Understanding Financial Statements

EIGHTH EDITION Lyn M. Fraser Aileen Ormiston

Financial Statements An Overview

Map or Maze

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Financial Statements An Overview

Map or Maze
Auditor s Report MD&A

Income Statement

Notes

Statement of Cash Flows

Statement of Shareholders Equity Balance Sheet

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Map:
Helps its user reach a desired destination through clarity of representation

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Maze:
On the other hand. . . Attempts to confuse its user by purposefully introducing conflicting elements and complexities that prevent reaching the desired goal

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Map or Maze
Financial statements are potentially both MAP and MAZE

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Financial Statements--MAP Statements--MAP

Form basis for understanding the financial position of a firm Allow users to assess historical and prospective financial performance Present picture of firm s financial health, leading to informed business decisions

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Financial Statements--MAZE Statements--MAZE

Contain large amounts of information Accounting policies and reporting requirements are complex and constantly changing Allow management considerable discretion Hide or omit key information
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Our Objective:
To ensure that financial statements serve as a map, not a maze The better one can read and understand the financial statements, the more useful they are as a MAP to intelligent decision-making decision(C) 2007 Prentice Hall, Inc. 1-9

Why use financial statements?

Savvy use of financial statements allows user to assess: Financial position of the company Success of its operations Policies and strategies of management Insight into future performance

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Questions one might ask:

  
Would an investment generate attractive returns? What is the degree of risk inherent in the investment? Should existing investing holdings be liquidated?

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Questions one might ask (cont.)

 
Will cash flows be sufficient to service interest and principal payments on debt? Does company provide a good opportunity for employment?

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Questions one might ask

 

(cont.)

How well does this company compete in its operating environment? Is this firm a good prospect as a customer?

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Volume of Information:
The Annual Report
Financial statements Notes to the financial statements The auditor s report FiveFive-year summary of key financial data

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Volume of Information
The Annual Report
(cont.)

High and low stock prices Management s discussion and analysis of operations Material included at the imagination and discretion of management
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Financial Statements
Prepared according to generally accepted accounting principles (GAAP) Present financial information that is understandable by users AND relevant and reliable for decision making
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GAAP
Two authorities primarily responsible for establishing GAAP in the United States are the SEC and the FASB

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SEC
Stands for Securities and Exchange Commission Regulates US companies that issue securities to the public

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SEC

(cont.)

Requires regular filing of  Annual reports (10-K) (10 Quarterly reports (10-Q); and (10 Other reports dependent upon particular
circumstances (filed as 8-K reports) 8Change in auditor Bankruptcy Financial restatements Other important events
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SEC

(cont.)

Has Congressional authority to set accounting policies, but usually delegates accounting rule-making to rulethe FASB

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FASB
Stands for

   

Financial Accounting Standards Board Comprised of 7 full-time paid members fullIssues Statements of Financial Accounting Standards (SFASs) and SFASs) Interpretations Lengthy deliberation process
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The FASB Deliberation Process

1. Introduction of topic or project on the FASB agenda 2. Research and analysis of the problem 3. Issuance of a discussion memorandum
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The FASB Deliberation Process (cont.)

4. 5. 6. 7. Public hearings Board analysis and evaluation Issuance of an exposure draft Period of public comment

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The FASB Deliberation Process

(cont.)

8. Review of public response, revision 9. Issuance of SFAS 10. Amendments and Interpretations, as needed

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The SEC and FASB

Have worked closely together in the development of accounting policy

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The SEC and FASB

(cont.)

Recent history of corporate failures and accounting scandals have focused attention and criticism on regulatory authorities The two organizations continue to examine potential rule changes or new rules in a variety of areas
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Where to Find a Company s Financial Statements:

  
Form 10-K 10Annual report Website

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The Four Basic Financial Statements

1. Balance Sheet 2. Income Statement or Earnings
Statement 3. Statement of Stockholders Equity 4. Statement of Cash Flows
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Financial Statement Notes

   
An INTEGRAL part of the statements Provide summary of accounting policies Present detail about particular accounts (e.g. inventory, investments, etc.) Include other information (e.g. leasing arrangements, pending legal proceedings, income taxes, etc.)
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Financial Statement Notes

(cont.)

Contain some supplementary information required by SEC and FASB Examples include:
  Information on foreign currency translations for firms operating in foreign countries Information by segment for firms with several lines of business
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Auditor s Report
Unqualified Qualified Adverse opinion Disclaimer of opinion

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Auditor s Report



(cont.)

