Monday, November 7, 2011

Financial Reporting Analysis: Accounting for CFA like Exams

How to deal with this subject for those who have no background in Finance.
By: Shivgan Joshi

FSA is a very interesting area for the CFA exams.

Introduction: In this article I am going to talk about some very interesting and practical things about FSA that is important to understand prices of share in the stock market. Also I will talk about this subject with respect to those who are reading it first time and also for those who plan to give CFA or work as financial analyst.

Now, the major areas that you should read in FSA and the one which I feel very interesting are:
  1. Common size analysis (interesting)
  2. Tricky assets and liabilities on Balance Sheet & contra entry
  3. Cash flow statement, esp CF to Equity as it is used in valuation
  4. Financial ratios esp Dupont (it is be taken 100+thing, and its simplest form is to calculate ROE with 3 parameters, be careful to calculate Assets/Equity)
  5. Inventory Valuation (lower of cost or net realizable values), FIFO LIFO Conversion
  6. Income Tax with variable rates, creation as assets and liabilities
  7. Bonds, lease and their placement and treatments
  8. Reserve FIFI LIFO, there are questions where reserves are given and impact of tax are given
  9. Comprehensive income, which has things like pension expense, things and items on sale and their losses. Also CI is something which has its impact on Equity
  10. Conversion from indirect to direct, like in direct we ignore change in inventories. And in indirect we have to be careful in selections. What to do about inventories in general cases
  11. Tax rate change and how liability and assets change
  12. Bond how do we report in Operating CF, income statement and BS.
  13. Operating vs Financial lease and words proble, capital lease is taken with assets and liabilities on the balance sheet and includes payment for interest and Principal payment.
  14. Available for sales in USGAP vs IFRS 
  15. LIFO FIFO reserves etc are there in the last few chapters


I believe, these are areas which have considerable depth and hence need to be relooked into.

Interesting conclusions from doing the 400 questions on FRA:
Some new words being used in inventory valuation, NRV: SP - completion cost - disposal cost.
The dilution questions were a majority but they were easy.
CFO using direct method is another interesting area when we have a lot of data.

  1. The depreciation, and change in inventory are not taken in the direct way of calculation of Cash flow. There were questions in which many data was given for CFO calcuations and some of them were used after getting NI like interest and tax etc . Also NI includes sales of equipment.
  2. I will try to make a video of tax questions to talk more on them.
  3. Tax mixed with retirement is more to do in Level 2.
  4. Terms like Tax base and carrying value where: TB - CV = deductible temp difference
  5. Direct method and use of Inventory in calculation.
Learning  and logic developed from Mock test:
  • Reason for asset turnover on sales is that NI is non-reliable factors but sales is the real thing.
  • Everything depends on ratio on sales as that is reliable parameter 


Good Questions of Scz talked about these things:

                               Interesting things I came to know about Dilutions; that you have to be careful when we have stock dividends in form of bonus stocks for common stock and when we have preferred shares with fixed returns. We cannot dilute and reduce the PF money and also take the dilution due to conversion of PF into common stock. I did a questions on this which I will try to add here.
                               In lease we have initial liability and assets equal, which then during the remaning time is matched in BS by cash, liability to pay the installment and depreciation. This was a tricky thing, and that intrest goes in CFO, and principal goes into CFF. This is one area where many concepts are required.

Accounting Sandal of the Enron is taken as case study in the official curriculum which is explored in great details. After that Sunbeam scandal is discussed. In both of these cases, it is about the Cash flow, sales and other parameter is tampered to fit the requirements. Interesting to note is that the other Tax and Audit agencies were also not able to understand these kind of things, or they too were included which I do not know about. I would say that rating and tax advisory services should be a good area to search.
Sunbeam: early recognition of sales and use of bill and hold transitions, +ive cash flow in-spite of loss
Enron: Sales to SPE


Another area is Stock Option and Secularization, both of which are played around. These areas are not talked about in details but they give you an idea of how companies might play with these modern financial engineering tools[5].


