Additional Aspects of Financial Reporting and Financial Analysis C hapter 6 An electronic presentation by Norman Sunderman Angelo State University An electronic presentation by Norman Sunderman Angelo State University COPYRIGHT © 2007 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Intermediate Accounting 10th edition Nikolai Bazley Jones

2 1. Describe an auditor’s report. 2. Explain the disclosure in management’s discussion and analysis. 3. Understand the meaning of an operating segment. 4. Describe the disclosure in a segment report. 5. Explain interim reporting. Objectives

3 6. Prepare an interim report. 7. Understand intracompany and intercompany comparisons (Appendix). 8. Prepare horizontal and vertical percentage analyses (Appendix). 9. Perform ratio analysis (Appendix). Objectives

4 The prices of securities traded in the capital market fully reflect all publicly available information. Evidence from research on an efficient market hypothesis tends to show-- These prices are adjusted almost immediately based on new information and in an unbiased manner. Market Efficiency

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6 1. The auditor is independent. 2. The audit was performed on specified financial statements. 3. The financial statements are the responsibility of the company’s management; the opinion is the responsibility of the auditors. 4. The audit was conducted according to generally accepted auditing standards. ContinuedContinued An auditor’s standard report includes these statements... Auditor’s Report (Opinion)

7 5. The audit was planned and performed to obtain reasonable assurance about whether the financial statements are free of material misstatements. 6. The audit included examination, assessment, and evaluation stages. 7. The audit provides a reasonable basis for an opinion. 8. An opinion is expressed concerning the fair presentation. Auditor’s Report (Opinion)

8 The first (introductory) paragraph lists the financial statements that were audited, declares that management is responsible for those statements, and asserts that the auditor is responsible for expressing an opinion on them. The second (scope) paragraph describes what the auditor has done. The third (opinion) paragraph gives the auditor’s opinion. An unqualified opinion contains 3 paragraphs. Auditor’s Report (Opinion)

9 1. An unqualified opinion is not a “clean bill of health.” 2. An unqualified opinion provides no assurance of the future success of the company. 3. An audit report does not provide an assurance that fraud has not been committed by a member, or members, of the company unless such fraud would cause a material misstatement in the financial statements. Auditor’s Report (Opinion)

10 The MD&A provides a narrative explanation of the financial statements so that investors can judge the “quality” of earnings and the likelihood that past performance is indicative of future performance in regard to cash flows. Management’s Discussion and Analysis

11 The MD&A provides a narrative explanation of the financial statements so that investors can judge the “quality” of earnings and the likelihood that past performance is indicative of future performance in regard to cash flows. The MD&A provides information regarding liquidity, capital resources, and the results of operations, as well as other information necessary to understand its financial condition and changes in financial condition. Where knowledge of segment information is useful to understanding a company’s business, the discussion is to focus on each relevant, reportable operating segment, as well as on the whole company. Management’s Discussion and Analysis

12  Liquidity  Capital Resources  Results of Operations  General Information Major discussion issues that may involve intracompany and intercompany comparisons. Management’s Discussion and Analysis

13 Disaggregation of Financial Information  Although investors and creditors know the importance of consolidated statements in evaluating overall company performance, the disaggregation of total financial data also can be important in their financial analysis.  A company improves the financial analysis information on risk and return by presenting disaggregated information on its operating segments.

14 1. that engages in business activities to earn revenues and incur expenses, 2. whose operating results are regularly reviewed by the company’s chief operating officer to make decisions about resources to be allocated to the segment and to assess its performance, and 3. for which financial information is available. An operating segment is a component of a company-- Segment Reporting

15 An operating segment is considered significant and is a reportable segment if it satisfies at least one of the following tests: 1.Revenue Test. Its reported revenues are 10% or more of the combined revenues of all the company’s reported operating segments. Segment Reporting

16 An operating segment is considered significant and is a reportable segment if it satisfies at least one of the following tests: 2.Profit Test. The absolute amount of its profit (loss) is 10% or more of the combined reported profits of all operating segments that did not report a loss. Segment Reporting

17 An operating segment is considered significant and is a reportable segment if it satisfies at least one of the following tests: 3.Asset Test. Its segment assets are 10% or more of the combined assets of all operating segments. Segment Reporting

18 TEAL COMPANY Operating Segment Financial Results for Year Ended December 31, 2007 Reportable Operating Segments All Other Total A B C Segments Results Segment revenues$ 300$2,530$ 370$ 600$ 3,800 Segment operating profit (pretax)$ 70$ 495$ 105$ 140$ 810 General corporate expenses(100) Corporate interest expense (80) Pretax income from cont’g operations$ 630 Segment assets at 12/31/2007$1,800$9,400$2,000$2,800$16,000 Gen. corp. assets 3,000 Total assets 12/31/2007$19,000 See page 256 >10% of total revenues >10% of total profits >10% of total assets

19 Interim Income Taxes To fairly present the results of operations, at the end of each interim period a company must make its best estimate of the effective income tax rate to be applicable for the entire year.

