Financial Reporting and Analysis

Lecture (1)
Course Info.
• Course Instructor:
Dr. Diana Mostafa
PhD, MSc. In Accounting
Room (B5-307)
Email: diana.mostafa@guc.edu.eg
Office Hours:
• Wednesdays: from 4:00 – 6:00 pm
 Course Material & Assessment
Material
Assessment
• Text Book Course work (Cases) 40%
• Financial Statement Analysis by
K.R. Subramanyam and Wild, Midterm Exam 20%
McGraw Hill. 10th or 11th edition Final Exam 40%
• Financial Reporting and Analysis
using financial accounting
information by Gibson – South-
Western Cenegage Learning - 11th
edition
What is Financial Reporting and Statement Analysis?

Financial reporting refers to the practices of the companies to

give stakeholders an accurate picture of a company’s finances,
including their revenues, expenses, profits, capital, and cash How???
flow, as formal records that provide in-depth insights into
financial information

Is the application of analytical tools and techniques to general purpose

financial statements and related data to derive estimates and
inferences useful in business analysis.
Importance of Financial Statement Analysis
• What are the future prospects of this business?
Investors and shareholders • Is its market expect to grow?
• what is the current earnings performance?

Creditors • What are the business’s likely sources of interest payments?

• How much cushion does the business have in its earnings and cashflows to pay interest
� � ‫اﻟ� ﺗﻤﺘﻠ�ﻬﺎ‬
�
‫اﻟ�ﻛﺔ �� أر�ﺎﺣﻬﺎ وﺗﺪﻓﻘﺎﺗﻬﺎ اﻟﻨﻘﺪ�ﺔ ﻟﺪﻓﻊ اﻟﻔﺎﺋﺪة‬ � ‫ﻣﻘﺪار اﻟﻮﺳﺎدة‬

Managers • What are the business’s strengths and weaknesses?

• What are the steps the business had taken to business opportunities or threats?

• how much the taxpayer makes to determine the tax due thereon ‫?اﻟﺿرﯾﺑﺔ اﻟﻣﺳﺗﺣﻘﺔ ﻋﻠﯾﮭﺎ‬.
Regulators

• Especially if the customer is dependent on the entity, (i.e. distributor), the

customer become interested in wondering about company’s ability to continue
Customers its existence and maintain stability of operations.

• What is the liquidity position of the firm?

Suppliers • To what extent the company is able to pay for our raw materials?
Process of Business Analysis
SWOT Analysis Business Environment and
Strategy Analysis
To what extent is the
company having a
Industry Analysis Strategy Analysis
competitive advantage

Today Forecasted earnings,

cashflows, ….etc
Financial Analysis

Accounting Profitability Risk Prospective

Analysis Analysis of Cash Flows Analysis
Analysis Analysis

Valuation models
The quality of financial
Cost of capital Intrinsic value
reporting and to what extent
estimates
records reflect reality
Financial Statement Analysis Tools

TOOLS

Comparative Common Size

Financial Financial Cash flow
Ratio Analysis Analysis Valuation
Statement Statement
Analysis Analysis

Year to Year
change Index Number Liquidity, Indirect
Analysis i.e. profitability, Direct Method Bond Stock
Trend Analysis Method
percentage or solvency and
dollar marketability

Dividend Free cash flow

Residual
Discount to equity
Income Model
Model model
Accounting Analysis
• Do the financial figures stated in the financial statements reflect the reality.
• Information should be both relevant and reliable,
• that’s why accounting standards should be followed
Accounting
Standards

GAAP IFRS EAS

(Generally Accepted (International Financial Egypt is following the

Accounting Principles). Reporting Standards). Egyptian Accounting
This is the system used This system is utilized by Standards depending
by the United States, and more than 110 countries on the International
almost no one else. around the world, Accounting
including Canada, Standards.
Australia, India, and China
Accounting Analysis : Reporting Standards
1. “Objectives of Financial Reporting by Business Enterprises.”
2. “Qualitative Characteristics of Accounting Information.”
3. “Elements of Financial Statements of Business Enterprises.”
4. “Recognition and Measurement in Financial Statements of Business
Enterprises.”
5. “Using Cash Flow Information and Present Value in Accounting
Measurements.
Objectives of Financial Reporting by Business
Enterprises.
i. Financial reporting is intended to provide information useful in making
business and economic decisions.
ii. The information should be comprehensible to those having a reasonable
understanding of business and economic activities.
Qualitative Characteristics of Accounting Information.
Makes Difference Objective Information is considered verifiable
when similar results are obtained
through independent measures, using
by helping [decision makers] to the same methods.
form predictions about
Outcomes of past, present, and
future events Relevance Reliability Faithfully presented
The numbers and descriptions on
your reports and statements should
Timely match what really existed or
happened.

