INTERNATIONAL FINANCIAL STATEMENT ANALYSIS CFA Institute is the premier association for investment professionals around the world, with over 124,000 members in 145 countries Since 1963 the organization has developed and administered the renowned Chartered Financial Analyst® Program With a rich history of leading the investment profession, CFA Institute has set the highest standards in ethics, education, and professional excellence within the global investment community and is the foremost authority on investment profession conduct and practice Each book in the CFA Institute Investment Series is geared toward industry practitioners along with graduate-level finance students and covers the most important topics in the industry The authors of these cutting-edge books are themselves industry professionals and academics and bring their wealth of knowledge and expertise to this series INTERNATIONAL FINANCIAL STATEMENT ANALYSIS Third Edition Thomas R Robinson, CFA Elaine Henry, CFA Wendy L Pirie, CFA Michael A Broihahn, CFA Cover image: © iStock.com / BreatheFitness Cover design: Wiley Copyright © 2015 by CFA Institute All rights reserved Published by John Wiley & Sons, Inc., Hoboken, New Jersey The First and Second Editions of this book were published by Wiley in 20XX and 20XX respectively Published simultaneously in Canada No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the Web at www copyright.com Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at www.wiley.com/go/permissions Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose No warranty may be created or extended by sales representatives or written sales materials The advice and strategies contained herein may not be suitable for your situation You should consult with a professional where appropriate Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762-2974, outside the United States at (317) 572-3993, or fax (317) 572-4002 Wiley publishes in a variety of print and electronic formats and by print-on-demand Some material included with standard print versions of this book may not be included in e-books or in print-on-demand If this book refers to media such as a CD or DVD that is not included in the version you purchased, you may download this material at http://booksupport.wiley.com For more information about Wiley products, visit www.wiley.com ISBN 9781118999479 (Hardcover) ISBN 9781119029748 (ePDF) ISBN 9781119029755 (ePub) Printed in the United States of America 10 CONTENTS Foreword xvii Preface xix Acknowledgments xxi About the CFA Investment Series CHAPTER Financial Statement Analysis: An Introduction Learning Outcomes Introduction Scope of Financial Statement Analysis Major Financial Statements and Other Information Sources 3.1 Financial Statements and Supplementary Information 3.2 Other Sources of Information Financial Statement Analysis Framework 4.1 Articulate the Purpose and Context of Analysis 4.2 Collect Data 4.3 Process Data 4.4 Analyze/Interpret the Processed Data 4.5 Develop and Communicate Conclusions/Recommendations 4.6 Follow-Up Summary References Problems xxiii 1 27 28 30 30 31 31 32 32 32 34 34 CHAPTER Financial Reporting Mechanics Learning Outcomes Introduction The Classification of Business Activities Accounts and Financial Statements 37 37 38 38 39 v vi Contents 3.1 Financial Statement Elements and Accounts 3.2 Accounting Equations The Accounting Process 4.1 An Illustration 4.2 The Accounting Records 4.3 Financial Statements Accruals and Valuation Adjustments 5.1 Accruals 5.2 Valuation Adjustments Accounting Systems 6.1 Flow of Information in an Accounting System 6.2 Debits and Credits Using Financial Statements in Security Analysis 7.1 The Use of Judgment in Accounts and Entries 7.2 Misrepresentations Summary Appendix: A Debit/Credit Accounting System Problems 40 42 47 47 49 62 65 65 67 67 68 69 69 69 70 71 71 87 CHAPTER Financial Reporting Standards Learning Outcomes Introduction The Objective of Financial Reporting Standard-Setting Bodies and Regulatory Authorities 3.1 Accounting Standards Boards 3.2 Regulatory Authorities Convergence of Global Financial Reporting Standards The International Financial Reporting Standards Framework 5.1 Objective of Financial Reports 5.2 Qualitative Characteristics of Financial Reports 5.3 Constraints on Financial Reports 5.4 The Elements of Financial Statements 5.5 General Requirements for Financial Statements 5.6 Convergence of Conceptual Framework Effective Financial Reporting 6.1 Characteristics of an Effective Financial Reporting Framework 6.2 Barriers to a Single Coherent Framework Comparison of IFRS with Alternative Reporting Systems Monitoring Developments in Financial Reporting Standards 8.1 New Products or Types of Transactions 8.2 Evolving Standards and the Role of CFA Institute 8.3 Company Disclosures Summary Problems 91 91 92 92 95 96 99 104 107 109 109 110 112 114 118 119 119 120 121 123 123 124 125 128 130 Contents vii CHAPTER Understanding Income Statements Learning Outcomes Introduction Components and Format of the Income Statement Revenue Recognition 3.1 General Principles 3.2 Revenue Recognition in Special Cases 3.3 Implications for Financial Analysis Expense Recognition 4.1 General Principles 4.2 Issues in Expense Recognition 4.3 Implications for