Financial Statements
Analysis
Course Requirements
Title of Subject : Analysis of Financial
Statements
Assessment : 10% Sessional, 30% Mid Semester,
60% Final Exam
Credit Hours : 3-0
Marks : 100
Minimum Contact Hours: 45
Attendance 75%
Recommended & Referred Books
Recommended Textbooks
1. The Analysis and use of Financial Statements (3rd
Edition), (2003) By:Gerald I. White, Ashwinpaul C.
Sondhi, and Dov Fried
2. Financial Statement analysis by Gokul Sinha
Chapter 1
Framework for Financial Statement Analysis
Learning Objectives
Students would be able to,
1. Comprehend the purpose of Financial statements Analysis
2. Understand the Conceptual Framework of financial
statements.
3. Differentiate among the assumptions, constraints and
principles of conceptual framework.
4. Understand the concept of Incorporation and Incorporate
Business analysis
• Business analysis is the evaluation of a company’s prospects and risks
for the purpose of making business decisions.
• Financial statement analysis is part of business analysis.
Need for information
• Reliable information is fundamental for financial reporting.
Companies need accurate data for their financial statements to
provide a clear picture of their performance, which is essential for
investors, stakeholders, and regulatory bodies.
• Understanding a company's financial health is pivotal for informed
decision-making.
Financial Statement Analysis
Financial statement analysis (or financial analysis) is the process of
reviewing and analyzing a company's financial statements to make better
economic decisions.
Financial statement analysis is a method or process involving specific
techniques for evaluating risks, performance, financial health, and future
prospects of an organization.
Users of Financial Statements Include: A company’s managers,
stockholders, bondholders, suppliers, lending institutions, employees, labor
unions, regulatory authorities, and the general public. They use the financial
reports to make decisions.
Objective of Financial Statement Analysis
• "The primary goal of financial statement analysis is to evaluate a
company's past, present, and potential future financial performance."
• "By scrutinizing financial statements, we gain insights into the
company's profitability, liquidity, solvency, and operational efficiency."
Importance of Analysis
• "Financial statement analysis aids stakeholders—investors, creditors,
management, and analysts—in making informed decisions."
• "It helps in assessing risk, determining investment opportunities, and
understanding a company's competitive position within its industry."
Components of Financial Statements
• Briefly mention the key components:Balance Sheet: Snapshot of
assets, liabilities, and equity.
• Income Statement: Overview of revenues, expenses, and profits.
• Cash Flow Statement: Tracks cash inflows and outflows.
• Statement of Retained Earnings: Records changes in retained
earnings.
What do we need for the
Financial Statement Analysis?
– Financial statements
– Notes to Financial Statements.
– The definition of accounting methods
– Auditing reports
– 5-10 years financial information
conceptual framework
• A conceptual framework establishes the concepts that underlie
financial reporting. A conceptual framework is a coherent system of
concepts that flow from an objective.
Development of conceptual work
• Both the IASB and the FASB have a conceptual framework. The IASB’s
conceptual framework is described in the document, “Framework for
Preparation and Presentation of Financial Statements.” The FASB’s
conceptual framework is developed in a series of concept statements,
which is generally referred to as the Conceptual Framework. The IASB
and the FASB are now working on a joint project to develop an
improved common conceptual framework that provides a sound
foundation for developing future accounting standard.
Overview of the Conceptual Framework
• The first level identifies the objective of financial reporting—that is,
the purpose of financial reporting. The second level provides the
qualitative characteristics that make accounting information useful
and the elements of financial statements (assets, liabilities, and so
on). The third level identifies the recognition, measurement, and
disclosure concepts used in establishing and applying accounting
standards and the specific concepts to implement the objective
ASSUMPTIONS PRINCIPLES CONSTRAINTS
1. Economic entity 1. Measurement 1. Cost-benefit
2. Going concern 2. Revenue recognition 2. Materiality
Third
3. Monetary unit 3. Expense recognition 3. Industry practice level
4. Periodicity 4. Full disclosure 4. Conservatism
QUALITATIVE
CHARACTERISTICS ELEMENTS
Relevance Assets, Liabilities, and Equity
Investments by owners
Reliability Distribution to owners Second level
Comparability Comprehensive income
Revenues and Expenses
Consistency Gains and Losses
OBJECTIVES
1. Useful in investment
and credit decisions
2. Useful in assessing
future cash flows First level
3. About enterprise
resources, claims to
resources, and changes
in them
Recognition and measurement concepts
ASSUMPTIONS
PRINCIPLES
CONSTRAINTS
Assumptions Principles Constraints
1)Economic entity 1) Cost-benefit
1)Historical cost
2)Going concern 2)Materiality
2)Revenue recognition
3)Monetary Unit 3)Industry practice
3)Matching
4)Periodicity 4) Conservatism
4)Full disclosure
Basic Assumptions
Economic Business Entity Assumption
• All of the business transactions should be separate from the business
owner’s personal transactions.