Unbiased
This means that a company can not
be selective about what information it
shares to favor one party over
another

After the balance sheet date but before the date of issuance of financial statements, a company wants to dispose of
one of its subsidiaries and is in final stages of reaching a deal but the outcome is still uncertain. If the company
waits, the uncertainty would resolve and it can disclose more certain information which would represent the
underlying phenomena more truthfully. But this would be at the cost of reduction in relevance. The information
would be outdated and no longer very relevant.
Example: The uncertainty surrounding a company’s potential liability in a legal claim might be too high thereby making
the estimate not very accurate. However, the company might still present an estimate, even if not fully true and fair, and
explain the sources of uncertainty for the sake of relevance.
Elements of Financial Statements of Business Enterprises.
1. Future economic benefits obtained or controlled by a particular entity as a result of past transactions or events………………
Assets
2. Future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other
entities in the future as a result of past transactions or events…………
Liabilities
Equity
3. The residual interest in the assets of an entity that remains after deducting its liabilities…………….

4. Increases in equity of a particular business enterprise resulting from transfers to the enterprise from other entities of something of value to
obtain or increase ownership interests (or equity) in it. Assets, most commonly received by owners, may also include services or satisfaction or
Investment
conversion of liabilities of the enterprise…………
5. Decrease in equity of a particular business enterprise resulting from transferring assets, rendering services, or incurring liabilities by the
enterprise to owners. Such distributions to owners decrease ownership interest (or equity) in an enterprise……………….
Withdrawals
6. The change in equity (net assets) of a business enterprise during a period from transactions and other events and circumstances from
nonowner sources. It includes all changes in equity during a period except those resulting from investments by owners and distributions to
owners…………………..
Comprehensive income
7. Inflows or other enhancements of assets of an entity or settlements of its liabilities (or a combination of both) from delivering or producing
goods, rendering services, or other activities that constitute the entity’s ongoing major or central operations………………………
Revenues
8. Outflows or other consumption or using up of assets or incurrences of liabilities (or a combination of both) from delivering or producing
goods, rendering services, or carrying out other activities that constitute the entity’s ongoing major or central operations………………….
expenses
9. Increases in equity (net assets) from peripheral or incidental transactions of an entity and from all other transactions and other events and
Gains
circumstances affecting the entity during a period except those that result from revenues or investments by owners………………..
10, Decreases in equity (net assets) from peripheral or incidental transactions of an entity and from all other transactions and other events and
Losses
circumstances affecting the entity during a period except those that result from expenses or distributions to owners…………………
Recognition and Measurement in Financial Statements of Business Enterprises.”
This concept recommended that a full set of financial statements for a period
should show the following:
• 1. Financial position at the end of the period (Balance sheet)
• 2. Earnings (net income)
• 3. Comprehensive income (total nonowner change in equity)
• 4. Cash flows during the period
• 5. Investments by and distributions to owners during the period (Statement of OE)
This concept statement five different measurement attributes currently used in
practice:
• 1. Historical cost (historical proceeds) ( E.g. Land)
• 2. Current cost ( E.g. inventory)
• 3. Current market value ( E.g. Fixed asset acquired in exchange for shares or other securities)
• 4. Net realizable (settlement) value ( E.g. Depreciable assets, accounts receivable)
• 5. Present (or discounted) value of future cash flows (E.g. Capital lease, pensions, retirement
plans benefits)
Reporting Guidelines: Business Entity
The concept of separate entity means that the business or entity for which the
financial statements are prepared is separate and distinct from the owners of the
entity.
In other words, the entity is viewed as an economic unit that stands on its own.
Example: A corporation such as Ford Motor Company has many owners
(stockholders). The entity concept enables us to account for the Ford Motor
Company entity separately from the transactions of the owners of Ford Motor
Company.
Reporting Guidelines: Going Concern
• The going-concern assumption, that the entity in question will remain in business for an
indefinite period of time, provides perspective on the future of the entity.
• The going-concern assumption deliberately disregards the possibility that the entity will go
bankrupt or be liquidated. If a particular entity is in fact threatened with bankruptcy or
liquidation ‫ﻣﻬﺪدة �ﺎﻹﻓﻼس أو اﻟﺘﺼﻔ�ﺔ‬, then the going-concern assumption should be dropped.
• In such a case, the reader of the financial statements is interested in the liquidation values, not
the values that can be used when making the assumption that the business will continue
indefinitely.
• In this case, conventional financial report analysis would not apply. Many of our present
financial statement figures would be misleading if it were not for the going-concern
assumption.
• Hence, the financial statements must clearly disclose that the statements were prepared with
the view that the entity will be liquidated or that it is a failing concern.
Example, under the going-concern assumption, the value of prepaid insurance is computed by
spreading the cost of the insurance over the period of the policy. If the entity were liquidated,
then only the cancellation value of the policy would be meaningful.
Reporting Guidelines: Going Concern
Example, Inventories are basically carried at their accumulated cost. If the entity was
liquidated, then the amount realized from the sale of the inventory, in a manner other than
through the usual channels, usually would be substantially less than the cost. Therefore, to
carry the inventory at market
Example the amounts provided for warranties and guarantees would not be realistic if
the entity were liquidating ‫اﻟﺘﺼﻔ�ﺔ‬.
• The going-concern assumption also influences the classification of assets and liabilities.
Without the going-concern assumption, all assets and liabilities would be current, with the
expectation that the assets would be liquidated and the liabilities paid in the near future.
Reporting Guidelines: Periodicity
• The reporting of transactions can be monthly, quarterly, semi-annually or
annually.
• Periodicity depends on using a calendar year or a fiscal year.

