Chapter 1 Financial Statements: An Overview

Map or Maze A map helps its user reach a desired destination through clarity of representation. A maze attempts to confuse its user by purposefully introducing conflicting elements and complexities that prevent reaching the desired goal. Financial statements have the potential for being both map and maze. Copyright © 2016 Pearson Education, Inc.

Financial Statements as a Map Form the basis for understanding the financial position of a firm Allow users to assess historical and prospective financial performance Present clear representations of a firm’s financial health Copyright © 2016 Pearson Education, Inc.

Financial Statements as a Maze Overwhelming amount of information Unreliable auditing Complex policies and reporting requirements Considerable discretion given to management Key information hidden or omitted Copyright © 2016 Pearson Education, Inc.

Map or Maze The main objectives of this book are to ensure that financial statements serve as a map, not a maze, demonstrate how to read and evaluate financial statements, provide the tools and techniques needed to complete a comprehensive financial statement analysis, and encourage intelligent decision making. Copyright © 2016 Pearson Education, Inc.

Map or Maze Usefulness of Information Financial position Success of operations Policies and strategies of management Insight into future performance Copyright © 2016 Pearson Education, Inc.

Map or Maze Volume of Information Financial statements Notes to the financial statements Auditor’s report Five-year summary of key financial data High and low stock prices Management’s discussion and analysis of operations Other material Copyright © 2016 Pearson Education, Inc.

Map or Maze Volume of Information Generally accepted accounting principles (GAAP) Securities and Exchange Commission (SEC) Financial Accounting Standards Board (FASB) International Accounting Standards Board (IASB) Copyright © 2016 Pearson Education, Inc.

Map or Maze Figure 1.1 FASB/SEC Relationship FIGURE 1.1 FASB/SEC Relationship Copyright © 2016 Pearson Education, Inc.

Map or Maze Global Economy Need for international accounting standards Lack of SEC recommendation to adopt IFRS standards in the U.S. Text focuses on U.S. GAAP, however the analysis process illustrated can be applied to reports based on IFRS. Copyright © 2016 Pearson Education, Inc.

Map or Maze Where to Find a Company’s Financial Statements Form 10-K Filed annually with the SEC Same order for all filing companies Electronic Data Gathering, Analysis, and Retrieval (EDGAR) Copyright © 2016 Pearson Education, Inc.

Map or Maze Where to Find a Company’s Financial Statements Annual report Financial statements Public relations material Sent to shareholders and prospective investors Corporate website Copyright © 2016 Pearson Education, Inc.

Map or Maze The Financial Statements Balance sheet (or statement of financial position) Income statement (or earnings statement) Statement of stockholders’ equity Statement of cash flows Copyright © 2016 Pearson Education, Inc.

Map or Maze Notes to the Financial Statements Integral part of the statements Summary of the firm’s accounting policies Details about particular accounts Other supplementary information Copyright © 2016 Pearson Education, Inc.

Map or Maze Auditor’s Report Attests to the fairness of the presentation of financial statements Sarbanes-Oxley (SOX) Act of 2002 Internal auditors and external auditors Copyright © 2016 Pearson Education, Inc.

Map or Maze Auditor’s Report Types of reports Unqualified reports Adverse opinion Disclaimer of opinion Unqualified opinion with explanatory language Copyright © 2016 Pearson Education, Inc.

Map or Maze Financial Reporting Reforms SOX Title I – Public Company Accounting Oversight Board (PCAOB) SOX Title II – prohibits non-audit services during an external audit SOX Titles III and IV – corporate responsibility SOX Title IX – harsh penalties for violations Copyright © 2016 Pearson Education, Inc.

Map or Maze Management Discussion and Analysis Sometimes labeled “Financial Review” Coverage of trends, events, and/or uncertainties in liquidity, capital resources, and results of operations Copyright © 2016 Pearson Education, Inc.

Map or Maze Five-year Summary of Selected Financial Data and Market Data Net sales or operating revenues Income or loss from continuing operations Total assets Long-term obligations and redeemable preferred stock Cash dividends per common share Two years of high and low common stock price by quarter Copyright © 2016 Pearson Education, Inc.

Map or Maze Pandora (a.k.a. “PR Fluff”) Colored photographs Charts Shareholders’ letter from the CEO Other items to make the report attractive Often informative but sometimes misleading Copyright © 2016 Pearson Education, Inc.

Map or Maze Proxy Statement Used to solicit shareholder votes Important in assessing who manages the firm, how management is paid, and conflict of interest issues Copyright © 2016 Pearson Education, Inc.

Map or Maze Missing and Hard-to-Find Information Employee relations with management Morale and efficiency of employees Reputation of the firm with customers Firm’s prestige in the community Effectiveness of management Copyright © 2016 Pearson Education, Inc.

Map or Maze Missing and Hard-to-Find Information Provisions for management succession Potential exposure to regulation changes Publicity in the media Companies operating in several lines of unrelated business Copyright © 2016 Pearson Education, Inc.

Map or Maze Characteristics, Assumptions, Principles, and Basis of Accounting Materiality Comparability Consistency The Going Concern Assumption The Time Period Assumption Copyright © 2016 Pearson Education, Inc.

Map or Maze Characteristics, Assumptions, Principles, and Basis of Accounting The Monetary Unit Assumption The Revenue Recognition Principle The Matching Principle The Accrual Basis of Accounting The Cash Basis of Accounting Copyright © 2016 Pearson Education, Inc.

Complexities and the Quality of Financial Reporting Accounting Choices Management discretion in application of reporting regulations Differing accounting methods impact comparability of companies Financial data appropriated to particular time periods Copyright © 2016 Pearson Education, Inc.

Complexities and the Quality of Financial Reporting Timing of Revenue and Expense Recognition Accrual basis of accounting Recognizes revenues when earned Recognizes expenses when incurred Recognizes revenues and expenses independent of cash inflows and outflows Involves judgments by management on timing Copyright © 2016 Pearson Education, Inc.

Complexities and the Quality of Financial Reporting Discretionary Items Equipment repair and maintenance Marketing and advertising Research and development Capital expansion Replacement of plant assets Development of new product lines Disposal of an operating division Copyright © 2016 Pearson Education, Inc.

Complexities and the Quality of Financial Reporting Discretionary Items Management choices have an immediate and long-term impact on profitability (perhaps not in the same direction). Financial analyst should scrutinize management’s policies regarding discretionary items. Copyright © 2016 Pearson Education, Inc.

The Journey Through the Maze Continues Chapter 2 – The Balance Sheet Chapter 3 – Income Statement and Statement of Stockholders’ Equity Chapter 4 – Statement of Cash Flows Chapter 5 – The Analysis of Financial Statements Copyright © 2016 Pearson Education, Inc.

Copyright Notice All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. Printed in the United States of America. Copyright © 2016 Pearson Education, Inc.