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. The Classification of Business Activities 38 3. Accounts and Financial Statements 39 3.1. Financial Statement Elements and Accounts 40 3.2. Accounting Equations 42 4. The Accounting Process 47 4.1. An Illustration 47 4.2. The 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. The 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. The 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. The 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. The Elements of Financial Statements 112 5.5. General Requirements for Financial Statements 114 5.6. Convergence of Conceptual Framework 118 6. Effective Financial Reporting 119 6.1. Characteristics of an Effective 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 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 Classification 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 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. Classification 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. The 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. The Financial Analysis Process 292 2.1. The Objectives of the Financial Analysis Process 293 2.2. Distinguishing between Computations and Analysis 294 3. Analytical Tools and Techniques 296 3.1. Ratios 300 3.2. Common-Size Analysis 304 3.3. The 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. The 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. The 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 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. The 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.