Some important aspects of Dupont analysis:
This analysis is used to calculated return on Equity which is the most important parameter for Equity analysis. Return on Equity = NI/Equity
Two ways to present this same form is=
(NI/sales)(sales/assets)(assets/equity)
Net profit margin which is NI/sales, Asset turnover which is sales/assets, leverage ratio which is Assets/Eq


Now coming to a detailed version of the same analysis
ROE= Tax Burden * Interest Burden * EBIT Margin * Asset turnover * Financial Leverage
It is quite obvious to show that, where we see this word burden it means we are liable and the more burden means more liable or worried or put in burden hence it is: NI/EBT the more the ratio this becomes the more burdened we become and the same logic for EBT/EBIT for interest burden. You should not go for pure raw memorization for these formula rather understand the meaning.
Also margin means that what over we are getting from the hard cash  or the sales we did, you might see during bargain that people say that I am not getting any good margin to sell you this thing at this cost. turnover is how well we can turn one thing around, how well we can turn assets around to generate revenue, and leveraged we are.

Other interesting thing is to learn and understand where and how these operating performance ratio analysis came from:
Turnover in itself means how well can you turn something into something larger, or how well you can turn around you resources into money. Therefore expanding on the same idea, suppose you have inventory and you want to know how well you can turn it around into sales is being measured by receivable turnover.
But, the other part which is even more interesting is how many days are there when things are out of your hand or days you get in the business to play on delays. These ratios are one of the most interesting ratio in the entire FRA.
Let us look at one of them days of sales outstanding = 365/ receivable turnover or 365*avg rev/sales. Now observe these 2 formulas very carefully, lets take an example, suppose your avg rec = 10 and your sales for the year is 100 then you convert like 10 receivable into 100 sales,  the more receivable you have the more time you require to convert them into sales, hence we have the ratio 10/100*365 as the number of days for sales outstanding. If someone came to you and asked how good are you in turning around your rec. then you will use the turnover, and if someone asks you the days then you will use the Days of sales outstanding. Also see that out of 100, 10 are always receivable so for each sales you have .1 receivable in a year, and the when you convert it into days you will multiply it into 565.

FCFF: NI + non cash charges + interest(1-t) - net capital investment - working capital investment


Impairment computation: There are some terms which you need to know like 1) Carrying value 2) Present value of expected future cash flows  3) Fair Value 4) Value in us. After this there are some algorithms to compute the impairment you need to do.
Step 1: Under IFRS, an asset is considered to be impaired when its carrying amount exceeds its recoverable amount
Step 2: Recoverable amount (higher value of PVCF vs Fair value less costs to sell)

Loss on redemption of bonds at different prices.You need to understand the meaning of unamortized discount.

Income tab payable is the Cheque we write to Govt, income tax expense is which we show in IS.

Current Portion Of Long-Term Debt (CPLTD) is recorded when we want to pay them within one year, so when you are calculating total debt then add this component to long term and short term borrowing

What can company amortize and what it will not. 

One of the difference that seems to be an important one in US GAP vs IFRS:
  • In IFRS non current assets should be placed before current assets
  • Minority interest should be shown as Equity under IFRS
  • In US minority interest can be shown in liability

Lately I found this interesting:
Prepaid in an asset, how to use it in CA? How to use it for tax?
Contra assets used in ratios
5 Point Dupoint analysis
contra assets in numerator
Salvage values in double declining used or not used?
WC=ca-cl
Ca= expand, how to move these things IS?
payable used with bad debts or not expected to use? how to mark these things in NI?
How to mark if we think inventory is becoming obsolete but not becoming
Pension account in details, and Comprehensive income in details again for L2
Merger acquisition accounting  and multi national operations L2
Sundry?
What happens if tax rate change to tax assets ?
Tax for Held for trade and on the 3 accounts?



Conclusion
I did talk about some of the areas that you should now, and try to develop some motivation of how and why these things are very important and very interesting as well.
But the bottom line still remains that you cannot remember many small things and ideas just by logic and common sense, you have to do the questions.

References:
[1]CFA Readings
[2]Important Links like wikipedia
[3]Scz
[4]Investopedia

[5]http://en.wikipedia.org/wiki/Securitization
[6] http://www.freegregmatclass.com/videos_cfa_free.html
Other Misc sources

Disclaimer: There are chances of errors due to mechanical typing or mis-reporting. I do not take any responsibility of the accuracy of this information. They represent only views.

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