Financial Analysis Non-Recurring Items and Non-Operating Items 5.1 Discontinued Operations 5.2 Extraordinary Items 5.3 Unusual or Infrequent Items 5.4 Changes in Accounting Policies 5.5 Non-Operating Items Earnings per Share 6.1 Simple versus Complex Capital Structure 6.2 Basic EPS 6.3 Diluted EPS 6.4 Changes in EPS Analysis of the Income Statement 7.1 Common-Size Analysis of the Income Statement 7.2 Income Statement Ratios Comprehensive Income Summary Problems 133 133 134 135 139 140 143 150 152 152 156 161 162 163 163 164 165 168 169 169 170 171 178 178 178 181 183 186 188 CHAPTER Understanding Balance Sheets Learning Outcomes Introduction Components and Format of the Balance Sheet 2.1 Balance Sheet Components 2.2 Current and Non-Current Classification 2.3 Liquidity-Based Presentation Current Assets and Current Liabilities 3.1 Current Assets 3.2 Current Liabilities Non-Current Assets 4.1 Property, Plant, and Equipment 4.2 Investment Property 4.3 Intangible Assets 193 193 193 194 195 197 198 199 199 206 209 211 212 212 viii Contents 4.4 Goodwill 4.5 Financial Assets Non-Current Liabilities 5.1 Long-term Financial Liabilities 5.2 Deferred Tax Liabilities Equity 6.1 Components of Equity 6.2 Statement of Changes in Equity Analysis of the Balance Sheet 7.1 Common-Size Analysis of the Balance Sheet 7.2 Balance Sheet Ratios Summary Problems 215 217 220 222 222 223 223 225 227 227 235 237 239 CHAPTER Understanding Cash Flow Statements Learning Outcomes Introduction Components and Format of the Cash Flow Statement 2.1 Classification of Cash Flows and Non-Cash Activities 2.2 A Summary of Differences between IFRS and US GAAP 2.3 Direct and Indirect Methods for Reporting Cash Flow from Operating Activities The Cash Flow Statement: Linkages and Preparation 3.1 Linkages of the Cash Flow Statement with the Income Statement and Balance Sheet 3.2 Steps in Preparing the Cash Flow Statement 3.3 Conversion of Cash Flows from the Indirect to the Direct Method Cash Flow Statement Analysis 4.1 Evaluation of the Sources and Uses of Cash 4.2 Common-Size Analysis of the Statement of Cash Flows 4.3 Free Cash Flow to the Firm and Free Cash Flow to Equity 4.4 Cash Flow Ratios Summary Reference Problems 243 243 243 244 245 247 248 258 258 260 272 273 274 277 282 283 285 286 286 CHAPTER Financial Analysis Techniques Learning Outcomes Introduction The Financial Analysis Process 2.1 The Objectives of the Financial Analysis Process 2.2 Distinguishing between Computations and Analysis Analytical Tools and Techniques 291 291 291 292 293 294 296 1022 Lease payments, 328n.9 Lenovo Group, 297–299, 298e, 316–318, 318e Lessee, 471, 525 accounting and reporting by, 475–486, 527–538 effects of leases for, 543e–544e and off-balance-sheet financing, 649 Lessor, 471, 525 accounting and reporting by, 486–493, 538–544 effects of leases for, 543e–544e Lev, B., 346 Leverage: financial, 326, 978, 979e, 980 and fixed costs, 325 operating, 326 Leveraged leases, 539n.13 Leverage ratios, 547–548 Levitt, Arthur, 573 Lewis, Craig M., 573–574 Liabilities: on balance sheets, contingent, see Contingent liabilities current, see Current liabilities determining tax base of, 669–671 excess purchase price allocated to, 761 financial, 771 and financial position, in financial position, 194 as financial statement elements, 39, 112 long-term, 220, 222, 506 monetary, 815–817, 823 net pension, 545, 721 non-current, see Non-current liabilities non-monetary, 815–816 reported at fair value, 515–517 unbiased measurement of, 922 LIFO conformity rule, 375 LIFO layer liquidation, 156e LIFO liquidations, 382–385, 385e LIFO (last-in, first-out) method: converting to FIFO, 376–382, 377e–378e, 641–645, 642e FIFO vs., 373–375 and financial reporting quality, 605 historical exchange rate for, 822 of inventory costing, 155–156 of inventory valuation, 366–370, 375–385, 377e–378e, 385e and inventory write-downs, 388 LIFO reserve, 375–382 Lin, Stephen, 622n.3 Index Lindsay, Don, 6e Line costs, 597, 907 Line graphs, 311, 312e Liquidity: of Apple, 618 and balance sheets, 196, 227 and cash flow, Liquidity presentation, 198, 198e Liquidity ratios, 313e as balance sheet ratios, 235 evaluation of, 323–324 in financial analysis, 320–325, 322e, 324e Litigation losses, 572 LM Ericsson Telephone Company, 549–550 Loans: as financial assets, 745 tax base for, 670, 671 temporary differences due to, 676 Loan loss reserves, 602e Local currency, 801 Long-lived assets, 421–495 accounting choices and estimate affecting, 602e amortization methods for, 449–450 capitalization of interest costs of, 434–437, 435e, 436e capitalization of internal development costs of, 437–440, 437e capitalizing vs expensing costs of, 429–434, 431e depreciation methods for, 441–449 derecognition of, 456–457, 457e–458e and expense recognition, 157 impairment of, 453–456 intangible assets acquisition, 426–429, 429e investment property as, 469–471, 470e leasing as, 471–493, 484e, 485e presentation and disclosures for, 458–469, 460e–462e, 467e property, plant, and equipment acquisition, 423–426 revaluation model for, 450–453, 453e Long-term assets, 422 See also Long-lived assets Long-term contracts, 144–147 Long-term debt, 268 Long-term investment, 945–972 Long-term liabilities, 220, 222, 506 See also Non-current