Chapter 5 Communicating and Interpreting Accounting Information

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 5-2 Players in the Accounting Communication Process An unqualified opinion states that the financial statements are fair presentations in all material respects in conformity with GAAP. Independent Auditors Verification Partners, Managers, Staff Guided by GAAS Independent Auditors Verification Partners, Managers, Staff Guided by GAAS ManagementPreparation CEO, CFO, Accounting Staff Guided by GAAP ManagementPreparation CEO, CFO, Accounting Staff Guided by GAAP

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 5-3 Information Intermediaries Analysis and Advice Financial analysis, Information services Information Intermediaries Analysis and Advice Financial analysis, Information services Financial analysts make predictions concerning companies’ future earnings and stock prices. Players in the Accounting Communication Process Independent Auditors Verification Partners, Managers, Staff Guided by GAAS Independent Auditors Verification Partners, Managers, Staff Guided by GAAS ManagementPreparation CFO, CEO, Accounting Staff Guided by GAAP ManagementPreparation CFO, CEO, Accounting Staff Guided by GAAP

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 5-4 Information Intermediaries Analysis and Advice Financial analysis, Information services Information Intermediaries Analysis and Advice Financial analysis, Information services Financial analysts make predictions concerning companies’ future earnings and stock prices. Players in the Accounting Communication Process Independent Auditors Verification Partners, Managers, Staff Guided by GAAS Independent Auditors Verification Partners, Managers, Staff Guided by GAAS ManagementPreparation CFO, CEO, Accounting Staff Guided by GAAP ManagementPreparation CFO, CEO, Accounting Staff Guided by GAAP Web Info Services: www/sec/gov

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 5-5 Government Regulators Verification SEC Members Guided by SEC regs. Government Regulators Verification SEC Members Guided by SEC regs. Users Analysis and Decision Investors, Lenders, etc. Users Analysis and Decision Investors, Lenders, etc. Public companies only ManagementPreparation CFO, CEO, Accounting Staff Guided by GAAP ManagementPreparation CFO, CEO, Accounting Staff Guided by GAAP Players in the Accounting Communication Process Information Intermediaries Analysis and Advice Financial analysis, Information services Information Intermediaries Analysis and Advice Financial analysis, Information services Independent Auditors Verification Partners, Managers, Staff Guided by GAAS Independent Auditors Verification Partners, Managers, Staff Guided by GAAS

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 5-6 Guiding Principles for Communicating Useful Information Primary Objective of External Financial Reporting To provide economic information to external users for decision making. Primary Objective of External Financial Reporting To provide economic information to external users for decision making. Primary Qualitative Characteristics Relevance: Timely and Predictive and Feedback Value Reliability: Accurate, Unbiased, and Verifiable Primary Qualitative Characteristics Relevance: Timely and Predictive and Feedback Value Reliability: Accurate, Unbiased, and Verifiable Secondary Qualitative Characteristics Comparability: Across businesses Consistency: Over time Secondary Qualitative Characteristics Comparability: Across businesses Consistency: Over time

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 5-7 Guiding Principles for Communicating Useful Information Primary Objective of External Financial Reporting To provide economic information to external users for decision making. Primary Objective of External Financial Reporting To provide economic information to external users for decision making. Primary Qualitative Characteristics Relevance: Timely and Predictive and Feedback Value Reliability: Accurate, Unbiased, and Verifiable Primary Qualitative Characteristics Relevance: Timely and Predictive and Feedback Value Reliability: Accurate, Unbiased, and Verifiable Secondary Qualitative Characteristics Comparability: Across businesses Consistency: Over time Secondary Qualitative Characteristics Comparability: Across businesses Consistency: Over time The full-disclosure principles requires... 1.A complete set of financial statements, and 2.Notes to the financial statements The full-disclosure principles requires... 1.A complete set of financial statements, and 2.Notes to the financial statements

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 5-8 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 Gallaway Golf Callaway® Golf CARLSBAD, Calif./April 25, 2001/ Gallaway Gold Company (NYSE:ELY) today reported record sales for the first quarter ended March 31, Reported net sales increased 32% to $261.4 million from $197.4 million during the first quarter of Net income increased Earnings Press Release Excerpt for Gallaway Golf Callaway® Golf CARLSBAD, Calif./April 25, 2001/ Gallaway Gold Company (NYSE:ELY) today reported record sales for the first quarter ended March 31, Reported net sales increased 32% to $261.4 million from $197.4 million during the first quarter of Net income increased......

