reading 22. FRA: An Introduction

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Reading 22. FRA: An Introduction

LOS 22 .b: describe the roles of the key financial statements (statement of
financial position, statement of comprehensive income, statement of
changes in equity, and statement of cash flows) in evaluating a companys
performance and financial position .

Statement of cash flow reports on the company's cash


receipts and payments.
These cash flows are classified as:
1.
2.

3.

Operating CF include the cash effects of transactions that involve the normal
business of the firm.
Investing CF are those resulting from the acquisition or sale of property, plant,
and equipment; of a subsidiary or segment; of securities; and of investments
in other firms.
Financing CF are those resulting from issuance or retirement of the firm's
debt and equity securities and include dividends paid to stockholders.

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Reading 22. FRA: An Introduction

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Reading 22. FRA: An Introduction

LOS 22 .b: describe the roles of the key financial statements (statement of
financial position, statement of comprehensive income, statement of
changes in equity, and statement of cash flows) in evaluating a companys
performance and financial position .

Statement of comprehensive income reports all changes in


equity expect for shareholder transactions (e.g., issuing
stock, repurchasing stock, and paying dividends).
Statement of changes in equity reports the amounts and
sources of changes in equity investors' investment in the firm
over a period of time.

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Reading 22. FRA: An Introduction

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Reading 22. FRA: An Introduction

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Reading 22. FRA: An Introduction

LOS 22 .b: describe the roles of the key financial statements (statement of
financial position, statement of comprehensive income, statement of
changes in equity, and statement of cash flows) in evaluating a companys
performance and financial position .

Information about a companys financial position at a point in


time is most likely found in the:
A. balance sheet.
B. income statement.
C. cash flow statement.
A is correct. The balance sheet reports the companys financial position at a point in time.
The income statement reports on financial performance over a period of time.
The cash flow statement reports a companys cash receipts and payments over a period of time.

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Reading 22. FRA: An Introduction

LOS 22 .b: describe the roles of the key financial statements (statement of
financial position, statement of comprehensive income, statement of
changes in equity, and statement of cash flows) in evaluating a companys
performance and financial position .

The financial statement that would be most helpful to an


analyst in understanding the changes that have occurred in a
companys retained earnings over a year is the statement of:
A. changes in equity.
B. financial position.
C. comprehensive income.
A is correct. The statement of changes in equity reports the changes in the components of
shareholders equity over the year, which would include the retained earnings account.
B is incorrect. The statement of financial position (Balance Sheet) reports a companys financial
position at a specific time.
C is incorrect. The statement of comprehensive income illustrates the financial performance and
results of operations of a particular company or entity for a period of time.
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Reading 22. FRA: An Introduction

LOS 22 .c: Describe the importance of financial statement notes and


supplementary information-including disclosures of accounting policies,
methods, and estimates-and management's commentary.

Financial statement notes/footnotes - detail


accounting methods, assumptions, and estimates used by
management
business acquisitions or disposals, legal actions, employee
benefit plans, contingencies and commitments, significant
customers, sales to related parties, and segments of the firm
Audited

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Reading 22. FRA: An Introduction

LOS 22 .c: Describe the importance of financial statement notes and


supplementary information-including disclosures of accounting policies,
methods, and estimates-and management's commentary.

Supplementary schedules
operating income or sales by region or business segments
reserves for an oil and gas company
info about hedging activities and financial instruments
not audited

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Reading 22. FRA: An Introduction

LOS 22 .c: Describe the importance of financial statement notes and


supplementary information-including disclosures of accounting policies,
methods, and estimates-and management's commentary.

Management's commentary/ management's report, operating


and financial review/management's discussion and analysis
(MD&A) - management
nature of the business, past performance, and future outlook
publicly held firms in the US - discuss trends and identify
significant events and uncertainties that affect the firm's liquidity,
capital resources, and results of operations
effects of inflation, impact of off-balance-sheet obligations,
accounting policies that require significant judgment, forwardlooking expenditures
not audited
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Reading 22. FRA: An Introduction

LOS 22 .c: Describe the importance of financial statement notes and


supplementary information-including disclosures of accounting policies,
methods, and estimates-and management's commentary.

Information about accounting estimates, assumptions, and


methods chosen for reporting is most likely found in:
A. the auditor's opinion.
B. financial statement notes.
C. Management's Discussion and Analysis
B is correct. Information about accounting methods and estimates is contained in the footnotes to the
financial statements.

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Reading 22. FRA: An Introduction

LOS 22 .c: Describe the importance of financial statement notes and


supplementary information-including disclosures of accounting policies,
methods, and estimates-and management's commentary.