liabilities Look-ahead bias, 639 L’Oreal, 968–970, 968e–971e Loss(es): contingent, 929n.23 defined, Index and expenses, 152 as financial statement element, 39n.1 reported, for long-term contracts, 144 on sales of long-lived assets, 456–457 from secondary activities, 140 Loss events, 747, 748 Lotte Group, 619e M McAfee, 801 McLeod Russel India Ltd., 619e McVay, Sarah E., 892n.12 Madoff, Bernie, 928–929 Managed basis information, 977, 978 Management commentary, 23–24, 577 See also Management discussion and analysis Management Commentary (IFRS), 933 Management discussion and analysis (MD&A): in analysis of Discover Financial Services, 977 debt extinguishment in, 518 disclosures in, 812 and financial reporting quality, 933–934, 934e–936e in financial statement analysis, 23–24 foreign currency disclosures in, 856 and inventories, 396, 399–400 of Volkswagen Group, 126e Margin: gross, 138, 606–607 gross profit, see Gross profit margin net profit, see Net profit margin operating, 606–607 operating profit, see Operating profit margin pretax, 182 pretax profit, 330–331 profit, 181 Margin stability, 634 Marketable securities, 201 Market-based valuation, 614, 624–629 Market interest rates, 507, 515 Market-oriented investors, 638 Market regulatory authorities, 575–577 Market value, 203, 387 Market value to book value (MV/BV), 647–649 Mark to market, 218 Mason, Andrew, 583 Matching principle, 153–154, 157 Materiality: of analyst adjustments, 640–641 of foreign currency transaction gains/losses, 813 of information, 109–110, 116, 558–559 MD&A, see Management discussion and analysis 1023 Mean reversion in earnings, 897–898 Measurement: conflicts between approaches to, 120–121 of financial statement elements, 113–114 of income taxes, 678–681 Merck & Co., 876–877, 877e Mergers, 768e Mergers and acquisitions, 879–881 Mexican GAAP, 621 Micron Technology, 682, 682e–685e, 686 Microsoft, 437, 437e MicroStrategy, Inc., 903–905, 904e–905e Middle East, 106e–107e Minority interests See also Non-controlling interests in business combinations, 775–779 and consolidated net income, 14 as equity, 224 on income statements, 137 Misreporting: concealing with acquisitions, 880 tools to assess likelihood of, 886–889 Misrepresentations, in security analysis, 70–71 Model building, 353 Modified Jones Model, 894 Monetary assets, 815–817, 823 Monetary liabilities, 815–817, 823 Monetary/non-monetary method, 819 Monte Carlo simulation, 632 Moody’s Investors Service, 634–636 Morl, Ian, 164e Most recent quarter (MRQ), 303 Motivation(s): in financial reporting, 573–574, 579–580 for poor accounting choices, 575 MTR Gaming Group, Inc., 435–436, 435e Multi-deliverables, 166 Multi-employer pension plans, 699n.3 Multinational operations, 799–862 disclosures on foreign currency effects, 856–860, 856e, 859e–860e disclosures related to translation methods, 847–853 and effective tax rate, 853–855 foreign currency transactions, 801–813, 809e–812e translation analytical issues in, 830–841, 842e translation conceptual issues in, 814–818 translation in a hyperinflationary economy, 842–846 translation methods for, 819–830, 819e–820e, 824e use of both translation methods in, 846–847 Multiple-deliverable arrangements, 904 1024 Multiple-period performance, 629–633 Multi-step format (income statements), 138 MV/BV (market value to book value), 647–649 N Narayanan, P., 349 National Datacomputer, Inc., 324–325, 324e Nautica Enterprises, 918–921, 919e–920e Negative audit opinions, 926 Nestlé Group: audit opinion for, 577, 578e creating forecasts for, 627–629 Nestlé S.A.: long-term equity investment by, 945–972 as multinational company, 800 Net asset balance sheet exposure, 818 Net book value, 160 Net earnings, 13 See also Net income/loss Net identifiable assets, 646, 760 Net income/loss: in accounting equations, 43 adjustments to, 270e, 272 and cash flow, 605–606 defined, 13 on income statements, 137 and operating cash flows, 894–896 and translation methods, 852–853 Net interest expense, 545, 704, 706e Net interest income, 704, 706e Net liability balance sheet exposure, 818 Net loss, 13 See also Net income/loss Net pension assets, 545, 721 Net pension liabilities, 545, 721 Net profit, 13 See also Net income/loss Net profit margin: in converting LIFO to FIFO, 381 as income statement ratio, 181 and inventory write-downs, 393 in Nestlé S.A analysis, 952, 953 as profitability ratio, 299, 331 Net realizable value (NRV), 203, 387 Net reporting, 149–150 Net revenue, 135 Net selling price, 763n.16 Neutrality, in accounting standards, 569–570 New Century Financial, 567 Nissim, Doron, 898 Nokia Corporation: disclosures by, 813 evaluating solvency of, 549–550 presentation of non-GAAP financial measures by, 564–566, 564e Index Nominal rate, of bonds, 506 See also Coupon rate Non-cash investing transactions, 247 Non-controlling interests: in business combinations, 775–779 and consolidated net income, 14 as equity, 224 on income statements, 137 valuation of, 776–778 Non-current assets, 422 See also Long-lived assets on balance sheets, 209–220, 210e, 219e current vs., 197–198 defined, 41 Non-current liabilities, 505–552 on balance sheets, 220–222, 221e and bond amortization, 510–515 bond issuance as, 506–510 current vs., 197–198 and debt covenants, 520–522 and derecognition of