CFA Level I Financial Reporting and Analysis (Part IV)

Today, I would like to talk about the last two readings in this chapter. Hopefully, all of you have a better understanding of my previous articles. In this study session, it introduces more about the quality of financial reporting. Candidates can learn what the differences of financial reporting quality that may exist in a company and what is the objective to identify them are. Let’s look at what we can learn in Reading 31 and Reading 32.

Reading 31 Financial Reporting Quality

In reading 31, candidates can have a better understanding of the concept of financial reporting quality. The International Accounting Standards Board (IASB) and the Financial Accounting Standard Board (FASB) are setting up the accounting standards to produce a high quality of financial reports which can lead to increase in the degree of relevance, faithful representation, comparability, timeliness, verifiability, and understandability in the financial statement. A proper financial report can provide analysts or investors to have an appropriate assessment of the company’s performance and prospect, helping them to make a sound investment decision. Whereas financial reporting contains inaccurate, misleading or incomplete information will lead the investors or analysts to suffer losses in their investment but also will reduce the confidence in the financial system.

Candidates are also able to learn how to distinguish between financial reporting quality and quality of reported results, which are also known as quality of earnings. Quality of earnings refers to the proportion of income attributes to the core operating activities of a business. The terms of ‘quality of earnings’ is used in practice to encompass the quality of earnings, cash flow and balance sheet items in a company. The concept of earnings quality and financial reporting quality are interrelated because there is a correct assessment of earnings quality only when the necessary level of financial reporting quality achieved.

The differences between conservative accounting and aggressive accounting, also will be discussed in this reading, together with some examples provided in the textbook. Conservative accounting is a practice that understates the financial performance of a company. It arises in a period when the management has exceeded the targets before the end of the period, they started to decrease the company’s reported performance and financial position in the current period and may increase its reported performance and financial position in a later period. While for aggressive accounting, it is a practice that used to obscure the poor performance where the financial performance will be overstated. It is also possible for poor reporting quality to occur the paint the company with high-quality earnings. Some of the companies are pressured to do so because they can present the company’s performance in the best light for investors and analysts. However, aggressive accounting will expose investors and managers to more risks because they are less likely to manage the risks carefully if they are more comfortable with their performance.

Furthermore, candidates are also able to learn on the: –

  • Spectrum for assessing financial reporting quality
  • Motivations cause management issues financial reports with low quality
  • Conditions that are conducive to issue fraudulent financial reports
  • Presentation choices, such as Non-GAAP measures
  • Accounting warning signs/methods to detect manipulation of information in financial reports


Reading 32 Financial Statement Analysis: Applications

In the last reading of this chapter, candidates can have a better understanding of how to evaluate a company’s past financial performance and explain how a company’s strategy is reflected in the previous financial performance. There are two types of analysis, such as cross-sectional analysis, and trend analysis are used by investors or analysts to measure the company’s historical performance over time. Cross-sectional analysis is a type of analysis which investors or analysts use to compare a firm’s ratio with some chosen industry’s benchmark or with its peers to produce unique insights for that industry. While for trend analysis, also known as time series data analysis, is a type of statistical technique which used by investors or analysts to predict the future stock price movements or performance by analysing the historical trends of data within the market.

Besides, candidates are also able to learn how to project future financial performance. Projection of future financial performance is used to determine the value of a company or its equity components. It may also use by credit analysis to project the finance or acquisition finance to determine whether a company cash flows are adequate to pay their interest and principal on its debts. Moreover, it will also be used to evaluate whether a company will likely remain in compliance with it financial covenants. Here are some of the examples source of data for analyst projections: company projections, company’s previous financial statements, industry structure and outlook, and macroeconomic forecast.

Furthermore, candidates also able to learn more on these together with some examples provided in the textbook: –

  • Describe the role of financial statement analysis in assessing the credit quality of a potential debt investment
  • Describe the use of financial statement analysis in screening for potential equity investments
  • Explain appropriate analyst adjustments to a company’s financial statements to facilitate comparison with another company.

Conclusion

In conclusion, based on these 2 readings, candidates can have a better understanding on selected applications of financial analysis, how to evaluate the past financial performance, projection of future financial performance, assessment of credit risk, and the screening of potential equity investment. However, analysts must know the financial reporting standard very well because the standard evolves, analysts must stay together with the current standards to make the right investment decision. Last but not least, it is essential that candidates must be familiar with the materials covered in this topic since this topic also carry a quite higher percentage of marks in the exam.

Written by Stella Goh | 8th August 2019

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