Communicating and Interpreting Accounting Information Chapter 5 Chapter 5: Communicating and Interpreting Accounting Information

LO1 Learning Objectives Recognize the people involved in the accounting communication process (regulators, managers, directors, auditors, information intermediaries and users), their role in the process and the guidance they receive from legal and professional standards. LO1 Our first learning objective in Chapter 5 is to recognize the people involved in the accounting communications process (regulators, managers, directors, auditors, information intermediaries and users), their role in the process and the guidance they receive from legal and professional standards.

Players in the Accounting Communication Process Management Preparation CEO, CFO, Accounting Staff Guided by GAAP Independent Auditors Verification Partners, Managers, Staff Guided by GAAS An unqualified opinion states that the financial statements are fair presentations in all material respects in conformity with GAAP. We will begin this chapter by looking at the players in the accounting communication process. Management is responsible for the preparation of financial statements. The chief executive officer and chief financial officer bear ultimate responsibility for the content of the financial statements. They are guided by members of the accounting staff who followed generally accepted accounting principles. Independent auditors verify the fairness of presentation of the financial statements in accordance with generally accepted accounting standards. Independent auditors are guided by generally accepted auditing standards.

Players in the Accounting Communication Process Management Preparation CFO, CEO, Accounting Staff Guided by GAAP Independent Auditors Verification Partners, Managers, Staff Guided by GAAS Information Intermediaries Analysis and Advice Financial analysis, Information services Financial analysts make predictions concerning companies’ future earnings and stock prices. Information intermediaries such as financial analysts make predictions concerning the company’s future earnings and stock prices as a result of past financial information.

Players in the Accounting Communication Process Management Preparation CFO, CEO, Accounting Staff Guided by GAAP Independent Auditors Verification Partners, Managers, Staff Guided by GAAS Information Intermediaries Analysis and Advice Financial analysis, Information services Financial analysts make predictions concerning companies’ future earnings and stock prices. Web Info Services: www/sec/gov www.compustat.com www.djnr.com www.bloomberg.com www.firstcall.com www.hoover.com Here are some web sites that contain extensive financial information about publicly listed companies.

Players in the Accounting Communication Process Management Preparation CFO, CEO, Accounting Staff Guided by GAAP Players in the Accounting Communication Process Independent Auditors Verification Partners, Managers, Staff Guided by GAAS Information Intermediaries Analysis and Advice Financial analysis, Information services Government Regulators Verification SEC Members Guided by SEC regs. Government regulators, primarily the securities and exchange commission, also verify the financial information presented by management. The staff of the securities and exchange commission is guided by regulations developed by the commission. Only publicly traded companies need to follow the regulations specified by the securities and exchange commission. Users of financial information such as investors and lenders incorporate information from all of these sources when making their final decision about the credit worthiness or long-term investment potential of the company. Users Analysis and Decision Investors, Lenders, etc. Public companies only

Ensuring the Integrity of Financial Information Communication Process Regulators Standard Setting and Verification SEC Management Primary Responsibility CFO, CEO, Accounting Staff To ensure the integrity of the financial communication process, the Board of Directors of a company establishes an independent audit committee. The committee is made up of outside directors. The responsibility of the committee is one of oversight. They are responsible to see that the financial information released to the public is in conformity with generally accepted accounting principles and is fairly presented. Directors Oversight Audit Committee (Independent directors) Auditors (CPAs) Verification Partners, Managers, Staff

Using Financial Reports Management Primary Responsibility CFO, CEO, Accounting Staff Information Intermediaries Analysis and Advice Financial analysts, Information services Users Analysis and Decision Institutional and private investors, Lenders, Suppliers, Customers, etc. Once financial intermediaries receive financial information from the company, they analyze this information. The financial intermediaries’ analysis of the information is of value to users of the financial information. Investors, creditors, lenders and suppliers rely upon information developed by financial intermediaries.

