4.CFA Level 1 Financial Reporting and Analysis Reading 22 LO1 to LO3

well we're beginning the next reading reading 23 in the financial reporting and analysis long series in this reading I think we can breathe through really quickly this is something you would have learnt in in a very introductory accounting course a lot of it is journal entries the idea of double entry accounting debits and credits I'm not going to go through that I have to assume a certain level of elementary knowledge and transactions I have to assume that you've you've seen transactions if you've never ever seen a transaction before and you're brand spanking new to accounting you're not ready to be here you're not ready for CFA because it'll murder you you're going to want to get a little bit more knowledge first so I'm going to assume that transactions you got that covered I'm not going to go through debits and credits and journal entries and trial balance and adjusted trial. I'm just not going to do that because that's that's taking us away from a statement analysis into actually accounting. so there's plenty of resources online for figuring that stuff out that there's no need for me to redo that. here it's, it goes beyond the scope of what we're doing so we will fly through this reading. I think and we'll stick to just the things that I want to highlight that are that are pertinent to financial analysis and not so much to accounting business activity classification. when we analyze companies we're really looking especially when it's a cash flow statement we find that a lot is broken out into these three activities operations, investing activity and financing activity. and all of them are important but they should all be analyzed sort of almost on their own. anyways the three categories here we have operating activities. this is your day-to-day business activities things. like revenues, expenses, taxes accounts, receivable, inventories accounts pay any transactions dealing with your working capital accounts. whether they be debt. the asset or liability accounts, investing activities this is the acquisition and disposal of non current assets. so capex capital expenditures is a big part here  especially for industrial companies or for mining companies E&P; exploration and production for energy resources. you want to have a look at their capex. what's their planned expenditure because for a lot of these companies that are more asset intensive. their growth comes through reinvestment in more assets. so that becomes important beyond that investments you got a bunch of cash. sitting around you're going to put it somewhere. where you're going to put it right financing activities. this is about obtaining and repaying capital. so here we're really looking at claims against assets whether they be creditors or whether they be new owners are they as the company going to do a secondary offering or more shares going up, how are they raising their debt are they matching their debt properly, they're using long term debt to finance long term assets and short term debt to finance short term assets. you want to make sure that makes is. there we're going to get into all of this later on so this is really just to to to sort of again we're just on the treadmill we're just preparing for hitting the gym and we're just warming up right so I put a note here what's what depends on the nature of the business so a company that earns interest income on an investment would be investing activities but a bank that earns interest income on a loan well that's an operating activity so what may be one company's investing activity may be another company's operating activity so there's no hard and fast rules about if it's this it's that it's a matter of if it's if it's day-to-day business activity no matter what it is its operating and that's the way we classify it again we're going to see more of this later I'm just I'm just sort of going over the highlights of the chapter elements and the counts there are five financial state elements these are sort of high-level categories that we can call almost anything and ask that a liability,  its equity, a revenue, or an expense. and an asset is an economic resource. the liability is a creditors claim - against those resources equity is the residual claim after creditors are done. revenues are inflows of economic resources. expenses are outflows of economic resources. if the inflows are greater than the outflows that builds equity if the outflows are greater than the inflows that tears away from equity. we can classify assets into groupings such as current and non-current. it makes it easier for us to read the statements also there are different measures and different ratios that we would take at the level of current assets and current liabilities that we wouldn't do at the level of non current assets and non current liabilities. so that's why we would break them up. we get a lot better feel of measures of solvency. when we look at just the current assets and current liabilities. we're going to get to all this later. accounts these are within assets we may have a whole bunch of accounts. they sum up the balances within the elements. so under assets and we move under current assets we may have a bunch of accounts like cash, inventory accounts,  receivable the sum of all the balances and all these accounts will sum up to the subtotal for current assets again for non current. we'll have a bunch of accounts under that. they sum up to a total for that those two. then sum up to a total for the whole element itself. the the whole amount of assets sometimes within specific elements we have accounts that do not add to the total of the element. it actually decreases the balance within elements. these are called contra accounts. so you may have an accounts receivable less allowance for doubtful accounts. property plant and equipment less accumulated depreciation. revenues or sales less returns and allowances. so these contracts appear under the element revenue. even though they have a balance that may not be credit or debit as with anything else so an allowance for doubtful accounts as a credit balance. while all other asset accounts have a debit balance this should be there should be nothing more than the new nod in your head going yep yep yep I remember all that yep let's move ahead and that's what we'll do we'll look at some accounting equal and we'll begin from the basic accounting equation. and I will get will add more complexity to it. so assets from from the from the balance sheet I know that is saying us there the B is missing for some reason.

balance sheet assets equal liabilities plus equity

that is the basic accounting identity. that must hold what this is saying is that your assets are going to be either financed with debt or liabilities or through equity. simple as that you can rearrange it

assets minus liabilities equals equity

so we can see that if we take all our assets and we subtract all the debt and all the liabilities we owe whatever is left over equity. That's why it's called a residual claim on assets goes by many names owner's equity , =shareholder equity, =net assets, =net worth, =net book value. all mean the same thing II.

and equity is contributed capital what the owners of the company put in plus anything that the business is retained so we can break out the e into

equals contributed capital plus retained earnings

so assets minus liabilities equals this from the income statement we have an accounting equation

revenues minus expenses equals net income or loss can also be called net profit or net loss or net earnings and revenues

for in this in this example here just for the sake of the equation revenues include all gains that would normally have been listed in other comprehensive income and all expenses including all losses so gains and losses are included in revenues and expenses. just to make the the formula simple. the income statement can also be called a statement of operations, statement of income, statement of profit loss. so we've got an accounting statement for the balance sheet. we've got one for the income statement. we can link them together ending retained earnings which is an equity account on the balance sheet ending

retained earnings is equal to the beginning retained earnings plus whatever net income is earned- whatever dividends are paid

we can then expand net income out because we know what that revenues minus expenses equal net income

so ending retained earnings equals beginning retained earnings plus revenue minus expenses minus dividends

there are four

assets equal liabilities plus contributed capital plus N in retained earnings

all we've done was we broken equity out because we said equity is is our contributed capital the amount given by the owners of the business plus whatever is retained in the business. well what's retained whatever the balance in the ending retained earnings account is and since ending retained earnings equals all of this we can take any retain earnings and lengthen it out so that assets equals liabilities plus and this is all equity now plus our contributed capital plus our beginning retained earnings plus whatever revenue minus whatever expenses minus dividends

and all of this can be found in a statement of retained earnings which may or may not be separate and on its own. so if we're given a bunch of data like this we have revenues of 350

beginning retain earnings of 90

expense of 280

dividends 25

liabilities 120

contribute capital 75

if we didn't know these accounting equations we could figure this out. it's not much to figure. though so if we had to come up with a value for total assets. we know that

assets equal liabilities plus equity well there's liabilities we can figure out what equity is going to be there's revenue minus expense. we can figure it out. but because we have the formula rather than a figure it out. little by little we could just go right to it. so total assets here it is equals all of this equals liabilities. what's our liabilities 120 plus our contributed capital 75 plus our beginning retained earnings is 90 plus our revenues are 350. now let's get rid of the stuff. that that we don't get to keep minus our expenses is 280 minus the dividends that we pay is 25. there we go we just put it all in one big formula. this is that statement of retained earnings. so we have 195 outside of the brackets plus 135 in the brackets our total assets are 330 it has to be Oh