Unqualified (what you want!)

Statements present information in conformity with GAAP


 

Qualified
Reports other than an unqualified opinion due to various circumstances Typically use word except for
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Auditor s Report



(cont.)

Adverse opinion (not what you want!)

Financial statements have not been presented fairly in accordance with GAAP

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Auditor s Report

  


(cont.)

Disclaimer of opinion is issued when

auditor can t evaluate the fairness of the statements and expresses no opinion there is material scope limitation of the audit there is lack of independence by the auditor
remember, the auditor is hired by the firm being audited, so there is always the possibility of conflict of interest
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Auditor s Report

  

(cont.)

Unqualified opinion with explanatory language is warranted when there is

a consistency departure due to a change in accounting principle uncertainty caused by future events such as contract disputes and lawsuits an event (or events) that the auditor wishes to describe because they may present business risk and/or goinggoingconcern problems
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SarbanesSarbanes-Oxley Act of 2002


Passed by Congress in hopes of ending future accounting scandals and renewing investor confidence in the marketplace Act established the Public Company Accounting Oversight Board (PCAOB)
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Public Company Accounting Oversight Board (PCAOB)

  
Has authority to register, inspect, and discipline auditors of all publicly owned companies Prohibits audit firms from providing certain non-audit services when nonconducting an external audit Requires chief executive officer (CEO) and chief financial officer (CFO) of a publicly owned company to certify the accuracy of the financial statements
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SarbanesSarbanes-Oxley Act of 2002

Example of actual Section 404 compliance statement on internal controls from a 10K*

 

Management report on internal control over financial reporting .. Management assessed our internal control over financial reporting as of December 31, .., the end of our fiscal year. Management based its assessment on criteria established in Internal Control Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. .
*Data from SEC website, www.sec.gov
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SarbanesSarbanes-Oxley Act of 2002

Example of actual Section 404 compliance statement on internal controls from a 10K*

 

Management report on internal control over financial reporting (cont.) Based on the material weaknesses described .., management has concluded that our internal control over financial reporting were not effective as of the end of the fiscal year. We reviewed the results of management s assessment with the Audit Committee of our Board of Directors
*Data from SEC website, www.sec.gov

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Management Discussion and Analysis (MD&A)

 
Sometimes labeled Financial Review Contains information that cannot be found in the financial data

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MD&A (cont.)
Includes discussion of: 1. 2. 3. Internal/external sources of liquidity Any material deficiencies in liquidity and how they will be remedied Commitments for capital expenditures/sources of funding
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MD&A (cont.)
4. 5. Anticipated changes in mix and cost of financing resources Unusual/infrequent transactions that affect income from continuing operations

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MD&A (cont.)
6. Events causing material changes in cost/revenue relationships (e.g. future price increase) Breakdown of sales increases into price & volume components

7.

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MD&A (cont.)
Alas, there are problems as well with the usefulness of the MD&A section Companies do a good job of describing historical events but. . . Very few provide accurate forecasts
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MD&A (cont.)
More helpful has been the addition to the MD&A of explanations about why changes have occurred in profitability and liquidity

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FiveFive-Year Summary of Selected Financial Data and Market Data

 
Required by SEC Offers a quick look at some overall trends

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FiveFive-Year Summary
Includes:

(cont.)

  

Net sales or operating revenues Income or loss from continuing operations Income or loss from continuing operations per common share

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FiveFive-Year Summary
  

(cont.)

Total assets LongLong-term obligations and redeemable preferred stock Cash dividends per common share

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Pandora (A.K.A.

PR Fluff )

Getting what is needed can be a challenge Colored photographs Charts Shareholders letter from the CEO Website

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Proxy Statement
  
Used to solicit shareholder votes Required by the SEC Important in assessing who manages the firm, how management is paid and potential conflict-ofconflict-of-interest issues
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Proxy Statement
Contains

(cont.)

 

Voting procedures and information Background information about the company s nominated directors

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Proxy Statement
  

(cont.)

Director compensation Executive compensation Any proposed changes in compensation plans

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Proxy Statement
 

(cont.)

Audit committee report Breakdown of audit and non-audit nonfees paid to the auditing firm

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Missing and Hard-toHard-to-Find Information

Not available in the financial statements:

  

Employee relations with management Morale/efficiency of employees Reputation/public perceptions of firm

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Missing and Hard-toHard-to-Find Information (cont.)