Reporting Guidelines: Monetary Unit

Accountants need some standard of measure to bring financial transactions
together in a meaningful way. Without some standard of measure,
accountants would be forced to report in such terms as 5 cars, 1 factory,
and 100 acres.
Reporting Guidelines: Historical Value
• Often, historical cost is used in practice because it is objective and
determinable.
• A deviation from historical cost is accepted when it becomes apparent that the
historical cost cannot be recovered.
Example, using the realizable value in case of liquidation
Reporting Guidelines: Conservatism
• The accountant is often faced with a choice of different measurements of a situation, with
each measurement having reasonable support.
• According to the concept of conservatism, the accountant must select the measurement
with the least favourable effect on net income and financial position in the current period.
• Examples of accepted conservatism
• writing down or writing off obsolete inventory prior to sale,
• recognizing a loss on a long-term construction contract when it can be reasonably anticipated (expected),
• Estimating of warranty expense reflects the least favourable effect on net income and the financial
position of the current period.
Reporting Guidelines: Realization
• Accountants face a problem of when to recognize revenue.
• The problem becomes how to determine objectively the contribution of each of the
segments toward revenue. Since this is not practical, accountants must determine when it is
practical to recognize revenue.
• In practice, revenue recognition has been the subject of much debate. This has resulted in
fairly wide interpretations.
• In general, the point of recognition of revenue should be the point in time when revenue
can be reasonably and objectively determined.
• The problem is when……………….?!!!!!
• Revenue is usually recognized at the point of sale where at this time, the earning process is
virtually complete, and the exchange value can be determined.
• There are times when the use of the point-of-sale approach does not give a fair result.
Example, the sale of land on credit to a buyer who does not have a reasonable ability to
pay. If revenue were recognized at the point of sale, there would be a reasonable chance
that sales had been overstated because of the material risk of default.
Point of Sale
• There are many other acceptable methods of recognizing revenue
that should be considered, such as the following:
• 1. End of production
• 2. Receipt of cash
• 3. During production
• 4. Cost recovery
Point of Sale
• End of Production The recognition of revenue at the completion of the production process is acceptable when
the price of the item is known and there is a ready market.
• Examples,
• The mining of gold or silver
• The harvesting of some farm products.
• Receipt of Cash The receipt of cash is another basis for revenue recognition. This method should be used
when collection is not capable of reasonable estimation at the time of sale.