Information regarding which of the following items is usually


included in the footnotes to financial statements?
A. A five-year summary of the companys financial
performance.
B. A summary of significant accounting policies.
C. A review of the companys operating performance and
financial condition.
B is correct. The summary of significant accounting policies is generally the first of the footnotes
presented with audited financial statements prepared in conformity with generally accepted accounting
principles. The footnotes are an integral part of statements.
A is incorrect. A five-year summary of financial performance is generally included with the (unaudited)
supplementary schedules, which are not part of the footnotes.
C is incorrect. A review of the companys operating performance and financial condition is included as
part of the management discussion and analysis (MD&A) section, which is not part of the footnotes.
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Reading 22. FRA: An Introduction

LOS 22 .c: Describe the importance of financial statement notes and


supplementary information-including disclosures of accounting policies,
methods, and estimates-and management's commentary.
An analyst finds information about significant uncertainties affecting
a companys liquidity, capital resources and results of operations in
the:
A. notes to the financial statements.
B. balance sheet and income statement.
C. management discussion and analysis.
C is correct. Management discussion and analysis includes topics: a review of the companys
consolidated operating performance and its financial condition, an assessment of the significant
effects of known treads, the capital resources available to the firm and its liquidity, extraordinary or
unusual events, and a review of the performance of operating segments.
Management must highlight any favorable and unfavorable trends and identify significant events and
uncertainties that affect the companys liquidity, capital resources and results of operations in the
management discussion and analysis (MD&A).
A is incorrect. Notes to the financial statement provide detailed disclosures. For example, a summary
of the significant accounting policies, disclosures for most asset categories and income taxes.
B is incorrect. Balance sheet reports major classes and amounts of assets, liabilities, and equity
capital at a specific point in time. The income statement reports on the performance of the firm for a
specific period of time.
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Reading 22. FRA: An Introduction

LOS 22 .d: Describe the objective of audits of financial statements, the


types of audit reports, and the importance of effective internal controls.

Objective - to provide an opinion on the statements' fairness


and reliability.
Standard auditor report:
Independent review though FS prepared by mgmt and are its responsibility
Reasonable assurance of no material errors
FS prepared in accordance with accepted accounting principles,
reasonable accounting principles and estimates, consistency
Explanatory paragraph: when a material loss is probable but amount cannot
be reasonably estimated. Uncertainties may relate to the going concern
assumption

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Reading 22. FRA: An Introduction

LOS 22 .d: Describe the objective of audits of financial statements, the


types of audit reports, and the importance of effective internal controls.

Types of audit report


unqualified (clean) opinion - the statements are free from material
omissions and errors
qualified opinion - notes any exceptions to accounting principle
adverse opinion - the statements are not presented fairly

disclaimer of opinion - the auditor is unable to express an opinion

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Reading 22. FRA: An Introduction

LOS 22 .d: Describe the objective of audits of financial statements, the


types of audit reports, and the importance of effective internal controls.

The importance of effective internal controls


Internal control - the processes by which the company
ensures that it presents accurate financial statements
(under US GAAP): Opinion on internal controls

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Reading 22. FRA: An Introduction

LOS 22 .d: Describe the objective of audits of financial statements, the


types of audit reports, and the importance of effective internal controls.
Which of the following statements is most accurate about the
responsibilities of an auditor for a publicly traded firm in the United
States? The auditor:
A. Assures the reader that the financial statements are free from
error, fraud, or illegal acts.
B. Must express an opinion about the effectiveness of the
companys internal control systems.
C. Must state that he prepared the financial statements according to
generally accepted accounting principles.
B is correct. For a publicly traded firm in the United States, the auditor must express an opinion as to
whether the companys internal control system is in accordance with the Public Company Accounting
Oversight Board, under the SarbanesOxley Act. This is done either as a final paragraph in the
auditors report or as a separate opinion.
A is incorrect. An auditor can only provide reasonable assurance that the financial statements are free
from error, fraud, or illegal acts.
C is incorrect. Auditors responsibility is to express an opinion that the financial statements are free
from error, fraud, or illegal acts. Preparing the financial statement is not the responsibility.
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Reading 22. FRA: An Introduction

LOS 22 .d: Describe the objective of audits of financial statements, the


types of audit reports, and the importance of effective internal controls.
Which of the following statements best describes the level of
accuracy provided by a standard audit report with respect to errors?
The audited financial statements are:
A. fully assured to be free of material errors.
B. reasonable assured to be free of all errors.
C. reasonable assured to be free of material errors.
C is correct. Audits provide reasonable assurance that the financial statements are fairly presented,
meaning that there is a high degree of probability that they are free of material error, fraud or illegal
acts.

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Reading 22. FRA: An Introduction

LOS 22 .d: Describe the objective of audits of financial statements, the


types of audit reports, and the importance of effective internal controls.
If an auditor finds that a company's financial statements have made
a specific exception to applicable accounting principles, she is most
likely to issue a:
A. dissenting opinion.
B. cautionary note.
C. qualified opinion.
C is correct. Audits provide reasonable assurance that the financial statements are fairly presented,
meaning that there is a high degree of probability that they are free of material error, fraud or illegal
acts.

