Understanding Financial Statements Seventh EDITION Lyn M. Fraser Aileen Ormiston

Financial Statements An Overview Map or Maze Chapter 1 (C) 2004 Prentice Hall, Inc.

Financial Statements An Overview Map or Maze Auditor’s Report MD&A Notes Statement of Cash Flows Income Statement Statement of Shareholders’ Equity Balance Sheet Chapter 1 (C) 2004 Prentice Hall, Inc.

Map: To help its user reach a desired destination through clarity of representation (C) 2004 Prentice Hall, Inc.

Maze: On the other hand. . . Attempts to confuse its user by purposefully introducing conflicting elements and complexities that prevent reaching the desired goal (C) 2004 Prentice Hall, Inc.

Financial statements are potentially Map or Maze Financial statements are potentially both MAP and MAZE (C) 2004 Prentice Hall, Inc.

Financial 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 (C) 2004 Prentice Hall, Inc.

Financial 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 (C) 2004 Prentice Hall, Inc.

To ensure that financial statements serve as a map, not a maze Our Goal: 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 (C) 2004 Prentice Hall, Inc.

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 (C) 2004 Prentice Hall, Inc.

Questions one might ask: What is the degree of risk inherent in the investment? Would an investment generate attractive returns? Should existing investing holdings be liquidated? (C) 2004 Prentice Hall, Inc.

More questions one might ask Will cash flows be sufficient to service interest and principal payments on debt? Does company provide a good opportunity for employment? (C) 2004 Prentice Hall, Inc.

More questions one might ask Con’t How well does this company compete in its operating environment? Is this firm a good prospect as a customer? (C) 2004 Prentice Hall, Inc.

Volume of Information The Annual Report Financial statements Notes to the financial statements The auditor’s report Five-year summary of key financial data (C) 2004 Prentice Hall, Inc.

The Annual Report Continued High and low stock prices Management’s discussion and analysis of operations Material included at the imagination and discretion of management (C) 2004 Prentice Hall, Inc.

Financial Statements Are prepared according to generally accepted accounting principles (GAAP) (C) 2004 Prentice Hall, Inc.

GAAP Two authorities primarily responsible for establishing GAAP in the United States are the SEC and the FASB (C) 2004 Prentice Hall, Inc.

SEC Stands for Securities and Exchange Commission Regulates US companies that issue securities to the public (C) 2004 Prentice Hall, Inc.

SEC Continued Requires Regular filing of annual reports (10-K) Quarterly reports (10-Q); and Other reports dependent upon particular circumstances Change in auditor Bankruptcy Other important events (C) 2004 Prentice Hall, Inc.

SEC Continued Has Congressional authority to set accounting policies, but usually delegates accounting rule-making to the FASB (C) 2004 Prentice Hall, Inc.

FASB Stands for Financial Accounting Standards Board Comprised of 7 full-time paid members Issues Statements of Financial Accounting Standards (SFAS) and Interpretations Lengthy deliberation process (C) 2004 Prentice Hall, Inc.

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 (C) 2004 Prentice Hall, Inc.

The FASB Deliberation Process Con’t. 4. Public hearings 5. Board analysis and evaluation 6. Issuance of an exposure draft 7. Period of public comment (C) 2004 Prentice Hall, Inc.

The FASB Deliberation Process Con’t. 8. Review of public response, revision 9. Issuance of SFAS 10. Amendments and Interpretations, as needed (C) 2004 Prentice Hall, Inc.

The SEC and FASB Have worked closely together in the development of account policy (C) 2004 Prentice Hall, Inc.

The SEC and FASB Continued Recent history of corporate failures and accounting scandals have focused attention and criticism on regulatory authorities (C) 2004 Prentice Hall, Inc.

Where to Find a Company’s Financial Statements: Form 10-K Annual report Website (C) 2004 Prentice Hall, Inc.

The Four Basic Financial Statements Balance Sheet Income Statement or Earnings Statement Statement of Shareholders’ Equity Statement of Cash Flows (C) 2004 Prentice Hall, Inc.

Financial Statement 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.) (C) 2004 Prentice Hall, Inc.

Financial Statement Notes: Continued 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 (C) 2004 Prentice Hall, Inc.

Auditor’s Report Unqualified Qualified Adverse opinion Scope limitation Disclaimer of opinion (C) 2004 Prentice Hall, Inc.

Auditor’s Report Continued Unqualified (what you want!)-- statements present information in conformity with GAAP Qualified (not what you want)—are reports other than an unqualified opinion (C) 2004 Prentice Hall, Inc.

Auditor’s Report Continued Adverse opinion states that the financial statements have not been presented fairly in accordance with GAAP Scope limitation means that the extent of the audit work has been limited (C) 2004 Prentice Hall, Inc.

Auditor’s Report Continued Disclaimer of opinion: Keep in mind that auditor is hired by the firm being audited--always the possibility of conflict of interest (C) 2004 Prentice Hall, Inc.

Management Discussion and Analysis (MD&A) Sometimes labeled “Financial Review” Contains information that cannot be found in the financial data (C) 2004 Prentice Hall, Inc.

(MD&A) Continued 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 (C) 2004 Prentice Hall, Inc.

(MD&A) Continued 4. Anticipated changes in mix and cost of financing resources 5. Unusual/infrequent transactions which affect income from continuing operations (C) 2004 Prentice Hall, Inc.

(MD&A) Continued 6. Events causing material changes in cost/revenue relationships (e.g. future price increase) 7. Breakdown of sales increases in price & volume components (C) 2004 Prentice Hall, Inc.

(MD&A) Continued 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 (C) 2004 Prentice Hall, Inc.