debt, 517–520 evaluating solvency of, 547–550, 548e and fair value reporting option for bonds, 515–517 leases as, 525–543, 543e–544e post-employment benefits as, 544–547 presentation and disclosure of long-term debt, 522–525, 523e Non-GAAP financial measures, 563–566 in financial reporting, 582–583 misuse and misreporting of, 583–586, 584e–585e as warning signs, 607 Non-monetary assets, 815–816 Non-monetary liabilities, 815–816 Non-operating income, 723–724 Non-operating items, 168–169, 606 Non-operating leases, 492 Non-recurring items, 890e and financial reporting quality, 606, 890–891 on income statements, 162–168, 164e, 165e Norse Energy Corp ASA, 600, 601e Nortel Inversora S A., 753, 753e–754e North America, 106e Notes payable, 207 Novartis Group, 577, 578e Novartis Medical Nutrition, 956 Novo Nordisk, 546–547 NRV (net realizable value), 203, 387 Number of days of inventory, 404 “Numbers Game” (Levitt), 573 Numbers of days payable, 318–319 Index O Objectives and Principles of Securities Regulation (IOSCO), 99–100 Oceana, 107e OCFs (operating cash flows), 894–896, 912–913 OCI, see Other comprehensive income Off-balance-sheet financing, 649–656, 921–922 Off-balance sheet leverage, 972–976, 973e–975e Office of the Comptroller of the Currency, 96 Office of the Superintendent of Financial Institutions (Canada), 95 Offsetting, under IFRS, 116 One-line consolidation, 756 See also Equity method Ongoing purchases, 433 OPB (other post-employment benefits), 700, 701e Operating activities: cash flows from, 19 on cash flow statements, 21, 245–247 defined, 38 direct method for, 261–266 evaluation of, 274 motivation to classify items as, 878 Operating cash flows (OCFs), 894–896, 912–913 Operating cycle, 570e Operating efficiency ratios, 314 See also Activity ratios Operating expenses, 265 Operating income, 723–724 Operating income/average total assets ratio, 302 Operating leases: accounting for, 883–884 analyst adjustments related to, 649–656, 654e case study of, 972–976, 973e–975e coverage ratios and adjustments to, 655 direct financing vs., 487–491 finance vs., 472–491, 526–544, 543e–544e as off-balance-sheet obligations, 921 present value of payments on, 651, 652, 652e Operating leverage, 326 Operating margin, 606–607 Operating profit, 15, 138, 806–807 Operating profit margin: historical, 624–626 as income statement ratio, 182 as profitability ratio, 330 Operating section, of cash flow statements, 597–598 1025 Operating segments, 350 Operational efficiency, 634 Oppenheimer, Peter, 5e Opportunity, for low-quality financial reports, 574–575 Options, and diluted EPS, 174–177 Ordinary shares, 169 Organic sales growth, 857–858 Other comprehensive income (OCI): and accounting equations, 42n.4 in analysis, 184–185 and financial assets, 220 on income statements, 183 items presented in, 884 periodic pension costs on, 704, 705, 721–722 in statements of comprehensive income, 16, 16e–17e, 17 Other post-employment benefits (OPB), 700, 701e Ou, J A., 346 Owners, capital contributed by, 223 Owners’ equity, 194 in accounting equations, 42 on balance sheets, as financial statement elements, 39 Ownership, and revenue recognition, 141 P PACCAR Inc., 561–562, 561e–562e Partial goodwill, 771 Past financial performance, 614–623, 616e–617e, 619e–621e Past service costs, 546 Payables turnover, 318–319 P/B (price to book value), 342–343 PBO (projected benefit obligation), 701 P/CF (price to cash flow), 342 P/CFO (price to operating cash flow per share), 439 Penman, Stephen H., 346, 898 Pension(s), 544–547 Pension obligations, 701–702, 708–712 Pension plans, multi-employer, 699n.3 Pension trust funds, 545 P/E ratio (price to earnings ratio), 341, 439 Percentage change, 308 Percentage-of-completion method, 144–146 Performance: in credit analysis, 636 projecting multiple-period, 629–633 Period costs, 153 Periodic inventory systems, 370–372 1026 Periodic pension costs, 704–707, 706e adjusting, 723–724 and assumptions, 714, 714e classification of, 722 recognition of, 721–722 total, 721 Permanent differences, 673 Perpetual inventory systems, 370–372 Persistence, earnings, 893–897, 895e–897e Phantom stock, 732 Pie graphs, 311 Pinto, Jerald E., 614n.1 Piotroski, J D., 346 P&L statements, see Profit and loss statements Political pressure, 104 Polly Peck International, 567 Pooling of interests method, 582, 769–770, 774n.24, 775n.25 Post Cereals, 163 Post-employment benefits, 698–725 disclosure of, 715–725, 716e, 719e in financial statement analysis, 621 financial statement reporting of, 702–715, 706e, 714e measuring pension obligations, 701–702 as non-current liabilities, 544–547 types of, 698–701, 700e–701e PowerLinx, Inc., 591, 592e PPE, see Property, plant, and equipment Preferred shares, 223 Premium (bonds), 513–515 Prepaid expenses, 66, 205 Presentation: for business combinations, 781, 781e–784e, 783 clear, 925 fair, 115 and financial reporting quality, 581–586, 584e–585e of income taxes, 682–687, 682e–685e inventory-related, 394 for investment property, 470–471, 470e liquidity, 198, 198e for long-lived assets, 458–469, 460e–462e, 467e for long-term debt, 522–525, 523e of non-GAAP financial measures, 564–566 Presentation currency, 801, 821–823 Present value (PV): of bonds, 508 of lease payments, 651, 652, 652e as measurement