Understanding Financial Statements NINTH EDITION Lyn M. Fraser Aileen Ormiston Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 1

Chapter 1: Financial Statements An Overview Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 1-2 maze (māz), n. 1. An intricate, usually confusing network of passages, some blind and some leading to a goal. 2. Anything made up of many confused or conflicting elements. 3. A mental state of confusion or perplexity.

Map or Maze Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 1-3 A map helps its user reach a desired destination through clarity of representation.

Map or Maze Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 1-4 A maze attempts to confuse its user by purposefully introducing conflicting elements and complexities that prevent reaching the desired goal.

Map or Maze Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 1-5 Auditor’s Report Statement of Cash Flows MD&A Statement of Shareholders’ Equity Balance Sheet Notes Income Statement A maze of information

Map or Maze Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 1-6 Business financial statements have the potential for being a map and maze.

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 firm’s financial health, leading to informed business decisions Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 1-7

Financial Statements as a Maze Overwhelming amount of information Unreliable auditing Constantly changing and complex policies and reporting requirements Considerable discretion given to management, influencing content and presentation Key information hidden or omitted Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 1-8

Usefulness Financial position of the company Success of operations Policies and strategies of management Insight into future performance Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 1-9 Financial statements and accompanying notes contain a wealth of information.

Usefulness Financial statement users should be able to find and interpret information to answer questions about a company. Financial statements and other data generated by corporate financial reporting can help users develop answers to the following questions (and many others). Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 1-10

Usefulness Questions One Might Ask Would an investment generate attractive returns? What is the degree of risk inherent in the investment? Should existing investing holdings be liquidated? Will cash flows be sufficient? Does the company provide a good opportunity for employment, advancement, and employee benefits? How well does this company compete in its operating environment? Is this firm a good prospect as a customer? Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 1-11

Exercise Review first pages of annual report – What kind of information? Pg 10 – Anyone identified in the writing? Pg 14 & 15 Pg 19 Pg 22 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 1-12

Volume of Information Annual Reports Financial statements (45 to 49) Notes to the financial statements (50 to 81) Auditor’s report (pg 44) Five-year summary of key financial data (82) High and low stock prices Management’s discussion and analysis of operations (pg 21 to 40) Material included at the imagination and discretion of management Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 1-13

Volume of Information Financial Statements Prepared according to generally accepted accounting principles (GAAP) Intended to present financial information that is understandable, relevant, and reliable for decision-making – Also consistency across companies – Makes the application of business events similar Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 1-14

Volume of Information Generally Accepted Accounting Principles Two authorities primarily responsible for establishing GAAP in the United States Securities and Exchange Commission (SEC), a public-sector organization Financial Accounting Standards Board (FASB), a private-sector organization Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 1-15

Volume of Information Securities and Exchange Commission Regulates US companies that issue securities to the public Requires regular filing of Annual reports (10-K) Quarterly reports (10-Q) 8-K reports in particular circumstances Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 1-16

Volume of Information Globalization IASB was created in 1973 with the goal of adopting uniform international accounting standards. Consistency in financial statements would benefit investors and creditors. Companies could list securities in any market with one set of statements. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 1-17

Where to Find a Company’s Financial Statements Form 10-K Filed annually with the SEC Contains uniform content Same order for all filing companies Can be accessed through the Electronic Data Gathering, Analysis, and Retrieval (EDGAR) database at Very dry; no fluff Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 1-18

Where to Find a Company’s Financial Statements Annual report Financial statements Other public relations material Sent to shareholders and prospective investors Marketing tool Corporate Web site go to investor website for coors Internet websites go to Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 1-19

The Financial Statements Balance Sheet Income Statement or Earnings Statement Statement of Cash Flows Statement of Stockholders’ Equity Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 1-20 Annual reports contain three basic financial statements and an additional statement.