Guiding Principles for Communicating Useful Information Primary Objective of External Financial Reporting To provide economic information to external users for decision making. Primary Qualitative Characteristics Relevance: Timely and Predictive Feedback Value Reliability: Accurate, Unbiased, and Verifiable The primary objective of external financial reporting is to provide economic information to external users that will assist them in the decision-making process. The primary qualitative characteristics of useful information include relevance and reliability. The secondary qualitative characteristics of useful information include comparability and consistency. Secondary Qualitative Characteristics Comparability: Across businesses Consistency: Over time

Guiding Principles for Communicating Useful Information Primary Objective of External Financial Reporting To provide economic information to external users for decision making. The full-disclosure principles require . . . A complete set of financial statements, and Notes to the financial statements Primary Qualitative Characteristics Relevance: Timely and Predictive and Feedback Value Reliability: Accurate, Unbiased, and Verifiable To meet the full disclosure principle, companies are required to publish a complete set of financial statements and all of the relevant notes to those financial statements. Secondary Qualitative Characteristics Comparability: Across businesses Consistency: Over time

International Accounting Standards Board and Global Differences in Accounting International Financial Reporting Standards The international accounting standards committee has formed the international reporting standards project. Here we can clearly see some of the differences between United States generally accepted accounting principles and standards established by the IFRS.

LO2 Learning Objectives Identify the steps in the accounting communication process, including the issuance of press releases, annual reports, quarterly reports and SEC filings as well as the role of electronic information services in this process. LO2 Our second learning objective in Chapter 5 is to identify the steps in the accounting communication process, including the issuance of press releases, annual reports, quarterly reports and SEC filings as well as the role of electronic information services in this process.

The Disclosure Process Press Releases are used to announce quarterly and annual earnings as soon as the verified figures are available. Earnings Press Release Excerpt for Callaway Golf Callaway® Golf CARLSBAD, Calif. -- Jan. 22, 2004-- Callaway Golf Company (NYSE:ELY) today reported record sales for the full year ended December 31, 2003, announcing net sales of $814 million compared with $793 million for the prior year. Net income for the full year was $46 million versus . . . . Press releases are used by companies to disseminate important information about the operation or earnings of the company. Here we see an example of an earnings press release for Callaway Golf Company.

Annual Reports For privately held companies, annual reports are simple documents that include: Four basic financial statements. Related notes (footnotes). Report of independent accountants (auditor’s opinion) if the statements are audited. Privately held companies whose reports are not distributed to the general public are required to issue the four basic financial statements, related notes to financial statements, and if the statements are audited, the auditor’s report.

Annual Reports For public companies, annual reports are elaborate due to SEC reporting requirements: A Nonfinancial Section A letter to the stockholders, a description of management’s philosophy, products, successes, etc. A Financial Section See next slide for a detailed listing . . . Due to elaborate reporting requirements of the Securities and Exchange Commission, publicly held companies issue an annual report that can be divided into two major sections. The first section deals with nonfinancial matters and the second section deals with the financials. The nonfinancial section contains a letter to the stockholders, usually from the CEO, a description of management’s philosophy, products produced and sold, and any major successes or failures the company has experienced in the past year.

Annual Reports - Financial Section Summarized financial data for 5- or 10-years. Management Discussion and Analysis (MD&A). The four basic financial statements. Notes (footnotes). Independent Accountant’s Report and the Management Certification. Recent stock price information. Summaries of the unaudited quarterly financial data. Lists of directors and officers of the company and relevant addresses. Here is a list of the major categories of information that you will find in the typical annual report of a publicly held company. Towards the end of the report there is a summary of financial data for five or ten years. Management is required to communicate to the reader certain financial and nonfinancial information. This is referred to as management discussion and analysis. All annual reports contain the four basic financial statements and related notes to those financial statements, and the report of the independent accountant. In addition, many annual reports contain information about the recent stock price for each quarter of the year. Also, we may find summaries of unaudited quarterly financial information, a listing of the company’s directors and officers, and relevant addresses and telephone numbers for contacting the company.

Usually begin with short letter to stockholders Quarterly Reports Usually begin with short letter to stockholders Condensed unaudited income statement and balance sheet for the quarter. Often, cash flow statement and statement of stockholders’ equity are omitted. Some notes to the financial statements also may be omitted. Publicly held companies usually produce quarterly reports. The typical quarterly report frequently begins with a short letter to the stockholders from either the CEO or the CFO. The quarterly report contains a condensed unaudited income statement and balance sheet for the quarter. In some quarterly reports, we can expect to find a statement of cash flows and the statement of stockholders’ equity, but these are often omitted. Additionally, some notes to the financial statements may be omitted.

