Management Discussion and Analysis (MD&A)

This requires management to discuss specific issues on the financial statements, and to assess the company's current financial condition, liquidity, and its planned capital expenditure for the next year. An analyst should look for specific concise disclosure as well as consistency with footnote disclosure.

Note that the MD&A section is not audited and is for public companies only.

Other Sources of Information

• Interim reports. Publicly held companies must file form 10-Q (interim report) on a quarterly basis. It is far less detailed than annual financial statements, as it contains unaudited basic financial statements, unaudited footnotes to financial statements, and management discussion and analysis.

• Proxy statements. An analyst should look for litigation, executive compensation, and related-party transactions, known as proxy statements. Proxy statements should be considered an integral part of the financial report, and they may contain special compensation "perks" for officers and directors, as well as lawsuits and other contingent obligations facing the company.

• Companies' websites, press releases, and conference calls.

The auditor (an independent certified public accountant) is responsible for seeing that the financial statements issued comply with generally accepted accounting principles. In contrast, the company's management is responsible for the preparation of the financial statements. The auditor must agree that management's choice of accounting principles is appropriate and that any estimates are reasonable. The auditor also examines the company's accounting and internal control systems, confirms assets and liabilities, and generally tries to be sure that there are no material errors in the financial statements.

Though hired by the management, the auditor is supposed to be independent and to serve the stockholders and the other users of the financial statements.

An auditor's report (also called the auditor's opinion) is issued as part of a company's audited financial report. It tells the end-user the following:

• Whether the financial statements are presented in accordance with generally accepted accounting principles.
• It identifies those circumstances in which such principles have not been consistently observed in the current period in relation to the preceding period.
• Informative disclosures in the financial statements are to be regarded as reasonably adequate unless otherwise stated in the report.

An auditor's report is considered an essential tool when reporting financial information to end-users, particularly in business. Since many third-party users prefer or even require financial information to be certified by an independent external auditor, many auditees rely on auditor reports to certify their information in order to attract investors, obtain loans, and improve public appearance. Some have even stated that financial information without an auditor's report is "essentially worthless" for investing purposes.

The Types of Audit Reports

There are four common types of auditor's reports, each one representing a different situation encountered during the auditor's work. The four reports are as follows:

• An unqualified opinion report is issued by an auditor when the financial statements presented are free of material misstatements and are in accordance with GAAP, which, in other words, means that the company's financial condition, position, and operations are fairly presented in the financial statements. It is the best type of report an auditee may receive from an external auditor. It is regarded by many as the equivalent of a "clean bill of health" to a patient, which has led many to call it the "clean opinion."
• A qualified opinion report is issued when the auditor encountered one or two situations that did not comply with generally accepted accounting principles; however, the rest of the financial statements are fairly presented. This type of opinion is very similar to an unqualified or "clean opinion," but the report states that the financial statements are fairly presented with a certain exception which is otherwise misstated.
• An adverse opinion is issued when the auditor determines that the financial statements of an auditee are materially misstated and generally do not comply with GAAP. It is considered the opposite of an unqualified or clean opinion, essentially stating that the information contained to assess the auditee's financial position and results of operations is materially incorrect, unreliable, and inaccurate.

• A disclaimer of opinion, commonly referred to simply as a disclaimer, is issued when the auditor could not form, and consequently refuses to present, an opinion on the financial statements. This type of report is issued when the auditor tried to audit a company but could not complete the work due to various reasons and does not issue an opinion.

Auditor's Report on Internal Controls

Following the enactment of the Sarbanes-Oxley Act of 2002, the Public Company Accounting Oversight Board (PCAOB) was established in order to monitor, regulate, inspect, and discipline audit and public accounting firms of public companies. The PCAOB Auditing Standards No. 2 now requires auditors of public companies to include an additional disclosure in the opinion report regarding the auditee's internal controls, and to opine about the company's and auditor's assessment of the company's internal controls over financial reporting. These new requirements are commonly referred to as the COSO Opinion.

he financial statement analysis framework provides steps that can be followed in any financial statement analysis project, including the following:

• Articulate the purpose and context of the analysis.
  What is the purpose of the analysis? Evaluating an equity or debt investment? Or issuing a credit rating?
  The context needs to be defined clearly too: Who is the intended audience? What is the nature and content of the final report? What is the time frame? What is the budget?

• Collect input data.
  Gather a company's financial data from financial statements and other sources described in Subject c (other financial information sources). Also gather information on the economy and industry to understand the environment in which the company operates.

• Process data.
  Compute ratios or growth rates, prepare common-size financial statements, create charts, perform statistical analyses, make adjustments to financial statements, etc.

• Analyze / interpret the processed data.
  Interpret the output to support a conclusion (e.g., a buy decision).

• Develop and communicate conclusions and recommendations.
  Communicate the conclusion or recommendation in an appropriate format.

• Follow up.
  Periodic review is required to determine if the original conclusions and recommendations are still valid.

PREVIOUS LOS

Business activities can be classified into three groups:

• Operating activities involve those activities conducted in the course of running a business. These activities determine net income and changes in the working capital account (accounts receivable, inventory, and accounts payable). Examples:
  • Selling goods and services
  • Employing managers and workers
  • Buying goods and services
  • Paying taxes

• Investing activities are those associated with spending funds to begin and continue operations. In general, these activities affect the long-term asset items on the balance sheet. Examples:
  • Buying resources such as land, buildings, and equipment needed in the operation of the business.
  • Selling these resources when no longer needed.
  Selling land, buildings, and equipment is associated with investing activities, even though it results in a cash inflow, because it involves resources used to begin and continue operations.

• Financing activities are related to obtaining or repaying capital. In general, these activities affect the debt and the equity items on the balance sheet. Examples:
  • Issuing stock
  • Paying dividends to stockholders
  • Obtaining loans from creditors
  • Repaying amounts plus interest to creditors
  Payments of dividends and interest are associated with financing activities, even though they involve cash outflows, because they are necessary to obtain funding.

An account is a label used for recording and reporting a quantity of almost anything. It is the:

• Means by which management keeps track of the effects of transactions.
• Basic storage unit for accounting data.

A chart of accounts is a list of all accounts tracked by a single accounting system, and should be designed to capture financial information to make good financial decisions. Each account in the Anglo-Saxon chart is classified into one of the five categories: Assets, Liabilities, Equity, Income, and Expenses.

Assets

Assets are economic resources controlled by a company that are expected to benefit future operations.

• An asset is usually listed on the balance sheet.
• It has a normal or usual balance of debit (i.e., asset account amounts appear on the left side of a ledger).