tool, 113–114 Present value of the defined benefit obligation (PVDBO), 701 Index Pretax margin, 182 Pretax profit margin, 330–331 Price, George, 914e Price to book value (P/B), 342–343 Price to cash flow (P/CF), 342 Price to earnings ratio (P/E ratio), 341, 439 Price to operating cash flow per share (P/CFO), 439 Price to sales (P/S), 342 PricewaterhouseCoopers AG, 578e PricewaterhouseCoopers LLP, 578e, 926e–927e Primary activities, 140 Principles-based approach, 120 Procter & Gamble, 800, 857–858 Products, reporting new, 123 Profit, 3–4 accounting, 661–667 net, 13 operating, 15, 806–807 Profitability ratios, 313e, 329–333, 329e–330e Profit and loss (P&L) statements, 13, 134, 704, 705, 721–724 See also Income statement(s) Profit margin, 181 gross, see Gross profit margin net, see Net profit margin operating, see Operating profit margin pretax, 330–331 Profit or loss, 13 See also Net income/loss Pro forma reporting, 582, 892–893 Projected benefit obligation (PBO), 701 Projection(s), 623–633, 630e–631e Property, plant, and equipment (PPE): acquisition of, 423–426 analyst adjustments related to, 645–646 disclosures for, 458 excess purchase price allocated to, 761 impairment of, 454–455 as long-lived assets, 157 of non-controlling interests, 777–778 as non-current assets, 211 valued in investments in associates and joint ventures, 759 valued under IFRS, 158 Prorated basis, for revenue recognition, 145 Proxy statements, 102 P/S (price to sales), 342 Public Company Accounting Oversight Board, 25 Publicis Groupe, 973–976, 973e–975e Purchase contracts, 921 Purchase costs, 375 Purchase method, 769–770 Index Purchasing power gain/loss, 843 PV, see Present value PVDBO (present value of the defined benefit obligation), 701 Q Qualified audit opinion, 25–26 Quality of reported results, 556 See also Earnings quality Quantitative models, 889 Quick ratio, 322 R Rajgopaul, Shiva, 574 Raju, Ramalinga, 874 Rating agencies, 5–6 Ratio(s) See also specific ratios in analysis of Discover Financial Services, 978, 979e, 980 in analysis of Publicis Groupe, 974, 974e in credit analysis, 636 in financial analysis, 313–341, 313e, 406 in financial statement analysis, 31 in forecasting, 632 for goodwill, 647–649 industry-specific, 344–345, 345e–346e interpreting, 301–302 inventory, 394–395 and inventory write-downs, 387–393 in screening of potential equity investments, 639–640 sources of, 303–304 and translation of foreign currency, 832 used by Standard & Poor’s, 348e–349e Ratio analysis: of balance sheets, 236–237 in financial analysis, 297–304, 297e–298e Rationalization, of poor accounting choices, 575 RCF (retained cash flow), 634 R&D (research and development), 789, 884 R/E (retained earnings), 43–44, 223, 823, 824e Realized value, 113 Reasonable assurance, 25 Receivables: as financial assets, 745 and revenue recognition, 901 securitization of, 786–788 Receivables turnover, 317 Recognition: of current and deferred taxes, 679–681 of expenses, see Expense recognition of financial statement elements, 113 1027 of income taxes, 678–681 of periodic pension costs, 721–722 reported amounts and timing of, 873–876 of revenue, see Revenue recognition temporary difference at initial, 676 of valuation allowance, 679 Recommendations, from analysis conclusions, 32 Reconciliation disclosures, 121, 122 Recoverable amount(s): of cash-generating units, 779 in impairment, 211 in investments in associates and joint ventures, 763n.16 Recurring earnings, 890–893, 890e, 892e Registration requirements, for securities, 576 Regression analysis, 312 Regulations, changes in, 124 Regulation FD, 103n.13 Regulatory authorities: financial reporting requirements enforced by, 576 for financial reporting standards, 99–104 management discussion and analysis required by, 24 standard-setting bodies vs., 95–96 Related-party transactions, 603e, 606 Relevance, of financial reports, 109–110 Relevant information, 558–559, 872n.3 Remaining useful life, 465–466 Remeasurements: for pension plans, 545 as periodic pension costs, 705, 706e in translation of foreign currency, 822 Rent, received in advance, 670, 671, 676 Reported amounts, of recognition, 873–876 Representation, faithful, 110 Required disclosures, 936–937 Research and development (R&D), 789, 884 Research costs: conservative accounting of, 572 of intangible assets, 4277 tax base for, 668–669 temporary differences due to, 675 Residual claim, 42 Residual value, 158, 441 Responsibility statements, 577 Restatements, 639, 899 Restricted stock grants, 729 Restructuring charges, 582, 608, 882–883 Restructuring costs, 789 Retail method (of inventory valuation), 203 Retail ratios, 345e 1028 Retained cash flow (RCF), 634 Retained earnings (R/E), 43–44, 223, 823, 824e Retention rate, 344 Retrospective application: of accounting policy changes, 165–166 of inventory method changes, 386 Return on assets (ROA), 302 in converting LIFO to FIFO, 381 in DuPont analysis, 339 in financial analysis, 404 as profitability ratio, 329, 331 Return on equity (ROE), 302 decomposition of, 335–341, 952 effects of accounting standards on, 620–622 in Nestlé S.A analysis, 953–954, 954e as profitability ratio, 329, 331 Return on net operating assets (RNOA), 898 Return on sales See also Net profit margin as income statement ratio, 181 as