SEC Reports Form 10-K Annual Report Due within 90 days of the fiscal year-end. Contains audited financial statements. Form 10-Q Quarterly Report Due within 45 days of the end of the quarter. Financial statements can be unaudited. Companies are required to prepare reports for the securities and exchange commission. One of the most common reports is known as form 10-K, or the annual report. The form is due within 90 days of the end of the company’s fiscal year and it must contain audited financial statements. The form 10-Q is a quarterly report. It is due within 45 days of the end of each quarter and contains financial statements that are usually unaudited. Form 8-K is a current events report. It is due within 15 days of the occurrence of a major reportable event. Any financial statements that are included in the form can be unaudited. Form 8-K Current Report Due within 15 days of the major event date. Financial statements can be unaudited.

LO3 Learning Objectives Recognize and apply the different financial statement and disclosure formats used by companies in practice. LO3 Our third learning objective in Chapter 5 is to recognize and apply the different financial statement and disclosure formats used by companies in practice.

Financial Statement Formats Let’s take a closer look at the asset section of the balance sheet! Let’s take a closer look at the asset section of the balance sheet.

Here is the asset section of the balance sheet of Callaway Golf Company for the years ended December 31, 2003 and 2002. Notice that the assets are divided among current assets, property plant and equipment, net of accumulated depreciation, intangible assets, net of amortization, and other assets. The total assets at December 31, 2003 are $748,566. Remember that all values on the balance sheet are reported in thousands of dollars. So the actual total assets for Callaway Golf Company at December 31, 2003 are $748,566,000.

Current assets are assets that will be turned into cash or expire (be used up) within the longer of one year or the operating cycle. Current assets are those assets that will be converted into cash or expire, that is, be used up, within the longer of one year or the company’s normal operating cycle. Remember, we discussed the company’s operating cycle earlier.

Property, plant and equipment includes assets with useful lives of more than one year acquired for use in the business rather than for resale. The amount is reported net of accumulated depreciation. Property, plant and equipment includes assets with useful lives of more than one year that will be used by the business to generate revenue. The amount is always reported net of accumulated depreciation.

Intangible assets have no physical existence and a long life Intangible assets have no physical existence and a long life. They include patents, copyrights, trademarks, etc. Intangible assets have no physical existence and usually have a long useful life, therefore they present difficult accounting problems. Intangible assets include items such as patents, copyrights, trademarks, goodwill and franchises. Intangible assets are reported net of related amortization.

Let’s now look at the liability section of a classified balance sheet. Now let’s look at the liability section of the balance sheet.

Here is the liability section of the balance sheet of Callaway Golf Company at December 31, 2003 and 2002.

Current liabilities are obligations that will be paid with current assets, normally within one year.

Long-term liabilities are debts that have maturity dates extending beyond one year from the balance sheet date. Long-term liabilities are debts that have maturity dates extending beyond one year from the balance sheet date. Long-term liabilities normally bear interest. There is no dollar amount associated with contingencies and commitments; rather, we describe these two types of items in the Notes to our financial statements.

Finally, we get to the stockholders’ equity section of a classified balance sheet. Finally, let’s look at the stockholders’ equity section of a classified balance sheet.

Contributed capital is often shown in two separate accounts Common stock. Additional paid-in capital. Contributed capital is normally shown in two accounts. The first is the common stock account and the second is additional paid-in capital. Notice that Callaway Golf Company has one penny par value common stock. At December 31, 2003 there were 83,710,094 common shares outstanding. When common stock is sold, any amount received in excess of the par value is placed in the additional paid-in capital account.

Retained earnings is the total earnings of the company less the total dividends declared since inception of operations. The retained earnings account represents the balance of all of the earnings of the company less the total of the dividends declared since inception of operation.

Balance Sheet Ratios and Debt Contracts When a company borrows money, it often agrees to certain restrictions on activity. Ratios typically part of the borrowing agreement include: Two ratios that are normally associated with borrowing of funds from a financial institution are the debt-to-equity ratio and the current ratio. The debt-to-equity ratio is determined by dividing total liabilities by total stockholders’ equity. The current ratio is determined by dividing current assets by current liabilities. The debt-to-equity ratio tells us what percentage of the funds contributed to the company were provided by creditors and what percentage was provided by owners. The current ratio is one of the most popular ratios used in business. The current ratio lets us know if the company has enough current assets to pay its current liabilities when they become due.