20 1.Estimated Annual Income: First quarter$ 20,000actual income Second quarter26,000actual income Third quarter25,000estimated income Fourth quarter 29,000estimated income $100,000estimated annual income ContinuedContinued Interim Income Taxes The tax rates are 15% on the first $20,000 and 30% on income over $20,000

21 2.Estimated Effective Income Tax Rate: 15% x $20,000 = $ 3,000 30% x ($100,000 – $20,000) = 24,000 Estimated total tax for the year = $27,000 27% Effective tax rate = $27,000 Estimated income tax $100,000 Estimated IncomeContinuedContinued Interim Income Taxes

22 4.Estimated Income Tax for Second Quarter: $12,420 estimated income tax on first six months of income (5,220)estimated income tax on first-quarter income (using annual estimate at that time) $ 7,200 estimated income tax on second-quarter income 3.Estimated Income Tax for First Six Months: $46,000 x 27% = $12,420 estimated income tax on first six months’ income Interim Income Taxes

23 When publicly held companies report interim summaries of financial information, the following data must be reported at a minimum. Preparation of Disclosure of Summarized Interim Financial Data

24 Sales or gross revenues, income taxes, extraordinary items (net of tax), the cumulative effect of a change in accounting principle, and net income. Earnings per share for each period presented. Seasonal revenues, costs, and expenses. Contingent items. Significant changes in financial position. Preparation of Disclosure of Summarized Interim Financial Data

25 Sales or gross revenues, income taxes, extraordinary items (net of tax), the cumulative effect of a change in accounting principle, and net income. Earnings per share for each period presented. Seasonal revenues, costs, and expenses. Contingent items. Significant changes in financial position. Preparation of Disclosure of Summarized Interim Financial Data Changes in accounting principles or estimates. Significant changes in estimates of income taxes.

26 For interim income statements for the second and third quarters: 1.Present the “year to date” income statement, 2.Deduct the amounts for each account from the previous quarter’s statement, 3.Present an income statement for the current quarter in the adjoining column Interim Statements

27 Two SEC forms that are important to accountants are-- Form 10-K Form 10-Q SEC Reports

28 Form 10-K is the most common SEC annual report form and is required to be filed with the SEC within 60 days of a company’s fiscal year-end. SEC Reports

29 Form 10-Q is used to report a company’s quarterly financial information to the SEC and is required to be filed within 40 days of the end of the company’s first three fiscal quarters in 2005 and within 35 days after December 15, SEC Reports

30 Financial Analysis Comparisons Intracompany Intercompany Percentage Analyses Horizontal Vertical Ratio Financial Analysis Comparison

31 In horizontal analysis, changes in a company’s operating results and financial position over time are shown in percentages as well as in dollars. In horizontal analysis, changes in a company’s operating results and financial position over time are shown in percentages as well as in dollars. Horizontal Analysis

32  from 12/31/07 to 12/31/08 Base Year % = Sales$138,000 $130,000 12/31/08 12/31/07 $8,000 $130,000 % = = 6.2% Now, using data from Example 6-3 on page 266, let’s examine Sales from December 31, 2007 to December 31, Horizontal Analysis

33  from 12/31/06 to 12/31/08 Base Year % = Gross profit$55,900 $42,000 12/31/08 12/31/06 $13,900 $42,000 % = = 33.1% Again using data from Example 6-3, let’s calculate the change in gross profit from December 31, 2006 to December 31, Horizontal Analysis

34 In vertical analysis, the monetary relationships between items on the financial statements are shown in percentages as well as in dollars. Vertical Analysis- Income Statement

Amount Percent Sales$138,000 Sales returns (8,000) Sales, net$130,000 Cost of goods sold(74,100) Gross profit$ 55,900 Sales, net $130, Sales, $138,000 Sales, net, $130,000 = Vertical Analysis- Income Statement