It is important to understand that in an accounting sense an asset is not the same as ownership. In accounting, ownership is described by the term "equity."

Types of Assets

• Current assets are cash and other assets expected to be converted into cash, sold, or consumed either in one year or in the operating cycle, whichever is longer. Current assets are presented in the balance sheet in order of liquidity. The five major items found in the current asset section are: cash, marketable securities, accounts receivables, inventories and prepaid expenses.
• Long-term investments are often referred to simply as investments. They are to be held for many years, and are not acquired with the intention of disposing of them in the near future.
• Property, plants, and equipment are properties of a durable nature used in the regular operations of a business. With the exception of land, most assets are either depreciable (such as a building) or consumable. The accumulated depreciation account is a contra-asset account used to total the depreciation expense to date on the asset.
• Intangible assets lack physical substance and usually have a high degree of uncertainty concerning their future benefits. They include patents, copyrights, franchises, goodwill, trademarks, trade names, secret processes, and organization costs. Generally, all of these intangibles are written off (amortized) as an expense over 5 to 40 years.

Liabilities

Liabilities are the financial obligations that the company must fulfill in the future. They are typically fulfilled by cash payment. They represent the source of financing provided to a company by its creditors.

Types of Liabilities

• Current liabilities are obligations that are reasonably expected to be liquidated either through the use of current assets or the creation of other current liabilities within one year or within the operating cycle, whichever is longer. They are not reported in any consistent order. A typical order is: notes payable, accounts payable, accrued items (e.g., accrued warranty costs, compensation, and benefits), income taxes payable, current maturities of long-term debt, etc.
• Long-term liabilities are obligations that are not reasonably expected to be liquidated within the normal operating cycle but instead at some date beyond that time. Bonds payable, notes payable, deferred income taxes, lease obligations, and pension obligations are the most common long-term liabilities.

Owners' Equity

Equity represents the source of financing provided to the company by the owners.

Owners' Equity = Contributed Capital + Retained Earnings

Owner's equity is the owners' investments and the total earnings retained from the commencement of the company.

• Contributed capital is the amount invested in the business by the owners.
• Retained earnings are the company's undistributed earnings: accumulated earnings since inception less any losses, dividends, or transfers to contributed capital.

Revenue

Income (often referred to as "revenue") for a company is generated by delivering or producing goods, rendering services, or other activities that constitute the company's ongoing major or central operations. Not all cash receipts are revenues; for example, cash received through a loan is not revenue.

Expenses

Expenses are outflows from delivering or producing goods, rendering services, or carrying out other activities that constitute an entity's ongoing major or central operations. An expense represents an event in which an asset is used up or a liability is incurred. Not all cash payments are expenses; for example, cash dividends paid to stockholders are not expenses.

Assets reported on the balance sheet are either purchased by the company or generated through operations; they are financed, directly or indirectly, by the creditors and stockholders of the company. This fundamental accounting relationship provides the basis for recording all transactions in financial reporting and is expressed as the balance sheet equation:

Assets (A) = Liabilities (L) + Owners' equity (E)

This equation is the foundation for the double-entry bookkeeping system because there are two or more accounts affected by every transaction.

If the equation is rearranged:

Assets - Liabilities = Owners' equity

The above equation shows that the owners' equity is the residual claim of the owners. It is the amount left over after liabilities are deducted from assets.

Owners' equity at a given date can be further classified by its origin: capital provided by owners, and earnings retained in the business up to that date.

Owners' equity = Contributed capital + Retained earnings

Net income is equal to the income that a company has after subtracting costs and expenses from total revenue.

Revenue - Expenses = Net income (loss)

Net income is informally called the "bottom line" because it is typically found on the last line of a company's income statement.

Balance sheets and income statements are interrelated through the retained earnings component of owners' equity.

Ending retained earnings = Beginning retained earnings + Net income - Dividends

The following expanded accounting equation, which is derived from the above equations, provides a combined representation of the balance sheet and income statement:

Assets = Liabilities + Contributed capital + Beginning retained earnings + Revenue - Expenses - Dividends

• Dividends and expenses decrease owners' equity.
• Revenues increase owners' equity.

Because dividends and expenses are deductions from owners' equity, move them to the left side of the equation:

The following illustrates how the business transactions of ABC Realty are recorded in a simplified accounting system.

1. Owners' Investments - Invested $50,000 in business in exchange for 5,000 shares of $10 par value stock.

Assets						=	Liab.	Owners' Equity
	Cash	A/R	Supplies	Land	Building		A/P	Common Stock	Retained Earnings
1	$50,000							$50,000
A = $50,000							L + OE = $50,000
Notice A = L + SE is always in balance.

2. Purchase of Assets with Cash - Purchased a lot for $10,000 and a small building on a lot for $25,000.

Assets						=	Liab.	Owners' Equity
	Cash	A/R	Supplies	Land	Building		A/P	Common Stock	Retained Earnings
1	$50,000							$50,000
2	-35,000			$10,000	$25,000			$50,000
bal	$15,000			$10,000	$25,000			$50,000
A = $50,000							L + OE = $50,000
This transaction only affects one side of the accounting equation: assets. Whenever a transaction affects only one side of the accounting equation, both assets and liabilities and owners' equity remain unchanged.

3. Purchase of Assets by Incurring a Liability - Purchased office supplies for $500 on credit.

Assets						=	Liab.	Owners' Equity
	Cash	A/R	Supplies	Land

...

Under strict cash basis accounting, revenue is recorded only when cash is received and expenses are recorded only when cash is paid. Net income is cash revenue minus cash expenses. The matching principle is ignored here, resulting inconformity with generally accepted accounting principles.

Most companies use accrual basis accounting, recognizing revenue when it is earned (the goods are sold or the services performed) and recognizing expenses in the period incurred without regard to the time of receipt or payment of cash. Net income is revenue earned minus expenses incurred.

Although operating a business is a continuous process, there must be a cut-off point for periodic reports. Reports are prepared at the end of an accounting period.

• A balance sheet must list all assets and liabilities at the end of the accounting period.
• An income statement must list all revenues and expenses applicable to the accounting period.

Some transactions span more than one accounting period and they require adjustments. Adjustments are necessary for determining key profitability performance measures because they affect net income, assets, and liabilities. Adjustments, however, never affect the cash account in the current period. They provide information about future cash flow. For example, accounts receivable indicates expected future cash inflows.

The four basic types of adjusting entries are:

• Unearned revenues are revenues that are received in cash before delivery of goods/services. These "revenues" are not earned yet and thus should be recorded as liabilities. An adjusting entry should be: a debit to a liability account (e.g., unearned revenue) and a credit to a revenue account (e.g., revenue). Examples are magazine subscription fees and customer deposits for services.