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 5-9 Annual Reports For privately held companies, annual reports are simple documents that include: For privately held companies, annual reports are simple documents that include: 1. Four basic financial statements. 2. Related footnotes. 3. Report of independent accountants (auditor’s opinion). For privately held companies, annual reports are simple documents that include: For privately held companies, annual reports are simple documents that include: 1. Four basic financial statements. 2. Related footnotes. 3. Report of independent accountants (auditor’s opinion).

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 5-10 Annual Reports For public companies, annual reports are elaborate because of SEC reporting requirements: For public companies, annual reports are elaborate because of SEC reporting requirements: 1. A Nonfinancial Section A letter to the stockholders, a description of management’s philosophy, products, successes, etc. A letter to the stockholders, a description of management’s philosophy, products, successes, etc. 2. A Financial Section See next slide for a detailed listing... See next slide for a detailed listing... For public companies, annual reports are elaborate because of SEC reporting requirements: For public companies, annual reports are elaborate because of SEC reporting requirements: 1. A Nonfinancial Section A letter to the stockholders, a description of management’s philosophy, products, successes, etc. A letter to the stockholders, a description of management’s philosophy, products, successes, etc. 2. A Financial Section See next slide for a detailed listing... See next slide for a detailed listing...

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 5-11 Annual Reports - Financial Section 1.Summarized financial data for 5- or 10-years. 2.Management Discussion and Analysis ( MD&A ). 3.The four basic financial statements. 4.Notes (footnotes). 5.Independent Accountant’s Report. 1.Summarized financial data for 5- or 10-years. 2.Management Discussion and Analysis ( MD&A ). 3.The four basic financial statements. 4.Notes (footnotes). 5.Independent Accountant’s Report. 6.Recent stock price information. 7.Summaries of the unaudited quarterly financial data. 8.Lists of directors and officers of the company and relevant addresses. 6.Recent stock price information. 7.Summaries of the unaudited quarterly financial data. 8.Lists of directors and officers of the company and relevant addresses.

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 5-12 Quarterly Reports Usually begin with short letter to stockholders, Condensed unaudited income statement and balance sheet for the quarter. 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. Often, cash flow statement and statement of stockholders’ equity are omitted. Some notes to the financial statements also may be omitted. Usually begin with short letter to stockholders, Condensed unaudited income statement and balance sheet for the quarter. 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. Often, cash flow statement and statement of stockholders’ equity are omitted. Some notes to the financial statements also may be omitted.

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 5-13 SEC Reports Form 10-K Annual Report Due within 90 days of the fiscal year-endDue within 90 days of the fiscal year-end Contains audited financial statementsContains audited financial statements Form 10-K Annual Report Due within 90 days of the fiscal year-endDue within 90 days of the fiscal year-end Contains audited financial statementsContains audited financial statements Form 10-Q Quarterly Report Due within 45 days of the end of the quarterDue within 45 days of the end of the quarter Financial statements can be unauditedFinancial statements can be unaudited Form 10-Q Quarterly Report Due within 45 days of the end of the quarterDue within 45 days of the end of the quarter Financial statements can be unauditedFinancial statements can be unaudited Form 8-K Current Report Due within 15 days of the major event dateDue within 15 days of the major event date Financial statements can be unauditedFinancial statements can be unaudited Form 8-K Current Report Due within 15 days of the major event dateDue within 15 days of the major event date Financial statements can be unauditedFinancial statements can be unaudited

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 5-14 Financial Statement Formats Let’s take a closer look at the asset section of the balance sheet!

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 5-15

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 5-16 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.

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 5-17 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.

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 5-18 Intangible assets have no physical existence and a long life. They include patents, copyrights, trademarks, etc.

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 5-19 Let’s now look at the liability section of a classified balance sheet.

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 5-20

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 5-21 Current liabilities are obligations that will be paid with current assets, normally within one year.

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 5-22 Long-term liabilities are debts that have maturity dates extending beyond one year from the balance sheet date.

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 5-23 Finally, we get to the stockholders’ equity section of a classified balance sheet.

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 5-24 Contributed capital is often shown in two separate accounts... 1.Common stock 2.Paid-in capital Contributed capital is often shown in two separate accounts... 1.Common stock 2.Paid-in capital

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 5-25 Comprehensive income includes unrealized gains/losses on security investments, minimum pension liability adjustment, and foreign currency translation adjustments.

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 5-26 Retained earnings is the total earnings of the company less the total dividends declared since inception of operations.

