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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 ad- ministered 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 fi nance students and covers the most important topics in the industry. Th e 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

Th ird Edition

Th omas R. Robinson, CFA

Elaine Henry, CFA

Wendy L. Pirie, CFA

Michael A. Broihahn, CFA

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Copyright © 2015 by CFA Institute. All rights reserved.

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v

CONTENTS

Foreword xvii

Preface xix

Acknowledgments xxi

About the CFA Investment Series xxiii

CHAPTER 1 Financial Statement Analysis: An Introduction 1

Learning Outcomes 1 1. Introduction 1 2. Scope of Financial Statement Analysis 2 3. Major Financial Statements and Other Information Sources 7

3.1. Financial Statements and Supplementary Information 8 3.2. Other Sources of Information 27

4. Financial Statement Analysis Framework 28 4.1. Articulate the Purpose and Context of Analysis 30 4.2. Collect Data 30 4.3. Process Data 31 4.4. Analyze/Interpret the Processed Data 31 4.5. Develop and Communicate Conclusions/Recommendations 32 4.6. Follow-Up 32

5. Summary 32 References 34 Problems 34

CHAPTER 2 Financial Reporting Mechanics 37

Learning Outcomes 37 1. Introduction 38 2. Th e Classifi cation of Business Activities 38 3. Accounts and Financial Statements 39

vi Contents

3.1. Financial Statement Elements and Accounts 40 3.2. Accounting Equations 42

4. Th e Accounting Process 47 4.1. An Illustration 47 4.2. Th e Accounting Records 49 4.3. Financial Statements 62

5. Accruals and Valuation Adjustments 65 5.1. Accruals 65 5.2. Valuation Adjustments 67

6. Accounting Systems 67 6.1. Flow of Information in an Accounting System 68 6.2. Debits and Credits 69

7. Using Financial Statements in Security Analysis 69 7.1. Th e Use of Judgment in Accounts and Entries 69 7.2. Misrepresentations 70

8. Summary 71 Appendix: A Debit/Credit Accounting System 71 Problems 87

CHAPTER 3 Financial Reporting Standards 91

Learning Outcomes 91 1. Introduction 92 2. Th e Objective of Financial Reporting 92 3. Standard-Setting Bodies and Regulatory Authorities 95

3.1. Accounting Standards Boards 96 3.2. Regulatory Authorities 99

4. Convergence of Global Financial Reporting Standards 104 5. Th e International Financial Reporting Standards Framework 107

5.1. Objective of Financial Reports 109 5.2. Qualitative Characteristics of Financial Reports 109 5.3. Constraints on Financial Reports 110 5.4. Th e Elements of Financial Statements 112 5.5. General Requirements for Financial Statements 114 5.6. Convergence of Conceptual Framework 118

6. Eff ective Financial Reporting 119 6.1. Characteristics of an Eff ective Financial Reporting

Framework 119 6.2. Barriers to a Single Coherent Framework 120

7. Comparison of IFRS with Alternative Reporting Systems 121 8. Monitoring Developments in Financial Reporting Standards 123

8.1. New Products or Types of Transactions 123 8.2. Evolving Standards and the Role of CFA Institute 124 8.3. Company Disclosures 125

9. Summary 128 Problems 130

Contents vii

CHAPTER 4 Understanding Income Statements 133

Learning Outcomes 133 1. Introduction 134 2. Components and Format of the Income Statement 135 3. Revenue Recognition 139

3.1. General Principles 140 3.2. Revenue Recognition in Special Cases 143 3.3. Implications for Financial Analysis 150

4. Expense Recognition 152 4.1. General Principles 152 4.2. Issues in Expense Recognition 156 4.3. Implications for Financial Analysis 161

5. Non-Recurring Items and Non-Operating Items 162 5.1. Discontinued Operations 163 5.2. Extraordinary Items 163 5.3. Unusual or Infrequent Items 164 5.4. Changes in Accounting Policies 165 5.5. Non-Operating Items 168

6. Earnings per Share 169 6.1. Simple versus Complex Capital Structure 169 6.2. Basic EPS 170 6.3. Diluted EPS 171 6.4. Changes in EPS 178

7. Analysis of the Income Statement 178 7.1. Common-Size Analysis of the Income Statement 178 7.2. Income Statement Ratios 181

8. Comprehensive Income 183 9. Summary 186 Problems 188

CHAPTER 5 Understanding Balance Sheets 193

Learning Outcomes 193 1. Introduction 193 2. Components and Format of the Balance Sheet 194