• Accrued revenues are revenues that are earned but not yet received or recorded. They are also called unrecorded revenues. An adjusting entry should be: a debit to an asset account (e.g., accounts receivable) and a credit to a revenue account (e.g., interest revenue). Examples include interest revenues, rent revenues, etc. Such revenues accumulate with the passing of time, but the company may have not received payment or billed the client.

• Deferred expenses are expenses that benefit more than one period. When these assets are consumed, expenses should be recognized: a debit to an expense account and a credit to an asset account. For example, prepaid expenses (e.g., prepaid insurance, rent, etc.) are expenses paid in advance and recorded as assets before they are used or consumed. Another example is depreciation. The cost of a long-term asset is allocated as an expense over its useful life. At the end of each period, a depreciation expense is recorded through an adjusting entry: a debit to a depreciation expense account and a credit to an accumulated depreciation account (a contra account used to total past depreciation expenses on specific long-term assets).

• Accrued expenses are expenses that are incurred but not yet paid or recorded. At the end of the accounting period, the accrued expense is recorded through an adjusting entry: a debit to an expense account (e.g., salaries expense) and a credit to a liability account (e.g., salaries payable). Examples are employee salaries and interest on borrowed money.

In some cases valuation adjustments entries are required for assets. For example, trading securities are always recorded at their current market value, which can change from time to time.

• If the value of an asset has increased, then there should be a gain on the income statement or an increase to other comprehensive income.
• If the value of an asset has decreased, then there should be a loss on the income statement or a decrease to other comprehensive income.

Here are financial statements based on previous transactions for ABC Realty.

It is important for an analyst to understand the flow of information through a financial reporting system.

1. Journal entries and adjusting entries

Journalizing is the process of chronologically recording transactions.

• General journal is the simplest and most flexible.
• A separate journal entry records each transaction.
• Useful for obtaining detailed information regarding a particular transaction.

2. General ledger and T-accounts

The items entered in a general journal must be transferred to the general ledger. This procedure, posting, is part of the summarizing and classifying process. The general ledger contains all the same entries as those posted to the general journal; the only difference is that the data are sorted by date in the journal and by account in the ledger.

There is a separate T-account for each item in the ledger. A T-account appears as follows:

3. Trial balance and adjusted trial balance

A trial balance is a list of all open accounts in the general ledger and their balances.

• For every amount debited, an equal amount must be credited.
• The total of debits and credits for all the T-accounts must be equal.
• A trial balance is prepared to test this. It proves whether or not the ledger is in balance.
• It is usually prepared at the end of a month or accounting period.

Since certain accounts may not be accurately stated, adjusting entries may be required to prepare an adjusted trial balance.

4. Finance statements

The financial statements can be prepared from the adjusted trial balance.

Financial statements are the primary information that firms publish about themselves, and investors and creditors are the primary users of financial statements. Analysts, who work for investors and creditors, may need to make adjustments to reflect items not reported in the statements or assess the reasonableness of managements' judgments. For example, an important first step in analyzing financial statements is identifying the types of accruals and valuation entries in a company's financial statements.

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

For example, companies may improperly record costs as assets rather than as expenses and amortize the assets over future periods. The goal is to impress shareholders and bankers with higher profits. Consider advertising expenses, which should be charged against income immediately. Certain companies, particularly those selling memberships to customers (e.g., health clubs and Internet access providers), aggressively capitalize these costs and spread them over several periods.

Companies may amortize long-term assets too slowly. Slow depreciation or amortization keeps assets on the balance sheet longer, resulting in a higher net worth. With slow amortization, expenses are lower and profits are higher.

The income statement summarizes revenues earned and expenses incurred, and thus measures the success of business operations for a given period of time. It explains some but not all of the changes in the assets, liabilities, and equity of the company between two consecutive balance sheet dates.

The income statement lists income and expenses as they are directly related to the company's recurring income. The format of the income statement is not specified by U.S. GAAP and actual format varies across companies.

The goal of income statement analysis is to derive an effective measure of future earnings and cash flows. Analysts need data with predictive ability, hence income from continuing (recurring) operations is considered to be the best indicator of future earnings.

As operating expenses do not include financing costs such as interest expenses, income from continuing operations is independent of the company's capital structure.

In the typical income statement analyisis one should segregate the results of normal, recurring operations from the effects of nonrecurring or extraordinary items to improve the forecasting of future earnings and cash flows. The idea here is that recurring income is persistent. If an item in the unusual or infrequent component of income from continuing operations is deemed not to be persistent, then recurring (pre-tax) income from continuing operations should be adjusted.

The net income figure is used to prepare the statement of retained earnings.

Financial Footnotes provide information about the accounting methods, assumptions and estimates used by management to develop the data reported in the financial statements. They provide additional disclosure in such areas as fixed assets, inventory methods, income taxes, pensions, debt, contingencies such as lawsuits, sales to related parties, etc.

Financial Footnotes are designed to allow users to improve assessments of the amounts, timing, and uncertainty of the estimates reported in the financial statements.

Financial footnotes are an integral part of financial statements.

PORTFOLIO MANAGEMENT

Why should investors take a portfolio approach instead of investing in individual stocks? Why not put all your eggs in one basket?

Portfolio theory is used to maximize an investment's expected rate of return for a given level of risk, or minimize the level of risk for a given expected rate of return.

For the purpose of investing, risk is defined as the variation of the return from what was expected (volatility). It is represented by a measure such as standard deviation.

Diversification is used to reduce a portfolio's overall volatility. By building a portfolio out of many unrelated (uncorrelated) investments total volatility (risk) is minimized. The idea is that most assets will provide a return similar to their expected return and will offset those in the portfolio that perform poorly. The diversification ratio is the ratio of the standard deviation of an equally weighted portfolio to the standard deviation of a randomly selected security.

• The composition of a portfolio matters a great deal. Different portfolios have different risk-return trade-offs.
• Portfolio diversification does not necessarily provide the same level of risk reduction during times of severe market turmoil as it does when the economy and markets are operating normally.
• The modern portfolio theory says that the value of an additional security to a portfolio ought to be measured with its relationship to all of the other securities in the portfolio.

There are different types of investment clients.

Different individual investors have different investment goals, risk tolerance and constraints. Some seek growth while others may invest to get regular income.

An institutional investor's role is to act as highly specialized investors on behalf of others. There are many types of institutional investors.

A pension plan is a fund that provides retirement income to employees. It is typically considered a long-term investor which has high risk tolerance and low liquidity needs.