 
Effectiveness of management team/provisions for succession Potential exposure to regulatory changes QUALITIES THAT IMPACT OPERATING SUCCESS BUT ARE DIFFICULT TO QUANTIFY
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Missing and Hard-toHard-to-Find Information

Publicity in the Media

(cont.)

  

Affects public perception of firm and can impact financial performance Proven correlation between financial returns and reputation A recent example of adverse publicity is Enron for denying their involvement in any wrongdoing
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Missing and Hard-toHard-to-Find Information

 

(cont.)

Facts are available, but may be difficult for an average user to find Many items must be extracted from notes, supplementary schedules and the MD&A section in order to interpret financial statement numbers--the numbers--the facts are there, but they are not self-evident! self1-57

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Complexities
A global marketplace International Accounting Standards Board (IASB) formed in 1973 with (IASB) goal of establishing international GAAP US presently has not accepted the current international accounting standards
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Complexities:
Stock Options:
IASB

(cont.)

Example of convergence of IASB and FASB accounting principles

IFRS 2, Share-based Payment, addresses Sharethe expensing of stock options and was released 2/04* FASB SFAS 123(R), Share-based Payment, Shareaddresses the expensing of stock options and was released 12/04*
*Data from www.iasb.org and www.fasb.org
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Complexities
Mythical Mountain

(cont.)

GAAP provide some measure of uniformity but they allow considerable discretion Accounting choices and estimates affect amounts on financial statements Depreciation of fixed assets is a good example (choice of method, different good faith estimates possible for asset life and salvage value)
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Complexities


(cont.)

Other Discretionary Issues

Statements are prepared on accrual basis which involves considerable estimation and judgment to match expense and revenue to accounting periods Although the firm s life is continuous, financial data is presented for arbitrary time periods--year, quarter, month, etc. periods--year,
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More Complications
  
Goodwill and Other Intangible Assets Consolidation of parent and subsidiaries Accounting for leases and pensions

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More Complications
  

(cont.)

Translation of foreign operations OffOff-balance sheet financing Accounting for derivatives

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More Complications
 

(cont.)

Comprehensive income reporting Two sets of books (yes, it s legal!!) - financial vs. tax reporting

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Quality of Financial Reporting

Management has considerable discretion within GAAP Potential exists to manipulate the profit/loss reported

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Quality of Financial Reporting

(cont.) Ideally, financial statements should:

 

Reflect an accurate picture of a company s financial condition and performance Information should be useful both to assess the past and predict the future
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Quality of Financial Reporting

(cont.)

The sharper and clearer the picture presented through the financial data and the closer that picture is to financial reality. . . The higher the quality of the financial statements and reported earnings
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Quality of Financial Reporting

(cont.)

Examples of opportunities for management to affect the quality of financial statements. . . .

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Quality of Financial Reporting

(cont.)

   

Accounting Policies, Estimates Choices and Changes Timing of Revenue and Expense Recognition Discretionary Items Nonrecurring and Nonoperating Items
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Accounting Policies, Estimates Choices and Changes

Choices Management makes choices with respect to accounting policies Management makes estimations in the applications of those policies
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Accounting Policies, Estimates Choices and Changes (cont.)

Changes Policy or estimate may be changed

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Timing of Revenue and Expense Recognition

The Matching Principle: Expenses are matched with the generation of revenues in order to determine net income for an accounting period

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Timing of Revenue and Expense Recognition (cont.)

Matching process involves judgments by management regarding the timing of expense and revenue recognition

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Timing of Revenue and Expense Recognition (cont.)

Generally, the more conservative the approach (least favorable to the firm) the higher the quality of earnings

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Discretionary Items
Budget level and timing of expenditures for many items are discretionary, e.g.
Advertising/marketing Repairs/maintenance Research and development Capital expansion

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Nonrecurring and Nonoperating Items

  
Are not part of normal ongoing business Should be reviewed and possibly eliminated from earnings Earnings figure should reflect future operating potential

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Nonrecurring and Nonoperating Items

Transactions include

(cont.)

   

Gains and losses on the sale of an asset or business segment WriteWrite-downs for the impairment of assets Accounting changes Extraordinary items
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The Journey Through the Maze Continues

Ch. 2: Ch. 3: Ch. 4: Ch. 5: Ch. 6:
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The Balance Sheet Income Statement and Statement of Stockholders Equity Statement of Cash Flows A Guide to Earnings and Financial Reporting Quality The Analysis of Financial Statements
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