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 5-27 Companies often purchase shares of its own common stock. This stock is said to be held in the treasury and can be used to satisfy employee stock purchase or option plans. Treasury shares may also be used in connection with the acquisition of another company.

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 5-28 Balance Sheet Ratios and Debt Contracts When a company borrows money, they often agree to certain restrictions on their activity. Ratios typically part of the borrowing agreement include:

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 5-29 Classified Income Statement Income statements may contain five sections: 1.Continuing operations 2.Discontinued operations 3.Extraordinary items 4.Cumulative effect of changes in accounting methods 5.Earnings per share Income statements may contain five sections: 1.Continuing operations 2.Discontinued operations 3.Extraordinary items 4.Cumulative effect of changes in accounting methods 5.Earnings per share

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 5-30 Classified Income Statement General Format for the Classified Income Statement Gross sales minus any discounts, returns, and allowances during the period.

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 5-31 Classified Income Statement General Format for the Classified Income Statement Cost of inventory sold.

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 5-32 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.

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 5-33 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. 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.

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 5-34 Discontinued Operations Income or loss on segment’s operation for the period. Gain or loss on disposal of the segment. Gain or loss on disposal of the segment. Sale or abandonment of a segment of a business. Show net of applicable taxes.

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 5-35 Extraordinary Items UnusualInfrequent Show net of applicable taxes.

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 5-36 Cumulative Effect of Changes in Accounting Methods The change must be to a preferable method and must be disclosed in notes to financial statements. GAAP Method Change to Alternative GAAP Method Show net of applicable taxes.

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 5-37 Classified Income Statement Now, let’s look at two common formats for presenting the continuing operations section. 1.Single-step income statement 2.Multiple-step income statement Now, let’s look at two common formats for presenting the continuing operations section. 1.Single-step income statement 2.Multiple-step income statement

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 5-38 In the single-step format, all revenues, income, and gains are listed first. Costs, expenses, and losses are then subtracted from total revenues to get net income. In the single-step format, all revenues, income, and gains are listed first. Costs, expenses, and losses are then subtracted from total revenues to get net income.

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 5-39 Cost of goods sold is shown along with a separation of non-operating income and expenses and non-recurring items.

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 5-40 Two unusual expenses that may recur in the future.

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 5-41 A nonrecurring item that is presented separately after income from operations.

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 5-42 Earnings Per Share EPS = Net Income Available to Common Shareholders Weighted Average Number of Shares Outstanding During the Reporting Period Basic EPS

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 5-43 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.

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 5-44 Both basic and diluted EPS are reported here.

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 5-45 Accounting-Based Executive Bonuses Executives are frequently paid bonuses based upon pretax earnings growth of the company. Pre-Tax Earnings Growth Percent = Last Year Pretax Earnings Current Year Pretax Earnings Last Year Pretax Earnings −

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 5-46 Statement of Cash Flows Recall that the Statement of Cash Flows is divided into three major sections. Recall that the Statement of Cash Flows is divided into three major sections. 1. Cash flows from operating activities. 2. Cash flows from investing activities. 3. 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. We will examine the indirect method of preparing the statement. This format begins with a reconciliation of accrual income to cash flows from operations.

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 5-47 The operating activities section of Callaway using the indirect method. Begin with accounting net income and arrive at cash provided by operating activities.

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 5-48 While these items are on the income statement, they have no current cash effect.

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 5-49 This table provides guidance for adjustments related to changes in current assets and current liabilities.

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 5-50 Here is the rest of Callaway’s Statement of Cash Flows showing the cash balance on the company’s balance sheet.

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 5-51 Notes to Financial Statements Descriptions of the key accounting rules applies to the company’s statements. Additional detail supporting reported numbers. Relevant financial information not disclosed on the statements.

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 5-52 Return on Equity (ROE) 1 (beginning equity + ending equity) ÷ 2 Return on Equity = Net Income Average Stockholder’s Equity 1 ROE measures how much the firm earned for each dollar of stockholders’ investment.

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 5-53 ROE Profit Driver Analysis ROE Net Profit Margin Asset Turnover Financial Leverage =×× Net Income Average Stockholders’ Equity Net Income Average Stockholders’ Equity Net Income Net Sales Net Income Net Sales Average Total Assets Net Sales Average Total Assets Average Stockholders’ Equity Average Total Assets Average Stockholders’ Equity ×× =

© 2004 The McGraw-Hill Companies McGraw-Hill/Irwin 5-54 The End of Chapter 5