• In a defined contribution plan, the employer agrees to contribute a certain sum each period based on a formula. Only the employer's contribution is defined; no promise is made regarding the ultimate benefits paid out to the employee. The employee accepts the investment risk.
• A defined benefit plan defines the benefits that the employee will receive at the time of retirement. That is, the employer assumes the risk of the investment, and is responsible for the payment of the defined benefits without regard to what happens in the trust.

An endowment or a foundation is an investment fund set up by an institution in which regular withdrawals from the invested capital are used for ongoing operations. Endowments and foundations are often used by universities, hospitals and churches. They are funded by donations. A typical investment object is to maintain the real value of the fund while generating income to fund the objectives of the institution.

A bank typically has very short investment horizon and low risk tolerance. Its investments are usually conservative. The investment objective of a bank's excess reserves is to earn a return that is higher than the interest rate it pays on its deposit.

Investments made by insurance companies are relatively conservative. Although the income needs are typically low, the liquidity needs of such investments are usually high in order for insurance companies to pay claims.

Both the risk tolerance and the return requirement of mutual funds are predefined for each fund and can vary sharply between funds. They are more specialized than pension funds or insurance companies. Study Session 18 discusses mutual funds in more detail.

A sovereign wealth fund is a state-owned investment fund. There are two types of funds: saving funds and stabilization funds. Stabilization funds are created to reduce the volatility of government revenues, to counter the boom-bust cycles' adverse effect on government spending and the national economy.

Step One: The Planning Step

The first step in the portfolio management process is to understand the client's needs and develop an investment policy statement (IPS).

The IPS covers the types of risks the investor is willing to assume along with the investment goals and constraints. It should focus on the investor's short-term and long-term needs, familiarity with capital market history, and investor expectations and constraints. Periodically the investor will need to review, update and change the policy statement.

A policy statement is like a road map: It forces investors to understand their own needs and constraints and to articulate them within the construct of realistic goals. It not only helps investors understand the risks and costs of investing, but also guides the actions of portfolio managers.

Step Two: The Execution Step

The second step is to construct the portfolio. The portfolio manager and the investor determine how to allocate available funds across different countries, asset classes, and securities. This involves constructing a portfolio that will minimize the investor's risk while meeting the needs specified in the policy statement.

Step Three: The Feedback Step

The process of managing an investment portfolio never stops. Once the funds are initially invested according to the plan, the real work begins in monitoring and updating the status of the portfolio and the investor's needs.

The last step is the continual monitoring of the investor's needs, capital market conditions, and, when necessary, updating the policy statement. One component of the monitoring process is to evaluate a portfolio's performance and compare the relative results to the expectations and the requirements listed in the policy statement. Some rebalancing may be required.

"Pooled investments" is a term given to a wide range of investment types, such as mutual funds, exchange traded funds, separately managed accounts. When you invest in a pooled investment, your money goes into an investment fund. Here, you pool your money with others so you can help spread the risk. Professional fund managers then invest the money on your behalf in a highly competitive environment.

Mutual Funds

An investment company invests a pool of funds belonging to many individuals in a single portfolio of securities. In exchange for this commitment of capital, the investment company issues to each investor new shares representing his or her proportional ownership of the mutually held securities portfolio, which is commonly known as a mutual fund.

Mutual funds are classified according to whether or not they stand ready to redeem investor shares.

• An open-end mutual fund continues to sell and repurchase shares after its initial public offering. It stands ready to redeem investor shares at market value.
• A closed-end mutual fund operates like any other public firm. It is initiated through a stock offering to raise capital. Its stock trades on the regular secondary market and the market price is determined by supply and demand. A typical closed-end fund offers no further shares and does not repurchases the shares on demand (no funds can be withdrawn). Therefore, investors must trade in public secondary markets (e.g. NASDAQ) to buy or sell shares.

Various fees charged by mutual funds:

• They charge fees for their efforts of setting up funds. Sales commissions are charged at purchase (front-end load) as a percentage of the investment.
  • A load fund has sales commission charges. A load fund's offering price = NAV of the share + a sales charge (7.5 - 8% of the NAV). The NAV price is the redemption (bid) price, and the offering (ask) price equals the NAV divided by 1 minus the percent load.
  • A no-load fund imposes no initial sales charge.

• Redemption fee (back-end load). A charge to exit the fund. This discourages quick trading turnover and are set up so that the fees decline the longer the shares are held (in this case, the fees are sometimes called contingent deferred sales charges). Load funds generally charge no redemption fees.
• All mutual funds charge annual fees.

There are four types of mutual funds based on portfolio makeup.

• Money Market Funds. These funds attempt to provide current income, safety of principal, and liquidity by investing in diversified portfolios of short-term securities, such as T-bills, banker certificates of deposit, bank acceptances, and commercial paper. They generally allow holders to write checks again their account so they are essentially cash holdings for holders. However, they are not insured in the same way as bank deposits.
• Bond Mutual Funds. Bond funds concentrate on various types of bonds to generate high current income with minimal risk. Bonds held include government bonds, high-grade corporate bonds, and junk bonds.
• Stock Mutual Funds. These funds invest almost solely in common stocks. Some funds focus on growth companies while others specialize in specific industries. Different stock mutual funds can suit almost any taste or investment objective.
  There are two investment styles.
  • Passive mutual fund management is a long-term buy-and-hold strategy. Usually stocks are purchased so the portfolio's returns will track those of an index over time. The purpose is not to beat the index but to match its performance.
  • An active mutual fund management is an attempt by the fund manager to outperform a passive benchmark portfolio on a risk-adjusted basis. The management fees are usually higher and there are usually more trading activities which can cause tax consequences for investors.

• Hybrid/Balanced Funds. They diversify outside the stock market by combining common stock with fixed-income securities.

Other Investment Products

2. Separately Managed Accounts

The key difference between mutual funds and separate accounts is that, in a separate account, the money manager is purchasing the securities in the portfolio on behalf on the investor, not on behalf of the fund. Therefore, the investor can determine which assets are bought or sold, and when.

A mutual fund investor owns shares of a company (mutual fund) that in turn owns other investments, whereas an SMA investor owns the invested assets directly in his own name.

An investor in an SMA typically has the ability to direct the investment manager to sell individual securities with the objective of raising capital gains or losses for tax planning purposes. This practice is known as "tax harvesting", and its objective is to attempt to equalize capital gains and losses across all of the investor's accounts for a given year in order to reduce capital gains taxes owed.

Another major advantage of individual cost basis is the ability to customize the portfolio by choosing to avoid investing in certain stocks or certain economic sectors (technology, sin stocks, etc).

