International Financial Statement Analysis Workbook. Elaine Henry

regarding the use of alternative accounting methods, estimates, and assumptions.

      ● In addition to the financial statements, a company provides other sources of information that are useful to the financial analyst. As part of his or her analysis, the financial analyst should read and assess this additional information, particularly that presented in the management commentary (also called management report[ing], operating and financial review, and management's discussion and analysis [MD&A]).

      ● A publicly traded company must have an independent audit performed on its annual financial statements. The auditor's report expresses an opinion on the financial statements and provides some assurance about whether the financial statements fairly present a company's financial position, performance, and cash flows. In addition, for US publicly traded companies, auditors must also express an opinion on the company's internal control systems.

      ● Information on the economy, industry, and peer companies is useful in putting the company's financial performance and position in perspective and in assessing the company's future. In most cases, information from sources apart from the company are crucial to an analyst's effectiveness.

      ● The financial statement analysis framework provides steps that can be followed in any financial statement analysis project. These steps are:

      ● articulate the purpose and context of the analysis;

      ● collect input data;

      ● process data;

      ● analyze/interpret the processed data;

      ● develop and communicate conclusions and recommendations; and

      ● follow up.

      PROBLEMS

      1. Providing information about the performance and financial position of companies so that users can make economic decisions best describes the role of:

      A. auditing.

      B. financial reporting.

      C. financial statement analysis.

      2. A company's current financial position would best be evaluated using the:

      A. balance sheet.

      B. income statement.

      C. statement of cash flows.

      3. A company's profitability for a period would best be evaluated using the:

      A. balance sheet.

      B. income statement.

      C. statement of cash flows.

      4. Accounting policies, methods, and estimates used in preparing financial statements are most likely found in the:

      A. auditor's report.

      B. management commentary.

      C. notes to the financial statements.

      5. Information about management and director compensation would least likely be found in the:

      A. auditor's report.

      B. proxy statement.

      C. notes to the financial statements.

      6. Information about a company's objectives, strategies, and significant risks would most likely be found in the:

      A. auditor's report.

      B. management commentary.

      C. notes to the financial statements.

      7. What type of audit opinion is preferred when analyzing financial statements?

      A. Qualified.

      B. Adverse.

      C. Unqualified.

      8. Ratios are an input into which step in the financial statement analysis framework?

      A. Process data.

      B. Collect input data.

      C. Analyze/interpret the processed data.

      CHAPTER 2

      FINANCIAL REPORTING MECHANICS

      LEARNING OUTCOMES

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

      ● explain the relationship of financial statement elements and accounts, and classify accounts into the financial statement elements;

      ● explain the accounting equation in its basic and expanded forms;

      ● describe the process of recording business transactions using an accounting system based on the accounting equation;

      ● describe the need for accruals and other adjustments in preparing financial statements;

      ● describe the relationships among the income statement, balance sheet, statement of cash flows, and statement of owners' equity;

      ● describe the flow of information in an accounting system;

      ● describe the use of the results of the accounting process in security analysis.

      SUMMARY OVERVIEW

      ● Business activities can be classified into three groups: operating activities, investing activities, and financing activities.

      ● Companies classify transactions into common accounts that are components of the five financial statement elements: assets, liabilities, equity, revenue, and expense.

      ● The core of the accounting process is the basic accounting equation: Assets = Liabilities + Owners' equity.

      ● The expanded accounting equation is Assets = Liabilities + Contributed capital + Beginning retained earnings + Revenue – Expenses – Dividends.

      ● Business transactions are recorded in an accounting system that is based on the basic and expanded accounting equations.

      ● The accounting system tracks and summarizes data used to create financial statements: the balance sheet, income statement, statement of cash flows, and statement of owners' equity. The statement of retained earnings is a component of the statement of owners' equity.

      ● Accruals are a necessary part of the accounting process and are designed to allocate activity to the proper period for financial reporting purposes.

      ● The results of the accounting process are financial reports that are used by managers, investors, creditors, analysts, and others in making business decisions.

      ● An analyst uses the financial statements to make judgments on the financial health of a company.

      ● Company management can manipulate financial statements, and a perceptive analyst can use his or her understanding of financial statements to detect misrepresentations.

      PROBLEMS

      1. Which of the following items would most likely be classified as an operating activity?

      A. Issuance of debt.

      B. Acquisition of a competitor.

      C. Sale of automobiles by an automobile dealer.

      2. Which of the following items would most likely be classified as a financing activity?

      A. Issuance of debt.

      B. Payment of income taxes.

      C. Investments in the stock of a supplier.

      3. Which of the following elements represents an economic resource?

      A. Asset.

      B. Liability.

      C. Owners' equity.

      4. Which of the following elements represents a residual claim?

      A. Asset.

      B. Liability.

      C. Owners' equity.

      5. An analyst has projected that