• There should be no co-mingling of personal funds with business
funds.
Going Concern Assumption
• This accounting principle assumes that a company will
continue to exist long enough to carry out its
objectives and commitments and will not liquidate in
the foreseeable future unless there is sufficient
evidence otherwise.
• If there is evidence that a company may possibly have
a going concern issue, this must be disclosed in the
financial statements
Monetary Unit Assumption
• Assumes a stable currency is going to be the unit of record.
• All transactions should be recorded in “currency”
Time Period Assumption
• The entity’s activities are separated into periods of time such as
months, quarters or years.
• Transactions must be accounted for within the time period they occur
regardless of when cash is exchanged.
Basic Principles
PRINCIPLES ARE ACCOUNTING RULES
USED TO PREPARE, PRESENT, AND
REPORT FINANCIAL STATEMENTS.
BASIC PRINCIPLES USED IN ACCOUNTING
Cost Principle
• Assets are recorded at historical cost, not fair market
value.
• For example, if a company purchases a building for
$500,000 it should be recorded as such, and should
remain on the books for that amount until disposed
of.
• If the building appreciates to $700,000 in the next
few years, no adjustment should be made.
Revenue Recognition Principle
• Revenue is earned and recognized upon product
delivery or service completion, without regard to when
cash is actually received.
• Also called accrual basis accounting
• Example: A customer purchases inventory from a
company on credit. Even though no cash has yet been
received, the sale is recorded.
Matching Principle
• The costs of doing business are recorded in the same
period as the revenue they help generate, regardless
of when the money is actually paid.
• Also called accrual basis accounting
• Example: A company orders merchandise on credit
and has 30 days in which to pay. This purchase is
recorded immediately, even though no cash has been
paid.
Full Disclosure Principle
• All information pertaining to the operations and
financial position of the entity must be reported
within the period of time in question.
• Circumstances and events that make a difference
to financial statement users should be disclosed.
Example
Full Disclosure – Provided through financial statements,
notes to the financial statements, and supplementary
information.
Constraints
Cost-Benefit
Cost-Benefit Relationship
Relationship
The cost of providing information should not
outweigh the benefit derived from the
information
However, costs and especially benefits are not
always obvious or measurable
Sound judgment must be used in providing
information.
Materiality
Materiality
Materiality is a concept that determines whether
the omission or misstatement of information in a
financial report would impact a reasonable user's
decision-making.
Industry
Industry Practices
Practices
An entity may follow the general practices in
the firm’s industry, which sometimes requires
departure from basic accounting theory.
Conservatism
Conservatism
The principle of conservatism gives guidance on
how to record uncertain events and estimates.
The principle of conservatism states that you
should always error on the most conservative side
of any transaction.
Most of the time this means minimizing profits by
recording uncertain losses or expenses and not
recording uncertain or estimated gains.
Qualitative Characteristics
• Relevance “To be relevant, accounting information must be capable
of making a difference in a decision”
Example:
A small abnormal expense is a good example of irrelevant accounting information.
If the company suffers a small causality loss because someone threw a brick
through the factory-building window, an investor will still invest in the company.
This is irrelevant information because it doesn't affect the end user.
Qualitative Characteristics
• Reliability “Means that the numbers and descriptions match what
really existed or happened”
Example:
if a Firm’s income statement reports sales of €60,510 million when it had sales of
€40,510 million, then the statement fails to faithfully represent the proper sales
amount. To be reliable, information must be complete, neutral, and free of error
Qualitative Characteristics
Comparability: Information that is measured and reported in a similar
manner for different companies is considered comparable.
Example:
Historically the accounting for pensions in Japan differs from that in the United States. In Japan,
companies generally recorded little or no charge to income for these costs. U.S. companies record
pension cost as incurred. As a result, it is difficult to compare and evaluate the financial results of
Toyota (JPN) or Honda (JPN) to General Motors (USA) or Ford (USA)
Qualitative Characteristics
• Consistency : The concept of accounting consistency refers to the
principle that companies should use the same accounting methods to
record similar transactions over time.