3. Hedge Funds

A hedge fund is an investment fund open to a limited range of investors that undertakes a wider range of investment and trading activities than traditional long-only investment funds, and that, in general, pays a performance fee to its investment manager. Every hedge fund has its own investment strategy that determines the type of investments and the methods of investment it undertakes.

Unlike mutual funds, most hedge funds are not regulated. The net effect is that hedge fund investor base is generally very different from that of the typical mutual fund.

Hedge funds employ many different trading strategies, which are classified in many different ways, with no standard system used. A hedge fund will typically commit itself to a particular strategy, particular investment types and leverage limits via statements in its offering documentation, thereby giving investors some indication of the nature of the particular fund.

4. Buyout and Venture Capital Funds

Both funds take equity positions and plan a very active role in the management of the company. The equity they hold is private, and they don't have long investment horizon.

• Buyout funds make only a few large investments in public companies with the intent of selling the restructured companies in three to five years.
• Venture capital funds buys start-up companies and grow them. They play a very active role in managing these companies.

Risk is exposure to uncertainty. In investment, risk includes the possibility of losses.

Taking risks is an active choice by institutions and individuals. Risks must be carefully understood, chosen, and well-managed.

Risk exposure is the extent to which an entity's value may be affected through sensitivity to underlying risks.

Risk management is a process that defines risk tolerance and measures, monitors, and modifies risks to put them in line with that tolerance.

• It is NOT about minimizing, avoiding or predicting risks.
• It is about understanding, measuring, monitoring, and modifying risks.

A risk management framework is the infrastructure, processes, and analytics needed to support effective risk management. It includes:

• Risk governance is the top-level foundation for risk management. It provides the overall context for an organization's risk management, which includes risk oversight and setting risk tolerance for the organization. It directs risk management activities to align with and support the goals of the overall enterprise.

• Risk identification and measurement is the quantitative and qualitative assessment of all potential sources of risk and risk exposures.

• Risk infrastructure comprises the resources and systems required to track and assess an organization's risk profile.

• Risk policies and processes are management's complement to risk governance at the operating level.

• Risk monitoring, mitigation and management is the active monitoring and adjusting of risk exposures, integrating all the other factors of the risk management framework.

• Communication includes risk reporting and active feedback loops so that the process improves decision making.

• Strategic risk analysis and integration involves using these risk tools to rigorously sort out the factors that are and are not adding value as well as incorporating this analysis into the management decision-making process, with the intent of improving outcomes.

Governance and the entire risk process should take an enterprise risk management perspective to ensure that the value of the entire enterprise is maximized. For example, a corporate pension fund manager should consider not only the pension assets and liabilities but also the parent corporation's business risk profile. In other words, the focus should be on the organization as a whole.

Useful approaches to ensuring a strong risk governance framework:

• Employ a risk management committee.
• Appoint a chief risk officer.

Risk Tolerance

Risk tolerance, a key element of good risk governance, establishes an organization's risk appetite.

Ascertaining risk tolerance starts from an inside view and an outside view. What shortfalls within an organization would cause the organization to fail to achieve some critical goals? What are the organization's risk drivers? Which risks are acceptable and which are unacceptable? How much risk can the overall organization be exposed to?

Risk tolerance is then formally chosen using a top-level analysis. The organization's goals, expertise in certain areas, and strategies should be considered when determining its risk tolerance. This process should be completed and communicated before a crisis.

Risk Budgeting

While risk tolerance determines which risks are acceptable, risk budgeting decides how to take risks. It is a means of implementing risk tolerance at a strategic level.

Risk budgeting is any means of allocating investments or assets based on their risk characteristics. Single or multiple dimensions of risk can be used. Common single-dimension risk measures are standard deviation, beta, value at risk, and scenario loss. The risk budgeting process forces the firm to consider risk trade-offs. As a result, the firm should choose to invest where the return per unit of risk is the highest.

Some risk budgeting practices:

• Limit the standard deviation of the entire portfolio to within 15%.
• Allocate 10%, 35% and 55% of total capital in T-bills, long-term corporate bonds, and stock market index-linked mutual funds, respectively.
• Use a risk factor approach to allocate assets.

There are two general categorizations of risks.

Financial Risks

Financial risks originate from the financial markets.

• Market risk arises from movements in stock prices, interest rates, exchange rates, and commodity prices.
• Credit risk is the risk that a counterparty will not pay an amount owed.
• Liquidity risk is the widening of the bid-ask spread on an asset. It is usually caused by degradation in market conditions or a lack of market participants.

Non-Financial Risks

Non-financial risks arise from actions within an entity or from external origins, such as the environment, the community, regulators, politicians, suppliers, and customers. They include:

• Settlement risk: one party fails to deliver the terms of a contract with another party at the time of settlement.
• Legal risk: the risk of being sued, or of the terms of a contract not being upheld by the legal system.
• Compliance risk: regulatory risk, accounting risk and tax risk. Companies may fail to respond quickly when laws and regulations are updated.
• Model risk: the risk of improperly using a model. An example is tail risk which suggests that distribution is not normal, but skewed, with fatter tails.
• Operational risk: the risk that arises from within the operations of an organization and includes both human and system or process errors.
• Solvency risk: the risk that the entity does not survive or succeed because it runs out of cash to meet its financial obligations.

Individuals face many of the same organizational risks outlined here, as well as health risks, mortality or longevity risks, and property and casualty risks.

Risks are not necessarily independent. because many risks arise as a result of other risks; risk interactions can be extremely non-linear and harmful. For example, fluctuations in the interest rate cause changes in the value of the derivative transactions but could also impact the creditworthiness of the counterparty. Another example might occur with an emerging-market counterparty, where there is country and possibly currency risk associated with the counterparty (however creditworthy it might otherwise be).

Learning Outcome Statements

g. describe methods for measuring and modifying risk exposures and factors to consider in choosing among the methods.


Drivers

To understand how to measure risk, we need to first understand what drives risk. Risk drivers are the fundamental global and domestic macroeconomic and industry factors that create risk.

• All risks come from uncertainties.
• Financial risks come from fundamental factors in macro-economies and industries.
• There are systematic risks and unsystematic (diversifiable) risks.

Risk management can control some risks but not all.

Metrics

Common measures of risk:

• Probability
• Standard deviation: measures dispersion in a probability distribution. This has significant limitations.
• Beta: measures the sensitivity of a security's returns to the returns on the market portfolio.
• Measures of derivatives risk: delta, gamma, vega and rho.
• Duration measures the interest rate sensitivity of a fixed income security.
• Value at Risk: measures the potential loss in value of a risky asset or portfolio over a defined period for a given confidence interval. If the VaR on an asset is $100 million at a one-week, 95% confidence level, there is only a 5% chance that the value of the asset will drop more than $ 100 million over any given week.
• CVaR: scenario analysis and stress testing, can be used to complement VaR.