2.1. Balance Sheet Components 195 2.2. Current and Non-Current Classifi cation 197 2.3. Liquidity-Based Presentation 198

3. Current Assets and Current Liabilities 199 3.1. Current Assets 199 3.2. Current Liabilities 206

4. Non-Current Assets 209 4.1. Property, Plant, and Equipment 211 4.2. Investment Property 212 4.3. Intangible Assets 212

viii Contents

4.4. Goodwill 215 4.5. Financial Assets 217

5. Non-Current Liabilities 220 5.1. Long-term Financial Liabilities 222 5.2. Deferred Tax Liabilities 222

6. Equity 223 6.1. Components of Equity 223 6.2. Statement of Changes in Equity 225

7. Analysis of the Balance Sheet 227 7.1. Common-Size Analysis of the Balance Sheet 227 7.2. Balance Sheet Ratios 235

8. Summary 237 Problems 239

CHAPTER 6 Understanding Cash Flow Statements 243

Learning Outcomes 243 1. Introduction 243 2. Components and Format of the Cash Flow Statement 244

2.1. Classifi cation of Cash Flows and Non-Cash Activities 245 2.2. A Summary of Diff erences between IFRS and US GAAP 247 2.3. Direct and Indirect Methods for Reporting Cash Flow from

Operating Activities 248 3. Th e Cash Flow Statement: Linkages and Preparation 258

3.1. Linkages of the Cash Flow Statement with the Income Statement and Balance Sheet 258

3.2. Steps in Preparing the Cash Flow Statement 260 3.3. Conversion of Cash Flows from the Indirect to the Direct Method 272

4. Cash Flow Statement Analysis 273 4.1. Evaluation of the Sources and Uses of Cash 274 4.2. Common-Size Analysis of the Statement of Cash Flows 277 4.3. Free Cash Flow to the Firm and Free Cash Flow to Equity 282 4.4. Cash Flow Ratios 283

5. Summary 285 Reference 286 Problems 286

CHAPTER 7 Financial Analysis Techniques 291

Learning Outcomes 291 1. Introduction 291 2. Th e Financial Analysis Process 292

2.1. Th e Objectives of the Financial Analysis Process 293 2.2. Distinguishing between Computations and Analysis 294

3. Analytical Tools and Techniques 296

Contents ix

3.1. Ratios 300 3.2. Common-Size Analysis 304 3.3. Th e Use of Graphs as an Analytical Tool 311 3.4. Regression Analysis 312

4. Common Ratios Used in Financial Analysis 313 4.1. Interpretation and Context 313 4.2. Activity Ratios 314 4.3. Liquidity Ratios 320 4.4. Solvency Ratios 325 4.5. Profi tability Ratios 329 4.6. Integrated Financial Ratio Analysis 333

5. Equity Analysis 341 5.1. Valuation Ratios 341 5.2. Industry-Specifi c Ratios 344 5.3. Research on Ratios in Equity Analysis 346

6. Credit Analysis 347 6.1. Th e Credit Rating Process 347 6.2. Research on Ratios in Credit Analysis 349

7. Business and Geographic Segments 350 7.1. Segment Reporting Requirements 350 7.2. Segment Ratios 351

8. Model Building and Forecasting 353 9. Summary 353 References 354 Problems 355

CHAPTER 8 Inventories 363

Learning Outcomes 363 1. Introduction 363 2. Cost of Inventories 365 3. Inventory Valuation Methods 366

3.1. Specific Identification 367 3.2. First-In, First-Out (FIFO) 367 3.3. Weighted Average Cost 367 3.4. Last-In, First-Out (LIFO) 368 3.5. Calculation of Cost of Sales, Gross Profit, and Ending Inventory 368 3.6. Periodic versus Perpetual Inventory Systems 370 3.7. Comparison of Inventory Valuation Methods 373

4. Th e LIFO Method 375 4.1. LIFO Reserve 375 4.2. LIFO Liquidations 382

5. Inventory Method Changes 386 6. Inventory Adjustments 386 7. Evaluation of Inventory Management 393

7.1. Presentation and Disclosure 394 7.2. Inventory Ratios 394

x Contents

7.3. Financial Analysis Illustrations 395 8. Summary 406 Problems 408

CHAPTER 9 Long-Lived Assets 421

Learning Outcomes 421 1. Introduction 422 2. Acquisition of Long-Lived Assets 423