• During Production Some long-term construction projects recognize revenue as the construction progresses.
• This exception tends to give a fairer picture of the results for a given period of time.
For example, in the building of a utility plant, which may take several years, recognizing revenue as work progresses
gives a fairer picture of the results than does having the entire revenue recognized in the period when the plant is
completed.
Reporting Standards: Matching
• Accountants need a related concept that addresses when to recognize the costs
associated with the recognized revenue
• The basic intent is to determine the revenue first and then match the appropriate
costs against this revenue.
• Some costs, such as the cost of inventory, can be easily matched with revenue. When
we sell the inventory and recognize the revenue, the cost of the inventory can be
matched against the revenue.
• Other costs have no direct connection with revenue, so some systematic policy must
be adopted in order to allocate these costs reasonably against revenues. Examples
are research and development costs and public relations costs.
Examples Both research and development costs and public relations costs are charged
off in the period incurred.
Reporting Standards: Consistency
• The consistency concept requires the entity to give the same treatment to comparable
transactions from period to period.
• This adds to the usefulness of the reports, since the reports from one period are comparable
to the reports from another period.
• It also facilitates the detection of trends.
• Many accounting methods could be used for any single item, such as inventory. If inventory
were determined in one period on one basis and in the next period on a different basis, the
resulting inventory and profits would not be comparable from period to period.
• Entities sometimes need to change particular accounting methods in order to adapt to
changing environments (examples, change of the industry, purchase of a different asset, a
new accounting pronouncement)
• If the entity can justify the use of an alternative accounting method, the change can be made.
The entity must be ready to defend the change—a responsibility that should not be taken
lightly in view of the liability for misleading financial statements.
• The justification for the change must be disclosed, along with an explanation of the effect on
the statements.
Reporting Standards: Full disclosure
• The financial statements are expected to summarize significant financial information.
• The accounting reports must disclose all facts that may influence the judgment of an
informed reader.
• Several methods of disclosure exist, such as parenthetical explanations, supporting
schedules, cross-references, and notes. Often, the additional disclosures must be made by a
note in order to explain the situation properly.
• For example, details of a pending lawsuit provision
Reporting Standards: Materiality
• The materiality concept involves the relative size and importance of an item to a firm. A
material item to one entity may not be material to another.
For example, an item that costs $100 might be expensed by General Motors, but the same
item might be carried as an asset by a small entity. It is essential that material items be
properly handled on the financial statements.
• Immaterial items are not subject to the concepts and principles that bind the accountant.
They may be handled in the most economical and expedient manner possible.
Reporting Standards: Industry Practices
• In some industries, it is very difficult to determine the cost of the inventory.
Example the flower industry
• In these areas, it may be necessary to determine the inventory value by working backward
from the anticipated selling price and subtracting the estimated cost to complete and dispose
of the inventory.
• The inventory would thus be valued at a net realizable value, which would depart from the
cost concept
Transaction Approach
• The accountant records only events that affect the financial position of the entity
and, at the same time, can be reasonably determined in monetary terms.
• Many important events that influence the prospects for the entity are not
recorded and, therefore, are not reflected in the financial statements because
they fall outside the transaction approach.
Examples
• The death of a top executive could have a material influence on future prospects, especially
for a small company.
• One of the company’s major suppliers could go bankrupt at a time when the entity does not
have an alternative source.
• The entity may have experienced a long strike by its employees or have a history of labor
problems.
• A major competitor may go out of business.
• All these events may be significant to the entity. They are not recorded because
they are not transactions.
• Thus, when projecting the future prospects of an entity, it is necessary to go
beyond current financial reports.
Reporting Standards: Cash vs Accrual Basis
• CASH BASIS it recognizes revenue when cash is received and recognizes expenses when
cash is paid. The cash basis usually does not provide reasonable information about the
earning capability of the entity in the short run. Therefore, the cash basis is usually not
acceptable.
• ACCRUAL BASIS The accrual basis of accounting recognizes revenue when realized
(realization concept) and expenses when incurred (matching concept).
• If the difference between the accrual basis and the cash basis is not material, the entity may
use the cash basis as an alternative to the accrual basis for income determination.
• Usually, the difference between the accrual basis and the cash basis is material.
Question (1): Accounting Standards: Identify the accounting principle(s) applicable to each of the following
situations:
a) A Tim Roberts owns a bar and a rental apartment and operates a consulting service. He has separate financial
statements for each. Business Entity
b) An advance collection for magazine subscriptions is reported as a liability titled Unearned Subscriptions. Realization