It is difficult to measure rare events such as operational risk and default risk.

Methods of Risk Modification

There are four broad categories of risk modification.

Risk prevention and avoidance. Completely avoiding risk sounds simple, but it may be difficult or sometimes impossible. Furthermore, does it even make sense to do so? Almost every risk has an upside. There is always a trade-off between risk and return.

Risk acceptance. Risk can be mitigated internally through self-insurance or diversification. This is to bear the risk but do so in the most efficient manner possible.

Risk transfer. This is to pass on a risk to another party, often in the form of an insurance policy. An insurer attempts to sell policies with risks that have low correlations and can be diversified away.

Risk shifting. This refers to actions that change the distribution of risk outcomes. The principal device is a derivative which can be used to shift risk across the probability distribution and from one party to another. There are two categories of derivatives: forward commitments and contingent claims.

The primary determinant of which method is best for modifying risk is weighing the benefits against the costs, with consideration for the overall final risk profile and adherence to risk governance objectives.

The auditor (an independent certified public accountant) is responsible for seeing that the financial statements issued comply with generally accepted accounting principles.

The auditor must agree that management's choice of accounting principles is appropriate and that any estimates are reasonable

The auditor examines the company's accounting and internal control systems, confirms assets and liabilities, and generally tries to be sure that there are no material errors in the financial statements.

Though hired by the management, the auditor is supposed to be independent and to serve the stockholders and the other users of the financial statements.

An asset is usually listed on the balance sheet.

Not all cash receipts are revenues; for example, cash received through a loan is not revenue.

Income or "revenue" is generated the company's major or central operations

Revenue - Expenses = Net income (loss)

Ending retained earnings = Beginning retained earnings + Net income - Dividends

LEARNING OUTCOMES

The candidate should be able to:

1. describe the roles of financial reporting and financial statement analysis;

2. describe the roles of the statement of financial position, statement of comprehensive income, statement of changes in equity, and statement of cash flows in evaluating a company’s performance and financial position;

3. describe the importance of financial statement notes and supplementary information—including disclosures of accounting policies, methods, and estimates—and management’s commentary;

4. describe the objective of audits of financial statements, the types of audit reports, and the importance of effective internal controls;

5. identify and describe information sources that analysts use in financial statement analysis besides annual financial statements and supplementary information;

6. describe the steps in the financial statement analysis framework.

Fundamental financial analysis starts with the information found in a company’s financial reports. These financial reports include audited financial statements, additional disclosures required by regulatory authorities, and any accompanying (unaudited) commentary by management. Basic financial statement analysis—as presented in this reading—provides a foundation that enables the analyst to better understand information gathered from research beyond the financial reports.

2. SCOPE OF FINANCIAL STATEMENT ANALYSIS

The role of financial reporting by companies is to provide information about a company’s performance, financial position, and changes in financial position that is useful to a wide range of users in making economic decisions.1The role of financial statement analysis is to use financial reports prepared by companies, combined with other information, to evaluate the past, current, and potential performance and financial position of a company for the purpose of making investment, credit, and other economic decisions. (Managers within a company perform financial analysis to make operating, investing, and financing decisions but do not necessarily rely on analysis of related financial statements. They have access to additional financial information that can be reported in whatever format is most useful to their decision.)

In evaluating financial reports, analysts typically have a specific economic decision in mind. Examples of these decisions include the following:

• Evaluating an equity investment for inclusion in a portfolio.

• Evaluating a merger or acquisition candidate.

• Evaluating a subsidiary or operating division of a parent company.

• Deciding whether to make a venture capital or other private equity investment.

• Determining the creditworthiness of a company in order to decide whether to extend a loan to the company and if so, what terms to offer.

• Extending credit to a customer.

• Examining compliance with debt covenants or other contractual arrangements.

• Assigning a debt rating to a company or bond issue.

• Valuing a security for making an investment recommendation to others.

• Forecasting future net income and cash flow.

These decisions demonstrate certain themes in financial analysis. In general, analysts seek to examine the past and current performance and financial position of a company in order to form expectations about its future performance and financial position. Analysts are also concerned about factors that affect risks to a company’s future performance and financial position. An examination of performance can include an assessment of a company’s profitability (the ability to earn a profit from delivering goods and services) and its ability to generate positive cash flows (cash receipts in excess of cash disbursements). Profit and cash flow are not equivalent. Profit (or loss) represents the difference between the prices at which goods or services are provided to customers and the expenses incurred to provide those goods and services. In addition, profit (or loss) includes other income (such as investing income or income from the sale of items other than goods and services) minus the expenses incurred to earn that income. Overall, profit (or loss) equals income minus expenses, and its recognition is mostly independent from when cash is received or paid.

The ability to meet short-term obligations is generally referred to as liquidity, and the ability to meet long-term obligations is generally referred to as solvency.

Earnings are also frequently used by analysts in valuation. For example, an analyst may value shares of a company by comparing its price-to-earnings ratio (P/E) to the P/Es of peer companies and/or may use forecasted future earnings as direct or indirect inputs into discounted cash flow models of valuation.

In conducting a financial analysis of a company, the analyst will regularly refer to the company’s financial statements, financial notes, and supplementary schedules and a variety of other information sources. The next section introduces the major financial statements and some commonly used information sources.

3. MAJOR FINANCIAL STATEMENTS AND OTHER INFORMATION SOURCES

In order to perform an equity or credit analysis of a company, an analyst collects a great deal of information. The nature of the information collected will vary on the basis of the individual decision to be made (or the specific purpose of the analysis) but will typically include information about the economy, industry, and company as well as information about comparable peer companies. Much of the information will likely come from outside the company, such as economic statistics, industry reports, trade publications, and databases containing information on competitors. The company itself provides some of the core information for analysis in its financial reports, press releases, investor conference calls, and webcasts.

Companies prepare financial reports at regular intervals (annually, semiannually, and/or quarterly depending on the applicable regulatory requirements). Financial reports include financial statements along with supplemental disclosures necessary to assess the company’s financial position and periodic performance. Financial statements are the result of an accounting recordkeeping process that records economic activities of a company, following the applicable accounting standards and principles. These statements summarize the accounting information, mainly for users outside the company (such as investors, creditors, analysts, and others) because users of financial information inside a company have direct access to the underlying financial data that are summarized in the financial statements and to other information that is collected but not included in the financial reporting process. Financial statements are almost always audited by independent accountants who provide an opinion on whether the financial statements present fairly the company’s performance and financial position in accordance with a specified, applicable set of accounting standards and principles.