2.1. Property, Plant, and Equipment 423 2.2. Intangible Assets 426 2.3. Capitalizing versus Expensing—Impact on Financial Statements and Ratios 429 2.4. Capitalization of Interest Costs 434 2.5. Capitalization of Internal Development Costs 437

3. Depreciation and Amortization of Long-Lived Assets 440 3.1. Depreciation Methods and Calculation of Depreciation Expense 441 3.2. Amortization Methods and Calculation of Amortization Expense 449

4. Th e Revaluation Model 450 5. Impairment of Assets 453

5.1. Impairment of Property, Plant, and Equipment 454 5.2. Impairment of Intangible Assets with a Finite Life 455 5.3. Impairment of Intangibles with Indefinite Lives 455 5.4. Impairment of Long-Lived Assets Held for Sale 455 5.5. Reversals of Impairments of Long-Lived Assets 455

6. Derecognition 456 6.1. Sale of Long-Lived Assets 456 6.2. Long-Lived Assets Disposed of Other Th an by a Sale 457

7. Presentation and Disclosures 458 8. Investment Property 469 9. Leasing 471

9.1. Th e Lease versus Buy Decision 472 9.2. Finance versus Operating Leases 472

10. Summary 493 Problems 495

CHAPTER 10 Non-Current (Long-Term) Liabilities 505

Learning Outcomes 505 1. Introduction 506 2. Bonds Payable 506

2.1. Accounting for Bond Issuance 506 2.2. Accounting for Bond Amortisation, Interest Expense,

and Interest Payments 510 2.3. Current Market Rates and Fair Value Reporting Option 515 2.4. Derecognition of Debt 517

Contents xi

2.5. Debt Covenants 520 2.6. Presentation and Disclosure of Long-Term Debt 522

3. Leases 525 3.1. Advantages of Leasing 526 3.2. Finance (or Capital) Leases versus Operating Leases 526

4. Introduction to Pensions and Other Post-Employment Benefi ts 544 5. Evaluating Solvency: Leverage and Coverage Ratios 547 6. Summary 551 Problems 552

CHAPTER 11 Financial Reporting Quality 555

Learning Outcomes 555 1. Introduction 556 2. Conceptual Overview 557

2.1. GAAP, Decision-Useful, Sustainable, and Adequate Returns 558 2.2. GAAP, Decision-Useful, but Sustainable? 559 2.3. Biased Accounting Choices 560 2.4. Departures from GAAP 567 2.5. Diff erentiate between Conservative and Aggressive Accounting 569

3. Context for Assessing Financial Reporting Quality 573 3.1. Motivations 573 3.2. Conditions Conducive to Issuing Low-Quality Financial Reports 574 3.3. Mechanisms Th at Discipline Financial Reporting Quality 575

4. Detection of Financial Reporting Quality Issues 581 4.1. Presentation Choices 581 4.2. Accounting Choices and Estimates 586 4.3. Warning Signs 603

5. Summary 609 References 610 Problems 611

CHAPTER 12 Financial Statement Analysis: Applications 613

Learning Outcomes 613 1. Introduction 614 2. Application: Evaluating Past Financial Performance 614 3. Application: Projecting Future Financial Performance 623

3.1. Projecting Performance: An Input to Market-Based Valuation 624 3.2. Projecting Multiple-Period Performance 629

4. Application: Assessing Credit Risk 633 5. Application: Screening for Potential Equity Investments 637 6. Analyst Adjustments to Reported Financials 640

6.1. A Framework for Analyst Adjustments 640 6.2. Analyst Adjustments Related to Investments 641

xii Contents

6.3. Analyst Adjustments Related to Inventory 641 6.4. Analyst Adjustments Related to Property, Plant, and Equipment 645 6.5. Analyst Adjustments Related to Goodwill 646 6.6. Analyst Adjustments Related to Off -Balance-Sheet Financing 649

7. Summary 656 References 656 Problems 657

CHAPTER 13 Income Taxes 661

Learning Outcomes 661 1. Introduction 662 2. Diff erences between Accounting Profi t and Taxable Income 662

2.1. Current Tax Assets and Liabilities 663 2.2. Deferred Tax Assets and Liabilities 664

3. Determining the Tax Base of Assets and Liabilities 667 3.1. Determining the Tax Base of an Asset 668 3.2. Determining the Tax Base of a Liability 669 3.3. Changes in Income Tax Rates 671