(MD&A) Continued More helpful has been the addition to the MD&A of explanations about why changes have occurred in profitability and liquidity (C) 2004 Prentice Hall, Inc.

Five-Year Summary of Selected Financial Data and Market Data Required by SEC Offers a quick look at some overall trends (C) 2004 Prentice Hall, Inc.

Five-Year Summary Continued Includes: Net sales or operating revenues Income or loss from continuing operations Income or loss from continuing operations per common share (C) 2004 Prentice Hall, Inc.

Five-Year Summary Continued Total assets Long-term obligations and redeemable preferred stock Cash dividends per common share (C) 2004 Prentice Hall, Inc.

Pandora (A.K.A. “PR Fluff”) Getting what is needed can be a challenge Colored photographs Charts Shareholders’ letter from the CEO Website (C) 2004 Prentice Hall, Inc.

Used to solicit shareholder votes Proxy Statement Used to solicit shareholder votes Required by the SEC (C) 2004 Prentice Hall, Inc.

Proxy Statement Continued Contains Voting procedures and information Background information about the company’s nominated directors (C) 2004 Prentice Hall, Inc.

Proxy Statement Continued Director compensation Executive compensation Any proposed changes in compensation plans (C) 2004 Prentice Hall, Inc.

Proxy Statement Continued Audit committee report Breakdown of audit and nonaudit fees paid to the auditing firm (C) 2004 Prentice Hall, Inc.

Missing and Hard-to-Find Information Not available in the financial statements: Employee relations with management Morale/efficiency of employees Reputation/public perceptions of firm (C) 2004 Prentice Hall, Inc.

Missing and Hard-to-Find Information Continued Effectiveness of management team/provisions for succession Potential exposure to regulatory changes IMPACT OPERATING SUCCESS BUT ARE DIFFICULT TO QUANTIFY (C) 2004 Prentice Hall, Inc.

Missing and Hard-to-Find Information Continued Publicity in the Media Affects public perception of firm and can impact financial performance Proven correlation between financial returns and reputation A recent example of adverse publicity is Bridgestone/Firestone for denying and covering up the deaths allegedly caused by their tires (C) 2004 Prentice Hall, Inc.

Missing and Hard-to-Find Information Continued Facts are available, but may be difficult for an average user 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! (C) 2004 Prentice Hall, Inc.

Complexities A Global Marketplace International Accounting Standards Committee (IASC) formed in 1973 with goal of determining international GAAP US presently has not accepted the current international accounting standards (C) 2004 Prentice Hall, Inc.

Complexities continued Mythical Mountain 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) (C) 2004 Prentice Hall, Inc.

Complexities continued Other Discretionary Issues 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 (C) 2004 Prentice Hall, Inc.

More Complications Goodwill and Other Intangible Assets Consolidation of parent and subsidiaries Reporting leases Reporting pensions (C) 2004 Prentice Hall, Inc.

More Complications Continued Translation of foreign operations Off-balance sheet financing Accounting for derivatives (C) 2004 Prentice Hall, Inc.

More Complications Continued “Comprehensive” income reporting Two sets of books (yes, it’s legal!!) - financial vs. tax reporting (C) 2004 Prentice Hall, Inc.

Quality of Financial Reporting Management has considerable discretion within GAAP Potential exists to “manipulate” the profit/loss reported (C) 2004 Prentice Hall, Inc.

Quality of Financial Reporting Continued 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 (C) 2004 Prentice Hall, Inc.

Quality of Financial Reporting Continued The sharper and clearer the picture presented through the financial data and the closer that picture is to financial reality. . . The higher is the quality of the financial statements and reported earnings (C) 2004 Prentice Hall, Inc.

Quality of Financial Reporting Continued Examples of opportunities for management to affect the quality of financial statements. . . . (C) 2004 Prentice Hall, Inc.

Quality of Financial Reporting Continued Accounting Policies, Estimates—Choices and Changes Timing of Revenue and Expense Recognition Discretionary Items Nonrecurring and Nonoperating Items (C) 2004 Prentice Hall, Inc.

Accounting Policies, Estimates—Choices and Changes Management makes choices with respect to accounting policies Management makes estimations in the applications of those policies (C) 2004 Prentice Hall, Inc.

Accounting Policies, Estimates—Choices and Changes Continued Policy or estimate may be changed (C) 2004 Prentice Hall, Inc.

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 (C) 2004 Prentice Hall, Inc.

Timing of Revenue and Expense Recognition Continued Matching process involves management judgments regarding the timing of expense and revenue recognition (C) 2004 Prentice Hall, Inc.

Timing of Revenue and Expense Recognition Continued Usually the more conservative the approach (least favorable to management) the higher the quality of earnings (C) 2004 Prentice Hall, Inc.

Discretionary Items Budget level and timing of expenditures for many items are discretionary, e.g. Advertising/marketing Repairs/maintenance Research and development Capital expansion (C) 2004 Prentice Hall, Inc.

Nonrecurring and Nonoperating Items Are not part of normal ongoing business Earnings figure should reflect future operating potential Should be reviewed and possibly eliminated from earnings (C) 2004 Prentice Hall, Inc.

Nonrecurring and Nonoperating Items Continued Other transactions to consider Write-downs for the impairment of assets Accounting changes Extraordinary items (C) 2004 Prentice Hall, Inc.

The Journey Through the Maze Continues Ch. 2: The Balance Sheet Ch. 3: The Income Statement and Statement of Stockholders’ Equity Ch. 4: Statement of Cash Flows Ch. 5: The Analysis of Financial Statements (C) 2004 Prentice Hall, Inc.