Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Understanding the Corporate Annual Report: Nuts, Bolts, and a Few Loose Screws Chapter 3

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Chapter 3 will cover: Statement of financial condition (balance sheet) Statement of shareholders’ equity

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Statement of Financial Condition Shows: What a firm owns (assets) What a firm owes –to outsiders (liabilities) –to owners (shareholders’ equity)

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Statement of Financial Condition is: Prepared at a specific point in time: End of year End of quarter

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing At all times... The balance sheet must balance Assets = Liabilities + Shareholders’ Equity

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Assets Current assets include: Cash Cash equivalents Other assets expected to be converted into cash within one year or one operating cycle, whichever is longer

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Operating Cycle Time required to purchase/manufacture goods, sell the goods, and collect the cash

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Cash Cash is cash in any form: Awaiting deposit On deposit

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Cash Equivalents Short-term, highly liquid investments Readily convertible into cash

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Marketable Securities Short-term investments Earn a return on cash not needed immediately Valuation depends upon the intent of investment

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Receivables (Accounts Receivable) Customer balances outstanding on credit sales Carried at net realizable value Net realizable value: Actual amount less allowance for estimated uncollectible accounts

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Allowance Account Important in assessing earnings quality There should be a consistent relationship among the changes in sales, accounts receivable, & the allowance account Caution flag raised if sales & accounts receivable are increasing, but allowance account is decreasing

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Inventories Are items that are: Held for sale Used in the manufacture of products

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing A Retail Company Has only one type of inventory Merchandise inventories purchased for resale

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing A Manufacturing Company Has three types of inventory: Raw materials Work in process Finished goods

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Cost Flow Assumption for Inventory Determines: Value on balance sheet Expense of cost of goods sold on income statement Is important for analysis

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Commonly Used Cost Flow Assumptions LIFO (last in, first out) FIFO (first in, first out) Average cost

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing LIFO Matches current costs with current revenue on income statement Undervalues balance sheet inventory during inflation Overvalues balance sheet inventory during deflation

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing FIFO Values balance sheet inventory close to current cost Understates cost of goods sold during inflation Overstates cost of goods sold during deflation

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing For Taxes & Reporting Purposes: Companies must use the same method if LIFO is chosen for tax purposes Many companies have switched to LIFO during inflation to pay lower taxes (with higher cost of goods sold expense)

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Accounting Convention of Conservatism If actual value falls below cost: Inventory written down Inventory never written up in value

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Common Size Balance Sheet Expresses all items on balance sheet as percent of total assets Useful in trend & structural analysis

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Result from temporary differences in recognizing revenue & expense for: Tax purposes (payments to I.R.S.) Reporting purposes (preparation of financial statements) Deferred Income Taxes

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Examples of Temporary Differences Accounting for: Depreciation expense Installment sales Leases Warranty & service contracts Pensions & other employee benefits Subsidiary investment earnings

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Permanent Differences Do not affect deferred taxes Example: Accounting for municipal bond revenue Recognized as income for reporting but not tax

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Deferred Taxes Can appear on balance sheet as: Asset and/or liability Current and/or noncurrent

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Property, Plant, & Equipment Tangible, long-lived assets Also called fixed assets or capital assets Produce benefit for more than one year Carrying value on balance sheet: Cost less accumulated depreciation

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Land is an Exception Carried at cost; not depreciated Assumed to have unlimited useful life

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Goodwill Results from one company acquiring another Price paid more than fair market value of net identifiable assets (Identifiable assets less liabilities assumed)

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Carrying Value of Goodwill Company evaluates value Decreased value requires write-off Increased value is not recorded

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Liabilities Represent claims against assets Current liabilities: Payment expected within one year (or one operating cycle, whichever is longer)

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Accounts Payable Short-term obligation Arise from supplier credit

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Short-term Borrowings Are promissory notes to: Suppliers Financial institutions

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Taxes Payable Taxes expensed but not yet paid

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Dividends Payable Dividends declared but not yet paid

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Long-term Borrowings Obligations with maturities beyond one year: Bonds Long-term notes payable Mortgages Obligations under leases

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Long-term Borrowings Continued: The current portion (amount due within one year) Is included in current liabilities

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Postemployment Liabilities Includes certain postemployment obligations For example: Accrued amount for expected medical bills of retired employees & spouses

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Pension Accounting Two types of plans: 1.Defined benefit: employer specifies amount contributed Example: 401 (k) Pension expense is amount contributed

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Pension Accounting Continued: 2.Defined benefit: specifies amount that will be paid to employees after retirement Pension expense is estimated based on assumptions

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Information About Defined Benefit Plans Is disclosed in notes You may need several accounting courses to understand notes Or read this book

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Leases Operating lease Conventional rental agreement Capital lease Treated as if it were a purchase of asset Requires recognition of asset & liability on balance sheet

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Hybrid Securities Example: Mandatorily redeemable preferred stock Have characteristics of debt & equity Carried between liabilities & equity on balance sheet

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Shareholders’ Equity or Stockholders’ Equity Ownership interests in company Residual interest in assets that would remain after satisfying all of the liabilities

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Preferred Stock Usually carries fixed annual dividend But no voting rights

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Common Stock Usually does not receive a fixed return (Dividends declared at discretion of company’s directors) But has voting rights

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Common Stock Continued: Carried at par or stated value Number of shares sold multiplied by par or stated value Bears no relationship to market price

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Additional Paid in Capital Reflects the amount by which original sales price exceeded par or stated value

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Retained Earnings Sum of all company profits less any payments made to shareholders in cash or stock dividends Are not piles of unused cash

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Accumulated Other Comprehensive Income or Loss Items “like” a revenue or expense but are not the same “Unrealized gains & losses” Not counted as part of earnings Changes go to equity

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Accumulated Other Comprehensive Income or Loss Include: Unrealized gains/losses in marketable securities classified as available for sale Specific type of pension liability adjustment Gains & losses on derivative financial instruments Foreign currency translation adjustments

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Treasury Stock Company repurchases their own shares for: Employee stock option & retirement plans Building holdings for prospective mergers Increasing earnings per share by reducing shares outstanding

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Treasury Stock Continued: Preventing takeovers by reducing shareholders Investing excess cash

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Stock Options Increasingly popular form of employee compensation Cost of options is not recognized as expense

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Stock Options Continued: Options: Gives the holder right to purchase company shares at a stated price by a certain date If price rises, holder exercises options, makes a profit

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Stock Options Continued: Difference between option price & market price: Is deductible for tax purposes Information about stock options disclosed in notes

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Statement of Shareholders’ Equity One of four required financial statements Shown for three-year period Explains changes in all shareholders’ equity accounts

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Shareholders’ Equity Accounts Include: Common stock Preferred stock Additional paid in capital Retained earnings Accumulated other comprehensive income (loss) Treasury stock

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Caution Flags Reductions in allowance for doubtful accounts when accounts receivable & sales are increasing Sales & receivables –Growing at different rates –Moving in opposite directions

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing More Caution Flags Categories of inventories moving in opposite directions Sales & inventories –Growing at different rates –Moving in opposite directions

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Even More Caution Flags Excessive use of “other” for material, unexplained items Write-down in value of goodwill Borrowings growing faster than assets being financed Debt rising when assets are decreasing

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Yet, More Caution Flags Financial statement notes obscure rather than enlighten Understanding notes requires Ph.D. in accounting

Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing Final Caution Flags Substantial income from unpredictable/possibly unsustainable sources (e.g., pension plans) Extensive use of stock options for employee compensation