4. Temporary and Permanent Diff erences between Taxable and Accounting Profi t 672 4.1. Taxable Temporary Diff erences 673 4.2. Deductible Temporary Diff erences 673 4.3. Examples of Taxable and Deductible Temporary Diff erences 674 4.4. Temporary Diff erences at Initial Recognition of Assets and

Liabilities 676 4.5. Business Combinations and Deferred Taxes 677 4.6. Investments in Subsidiaries, Branches, Associates and Interests

in Joint Ventures 677 5. Unused Tax Losses and Tax Credits 677 6. Recognition and Measurement of Current and Deferred Tax 678

6.1. Recognition of a Valuation Allowance 679 6.2. Recognition of Current and Deferred Tax Charged Directly to Equity 679

7. Presentation and Disclosure 682 8. Comparison of IFRS and US GAAP 687 9. Summary 690 Problems 691

CHAPTER 14 Employee Compensation: Post-Employment and Share-Based 697

Learning Outcomes 697 1. Introduction 697 2. Pensions and Other Post-Employment Benefi ts 698

2.1. Types of Post-Employment Benefi t Plans 698 2.2. Measuring a Defi ned Benefi t Pension Plan’s Obligations 701

Contents xiii

2.3. Financial Statement Reporting of Pension Plans and Other Post-Employment Benefi ts 702

2.4. Disclosures of Pension and Other Post-Employment Benefi ts 715 3. Share-Based Compensation 726

3.1. Stock Grants 728 3.2. Stock Options 729 3.3. Other Types of Share-Based Compensation 732

4. Summary 732 Reference 733 Problems 733

CHAPTER 15 Intercorporate Investments 739

Learning Outcomes 739 1. Introduction 739 2. Basic Corporate Investment Categories 741 3. Investments in Financial Assets: Standard IAS 39

(as of December 2012) 742 3.1. Held-to-Maturity 743 3.2. Fair Value through Profi t or Loss 743 3.3. Available-for-Sale 744 3.4. Loans and Receivables 745 3.5. Reclassifi cation of Investments 746 3.6. Impairments 747

4. Investments in Financial Assets: IFRS 9 (as of December 2012) 752 4.1. Classifi cation and Measurement 752 4.2. Reclassifi cation of Investments 754

5. Investments in Associates and Joint Ventures 755 5.1. Equity Method of Accounting: Basic Principles 756 5.2. Investment Costs Th at Exceed the Book Value of the Investee 759 5.3. Amortization of Excess Purchase Price 761 5.4. Fair Value Option 763 5.5. Impairment 763 5.6. Transactions with Associates 764 5.7. Disclosure 766 5.8. Issues for Analysts 767

6. Business Combinations 767 6.1. Pooling of Interests and Purchase Methods 769 6.2. Acquisition Method 770 6.3. Impact of the Acquisition Method on Financial Statements,

Post-Acquisition 772 6.4. Th e Consolidation Process 775 6.5. Financial Statement Presentation Subsequent to the

Business Combination 781 6.6. Variable Interest and Special Purpose Entities 784

xiv Contents

6.7. Additional Issues in Business Combinations Th at Impair Comparability 788

7. Summary 789 Problems 790

CHAPTER 16 Multinational Operations 799

Learning Outcomes 799 1. Introduction 800 2. Foreign Currency Transactions 801

2.1. Foreign Currency Transaction Exposure to Foreign Exchange Risk 802 2.2. Analytical Issues 805 2.3. Disclosures Related to Foreign Currency Transaction Gains and Losses 808

3. Translation of Foreign Currency Financial Statements 814 3.1. Translation Conceptual Issues 814 3.2. Translation Methods 819 3.3. Illustration of Translation Methods (Excluding Hyperinfl ationary

Economies) 827 3.4. Translation Analytical Issues 830 3.5. Translation when a Foreign Subsidiary Operates in a Hyperinfl ationary

Economy 842 3.6. Companies Use Both Translation Methods at the Same Time 846 3.7. Disclosures Related to Translation Methods 847

4. Multinational Operations and a Company’s Eff ective Tax Rate 853 5. Additional Disclosures on the Eff ects of Foreign Currency 856

