Class 1 The Language of Accounting, The Corporate Annual Report, and the SEC

Companies Under Investigation Aldelphia Arthur Andersen AOL Bristol Myers Squibb Computer Associates International Deloitte & Touche Enron Ernst & Young Global Crossing

Investigation cont’d HalliburtonImcloneKmartKPMGPeregrinePricewaterhouseCoopersQwestTyco Worldcom Inc. Xerox

Why? Quality of earnings Where were the auditors? Responsibility of management

What is accounting? Often called the language of business –Measures financial aspects of a business –Communicates this information to decision makers

Why should everyone in business study accounting?? Many business decisions are based on accounting information. Since accounting information is prepared according to “rules,” an understanding of these rules is necessary for the appropriate use of the information. Personal need for understanding financial statements

The Accounting Equation Assets = Claims or Assets = Claims or Assets = Liabilities + Equity Asset: something of value Liability: something owed (creditors’ share of the assets) Equity: what remains (owners’ share of the assets)

Four Basic Financial Statements Balance Sheet –Assets = Liabilities + Equity Income Statement –Revenues - Expenses = Net income Statement of Changes in Equity –Beginning equity + Contributions + Net income - Distributions = Ending equity Statement of Cash Flows –Cash inflow - Cash outflow = Net cash flow

The Annual Report includes: financial statements notes to the financial statements auditor’s report 5-year summary of key financial data high and low stock selling prices management discussion & analysis of operations (“forward-looking” info)

On-line Annual Reports Most companies provide their annual reports online. Click on the link below to look at Delta Airlines’ most recent annual report. Delta Annual Report Delta Annual Report Delta Annual Report Describe the 2004 operating results What steps has Delta taken to improve corporate governance?

Notes Are 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.)

Notes (more stuff included) Contain some supplementary information required by SEC and FASB Examples include: –information on foreign currency translations for firms doing business in/with foreign countries –information by segment for firms with several lines of business Look at Delta’s notes…what is included in Notes 1 and 20? Delta’s

Auditor’s Report Auditor’s Report (Delta p. 50) Auditor’s Report Unqualified (what you want!) -- states that statements present information in conformity with GAAP (sometimes with explanatory language) Sometimes qualified or adverse opinions are issued (not what you want!) Disclaimer Keep in mind that auditor is hired by the firm -- always the possibility of conflict of interest

Look at an auditor’s opinion Auditor’s Report Auditor’s Report (Delta p. 50) Auditor’s Report Click on the link above and try to find the auditor’s opinion (Hint: It’s after the notes) What type of opinion is it and who were their auditors in 2004?

Example of a qualified opinion The accompanying consolidated financial statements have been prepared assuming Carolco Pictures Inc. and subsidiaries will continue as a going concern. As more fully described in Note B, the Company has incurred continuing significant losses and has a deficiency in assets $64,521,000 at December 31, Further, the Company has experienced significant cash flow difficulties and does not have sufficient cash resources and financing sources to meet its operating expenses and scheduled debt service obligations, and continue to fund its principal business activity. These conditions raise substantial doubts about the Company's ability to continue as a going concern. (Management's plans in regard to these matters are also described in Note B). The 1994 consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty. Carolco Pictures produced the Terminator movies!

MD&A (Financial Review) 1.Internal/external sources of liquidity 2.Any material deficiencies in liquidity and how they will be remedied 3.Commitments for capital expenditures/sources of funding 4.Anticipated changes in mix and cost of financing resources

MD&A (continued) 5.Unusual/infrequent transactions which affect income from continuing operations 6.Events causing material changes in cost/revenue relationships (e.g. future price increase) 7.Breakdown of sales increases in price & volume components

“PR Fluff” Amount sometimes varies INVERSELY with performance... Can visit many corporate websites to view some interesting “creations”

SEC Filings K10Q8KProspectus What is insider trading? SEC’s answer SEC’s answerSEC’s answer

CEO/CFO certification Section 302 of the Sarbanes-Oxley Act requires the principal executive and financial officers of a company filing periodic reports to certify in each quarterly and annual report that the report does not contain any untrue statement of a material fact or omit to state a material fact necessary in order to make the statements made, in light of the circumstances under which such statements were made, not misleading, and the financial statements, and other financial information included in the report, fairly present in all material respects the financial condition and results of operations of the company. Section 906 of the Sarbanes-Oxley Act adds a provision to the U.S. criminal laws that contains a separate certification requirement. This provision expressly created new criminal penalties for a knowingly or willfully false certification.

Do rules = uniformity? GAAP provide some measure 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)

Accounting Period Another complexity Although the firm’s life is continuous, financial data is presented for arbitrary time periods -- year, quarter and the like Leads to need for more adjustments and estimates Statements are prepared on “accrual” basis

Cash versus “Accrual” Financial statements are prepared on an “accrual” basis Attempt to MATCH expenses with revenue in a given accounting period Revenues reported when “earned” rather than when received in cash Expenses are recorded when incurred rather than when paid in cash

More Sources of “Confusion” Earnings per share Consolidation of parent and subs Reporting leases Reporting pensions Translation of foreign operations Off-balance sheet financing Accounting for derivatives (continued…….)

Even MORE Confusion... Even MORE Confusion... “Comprehensive” income reporting Two sets of books (yes, it’s legal!!) - financial vs. tax reporting Pro forma earning

Quality of Financial Reporting Management has considerable discretion within GAAP Potential exists to “manipulate” the profit/loss reported The closer the financial data presented represent financial reality, the higher the quality of the financial statements and reported earnings

Means to Affect Quality Accounting policies and estimates –choices and changes Timing of revenues and expenses Discretionary items Nonrecurring and nonoperating items ALL ARE WITHIN THE PURVIEW OF MANAGEMENT

Accounting Policies/Estimates Choices –Management may choose among acceptable accounting policies –Management has opportunity to make estimates when applying policies Changes –Policy or estimate may be changed

Timing of Revenues/Expenses Matching process involves judgments by management regarding recognition of revenues and/or expenses Usually the more conservative the approach (least favorable to management) the higher the quality of earnings

Discretionary Items Budget level and timing of expenditures for many items are discretionary, e.g. –advertising/marketing –repairs/maintenance –research and development –capital expansion

Nonrecurring and Nonoperating Items Nonrecurring and nonoperating items are not part of normal ongoing business Earnings figure should reflect future operating potential Therefore segregate such things as major asset sales, accounting changes, asset impairments, extraordinary items

Look at an example of an accounting change Coca Cola Annual Report Coca Cola Annual Report Is the accounting change shown net of tax? P. 17 Look at page 24 of the annual report. What SFAS caused the change?

What about Inflation??? Historical cost principle prevails in financial reporting Impact of inflation is uneven -- relevance vs. reliability tradeoff Produces both purchasing power gains and losses -- e.g. debt is good in inflationary situation

Missing Information Morale/efficiency of employees Reputation/public perceptions of firm Effectiveness of management team/provisions for succession Potential exposure to regulatory changes IMPACT OPERATING SUCCESS BUT ARE DIFFICULT TO QUANTIFY

What about publicity? Affects public perception of firm and can impact financial performance Proven correlation between financial returns and reputation Recent examples are adverse publicity for Coca Cola and Northwest Airlines -- countered by the respective companies to minimize impact

What Info is Hard to Find? Many items must be extracted from notes, supplementary schedules, MD&A section in order to interpret financial statement numbers - the facts are there, but they are not self-evident! Coverage in Chapters 2-5 is geared to helping FIND and EFFECTIVELY USE information in financial statements and supplementary materials

That’s all!