Classified Income Statement Income statements may contain five sections: Continuing operations Discontinued operations Extraordinary items Cumulative effect of changes in accounting methods Earnings per share A classified income statement may contain as many as five separate sections. The first section, which we see on every classified income statement, is income from operations. The next three items are referred to as D’s, E’s and C’s. The D represents amounts associated with discontinued operations, the E represents amounts associated with extraordinary items and the C represents the cumulative effect of changes in certain accounting methods. It is highly unlikely that a company will have all items 2, 3, and 4 in their classified income statement. If the company has more than one of these three items they are reported in this order: number 2 first; number 3, second, and number 4, last. All publicly owned companies are required to disclose earnings per share.

Classified Income Statement General Format for the Classified Income Statement Gross sales minus any discounts, returns, and allowances during the period. This table shows the general format for the classified income statement. Net sales is equal to gross sales less any sales discounts, less any sales returns, and less any sales allowances for the period.

Classified Income Statement General Format for the Classified Income Statement Cost of inventory sold. Cost of goods sold represents the inventory items that have been sold to customers.

Classified Income Statement General Format for the Classified Income Statement Not related to the company’s primary operations. Usually includes interest income or expense and any gains or losses from the retirement of equipment. One of the most important income measures that we will encounter is the income from operations. Financial analysts and others who exam our financial statements closely examine income from operations. It is a measure of how much profit or loss we incurred as a result of the normal operations of our business. Nonoperating revenues and expenses or gains and losses are not integral parts of the operations of our business, and are therefore separated out from income from operations.

Common-Size Income Statement Total revenue is equal to 100%. Here is Papa John’s income statement for the one month ended January 31, 2004. Notice that besides expressing the income in dollar amounts, we also show income in percentage amounts. This type of presentation is referred to as a common size income statement. We normally let total revenues equal 100%, and express all other amounts on the income statement as a percent of total revenues. For example, we can see the cost of sales is 51.58% of total revenue. Income tax expense is 5.59% of total revenue. The common size income statement provides us with another way to analyze financial information. Notice for the one month ended January 31, 2004, Papa John’s reported earnings per share of 40 cents.

Net Income Available to Common Shareholders Earnings Per Share EPS = Net Income Available to Common Shareholders Weighted Average Number of Shares Outstanding During the Reporting Period Basic earnings per share is calculated by dividing net income available to common shareholders by the weighted average number of shares outstanding during the reporting period. Net income available to common shareholders is equal to net income less dividends on preferred stock. Basic EPS

Net Income Available to Common Shareholders Earnings Per Share EPS = Net Income Available to Common Shareholders Weighted Average Number of Shares Outstanding During the Reporting Period Diluted EPS Stock options, debt securities, equity securities are assumed to be converted into common stock at the beginning of the period. A company may also be required to report diluted earnings per share. Diluted earnings per share is always less than basic earnings per share. Diluted earnings per share takes into consideration stock options the company may have outstanding and debt or equity securities that may be converted into common stock.

Statement of Cash Flows Recall that the Statement of Cash Flows is divided into three major sections. Cash flows from operating activities. Cash flows from investing activities. Cash flows from financing activities. We will examine the indirect method of preparing the statement. This format begins with a reconciliation of accrual income to cash flows from operations. Recall that the statement of cash flows is divided into three major sections. The first section is cash flows from operating activities, followed by cash flows from investing activities, and completed with cash flows from financing activities. In addition, we reconcile the beginning and ending cash balance.

This is the operating activities section of Calloway’s statement of cash flows for the year ended December 31, 2003. The statement is prepared on what’s called the indirect method. When we use the indirect method, we start with net income reported on the income statement and adjust it for reconciling items until we are able to calculate net cash provided from operating activities. This is the operating activities section of Callaway using the indirect method. Begin with accounting net income and arrive at cash provided by operating activities.

While these items are on the income statement, they have no current cash effect. Depreciation and amortization and similar non-cash charges to income appear on the income statement as expenses, but they have no cash flow impact. As a result, we add these items back to net income when we calculate cash provided from operating activities.

This table provides guidance for adjustments related to changes in current assets and current liabilities. The impact of changes in current assets and current liabilities, other than cash, affect the calculation of net cash provided from operating activities. You can use the table at the top of your screen to analyze the impact of the change in specific current assets and current liabilities accounts. For example, accounts receivable is a current asset. If accounts receivable decreases, we add the net decrease to net income to arrive at net cash provided from operating activities. We would complete a similar analysis for all other current assets and current liabilities other than cash.