5.1. Disclosures Related to Sales Growth 856 5.2. Disclosures Related to Major Sources of Foreign Exchange Risk 859

6. Summary 860 Problems 862

CHAPTER 17 Evaluating Quality of Financial Reports 869

Learning Outcomes 869 1. Introduction 869 2. Quality of Financial Reports 871

2.1. Conceptual Framework for Assessing the Quality of Financial Reports 871

2.2. Potential Problems Th at Aff ect the Quality of Financial Reports 873 3. Evaluating the Quality of Financial Reports 884

3.1. General Steps to Evaluate the Quality of Financial Reports 885 3.2. Quantitative Tools to Assess the Likelihood of Misreporting 886

4. Earnings Quality 889 4.1. Indicators of Earnings Quality 889 4.2. Evaluating the Earnings Quality of a Company (Cases) 899 4.3. Bankruptcy Prediction Models 910

Contents xv

5. Cash Flow Quality 911 5.1. Indicators of Cash Flow Quality 912 5.2. Evaluating Cash Flow Quality 913

6. Balance Sheet Quality 921 7. Sources of Information about Risk 925

7.1. Limited Usefulness of Auditor’s Opinion as a Source of Information about Risk 925

7.2. Risk-Related Disclosures in the Notes 929 7.3. Management Commentary (Management Discussion

and Analysis, or MD&A) 933 7.4. Other Required Disclosures 936 7.5. Financial Press as a Source of Information about Risk 937

8. Summary 937 References 939 Problems 940

CHAPTER 18 Integration of Financial Statement Analysis Techniques 943

Learning Outcomes 943 1. Introduction 944 2. Case Study 1: Long-Term Equity Investment 945

2.1. Phase 1: Defi ne a Purpose for the Analysis 945 2.2. Phase 2: Collect Input Data 945 2.3. Phase 3: Process Data/Phase 4: Analyze/Interpret the

Processed Data 946 2.4. Phase 5: Develop and Communicate Conclusions and

Recommendations (e.g., with an Analysis Report) 971 2.5. Phase 6: Follow-up 972

3. Case Study 2: Off -Balance Sheet Leverage from Operating Leases 972 3.1. Phase 1: Defi ne a Purpose for the Analysis 973 3.2. Phase 2: Collect Input Data 973 3.3. Phase 3: Process Data/Phase 4: Analyze/Interpret the

Processed Data 973 3.4. Phase 5: Develop and Communicate Conclusions and

Recommendations (e.g., with an Analysis Report) 975 3.5. Phase 6: Follow-up 976

4. Case Study 3: Anticipating Eff ects of Changes in Accounting Standards 976 4.1. Phase 1: Defi ne a Purpose for the Analysis 977 4.2. Phase 2: Collect Input Data 977 4.3. Phase 3: Process Data/Phase 4: Analyze/Interpret the

Processed Data 977 4.4. Phase 5: Develop and Communicate Conclusions and

Recommendations (e.g., with an Analysis Report) 980 4.5. Phase 6: Follow-up 980

5. Summary 980 Problems 981

xvi Contents

Glossary 987

About the Authors 999

About the CFA Program 1003

Index 1005

xvii

FOREWORD

Th e stated objective of the International Accounting Standards Board (IASB) is to produce accounting standards that are principle-based, internally consistent, and internationally con- verged. Th e resulting fi nancial statements should provide a framework that gives capital market participants the tools to make rational and intelligent decisions. Th e role of the analyst as an interpreter of the numbers that appear in the fi nancial statements is critical in this process.

Making valuation estimates and the accompanying decisions in an international context is, in principle, no diff erent from a purely domestic one. In both cases, the fi nancial reporting model is the primary source of the information required. Recommendations and decisions have to be made based on careful analysis. Th e learning outcomes and techniques described in this volume are designed to enable the analyst to do just that.

Collecting and analyzing data is the core analytical function, but communication is also critical. Th e best and most rigorous analysis has to be supplemented by an understanding of how investment decisions are made, or it will fail its purpose. It must be communicated to the intended recipient in a way that explains the logic behind the valuation estimate or rec- ommendation and promotes understanding and action. Communication skills, in addition to analytical methods, are discussed in the readings.

Th e readings also point to the necessity of exercising judgment as part of the ana- lytical process. Th is is particularly important in the context of International Financial Reporting Standards (IFRS). As noted, an important element of IFRS is that the standards are principle-based and not unduly prescriptive (as some perceive US Generally Accepted Accounting Principles to be). Th e objective is to allow a degree of fl exibility that permits company management to present corporate results in the most meaningful way, while pre- serving the spirit intended—substance over form. However, this presents the analyst with an additional challenge in interpreting the published fi gures and comparing them with those of other entities.