Amount Percent Sales$138,000 Sales returns (8,000) Sales, net$130,000 Cost of goods sold(74,100) Gross profit$ 55,900 Sales, net $130, (6.2)% Sales returns, ($8,000) Sales, net, $130,000 = (6.2) Vertical Analysis- Income Statement

Amount Percent Sales$138,000 Sales returns (8,000) Sales, net$130,000 Cost of goods sold(74,100) Gross profit$ 55,900 Sales, net $130, (57.0)% Cost of goods sold, ($74,100) Sales, net, $130,000 = (6.2) (57.0) Vertical Analysis- Income Statement

Amount Percent Sales$138,000 Sales returns (8,000) Sales, net$130,000 Cost of goods sold(74,100) Gross profit$ 55,900 Sales, net $130, % Gross profit, $55,900 Sales, net, $130,000 = (6.2) (57.0) 43.0 Vertical Analysis- Income Statement

Amount Percent Cash$ 3,900 Receivables (net)7,600 Inventories8,900 Prepaid Items 1,000 Total current assets$ 21,400 Noncurrent assets (net)107,800 Total Assets$129, % Cash, $3,900 Total Assets, $129,200 = 3.0 Total Assets $129, Vertical Analysis- Balance Sheet

Amount Percent Cash$ 3,900 Receivables (net)7,600 Inventories8,900 Prepaid Items 1,000 Total current assets$ 21,400 Noncurrent assets (net)107,800 Total Assets$129, Total Assets $129, % Receivables (net), $7,600 Total Assets, $129,200 = 5.9 Vertical Analysis- Balance Sheet

41 Using this approach on the rest of the assets, this section can be completed. Vertical Analysis- Balance Sheet

Amount Percent Cash$ 3,900 Receivables (net)7,600 Inventories8,900 Prepaid Items 1,000 Total current assets$ 21,400 Noncurrent assets (net)107,800 Total Assets$129, Total Assets $129, Vertical Analysis- Balance Sheet

43 In calculating vertical analysis amounts for liabilities and stockholders’ equity, all items are divided by “total liabilities and stockholders’ equity.” 3.9% Accounts Payable, $5,000 Total L& SE, $129,200 = Vertical Analysis- Balance Sheet

44 Sales$138,000 Sales returns8,000 Net sales (70% on credit)$130,000 Cost of goods sold74,100 Gross profit$55,900 Selling expenses$14,900 General expenses22,300 Interest expenses3,00040,200 Pretax continuing income$15,700 Income tax expense4,700 Net income$11,000 Cooper Company Income Statement 2008

45 Beginning retained earnings$32,000 Net income11,000 $43,000 Preferred dividends, $8 per share (1,200) Common dividends, $1 per share(5,400) Ending retained earnings$36,400 Cooper Company Retained Earnings Statement 2008

Cash$3,900$4,800 Receivables (net)7,6008,600 Inventories8,90010,100 Prepaid items1,0001,200 Total current assets$21,400$24,700 Noncurrent assets (net)107,80087,300 Total assets$129,200$112,000 ContinuedContinued Cooper Company Comparative Balance Sheets

Accounts payable$5,000$6,600 Other current liabilities6,2006,400 Long term liabilities25,00020,000 Total liabilities$36,200$33,000 Preferred stock, 8%, $100 par15,00015,000 Common stock, $5 par27,00024,000 Additional paid in capital14,6008,000 Retained earnings36,40032,000 Total stockholders’ equity$93,000$79,000 Total liabilities & stockholders’ equity$129,200$112,000 Cooper Company Comparative Balance Sheets The market price of the common stock was $14.25 on Dec. 31, 2008

48 Continue using Cooper Company information on previous slides and on pages

49 Earnings per share is probably the most frequently cited ratio in a financial analysis. Net Income - Preferred Dividends Average Common Shares Outstanding Ratio Analysis Stockholders’ Profitability Ratios

50 Earnings per share is probably the most frequently cited ratio in a financial analysis. $11,000- $1,200 5,400 = $1.81 Ratio Analysis Stockholders’ Profitability Ratios

51 Price/earnings is used by actual and potential stockholders to evaluate the attractiveness of an investment in the stock of a company. Market Price per Common Share Earnings per Share Ratio Analysis Stockholders’ Profitability Ratios

52 Price/earnings is used by actual and potential stockholders to evaluate the attractiveness of an investment in the stock of a company. $14.25 $1.81 = 7.9 times Ratio Analysis Stockholders’ Profitability Ratios