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Reading 22. FRA: An Introduction

LOS 22 .d: Describe the objective of audits of financial statements, the


types of audit reports, and the importance of effective internal controls.
When the financial statements materially depart from accounting
standards and are not fairly presented, the audit opinion would be
a(n):
A. adverse opinion.
B. qualified opinion.
C. disclaimer of opinion.
A is correct. An adverse opinion occurs when the financial statements materially depart from
accounting standards and are not fairly presented. A qualified opinion is one in which there is some
limitation or exception to accounting standards.
B is incorrect. A qualified opinion is issued when there is a material instance of noncompliance with
applicable accounting standards or there is a limitation on the auditors ability to complete the audit as
required by auditing standards. A qualified opinion will include an explanatory paragraph describing the
problem that prevents the auditors from issuing an unqualified opinion.
C is incorrect. A disclaimer of opinion s issued when the auditor doer not have the ability to issue an
opinion for some reason.

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Reading 22. FRA: An Introduction

LOS 22 .e: Identify and explain information sources that analysts use
in financial statement analysis besides annual financial statements and
supplementary information.

Interim reports - Quarterly or Semiannual reports


SEC filings 8K,10K,10Q
Proxy statements - to shareholders when there are matters that
require a shareholder vote. About election of board members,
compensation, management and qualifications and issuance of
stock options
Corporate reports and press releases

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Reading 22. FRA: An Introduction

LOS 22 .e: Identify and explain information sources that analysts use
in financial statement analysis besides annual financial statements and
supplementary information.

Information about management compensation and any


potential conflicts of interest that may exist between
management and shareholders is most likely found in the:
A. Proxy statement.
B. Notes to the financial statements.
C. Management discussion and analysis
A is correct. Information about management compensation and any potential conflicts of interest that
may exist between management and shareholders is typically provided in the proxy statement.
B is incorrect. Notes to the financial statement provide detailed disclosures. For example, a summary
of the significant accounting policies, disclosures for most asset categories and income taxes.
C is incorrect. Management discussion and analysis includes topics: a review of the companys
consolidated operating performance and its financial condition, an assessment of the significant
effects of known treads, the capital resources available to the firm and its liquidity, extraordinary or
unusual events, and a review of the performance of operating segments.
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Reading 22. FRA: An Introduction

LOS 22 .e: Identify and explain information sources that analysts use
in financial statement analysis besides annual financial statements and
supplementary information.

Which of the following is least likely to appear in a companys


proxy statement?
A. Compensation arrangements for management and
directors
B. Significant event and contingencies that may affect future
operations
C. Potential conflicts of interest between management,
directors, and shareholders.
B is correct. Proxy statements are issued by publicly held companies in connection with shareholder
meetings and contain useful information about board members and management, executive
compensation, stock options and major shareholders.
Significant events, conditions, trends, and contingencies that may affect future operations are
contained in Managements Discussion and Analysis. Compensation agreements for directors and
management and their potential conflicts of interest are required in the proxy statement.
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Reading 22. FRA: An Introduction

LOS 22 .e: Identify and explain information sources that analysts use
in financial statement analysis besides annual financial statements and
supplementary information.

Which of the following sources of information should an


analyst consider the least reliable?
A. Form 10-Q.
B. Proxy statement.
C. Corporate press release.
C is correct. Corporate press releases are written by management and are often view as public
relations or sales materials because of the great possibility of inherent management bias in such
documents. Often, little or none of the material is independently reviewed by outside auditors. Such
documents are not mandated by the securities regulators.
A and B are incorrect. Form 10-Q (quarterly financial statements) and Proxy statement are mandatory
SEC filings in the U.S., which inherently increases their reliability given the penalties that can be
imposed by the SEC if any serious irregularities are subsequently found.

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Reading 22. FRA: An Introduction

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


framework.

Step 1: State the objective and context.


Step 2: Gather data.
Step 3: Process the data.
Step 4: Analyze and interpret the data.
Step 5: Report the conclusions or recommendations.
Step 6: Update the analysis.

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Reading 22. FRA: An Introduction

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


framework.

Common-size financial statements are most likely an output of


which step in the financial analysis framework?
A. Collect data
B. Process data
C. Analyze/interpret data
B is correct. Process the data. Make any appropriate adjustments to the financial statements.
Calculate ratios. Prepare exhibits such as graphs and common-size balance sheets.

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Reading 22. FRA: An Introduction

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


framework.

Common-size financial statements are most likely an output of


which step in the financial analysis framework?
A. Collect data
B. Process data
C. Analyze/interpret data
B is correct. Process the data. Make any appropriate adjustments to the financial statements.
Calculate ratios. Prepare exhibits such as graphs and common-size balance sheets.

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Reading 22. FRA: An Introduction

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


framework.

Which of these steps is least likely to be a part of the financial


statement analysis framework?
A. State the purpose and context of the analysis.
B. Determine whether the company's securities are suitable for the
client.
C. Adjust the financial statement data and compare the company to
its industry peers.
B is correct. Determining the suitability of an investment for a client is not one of the six steps in the
financial statement analysis framework. The analyst would only perform this function if he also had an
advisory relationship with the client. Stating the objective and processing the data are two of the six
steps in the framework. The others are gathering the data, analyzing the data, updating the analysis,
and reporting the conclusions.

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