CFA Institute and its members have long supported the development of a global set of ac- counting standards; the benefi ts, in terms of improved comparability for investors and lowered cost of capital for corporations, are evident. IFRS are now accepted or required, in whole or in part, in some 100 or more jurisdictions around the world. (So far, in the United States, only a few foreign registrants with the SEC are permitted to use the Standards.) Achieving com- parability between companies reporting in Tokyo, Toronto, or Turin would seem to meet the cherished goal of a global fi nancial reporting system. But a word of caution is warranted. Few countries want to give up sovereignty to an independent authority based in London, no matter how high the quality of the output may be. Standard setting is ultimately a political process, and powerful constituencies abound that have objectives that may diff er from the provision of decision-useful information for investors. And in order to become law in many jurisdictions, some sort of endorsement mechanism has to be established. Endorsements can, in some cases, exclude provisions in standards, or off er exceptions or options not present in the original text. Th e result can be deviations from the published standards. While there may be one language,

xviii Foreword

various dialects can emerge, and the analyst must be vigilant to discern these diff erences, and their signifi cance.

Addendum: 30 September 2014 Regrettably, Tony Cope, author of the preceding foreword, passed away in November 2013. As we prepare for the third edition an d review his foreword to the second edition of the book, we cannot help but note how well his comments stand the test of time.

Tony was on the forefront of advocating for convergence in international accounting standards and for assuring consistency and transparency in how company performance is re- ported. Tony was a member of the US Financial Accounting Standards Board from 1993 to 2001. After playing a leading role in the Strategy Working Party that led to the creation of the International Accounting Standards Board (IASB) in 2001, Tony served as a member of the IASB from 2001 through 2007.

Tony made substantial, long-lasting contributions to the quality of global fi nancial report- ing. More than that, he was a friendly, caring person and is deeply missed by his many friends and colleagues.

Sandra Peters, CFA 11 November 2014

xix

PREFACE

International Financial Statement Analysis is a practically oriented introduction to fi nancial statement analysis. Each chapter covers one major area of fi nancial statement analysis and is written by highly credentialed experts. By taking a global perspective on accounting standards, with a focus on international fi nancial reporting standards (IFRS), and by selecting a broad range of companies for illustration, the book well equips the reader for practice in today’s global marketplace.

Th e content was developed in partnership by a team of distinguished academics and prac- titioners, chosen for their acknowledged expertise in the fi eld, and guided by CFA Institute. It is written specifi cally with the investment practitioner in mind and is replete with examples and practice problems that reinforce the learning outcomes and demonstrate real-world ap- plicability.

Th e CFA Program Curriculum, from which the content of this book was drawn, is sub- jected to a rigorous review process to assure that it is:

• Faithful to the fi ndings of our ongoing industry practice analysis • Valuable to members, employers, and investors • Globally relevant • Generalist (as opposed to specialist) in nature • Replete with suffi cient examples and practice opportunities • Pedagogically sound

Th e accompanying workbook is a useful reference that provides Learning Outcome State- ments, which describe exactly what readers will learn and be able to demonstrate after mas- tering the accompanying material. Additionally, the workbook has summary overviews and practice problems for each chapter.

We hope you will fi nd this and other books in the CFA Institute Investment Series helpful in your eff orts to grow your investment knowledge, whether you are a relatively new entrant or an experienced veteran striving to keep up to date in the ever-changing market environment. CFA Institute, as a long-term committed participant in the investment profession and a not- for-profi t global membership association, is pleased to provide you with this opportunity.

THE CFA PROGRAM

If the subject matter of this book interests you, and you are not already a CFA charterholder, we hope you will consider registering for the CFA Program and starting progress toward earn- ing the Chartered Financial Analyst designation. Th e CFA designation is a globally recognized standard of excellence for measuring the competence and integrity of investment professionals.

xx Preface

To earn the CFA charter, candidates must successfully complete the CFA Program, a global graduate-level self-study program that combines a broad curriculum with professional conduct requirements as preparation for a career as an investment professional.