profitability ratio, 329 Return on total capital, 331 Revaluation model: for intangible assets, 212 for long-lived assets, 441, 450–453, 453e for property, plant, and equipment, 158, 211 Revenue(s): accrued, 66 classifications of, 878 deferred, 66, 208–209 evaluating quality of, 905, 906e–907e and financial reporting quality, 606 as financial statement elements, 39 gains vs., 140 and income statements, 13, 135 net, 135 and receivables, 901 sales vs., 300n.4 unbilled, 66 unearned, 66 Revenue recognition: accounting choices and estimate affecting, 601e–602e and financial reporting quality, 604–605, 874 on income statements, 139–152, 142e–143e by MicroStrategy, Inc., 903–905, 904e–905e misrepresentation in, 899 by Sunbeam Corporation, 899–903, 900e, 902e–903e Reversals of impairment, 455–456 Risk, information about, 925–937 Risk-related disclosures, 929–933, 929e–932e RNOA (return on net operating assets), 898 Index ROA, see Return on assets Robert, B E., 349 Roche Group, 165, 165e ROE, see Return on equity Royal Ahold, 870 Royal Dutch Shell PLC: decomposing ROE of, 340 disclosures by, 929, 929e–930e, 931–933, 931e–932e lease disclosures by, 533–538 Rules-based approach, 120 S SABMiller plc, 723–724, 726, 726e–727e Safeway, Inc., 216–217 Sale(s): of long-lived assets, 456–457 revenue vs., 135n.4, 300n.4 Sales and turnover, see Net income/loss Sales forecasts, 631 Sales growth, 856–858, 856e–857e Sale of equipment, 267–268 Sales order backlog, 884 Sales returns and allowances, 40 Sales-type leases, 492–493, 539, 541 Saluja, Kawaljeet, 915e–916e Salvage value, 595, 596 SAP Group: balance sheet of, 195, 195e, 196 current assets of, 201, 203, 206e current liabilities of, 206e, 207–209 deferred tax assets of, 205 equity of, 224, 225e non-current assets of, 210e, 211, 220 non-current liabilities of, 220, 221e, 222 ratio analysis of, 236–237 SARs (stock appreciation rights), 732 Sarbanes–Oxley Act of 2002, 25, 27, 100–101 Satyam Computer Services Limited, 874–876, 913–916, 913e–916e Scale and diversification (in credit analysis), 634 Scenario analysis, 353, 632 Screening, for potential investments, 637–640 Sealed Air Corporation, 922–924, 923e–924e Sears, 582 SEC, see Securities and Exchange Commission Secondary activities, 140 Securities: available-for-sale, see Available-for-sale securities held for trading, see Held for trading securities held-to-maturity, see Held-to-maturity securities marketable, 201 Index Securities Act of 1933, 100 Securities and Exchange Commission (SEC): on accounting bias, 573 on accruals, 894 adoption of IFRS by, 105, 375 on classification shifting, 892e disclosures required by, 936 financial reporting quality discipline by, 576 on management discussion and analysis, 24, 933 on non-GAAP financial measures, 583 on off-balance-sheet financing, 649 on PowerLinx, Inc., 591, 592e as regulatory authority, 100–103 reporting requirements of, 577 requirement of, for non-US companies, 620 on revenue recognition, 141 special purpose entities under, 881–882 as standard-setting body, 98 on use of non-GAAP financial measures, 563 Securities Exchange Act of 1934, 100 Securities Offerings Registration Statement, 101 Securitization, of assets, 786–788 Security analysis, 69–71 Segments, operating, 350 Segment analysis: in financial analysis, 350–353, 351e, 352e in Nestlé S.A analysis, 956–962, 957e–958e, 960e–962e Segment ratios, 351–353, 351e, 352e Segment reporting requirements, 350–351 Self-regulatory organizations (SROs), 100 Sensitivity analysis, 353 Services, revenue from, 141 Service companies ratios, 345e Service costs, 545, 704, 705, 706e Service period, 730 Settlement value, 113 SFAS No 109, 662 SFAS No 141(R), 740 SFAS No 160, 740 Shares: common, 169, 223 diluted, 15 ordinary, 169 preferred, 223 treasury, 223 Share-based compensation, 726–732, 726e–727e stock grants as, 728–729 stock options as, 729–732, 730e Shareholders’ equity, 194 Shumway, Tyler, 911 1029 Significant influence, of investors, 755 Simple capital structure: complex vs., 169–170 and diluted EPS, 171 Simulation, in analysis, 353 Single-step format (income statements), 138 Software development costs, 437–440, 437e, 438e Solvency: and balance sheets, 227 and cash flow, defined, 325 of non-current liabilities, 547–550, 548e Solvency ratios, 313e as balance sheet ratios, 235 in financial analysis, 325–329, 327e for non-current liabilities, 547–550, 548e Sony Corporation, 516–517, 607 South America, 106e S&P 500, 180, 180e–181e Special purpose entities (SPEs): as business combination, 768e, 784–788, 786e and financial reporting quality, 881–882 Specific identification method: of inventory costing, 154 of inventory valuation, 366–370 and inventory write-downs, 388 Spin-offs, 457, 457e–458e S&P/MSCI Global Industrial Classification System (GICS) sectors, 180, 180e–181e, 231e–232e SROs (self-regulatory organizations), 100 Stacked column graph, 311, 311e Staff Accounting Bulletins, 98 Standards Advice Review Group (European Union), 103 Standard cost method (of inventory valuation), 203 Standard IAS 39, 742–752, 745e–746e, 748e–749e Standards of Practice Handbook (CFA Institute), 32 Standard & Poor’s, 6e, 348e–349e Standard-setting bodies: FASB as, 98 financial reporting requirements set by, 576 IASB as, 97 regulatory