c) Purchases for office or store equipment for less than $25 are entered in Miscellaneous Expense. Materiality
d) A company uses the lower of cost or market for valuation of its inventory. Conservatism
e) Partially completed television sets are carried at the sum of the cost incurred to date. Realization – point of sale
f) Land purchased 15 years ago for $40,500 is now worth $346,000. It is still carried on the books at $40,500. Historical
g) Zero Corporation is being sued for $1,000,000 for breach of contract. Its lawyers believe that the damages will be
minimal. Zero reports the possible loss in a note. Full Disclosure
Process of Business Analysis
SWOT Analysis Business Environment and
Strategy Analysis
To what extent is the
Strategy Analysis company having a
Industry Analysis
competitive advantage

Today Forecasted earnings,

cashflows, ….etc
Financial Analysis

Accounting Profitability Risk Prospective

Analysis Analysis of Cash Flows Analysis
Analysis Analysis

Valuation models
The quality of financial
Cost of capital Intrinsic value
reporting and to what extent
estimates
records reflect reality
Financial Statement Analysis Tools

TOOLS

Comparative Common Size

Financial Financial Cash flow
Ratio Analysis Analysis Valuation
Statement Statement
Analysis Analysis

Year to Year
change Index Number Liquidity, Indirect
Analysis i.e. profitability, Direct Method Bond Stock
Trend Analysis Method
percentage or solvency and
dollar marketability

Dividend Free cash flow

Residual
Discount to equity
Income Model
Model model
Question (3): Financial Statement Analysis Tools
A. Comparative Financial Statements: Compute the dollar value and percent increase for each of the following
accounting balances.
Year 2 Year 1 $ change % change
Short term investments $217,800 $165,000 $52,800 32%
Accounts Receivable $42,120 $48,000 ($5,880) 12.25%
Notes Payable $57,000 0 $57,000 meaningless

Dollar Change = New – Old

Dollar Change = [New – Old]/old

B. Comparative Financial Statements: Compute the Trend Analysis using year 1 as base year.
Year 5 Year 4 Year 3 Year 2 Year 1

Sales $283,880 $271,800 $253,680 $235,560 $151,000

COGS $129,200 $123,080 $116,280 $107,440 $68,000
Accounts Receivable $19,100 $18,300 $17,400 $16,200 $10,000

Fix a base year as optimal = 100%

Present every year with respect to it , [i.e selected year figure/base year figure] x 100

Year 5 Year 4 Year 3 Year 2 Year 1

Sales
188% 180% 168% 156% 100 %

COGS 181% 171% 100

190% 158%

Accounts Receivable 191% 183% 174% 162% 100

C. Express the following income statement information in common Size percent and assess whether the company’s situation is
favorable or unfavorable.
Harrison Incorporation
Comparative Income Statement
For the years ended, December 31, 2006 and 2005
2006 2005
Sales $720,000 $535,000
COGS ($475,200) ($280,340)
Gross Profit $244,800 $254,660
Operating Expenses ($151,200) ($103,790)
Net income $93,600 $150,870

Same as trend but fix a base figure example sales in the income statement and total assets in the balance sheet
2006 2005
Sales 100%
100%
COGS 66% 52.4%
Gross Profit 34 % 47.6%
Operating Expenses 21% 19.4%

Net income 13% 28.2%

 End of Lecture (1)
• Covered Today
• Difference between financial reporting and financial analysis
• Steps of Business Analysis
• Standards of Financial Reporting
• Tools of Financial Analysis
• Common Size Analysis
• Comparative financial statement Analysis