Introduction to Financial Statement Analysis

This reading sets out the six steps of the financial statement analysis framework and separates the role of financial reporting from the role of financial statement analysis. It then covers the information an analyst works with: regulatory filings, footnotes, segment data, management commentary and the audit report, the differences between IFRS and US GAAP as standards evolve, and sources outside the company's filings.

LOS 27.a — The financial statement analysis framework

The framework is a generic, repeatable process that works for any analytical purpose, whether valuing equity, judging a bond issue or assessing a merger. It has six steps, taken in this order:

Each step works on the output of the one before it. The questions written down in step 1 decide which data are collected in step 2, and those data decide which adjustments, ratios and exhibits can be prepared in step 3. Skipping step 1 therefore leaves the later steps without a target.

LOS 27.b — Financial reporting and financial statement analysis

• Financial reporting is the way a company prepares and publishes financial statements that show its performance and position to investors, creditors and anyone else with an interest in it. Its role is to give a wide range of users useful information about the company's performance and financial position.
• Financial statement analysis is the use of that information, together with other relevant data, to make economic decisions about the company: whether to buy or recommend its securities, extend trade or bank credit, or assign a credit rating. Analysts evaluate past performance and the current position to judge how well the firm is likely to generate profits and cash flow in the future, and they identify the risk factors along the way.

Financial statement analysis as described here is done by external users. Management also analyzes financial information for day-to-day decisions, but it can draw on internal data kept in other formats that outsiders never see.

LOS 27.c — Filings, notes, management commentary and audit reports

Standard setters and regulators

Standard-setting bodies are private professional bodies that write the reporting rules. The FASB issues US GAAP; the IASB issues IFRS, and older IASB standards are called IAS. Other national standard setters also exist. Regulatory authorities are government agencies with legal power to enforce the rules, such as the Securities and Exchange Commission (SEC) in the United States and the UK's Financial Conduct Authority. Most national regulators belong to the International Organization of Securities Commissions (IOSCO), whose members between them regulate over 95% of global financial markets. IOSCO itself is not a regulator. Its members cooperate across borders to make national regulation and enforcement more uniform. Its Objectives and Principles of Securities Regulation rest on three objectives: protecting investors; ensuring that markets are fair, efficient and transparent; and reducing systemic risk. IOSCO expects issuers to give full, accurate and timely disclosure of financial results, risks and other decision-relevant information, prepared under high-quality, internationally accepted accounting standards.

The Sarbanes-Oxley Act, enforced by the SEC, limits the non-audit services a company's external auditor may provide. The purpose of that limit is to avoid conflicts of interest and protect auditor independence. The act also requires executives to certify that the statements are fairly presented and to include a statement on the effectiveness of internal control over financial reporting.

Exam convention: the external auditor must also confirm the effectiveness of the company's internal controls. Current practice: the auditor attestation in Section 404(b) applies to accelerated and large accelerated filers; non-accelerated filers and emerging growth companies (EGCs) are exempt.

Securities regulation in the EU is set by each member state separately. Exam convention: all EU countries are required to report using IFRS. Current practice: the EU IAS Regulation requires IFRS for the consolidated statements of listed companies. Exam convention: the body that advises the European Commission on securities regulation is called the European Securities Commission. Current practice: its official name is the European Securities Committee. The European Securities and Markets Authority (ESMA) coordinates regulation within the EU.

Key SEC filings:

Financial statement notes

Financial statement notes (footnotes) give the detail behind the summary numbers so that users can judge the amount, timing and uncertainty of estimates. They cover the basis of presentation (fiscal period, IFRS or US GAAP, consolidated entities) and the accounting methods, assumptions and estimates chosen by management. They also give details on contingencies and commitments, legal actions, acquisitions and disposals, employee benefit plans, related-party transactions, significant customers, segments and post-balance-sheet events. Footnotes are audited together with the primary statements.

Segment reporting

Both IFRS (IFRS 8) and US GAAP require segment disclosures. For each segment, a smaller set of items than the company-wide statements is reported: a measure of profit or loss; revenue, split into sales to outside customers and sales to other segments; measures of assets and liabilities; interest revenue and interest expense; income tax expense; depreciation and amortization; other noncash expenses; spending on PP&E and intangibles; and the share of results of equity-accounted investments. A business segment (operating segment) is a portion of the company whose risk and return characteristics are distinguishable from those of the company's other lines of business.

Exam convention: a business segment is one whose revenues, assets or income exceed 10% of the company's totals. Current practice (IFRS 8 and ASC 280): an operating segment is a part of the company that earns revenues and incurs expenses and whose results management reviews separately. It must be reported separately, as a reportable segment, when it meets any one of three size tests. It accounts for 10% or more of:

1. the combined revenue (external and intersegment) of all operating segments;
2. the combined assets of all operating segments; or
3. the larger of (i) the combined profit of all segments that report a profit and (ii) the combined loss of all segments that report a loss, with the segment's own profit or loss taken in absolute amount.