authorities vs., 95–96 SEC as, 98 Stated rate, of bonds, 506 See also Coupon rate Statement 140, 976 “Statement in Support of Convergence and Global Accounting Standards” (SEC), 105 1030 Statements of changes in equity, 17–19, 18e, 117e, 225–226, 226e–227e Statements of changes in owners’ equity, 17 See also Statements of changes in equity Statements of changes in shareholders’ equity, 17 See also Statements of changes in equity Statements of comprehensive income, 117e Statements of earning, 134 See also Income statement(s) Statements of financial condition, 8, 194 See also Balance Sheet(s) Statements of financial position, 8, 194 See also Balance Sheet(s) Statements of operations, 13, 134 See also Income statement(s) Statements of owner’s equity, 63e, 64 Statements of retained earnings, 44, 44e, 64 Stock appreciation rights (SARs), 732 Stock grants, 728–729 Stock options: and diluted EPS, 174–177 as share-based compensation, 729–732, 730e Stock returns, 300 Stock screens, 637, 637e, 638 Straight from the Gut (Welsch), 608 Straight-line method (of depreciation): accounting choices for, 592–593, 594e, 595, 596e of bond amortization, 511 for income statements, 158–159, 159e for long-lived assets, 441–446 Sturm Ruger & Co., Inc., 383–384 Subscription accounting, 166 Subsidiaries: consolidation of, 137 foreign, in multinational operations, 800 temporary differences due to investments in, 677 Sunbeam Corporation: cash flow statements of, 916–918, 917e improper accounting by, 567, 574, 606 revenue recognition by, 899–903, 900e, 902e–903e Supplementary information, Supplementary schedules, 21–23 Suppliers, cash paid to, 263–264 Survivorship bias, 639 Sustainable earnings, 872 Sustainable growth rate, 344 Switzerland, 99 Syngenta AG, 121–122, 122e Synthetic leases, 472 Index T T-accounts, 68e, 72 Tangible assets, 211 Taxable income, 661–667 Taxable temporary differences, 673–676 Tax assets: current, 663–664 deferred, see Deferred tax assets Tax base, 663, 667–672 Tax basis, 663n.3 Tax credits, unused, 677–678 Tax expense, 663 Tax liabilities: current, 663–664 deferred, see Deferred tax liabilities Tax loss carry forward, 663 Tax losses, unused, 677–678 TD Ameritrade Holding Corporation, 647–649 Tech Data Corporation, 254, 254e–256e, 256 Teck Resources Ltd., 5–6, 6e–7e Telefónica Group, 252–254, 252e–253e Teléfonos de Mộxico, 620622, 620e, 622e Tele Norte Leste Participaỗừes S.A., 620–622, 620e, 622e Temporal method: and balance sheet exposure, 833–836 effect of exchange rate change on, 839–841, 842e for translation of foreign currency, 819, 822–823, 826–827 Temporary differences: and deferred tax assets and liabilities, 664–665 defined, 662 and income taxes, 672–677 Tesco, 41 Thiagarajan, S R., 346 Timeliness, of financial reports, 110 Time series analysis, 94, 606 Timing, of recognition, 873–876 Tolerance for leverage, 634 Top-down analysis, 637 Top-down approach, 30–31 TORM A/S, 521–522 Toshiba Corporation, 297–299, 298e Total asset turnover: as activity ratio, 319, 320 in Nestlé S.A analysis, 953 Total comprehensive income, 183 Total invested capital, 623n.4 Total liabilities-to-equity ratio, 381–382 Total periodic pension costs, 721 Toyota Motor Corporation, 559, 560e Index Trade payables, 207 Trade receivables, 42, 201–202 Trading securities, 184 Trailing twelve months (TTM), 303–304 Transaction(s): with associates, 764–766 bill-and-hold, 900, 903 downstream, 764–766 financial reporting standards for new, 123 financing, 247 foreign currency, see Foreign currency transactions non-cash investing and financing, 247 related-party, 603e, 606 upstream, 764–765 Transaction exposure, 802 Transactions with associates, 764–766 Transfer pricing, 853 Translation adjustment(s): as dirty-surplus item, 853 of foreign currency, 816, 818, 829 Translation methods, 819–830, 819e–820e, 824e, 846–847 Translation of foreign currency: analytical issues in, 830–841, 842e conceptual issues in, 814–818 disclosures related to translation methods, 847–853 in a hyperinflationary economy, 842–846 translation methods for, 819–830, 819e–820e, 824e use of both translation methods in, 846–847 Transparency, in financial reporting, 119 Treasury shares, 223 Treasury stock method (for diluted EPS), 174–176 Trend analysis, 308–310, 309e for expense recognition, 909e of past financial performance, 615 Trial balances, 68e, 83 Trump Hotels & Casino Resorts, 563, 563e, 606 Tsingtao Brewery, 619e TTM (trailing twelve months), 303–304 Turkey, 825 Tyco International Ltd., 608–609 U Unbiased measurement, 922 Unbilled revenue, as accrual, 66 Understandability, of financial reports, 110 Unearned fees, 53 Unearned revenue, 53 1031 as accrual, 66 as current liability, 208 on income statements, 140 Unilever Group, 249, 249e–251e, 251–252 United Agri-Products, 590, 590e Uniting of interest method, 770, 774n.24, 775n.25 Units-of-production method (of depreciation), 441–446, 592–593, 594e–596e, 595 Unqualified audit opinion, 25 Unrealized income, 803–804 Unused tax credits/losses, 677–678 Unusual items, 164–165 UPM-Kymmene Corporation, 467–469, 467e Upstream transactions, 764–765 Useful information, 559, 615, 872n.3 Useful life, 158, 606 US GAAP (generally accepted accounting principles): as authoritative, 98 barter transactions under, 149 business