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FCFA: Financial Reporting and Analysis

FCFA · Work through your exam, one topic at a time.

All guide sections

Financial Reporting and Analysis

The Financial Reporting and Analysis domain tests whether you can read a set of statements as evidence rather than as arithmetic: which recognition rules produced the numbers, how the three statements articulate, and how accounting choices distort the ratios you compute. Expect items on revenue and expense recognition, inventory and depreciation methods, deferred tax, and DuPont-style ratio work.

Articulation and recognition

  • The balance sheet is a snapshot; the income statement and cash flow statement are flows. Net income closes to retained earnings, and ending cash on the cash flow statement must equal cash on the balance sheet.
  • Revenue is recognised when a performance obligation is satisfied, that is, when control transfers, not when cash arrives.
  • IFRS carries inventory at the lower of cost and net realisable value; US GAAP uses lower of cost or market and permits LIFO.
  • Capitalising rather than expensing an outlay raises current profit, assets and equity, and in early years depresses asset turnover.

DuPont decomposition

ROE = net profit margin x asset turnover x financial leverage, i.e. (NI/Revenue) x (Revenue/Average assets) x (Average assets/Average equity). It tells you whether a change in ROE came from operations or from borrowing.

Worked example

Revenue 800, net income 60, average assets 500, average equity 250. Net margin = 60/800 = 7.5%. Asset turnover = 800/500 = 1.6. Leverage = 500/250 = 2.0. ROE = 0.075 x 1.6 x 2.0 = 24%. Direct check: 60/250 = 24%. Now suppose the firm had expensed an item it actually capitalised, cutting net income to 40 and equity to 230. ROE falls to 17.4%, but asset turnover rises because the asset base is smaller. Isolating which ratio moved, and why, is the skill being tested.

Traps that cost marks

  • Comparing a FIFO firm with a LIFO firm during inflation without adjusting inventory and cost of sales: LIFO shows lower inventory, higher cost of sales, lower profit and a lower current ratio.
  • Forgetting that depreciation is added back in the operating section while the cash spent on the asset sits in investing.
  • Treating unrealised fair-value gains on trading securities as OCI; under both IFRS and US GAAP they go to profit or loss.
  • Interest paid is an operating outflow under US GAAP, but a policy choice under IFRS.
  • Using year-end rather than average balances in turnover ratios.