In order to perform an equity or credit analysis of a company, an analyst collects a great deal of information. The nature of the information collected will vary on the basis of the individual decision to be made (or the specific purpose of the analysis) but will typically include information about the economy, industry, and company as well as information about comparable peer companies. Much of the information will likely come from outside the company, such as economic statistics, industry reports, trade publications, and databases containing information on competitors.

Financial Statements and Supplementary Information

A complete set of financial statements include a statement of financial position (i.e., a balance sheet), a statement of comprehensive income (i.e., a single statement of comprehensive income or an income statement and a statement of comprehensive income), a statement of changes in equity, and a statement of cash flows.2 The balance sheet portrays the company’s financial position at a given point in time. The statement of comprehensive income and statement of cash flows present different aspects of a company’s performance over a period of time. The statement of changes in equity provides additional information regarding the changes in a company’s financial position. In addition, the accompanying notes or footnotes to the financial statements are required and considered an integral part of a complete set of financial statements.

Along with the required financial statements, a company typically provides additional information in its financial reports. In many jurisdictions, some or all of this additional information is mandated by regulators or accounting standards boards. The additional information provided may include a letter from the chairman of the company, a report from management discussing the results (typically called management discussion and analysis [MD&A] or management commentary), an external auditor’s report providing assurances, a governance report describing the structure of the company’s board of directors, and a corporate responsibility report. As part of his or her analysis, the financial analyst should read and assess this additional information along with the financial statements. The following sections describe and illustrate each financial statement and some of the additional information.

The balance sheet (also called the statement of financial position or statement of financial condition)

Volkswagen, a German-based automobile manufacturer, prepares its financial statements in accordance with International Financial Reporting Standards (IFRS). IFRS require companies to present classified balance sheets that show current and non-current assets and current and non-current liabilities as separate classifications.However, IFRS do not prescribe a particular ordering or format, and the order in which companies present their balance sheet items is largely a function of tradition. As shown, Volkswagen presents non-current assets before current assets, owners’ equity before liabilities, and within liabilities, non-current liabilities before current liabilities. This method generally reflects a presentation from least liquid to most liquid. In other countries, the typical order of presentation may differ. For example, in the United States, Australia, and Canada, companies usually present their assets and liabilities from most liquid to least liquid. Cash is typically the first asset shown, and equity is presented after liabilities.

3.1.2. Statement of Comprehensive Income

The statement of comprehensive income, under IFRS, can be presented as a single statement of comprehensive income or as two statements, an income statement and a statement of comprehensive income that begins with profit or loss from the income statement.

The income statement presents information on the financial results of a company’s business activities over a period of time. The income statement communicates how much revenue and other income the company generated during a period and the expenses it incurred to generate that revenue and other income. Revenue typically refers to amounts charged for the delivery of goods or services in the ordinary activities of a business. Other income includes gains, which may or may not arise in the ordinary activities of the business. Expensesreflect outflows, depletions of assets, and incurrences of liabilities that decrease equity. Expenses typically include such items as cost of sales (cost of goods sold), administrative expenses, and income tax expenses and may be defined to include losses. Net income (revenue plus other income minus expenses) on the income statement is often referred to as the “bottom line” because of its proximity to the bottom of the income statement. Net income may also be referred to as “net earnings,” “net profit,” and “profit or loss.” In the event that expenses exceed revenues and other income, the result is referred to as “net loss.”

Income statements are reported on a consolidated basis, meaning that they include the income and expenses of subsidiary companies under the control of the parent (reporting) company. The income statement is sometimes referred to as a statement of operations or profit and loss (P&L) statement. The basic equation underlying the income statement is Revenue + Other income – Expenses = Income – Expenses = Net income.

In general terms, when one company (the parent) controls another company (the subsidiary), the parent presents its own financial statement information consolidated with that of the subsidiary. (When a parent company owns more than 50 percent of the voting shares of a subsidiary company, it is presumed to control the subsidiary and thus presents consolidated financial statements.) Each line item of the consolidated income statement includes the entire amount from the relevant line item on the subsidiary’s income statement (after removing any intercompany transactions); however, if the parent does not own 100 percent of the subsidiary, it is necessary for the parent to present an allocation of net income to the minority interests. Minority interests, also called non-controlling interests, refer to owners of the remaining shares of the subsidiary that are not owned by the parent. The share of consolidated net income attributable to minority interests is shown at the bottom of the income statement along with the net income attributable to shareholders of the parent company.

Exhibit 5 presents the income statement of the Volkswagen Group from its Annual Report 2009.

Exhibit 5. Income Statement of the Volkswagen Group for the Period 1 January to 31 December*

€ million	Note		2009		2008
Sales revenue	1		105,187		113,808
Cost of sales	2		–91,608		–96,612
Gross profit			13,579		17,196
Distribution expenses	3		–10,537		–10,552
Administrative expenses	4		–2,739		–2,742
Other operating income	5		7,904		8,770
Other operating expenses	6		–6,352		–6,339
Operating profit			1,855		6,333
Share of profits and losses of equity-accounted investments	7		701		910
Finance costs	8		–2,268		–1,815
Other financial result	9		972		1,180
Financial result			–595		275
Profit before tax			1,261		6,608
Income tax income/expense	10		–349		–1,920
Current			–1,145		–2,338
Deferred			796		418
Profit after tax			911		4,688
Minority interests			–49		–65
Profit attributable to shareholders of Volkswagen AG			960		4,753
Basic earnings per ordinary share in €	11		2.38		11.92
Basic earnings per preferred share in €	11		2.44		11.98
Diluted earnings per ordinary share in €	11		2.38		11.88
Diluted earnings per preferred share in €	11		2.44		11.94

*The numbers are as shown in the annual report and may not add because of rounding.

Exhibit 5 shows that Volkswagen’s sales revenue for the fiscal year ended 31 December 2009 was €105,187 million. Subtracting cost of sales from revenue gives gross profit of €13,579 million. After subtracting operating costs and expenses and adding other operating income, the company’s operating profit totals €1,855 million. Operating profit represents the results of the company’s usual business activities before deducting interest expense or taxes. Operating profit (also called operating income) is thus often referred to as earnings before interest and taxes (EBIT). Next, operating profit is increased by Volkswagen’s share of the profits generated by certain of its investments (€701 million) and by profits from its other financial

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3.1.2.2. Other Comprehensive Income

Comprehensive income includes all items that impact owners’ equity but are not the result of transactions with shareowners. Some of these items are included in the calculation of net income, and some are included in other comprehensive income (OCI). Under IFRS, when comprehensive income is presented in two statements, the statement of comprehensive income begins with the profit or loss from the income statement and then presents the components of other comprehensive income. Although US generally accepted accounting principles (US GAAP) indicate a preference for this type of presentation when a single statement of comprehensive income is not presented, they permit companies to present the components of other comprehensive income in the statement of changes in equity.5

Exhibit 6 presents the statement of comprehensive income of the Volkswagen Group from its Annual Report 2009.