combination under, 767, 769–771, 775, 776, 778, 779 cash flow statements under, 246–248, 247e–248e, 254–258, 254e–258e classification shifting under, 918 comprehensive income under, 183, 186 conservatism of, 572 consolidation under, 881 converging with IFRS, 105 debt issuance costs under, 510 deferred tax assets and liabilities under, 664, 665, 672–674, 677, 679 departures from, 567–568 depreciation under, 447 disclosures required by, 929 finance and operating leases under, 472, 486, 527, 538–539 financial assets under, 218, 743–747, 749, 754–755 financial statement elements used by, 39n.1 financial statement presentation under, 114n.29 foreign currency transactions under, 802, 803, 805–806, 808 goodwill impairment under, 780–781 goodwill under, 215 gross vs net reporting under, 149 and IFRS framework, 118, 118e–119e, 119 IFRS vs., 121–123, 122e impairment of assets under, 454 impairment of long-lived assets under, 571 income statements under, 134 1032 US GAAP (continued) income taxes under, 687, 688e–690e intangible assets under, 212, 213, 427–429 intercorporate investments under, 740, 742e inventories under, 203, 364, 386, 394 inventory costing methods under, 154, 155, 365 investments in associates and joint ventures under, 755, 756, 759, 760, 763, 764 issued by FASB, 2n.1 long-term contracts under, 144 non-recurring items under, 163 operating activities under, 168 other comprehensive income under, 16 pensions under, 545, 546 post-employment benefits under, 698, 699, 701, 704, 705, 706e property, plant, and equipment under, 158, 211 required disclosures under, 458–459 revaluation model under, 450 revenue recognition under, 141 share-based compensation under, 726, 728, 729 special purpose entities under, 785, 788, 789 statements of changes in equity under, 226 tax base determination under, 669 translation of foreign currency under, 814, 819, 824e, 825, 842, 847–848, 853 V Vadlamani, Srinivas, 914e–916e Valuation: of company, in Nestlé S.A analysis, 968–970, 968e–971e market-based, 614, 624–629 of non-controlling interests, 776–778 varying bases for, 120 Valuation adjustments, 67 Valuation allowance, 663, 679 Valuation methods: comparison of, 373–375 for inventories, 366–375 for stock options, 729 Valuation ratios, 313e, 341–344, 341e–342e Value in use: in impairment, 211 in investments in associates and joint ventures, 763n.16 Value investors, 638 Variable costs, 326 Variable interest entities (VIEs) See also Special purpose entities as business combination, 768e Index under FASB, 785 and financial reporting quality, 881–882 under US GAAP, 769 Variable production overhead costs, 365n.7 VBO (vested benefit obligation), 701n.5 Verifiability, of financial reports, 110 Verizon Communications Inc., 620–622, 621e, 622e Vertical common-size analysis, 178n.50, 180, 233, 305, 306e–307e Vested benefit obligation (VBO), 701n.5 Vesting, of pension obligations, 702 Vesting date, 730 VIEs, see Variable interest entities Vodafone Group Plc, 460–465, 460e–462e Volkswagen Group: audit report from, 26, 26e–27e balance sheet of, 9e–10e, 10–11 cash flow statement for, 19, 19e–20e, 21 disclosures by, 126, 126e, 127 financial notes from, 21, 23, 23e income statement of, 14e, 15 management discussion and analysis from, 24 statement of changes in equity for, 17, 18e, 19 statement of comprehensive income for, 16e–17e Volvo Group: assumed discount rates for, 716e, 717 financial asset investments by, 745, 745e–746e inventories of, 389–393, 389e–391e inventory valuation method of, 396–399 management discussion and analysis from, 399–400 W Wall Street Journal, 599, 922 Wal-Mart Stores, Inc.: balance sheet of, 11e–13e, 13 cash flow statements of, 254, 256, 257e–258e, 258, 259 War chests, 619, 619e Warrants, 169n.48 bonds with, 524–525 and diluted EPS, 174–177 Warranty(-ies): accounting choices and estimate affecting, 603e and expense recognition, 157 Waste Management, 892e Watts, Ross, 572 Weighted average cost method: and historical exchange rates, 822 of inventory costing, 155 1033 Index of inventory valuation, 366–370 and inventory write-downs, 388 Weil, Jonathan, 937 Welsh, Jack, 608 Working capital: changes in, 270 in forecasts, 632 turnover of, 319 Working capital turnover, 319 WorldCom Corp., 70 cost capitalization by, 907–908, 908e fraudulent reporting by, 597, 897, 897e improper accounting by, 567 World Trade Organization, 800 Write-downs, of inventory, 203, 387–393, 396 X XBRL (eXtensible Business Reporting Language), 304 Y Yahoo! Inc., 812, 848–851 Yang, Ya-wen, 622n.3 Yawtiz, J B., 349 Z Zero-coupon bonds, 510 Z-score, 349 WILEY END USER LICENSE AGREEMENT Go to www.wiley.com/go/eula to access Wiley’s ebook EULA ... CHAPTER Financial Statement Analysis: An Introduction Learning Outcomes Introduction Scope of Financial Statement Analysis Major Financial Statements and Other Information Sources 3.1 Financial Statements... roles of financial reporting and financial statement analysis; • describe the roles of the key financial statements (statement of financial position, statement of comprehensive income, statement. .. the scope of financial statement analysis Section describes the sources of information used in financial statement analysis, including the primary financial statements (balance sheet, statement