Reportable segments must together cover at least 75% of the company's external revenue; if they do not, more segments are reported. Geographic segments are identified on the same size criterion when an area's business environment differs from that of the rest of the company. Segment profit margins, asset turnover and return on assets give a clearer picture of the whole firm, and growth rates of segment revenues and profits help forecast future sales and profits.

Management commentary

Management commentary is also called the management report, the operating and financial review, or management's discussion and analysis (MD&A). IFRS guidance recommends, but does not require, that it cover the nature of the business, management's objectives, past performance, performance measures, and the company's key relationships, resources and risks. Parts of it may be unaudited.

For US public companies, the SEC requires a discussion of trends and significant events and uncertainties affecting liquidity, capital resources and results of operations. Exam convention: management must also discuss any material effects of inflation and changing prices, contractual and off-balance-sheet obligations (purchase commitments, for example), accounting policies that call for significant judgment, and forward-looking expenditures and divestitures. Current practice: since the SEC's MD&A amendments took effect in 2021, inflation, off-balance-sheet arrangements and the contractual obligations table are no longer separate items; material effects are covered in the known-trends, liquidity and capital resources discussion. SEC rules also require a description of unusual or infrequent events or transactions that materially affected reported income from continuing operations. Information that belongs in other filings is not an MD&A requirement; the compensation of individual directors, for example, appears in the proxy statement.

Audits and the auditor's report

An audit is an independent review that aims to give an opinion on whether the statements are fair and reliable. Management prepares the statements and is responsible for them. The auditor is an independent accounting firm engaged by the board of directors. It reviews the company's accounting systems and internal controls, verifies its assets and liabilities, and tries to determine that the statements contain no material errors. The standard opinion states that:

1. the statements are management's responsibility, and the auditor performed an independent review;
2. generally accepted auditing standards were followed, giving reasonable assurance (not a guarantee) that there are no material errors; and
3. the statements conform to accepted accounting principles, and the principles and estimates chosen are reasonable.

The report must also explain any accounting method that has not been applied consistently between periods.

Any opinion other than unqualified is a modified opinion. Exam convention: an explanatory paragraph is added when a material loss is probable but cannot be reasonably estimated; the uncertainty may concern the going concern assumption (that the company will keep operating for the foreseeable future), the valuation or realization of assets, or litigation. Current practice: auditing standards still require a separate paragraph or section when there is substantial doubt about the company's ability to continue as a going concern, but for other uncertainties, such as pending litigation, an emphasis-of-matter paragraph is at the auditor's discretion. Such a paragraph can signal serious problems and deserves close attention from the analyst.

Reports also include key audit matters (international) or critical audit matters (US). These are the accounting areas of most significance to users: areas that need significant management judgment and estimates, the accounting for significant transactions, and areas the auditor found especially challenging or subjective, where the risk of misstatement is highest.

Internal controls are the processes that make the statements accurate, and they are management's responsibility. Weak controls open the door to low-quality or fraudulent reporting. Exam convention: for US publicly traded firms, the auditor must express an opinion on internal control, either as a fourth element of the standard opinion or separately. Current practice: this applies to accelerated and large accelerated filers; non-accelerated filers and emerging growth companies are exempt.

LOS 27.d — Alternative reporting systems and evolving standards

The IASB and FASB work toward convergence, but significant differences remain, so comparisons of firms in different jurisdictions need care:

Exam convention: under IFRS, interest paid may be classified in CFO or CFF (the IAS 7 choice). Current practice: IFRS 18, effective for annual periods beginning on or after 1 January 2027, removes that choice for companies whose main business is not financing; they report interest paid in CFF.

Standards keep changing, and new products and transactions may not fit existing standards. The analyst can use the financial reporting framework as a guide to their likely effect on the statements. The analyst should also follow the IASB and FASB websites, professional journals and CFA Institute position papers, and monitor company disclosures of significant accounting policies and estimates.

LOS 27.e — Other information sources

Besides annual reports, quarterly and semiannual reports and other regulatory filings, analysts use:

Many companies publish earnings guidance ahead of their results. Once results are out, management often holds a call with analysts, takes their questions and gives detail beyond what the filings contain. Outside the company, trade publications, statistical data services and government statistics help the analyst judge the wider economy and the industry and benchmark the firm against its rivals.

Proxy statements are sent to shareholders when a vote is needed. They are a good source of information on board elections and qualifications, compensation, management qualifications and stock option issuance. Proxy statements are also filed with the SEC (Form DEF-14A), like the 10-K, 10-Q and 8-K. Press releases are issuer communications distributed by the company itself.