Anchored by a practice-based curriculum, the CFA Program Body of Knowledge refl ects the knowledge, skills, and abilities identifi ed by professionals as essential to the investment decision-making process. Th is body of knowledge maintains its relevance through a regular, extensive survey of practicing CFA charterholders across the globe. Th e curriculum covers 10 general topic areas, ranging from equity and fi xed-income analysis to portfolio management to corporate fi nance—all with a heavy emphasis on the application of ethics in professional practice. Known for its rigor and breadth, the CFA Program curriculum highlights principles common to every market so that professionals who earn the CFA designation have a thor- oughly global investment perspective and a profound understanding of the global marketplace.

xxi

ACKNOWLEDGMENTS

Authors We would like to thank the many distinguished editors and authors who contributed out- standing chapters in their respective areas of expertise:

Th omas R. Robinson, PhD, CFA Elaine Henry, PhD, CFA Wendy L. Pirie, PhD, CFA Michael A. Broihahn, CFA Jack T. Ciesielski, CFA, CPA Timothy S. Doupnik, PhD

Elizabeth A. Gordon Elbie Louw, CFA Karen O’Connor Rubsam, CPA, CFA Th omas I. Selling, PhD, CPA Hennie van Greuning, CFA Susan Perry Williams, PhD

Reviewers Special thanks to all the reviewers who helped shape the materials to ensure high practical relevance, technical correctness, and understandability.

Evan Ashcraft, CFA Christoph Behr, CFA Lachlan Christie, CFA Tony Cope, CFA Timothy Doupnik, PhD Bryan Gardiner, CFA Ioannis Georgiou, CFA Osman Ghani, CFA Karen O’Connor Rubsam, CFA Murli Rajan, CFA

Raymond Rath, CFA Rodrigo Ribeiro, CFA Sanjiv Sabherwal Zhiyi Song, CFA George Troughton, CFA Patricia Walters, CFA Lavone Whitmer, CFA Pamela Yang, CFA Philip Young, CFA

Production We would lastly like to thank the many others who played a role in the conception and pro- duction of this book: Robert E. Lamy, CFA; Christopher B. Wiese, CFA; Wanda Lauziere; Carey Hare; Margaret Hill; Kelly Faulconer; Julia MacKesson and the production team at CFA Institute; Maryann Dupes and the Editorial Services group at CFA Institute; and Brent Wilson and the Quality Control group at CFA Institute.

xxiii

ABOUT THE CFA INSTITUTE INVESTMENT SERIES

CFA Institute is pleased to provide you with the CFA Institute Investment Series, which cov- ers major areas in the fi eld of investments. We provide this best-in-class series for the same reason we have been chartering investment professionals for more than 50 years: to lead the investment profession globally by promoting the highest standards of ethics, education, and professional excellence for the ultimate benefi t of society.

Th e books in the CFA Institute Investment Series contain practical, globally relevant ma- terial. Th ey are intended both for those contemplating entry into the extremely competitive fi eld of investment management as well as for those seeking a means of keeping their knowl- edge fresh and up to date. Th is series was designed to be user friendly and highly relevant.

We hope you fi nd this series helpful in your eff orts to grow your investment knowledge, whether you are a relatively new entrant or an experienced veteran ethically bound to keep up to date in the ever-changing market environment. As a long-term, committed participant in the investment profession and a not-for-profi t global membership association, CFA Institute is pleased to provide you with this opportunity.

THE TEXTS

Corporate Finance: A Practical Approach is a solid foundation for those looking to achieve lasting business growth. In today’s competitive business environment, companies must fi nd innovative ways to enable rapid and sustainable growth. Th is text equips readers with the foundational knowledge and tools for making smart business decisions and formulating strat- egies to maximize company value. It covers everything from managing relationships between stakeholders to evaluating merger and acquisition bids, as well as the companies behind them. Th rough extensive use of real-world examples, readers will gain critical perspective into inter- preting corporate fi nancial data, evaluating projects, and allocating funds in ways that increase corporate value. Readers will gain insights into the tools and strategies used in modern corpo- rate fi nancial management.

Equity Asset Valuation is a particularly cogent and important resource for anyone involved in estimating the value of securities and understanding security pricing. A well-informed pro- fessional knows that the common forms of equity valuation—dividend discount modeling, free cash fl ow modeling, price/earnings modeling, and residual income modeling—can all be reconciled with one another under certain assumptions. With a deep understanding of the underlying assumptions, the professional investor can better understand what other investors assume when calculating their valuation estimates. Th is text has a global orientation, including emerging markets.

xxiv About the CFA Institute Investment Series

International Financial Statement Analysis is designed to address the ever-increasing need for investment professionals and students to think about fi nancial statement analysis from a global perspective. Th e text is a practically oriented introduction to fi nancial statement analysis that is distinguished by its combination of a true international orientation, a structured pres- entation style, and abundant illustrations and tools covering concepts as they are introduced in the text. Th e authors cover this discipline comprehensively and with an eye to ensuring the reader’s success at all levels in the complex world of fi nancial statement analysis.