53 Stockholders’ Profitability Ratios Dividend yield provides the stockholders’ their individual rates of return based on the actual dividends received as compared with the ending market price of the stock. Dividends per Common Share Market Price per Common Share $1.00 $14.25 = 7.0% Ratio Analysis

54 Profit margin is used to evaluate a company’s efficiency in controlling costs and expenses in relation to sales. Net Income Net Sales Ratio Analysis Company Profitability Ratios

55 Profit margin is used to evaluate a company’s efficiency in controlling costs and expenses in relation to sales. $11,000 $130,000 = 8.5% Ratio Analysis Company Profitability Ratios

56 Return on total assets indicates how efficiently a company uses its economic resources. Net Income + Interest Expense (net of tax) Average Total Assets Ratio Analysis Company Profitability Ratios

57 $11,000 + ($3,000 x 0.7) ($129,200 + $112,000)/2 = 10.9% Ratio Analysis Company Profitability Ratios Return on total assets indicates how efficiently a company uses its economic resources.

58 Return on stockholders’ equity shows the residual returns on the owners’ equity. Net Income Average Stockholders’ Equity Ratio Analysis Company Profitability Ratios

59 Return on stockholders’ equity shows the residual returns on the owners’ equity. Company Profitability Ratios $11,000 ($93,000 + $79,000)/2 = 12.8% Ratio Analysis

60 The current ratio is used to evaluate a company’s short-run liquidity. Current Assets Current Liabilities Ratio Analysis Liquidity Ratios 1.Cash 2.Short-term investments 3.Accounts receivable 4.Inventory 5.Prepaid expenses/supplies

61 The current ratio is used to evaluate a company’s short-run liquidity. $21,400 $11,200 = 1.91 times Ratio Analysis Liquidity Ratios

62 Ratio Analysis The acid-test ratio is a more severe test of a company’s short-term debt-paying abilities. Quick Assets Current Liabilities Liquidity Ratios 1.Cash 2.Short-term investments 3.Accounts receivable

63 Ratio Analysis The acid-test ratio is a more severe test of a company’s short-term debt-paying abilities. Liquidity Ratios $11,500 $11,200 = 1.03 times

64 Inventory turnover indicates the number of times the inventory is “turned over” or sold during that period. Cost of Goods Sold Average Inventory Ratio Analysis Activity Ratios

65 Activity Ratios $74,100 ($8,900 + $10,100)/2 = 7.8 times or 47 days Ratio Analysis Inventory turnover indicates the number of times the inventory is “turned over” or sold during that period.

66 Net Credit Sales Average Net Receivables Receivables turnover indicates how many times receivables are “turned over” or collected each period. Activity Ratios Ratio Analysis

67 Net Credit Sales Average Net Receivables $130,000 x 0.70 Activity Ratios ($7,600 + $8,600)/2 = 11.2 times or 33 days Ratio Analysis Receivables turnover indicates how many times receivables are “turned over” or collected each period.

68 Activity Ratios Cost of Goods Sold Average Accounts Payable Ratio Analysis The payables turnover ratio measures the number of times accounts payable turns over during the year.

69 The payables turnover ratio measures the number of times accounts payable turns over during the year. Activity Ratios Cost of Goods Sold Average Accounts Payable $74,100 ($5,000 + $6,600)/2 = 12.8 times or 29 days Ratio Analysis

70 The debt ratio indicates the percentage of total assets contributed by creditors. Stability Ratios Total Liabilities Total Assets Ratio Analysis

71 The debt ratio indicates the percentage of total assets contributed by creditors. Stability Ratios Total Liabilities Total Assets $36,200 $129,200 = 28% Ratio Analysis

72 Times interest earned is used to evaluate the ability of a company to cover its interest obligations through its annual earnings. Stability Ratios Pretax Operating Income Interest Expense Ratio Analysis

73 Stability Ratios $15,700 + $3,000 $3,000 = 6.2 times Ratio Analysis Times interest earned is used to evaluate the ability of a company to cover its interest obligations through its annual earnings.

74 Book value per common share shows the net assets per share of stock. Stability Ratios Common Stockholders’ Equity Outstanding Common Shares Ratio Analysis

75 Stability Ratios $93,000 - ($140 x 150) 5,400 =$ per common share Ratio Analysis Book value per common share shows the net assets per share of stock.

76 C hapter 6 Task Force Image Gallery clip art included in this electronic presentation is used with the permission of NVTech Inc.