Here is the rest of Callaway’s Statement of Cash Flows showing the cash balance on the company’s balance sheet. On this screen we show you the net cash used in investing activities, and the net cash used in financing activities. As a result of the amounts in the three categories on the statement of cash flows, the cash account decreased by $61,112. The beginning balance in cash was $108,452. We add that amount to the net decrease in cash to arrive at the ending cash balance of $47,340, which is the ending cash balance that will appear on the balance sheet of Callaway Golf Company.

Notes to Financial Statements Descriptions of the key accounting rules that apply to the company’s statements. Additional detail supporting reported numbers. The notes to financial statements provide the reader with descriptions of key accounting rules applied to the company’s financial statements. Detailed supporting schedules are used to report additional information to the reader, and information that is relevant to the reader but is not included in the financial statements may be disclosed in the notes to the financial statements. Relevant financial information not disclosed on the statements.

LO4 Learning Objectives Analyze a company’s performance based on return on equity and its components. LO4 Our fourth learning objective in Chapter 5 is to analyze the company’s performance based upon return on equity and its components.

Return on Equity (ROE) Return on Equity = Net Income Average Stockholders’ Equity1 ROE measures how much the firm earned for each dollar of stockholders’ investment. In its broadest measure, return on equity is calculated by dividing net income by average stockholders’ equity. Remember that average stockholders’ equity is the beginning equity balance plus the ending equity balance divided by two. We can refine this equation for return on equity to learn more about the company. 1(beginning equity + ending equity) ÷ 2

ROE Profit Driver Analysis Net Profit Margin Asset Turnover Financial Leverage = × × Net Income Average Stockholders’ Equity Net Sales Average Total Assets × = Part I Return on equity is equal to our net profit margin times our asset turnover times our financial leverage. Part II Recall that our net profit margin is calculated by dividing net income by net sales. Asset turnover is calculated by dividing net sales by average total assets. Finally, financial leverage is calculated by dividing average total assets by average stockholders’ equity. By dividing return on equity into its three major constituent parts, we can learn a great deal more about the company.

Profit Drivers and Business Strategy High-value or product-differentiation. Rely on R&D and product promotion to convince customers of the superiority of your product. Low-Cost. Rely on efficient management of accounts receivable, inventory and productive assets to produce high asset turnover. Some companies may develop a business strategy to promote a high value product or to differentiate their products from the competition. The company is usually required to spend a significant amount of money on research and development and to heavily promote the product so that customers believe it is superior to the competition. Other companies use a strategy to promote the low cost of their product. To produce a low-cost product, management must efficiently manage accounts receivable, inventory and other productive assets. Failure to control these assets will increase the cost of the product and decrease the company’s profit margin.

Other Items Reported on the Income Statement Chapter Supplement A Other Items Reported on the Income Statement Chapter Supplement A: Changes in Depreciation Estimates.

Classified Income Statement General Format for the Classified Income Statement In addition, companies may have nonrecurring items. These nonrecurring items may include: 1. Discontinued operations, 2. Extraordinary items, 3. Cumulative effect of changes in accounting methods. These items are reported separately because they are not useful in predicting future income of the company. If the company had incurred discontinued operations, an extraordinary item, or the cumulative effect of a change in accounting principle, it would be reported after our other income and expense category. These three items are not likely to occur on a regular basis, and are therefore reported separately.

Discontinued Operations Sale or abandonment of a segment of a business. Income or loss on segment’s operation for the period. Gain or loss on disposal of the segment. Discontinued operations result from the sale or abandonment of a segment of our business operations. We divide discontinued operations into two categories. The first is the income or loss of the segment reported during the period. The second category is the gain or loss on disposal of the segment’s assets and liabilities. Each of these two categories are reported net of applicable taxes. Show net of applicable taxes.

Show net of applicable taxes. Extraordinary Items Unusual Infrequent An extraordinary item is a material amount that is both unusual in nature and infrequent in occurrence. Extraordinary items also are reported net of applicable taxes. Show net of applicable taxes.

Cumulative Effect of Changes in Accounting Methods GAAP Method GAAP Method Change to Alternative The change must be to a preferable method and must be disclosed in notes to financial statements. The cumulative effect of the change in accounting method results when we change from one principle that has general acceptance to another principle that also has general acceptance. The new method must be preferable to the old method and the nature of the change must be disclosed in the Notes to the financial statements. The cumulative effect of changes in accounting methods is reported net of applicable taxes. Show net of applicable taxes.

End of Chapter 5 End of Chapter 5.