Investments: Principles of Portfolio and Equity Analysis provides an accessible yet rigorous introduction to portfolio and equity analysis. Portfolio planning and portfolio management are presented within a context of up-to-date, global coverage of security markets, trad- ing, and market-related concepts and products. Th e essentials of equity analysis and valuation are explained in detail and profusely illustrated. Th e book includes coverage of practitioner-important but often neglected topics, such as industry analysis. Th roughout, the focus is on the practical application of key concepts with examples drawn from both emerging and developed markets. Each chapter aff ords the reader many opportunities to self-check his or her understanding of topics.

One of the most prominent texts over the years in the investment management industry has been Maginn and Tuttle’s Managing Investment Portfolios: A Dynamic Process. Th e third edition updates key concepts from the 1990 second edition. Some of the more experienced members of our community own the prior two editions and will add the third edition to their libraries. Not only does this seminal work take the concepts from the other readings and put them in a portfolio context, but it also updates the concepts of alternative investments, perfor- mance presentation standards, portfolio execution, and, very importantly, individual investor portfolio management. Focusing attention away from institutional portfolios and toward the individual investor makes this edition an important and timely work.

Th e New Wealth Management: Th e Financial Advisor’s Guide to Managing and Investing Client Assets is an updated version of Harold Evensky’s mainstay reference guide for wealth managers. Harold Evensky, Stephen Horan, and Th omas Robinson have updated the core text of the 1997 fi rst edition and added an abundance of new material to fully refl ect today’s invest- ment challenges. Th e text provides authoritative coverage across the full spectrum of wealth management and serves as a comprehensive guide for fi nancial advisers. Th e book expertly blends investment theory and real-world applications and is written in the same thorough but highly accessible style as the fi rst edition.

Quantitative Investment Analysis focuses on some key tools that are needed by today’s professional investor. In addition to classic time value of money, discounted cash fl ow appli- cations, and probability material, there are two aspects that can be of value over traditional thinking. Th e fi rst involves the chapters dealing with correlation and regression that ultimately fi gure into the formation of hypotheses for purposes of testing. Th is gets to a critical skill that challenges many professionals: the ability to distinguish useful information from the over- whelming quantity of available data. Second, the fi nal chapter of Quantitative Investment Anal- ysis covers portfolio concepts and takes the reader beyond the traditional capital asset pricing model (CAPM) type of tools and into the more practical world of multifactor models and arbitrage pricing theory.

All books in the CFA Institute Investment Series are available through all major book- sellers. All titles also are available on the Wiley Custom Select platform at http://customselect. wiley.com, where individual chapters for all the books may be mixed and matched to create custom textbooks for the classroom.

http://customselect.wiley.com

http://customselect.wiley.com

INTERNATIONAL FINANCIAL

STATEMENT ANALYSIS

1

CHAPTER 1 FINANCIAL STATEMENT

ANALYSIS: AN INTRODUCTION Elaine Henry , CFA

Th omas R. Robinson , CFA

LEARNING OUTCOMES

After completing this chapter, you will be able to do the following:

• describe the roles of fi nancial reporting and fi nancial statement analysis; • describe the roles of the key fi nancial statements (statement of fi nancial position, statement

of comprehensive income, statement of changes in equity, and statement of cash fl ows) in evaluating a company’s performance and fi nancial position;

• describe the importance of fi nancial statement notes and supplementary information— including disclosures of accounting policies, methods, and estimates—and management’s commentary;

• describe the objective of audits of fi nancial statements, the types of audit reports, and the importance of eff ective internal controls;

• identify and describe information sources that analysts use in fi nancial statement analysis besides annual fi nancial statements and supplementary information;

• describe the steps in the fi nancial statement analysis framework.

1. INTRODUCTION

Financial analysis is the process of examining a company’s performance in the context of its in- dustry and economic environment in order to arrive at a decision or recommendation. Often, the decisions and recommendations addressed by fi nancial analysts pertain to providing capital to companies—specifi cally, whether to invest in the company’s debt or equity securities and at wh

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