The Financial Statements The Balance Sheet Also called the statement of financial position Shows the financial position of the firm on a particular date Assets Liabilities Stockholders’ equity Pg 46 & 47 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 1-21

Molson Coors (TAP)

The Financial Statements The Income Statement Also called the earnings statement Presents the results of operations for the accounting period Revenues Expenses Net profit or loss Net profit or loss per share Pg 45 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 1-23

Molson Coors (TAP) Financial Statement Analysis

The Financial Statements The Statement of Cash Flows Provides information about the cash inflows and outflows during an accounting period Operating activities What has happened to the amount of cash generated by running the company. Financing activities What has happened to the amount of cash flow changes from changing the way we manage our financing of operations. Investing activities What has happened to the amount of cash from investing (and divesting) in assets Pg 48 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 1-25

Statement of Cash Flows

Exercise Take a minute to review the annual report. – Total assets? Total Current Assets – Total Liability Total Current Liability – Amount of Retained Earnings Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 1-27

Notes to the Financial Statements An integral part of the statements Provide a summary of the firm’s accounting policies Explain any changes in accounting policies Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 1-28

Auditor’s Report Report of an independent or external auditor Attests to the fairness of the presentation of financial statements Sarbanes-Oxley (SOX) Act of 2002 Internal control report Management’s assessment of internal control structures Auditors detailpage&v=Pitb4v9hRZc detailpage&v=Pitb4v9hRZc Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 1-29

Auditor’s Report Unqualified reports – Statements present information in conformity with GAAP. Qualified reports – “In our opinion, except for the (nature of the departure explained), the financial statements present fairly…” Adverse opinion – Financial statements have not been presented fairly in accordance with GAAP. Disclaimer of opinion – Auditor cannot evaluate the fairness of the statements and expresses no opinion Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 1-30

Auditor’s Report Unqualified opinion with explanatory language – Additional explanatory paragraphs – Occurs under many circumstances Change in accounting principle Uncertainty caused by future events Events that may present business risk and/or going- concern problems Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 1-31

Exercise Review Annual Report – What does the auditor say? – What kind of audit finding? Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 1-32

Management Discussion and Analysis (MD&A) Sometimes labeled “Financial Review” Contains information that cannot be found in the financial data Includes coverage of favorable or unfavorable trends and significant events or uncertainties in particular areas Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 1-33

MD&A Elements of discussion Internal and external sources of liquidity Any material deficiencies in liquidity and how they will be remedied Commitments for capital expenditures, the purpose of such commitments, and expected sources of funding Anticipated changes in the mix and cost of financing resources Unusual or infrequent transactions that affect income from continuing operations Events causing material changes in cost/revenue relationships (e.g. future price increase) Breakdown of sales increases into price & volume components Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 1-34

MD&A Usefulness Companies do a good job of describing historical events. Very few firms provide accurate and meaningful forecasts. Explanations about why changes have occurred in profitability and liquidity are helpful. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 1-35

Exercise Review Annual Report – Pg 21 Executive summary – Pg 22 sales and other operating expenses Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 1-36

Five-Year Summary of Selected Financial Data and Market Data Net sales or operating revenues Income or loss from continuing operations per common share Total assets Long-term obligations and redeemable preferred stock Cash dividends per common share Two years of high and low common stock prices by quarter Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 1-37

Missing and Hard-to-Find Information These qualities impact the firm’s operating success both directly and indirectly but are difficult to quantify Employee relations with management Morale and efficiency of employees Reputation of the firm Firm’s prestige in the community Effectiveness of management Provisions for management succession Potential exposure to regulation changes Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 1-38

Missing and Hard-to-Find Information Affects public perception of firm Can impact financial performance Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 1-39 Publicity in the Media Breakdown of financial data is found in notes to financial statements Companies Operating in Several Lines of Unrelated Business

The Future of Financial Statements FASB tends to develop detailed rules. IASB uses broader principles. FASB and IASB are working together to develop one set of standards. Significant changes being worked on include lease accounting, classification of financial instruments, inventory accounting, and revenue recognition. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 1-40

Quality of Financial Reporting Timing of Revenue and Expense Recognition Expenses are matched with the generation of revenues to determine net income. Matching process involves judgments by management regarding the timing of expense and revenue recognition. The more conservative the approach, the higher the quality of earnings. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 1-41 The Matching Principle