1 CHAPTER 5 Communicating and Interpreting Accounting Information ACCT 2301 Professor Zining Li

2 Responsibility for accounting information Company management –CEO and CFO Independent auditor –Unqualified audit opinion (clean opinion) Board of directors –Audit committee

3 Users of accounting information Private investors Financial analysts Creditors (lenders) Institutional investors –Pension funds, mutual funds, endowment funds, etc.

4 Guiding Principles Relevant: useful to assess past activity and predict future performance Reliable: accurate, unbiased, and verifiable Consistent and comparable: similar accounting methods are applied over time and across firms Material: Amounts that are large enough to influence decisions Conservative: Care should be taken NOT to overstate assets (revenues) or understate liabilities (expenses)

5 Disclosure of accounting information Press release –Earnings announcement –Conference call Annual report Quarterly reports SEC reports –Forms 10-K & 10-Q –Form 8-K (current events)

6 Annual Report ( 10-K) Basic financial statements (balance sheet, income statement, statement of cash flows, statement of shareholders’ equity) Notes to the financial statements Report of the Auditor Other information: letter to shareholders, management discussion and analysis (MD&A), financial data (past 5-10 years), stock price data, list of director and officers of the company

7 Quarterly Report ( 10-Q) 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

8 SEC report: 8-K Example “On July 28, 2006, Pacific Sunwear of California, Inc. (the “Company”) elected to extend the employment agreement between the Company and Seth R. Johnson, Chief Executive Officer, for an additional one-year period ending October 31, The full text of the Company’s notification to Mr. Johnson regarding this election is included as Exhibit 99.1 to this report and is incorporated herein by this reference.”

9 Classified Balance Sheet Assets (by order of liquidity) –Current assets (short-term) –Noncurrent assets –Total assets Liabilities (by order of time to maturity) –Current liabilities (short-term) –Noncurrent liabilities –Total liabilities Stockholder’s equity –Contributed capital –Retained earnings –Total stockholder’s equity –Total liabilities & stockholder’s equity

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13 Accounting for new investments Contributed Capital –Common Stock Par value is a legal amount per share –Paid-in Capital Example: Callaway set its par value at $0.01 per share. The company issued 1 million shares at the price of $16 per share. Common Stock is $10,000 and additional paid in capital is $15,990,000

14 Elements of the Income Statement Revenues Cost of goods sold Gross Profit Operating costs and expenses Operating Income Nonoperating revenues and expenses and gains and losses Pretax Income Income tax expense Net Income –=–=–=–=–=–=–=–= Earnings per share (EPS) must be reported on the income statement

15 Common-Size Income Statement

16 Statement of Cash Flows 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. For the operating activities, companies can use either indirect method or direct method. The indirect method begins with a reconciliation of net income to “cash flows from operations”.

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19 Return On Equity (Assets) Return on Equity (ROE) = Net Income Avg. Total Equity Return on Assets (ROA) = Net Income Avg. Total Assets ROE = ROA X Financial Leverage ratio

20 Profit Driver Analysis ROA = Net Profit X Asset Margin Turnover Net Profit = Net Income Margin Sales Asset = Sales TurnoverAverage Assets