Exhibit 6. Statement of Comprehensive Income of the Volkswagen Group for the Period 1 January to 31 December

€ million	2009		2008
Profit after tax	911		4,688
Exchange differences on translating foreign operations:
Fair value changes recognized in other comprehensive income	917		–1,445
Transferred to profit or loss	57
Actuarial gains/losses	–860		190
Cash flow hedges:
Fair value changes recognized in other comprehensive income	683		1,054
Transferred to profit or loss	–908		–1,427
Available-for-sale financial assets (marketable securities):
Fair value changes recognized in other comprehensive income	200		–330
Transferred to profit or loss	71		100
Deferred taxes	216		145
Share of profits and losses of equity-accounted investments recognized directly in equity, after tax	30		–188
Other comprehensive income	406		–1,901
Total comprehensive income	1,317		2,787
Of which attributable to
Shareholders of Volkswagen AG	1,138		3,310
Minority interests	179		–523

Exhibit 6 shows that other comprehensive income, although smaller in absolute terms than profit after tax (net income), had a significant effect on total comprehensive income. In 2009, other comprehensive income represented approximately 31 percent of total comprehensive income and was approximately 45 percent of the size of profit after tax (net income). In 2008, other comprehensive income was negative (a loss) and was approximately 41 percent of the size of profit after tax (net income) in absolute terms. The statement

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3.1.3. Statement of Changes in Equity

The statement of changes in equity, variously called the “statement of changes in owners’ equity” or “statement of changes in shareholders’ equity,” primarily serves to report changes in the owners’ investment in the business over time. The basic components of owners’ equity are paid-in capital and retained earnings. Retained earnings include the cumulative amount of the company’s profits that have been retained in the company. In addition, non-controlling or minority interests and reserves that represent accumulated other comprehensive income items are included in equity. The latter items may be shown separately or included in retained earnings. Volkswagen includes reserves as components of retained earnings.

The statement of changes in equity is organized to present, for each component of equity, the beginning balance, any increases during the period, any decreases during the period, and the ending balance. For paid-in capital, an example of an increase is a new issuance of equity and an example of a decrease is a repurchase of previously issued stock. For retained earnings, income (both net income as reported on the income statement and other comprehensive income) is the most common increase and a dividend payment is the most common decrease.

Volkswagen’s balance sheet in Exhibit 3 shows that equity at the end of 2009 totaled €37,430 million, compared with €37,388 million at the end of 2008. The company’s statement of changes in equity presents additional detail on the change in each line item. Exhibit 7 presents an excerpt of the statement of changes in equity of the Volkswagen Group from its Annual Report 2009.

Exhibit 7. Excerpt from Statement of Changes in Equity of the Volkswagen Group for the Period 1 January to 31 December 2009*

	Sub-scribed capital	Capital reserves	RETAINED EARNINGS						Equity attributable to shareholders of VW AG	Minority interests	Total equity
€ millions			Accumu-lated profit	Currency translation reserve	Reserve for actuarial gains/losses	Cash flow hedge reserve	Fair value reserve for securities	Equity- accounted investments
⋮	⋮	⋮	⋮	⋮	⋮	⋮	⋮	⋮	⋮	⋮	⋮
Balance at 1 Jan. 2009	1,024	5,351	31,522	–2,721	–672	1,138	–192	–439	35,011	2,377	37,388
Capital increase	0	4							4		4
Dividend payment			–779						–779	–95	–874
Capital transactions involving change in ownership			–76						–76	–316	–392
Total comprehensive income			960	839	–851	–361	271	30	888	214	1,102
Deferred taxes					247	83	–80		250	–34	216
Other

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3.1.4. Cash Flow Statement

Although the income statement and balance sheet provide measures of a company’s success in terms of performance and financial position, cash flow is also vital to a company’s long-term success. Disclosing the sources and uses of cash helps creditors, investors, and other statement users evaluate the company’s liquidity, solvency, and financial flexibility. Financial flexibility is the ability of the company to react and adapt to financial adversities and opportunities. The cash flow statement classifies all cash flows of the company into three categories: operating, investing, and financing. Cash flows from operating activities are those cash flows not classified as investing or financing and generally involve the cash effects of transactions that enter into the determination of net income and, hence, comprise the day-to-day operations of the company. Cash flows frominvesting activities are those cash flows from activities associated with the acquisition and disposal of long-term assets, such as property and equipment. Cash flows from financing activities are those cash flows from activities related to obtaining or repaying capital to be used in the business. IFRS permit more flexibility than US GAAP in classifying dividend and interest receipts and payments within these categories.

Exhibit 8 presents Volkswagen’s statement of cash flows for the fiscal years ended 31 December 2009 and 2008.

Exhibit 8. Cash Flow Statement of the Volkswagen Group: 1 January to 31 December

€ million	2009		2008
Cash and cash equivalents at beginning of period (excluding time deposit investments)	9,443		9,914
Profit before tax	1,261		6,608
Income taxes paid	–529		–2,075
Depreciation and amortization of property, plant and equipment, intangible assets and investment property	5,028		5,198
Amortization of capitalized development costs	1,586		1,392
Impairment losses on equity investments	16		32
Depreciation of leasing and rental assets	2,247		1,816
Gain/loss on disposal of noncurrent assets	–547		37
Share of profit or loss of equity-accounted investments	–298		–219
Other noncash expense/income	727		765
Change in inventories	4,155		–3,056
Change in receivables (excluding financial services)	465		–1,333
Change in liabilities (excluding financial liabilities)	260		815
Change in provisions	1,660		509
Change in leasing and rental assets	–2,571		–2,734
Change in financial services receivables	–719		–5,053
Cash

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A trial balance is a list of all open accounts in the general ledger and their balances.

• For every amount debited, an equal amount must be credited.
• The total of debits and credits for all the T-accounts must be equal.
• A trial balance is prepared to test this. It proves whether or not the ledger is in balance.
• It is usually prepared at the end of a month or accounting period.

Since certain accounts may not be accurately stated, adjusting entries may be required to prepare an adjusted trial balance.

Liquidity refers to the "nearness to cash" of assets and liabilities, or having enough cash available to pay debts when they are due.