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

2. Copyright Notice
All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. Printed in the United States of America.
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3. Chapter 1: Financial Statements An Overview
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.
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4. Map or Maze A map helps its user reach a desired destination through
clarity of
representation.
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5. Map or Maze
A maze attempts to confuse its user by purposefully introducing conflicting elements and complexities that prevent reaching the desired goal.
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6. Map or Maze A maze of information Auditor’s Report MD&A Notes
Statement of Cash Flows
Income Statement
Statement of Shareholders’ Equity
Balance Sheet
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7. Map or Maze
Business financial statements have the potential for being map and maze.
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8. 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
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9. 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
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10. Main Objectives of This Book
Ensure that financial statements serve as a map, not a maze
Demonstrate how to read and evaluate business financial statements
Provide the tools and techniques needed to complete a comprehensive financial statement analysis
Encourage intelligent decision making
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11. Usefulness
Financial statements and accompanying notes contain a wealth of information.
Financial position of the company
Success of operations
Policies and strategies of management
Insight into future performance
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12. 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).
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13. 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 to service interest and principal payments on debt?
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14. Usefulness Questions One Might Ask
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?
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15. Volume of Information Annual Reports
Annual reports contain a great quantity of information.
Financial statements
Notes to the financial statements
Auditor’s report
Five-year summary of key financial data
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16. Volume of Information Annual Reports
High and low stock prices
Management’s discussion and analysis of operations
Material included at the imagination and discretion of management
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17. Volume of Information Financial Statements
Prepared according to generally accepted accounting principles (GAAP)
Intended to present financial information that is understandable and relevant and reliable for decision-making
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18. 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
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19. 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
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20. Volume of Information Securities and Exchange Commission
Has congressional authority to set accounting policies
Has issued rulings called Accounting Series Releases (ASRs) and Financial Reporting Rulings (FRRs)
For the most part, rule making has been delegated to the FASB.
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21. Volume of Information Financial Accounting Standards Board
Issues Statements of Financial Accounting Standards (SFASs) and interpretations
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22. Volume of Information The SEC and the FASB
Work closely together in the development of accounting policy
SEC has played a largely supportive role.
Corporate scandals have brought the challenges and pressures the FASB faces to the forefront.
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23. Volume of Information The SEC and the FASB
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24. Volume of Information The SEC and the FASB
SEC and the FASB continue to examine potential rule changes and new rules.
Changes will most likely evolve through joint projects between U.S. rule-making bodies and the International Accounting Standards Board (IASB).
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25. 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.
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26. 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
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27. Where to Find a Company’s Financial Statements
Annual report
Financial statements
Other public relations material
Sent to shareholders and prospective investors
Corporate Web site
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28. The Financial Statements
Annual reports contain four basic financial statements.
Balance Sheet
Income Statement or Earnings Statement
Statement of Stockholders’ Equity
Statement of Cash Flows
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29. 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
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30. 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
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31. The Financial Statements The Statement of Stockholder’s Equity
Reconciles the beginning and ending balances of all accounts that appear in the stockholders’ equity section of the balance sheet
Some firms prepare a statement of retained earnings which reconciles the beginning and ending balances of the retained earnings account.
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32. The Financial Statements The Statement of Cash Flows
Provides information about the cash inflows and outflows during an accounting period
Operating activities
Financing activities
Investing activities
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33. 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
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34. Notes to the Financial Statements
Present detail about particular accounts
Inventory
Property, plant, and equipment
Investments
Long-term debt
Equity accounts
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35. Notes to the Financial Statements
Include other information
Major acquisitions or divestitures
Officer and employee retirement, pension, and stock option plans
Leasing arrangements
Term, cost, and maturity of debt
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36. Notes to the Financial Statements
Include other information
Pending legal proceedings
Income taxes
Contingencies and commitments
Quarterly results of operations
Operating segments
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37. Notes to the Financial Statements
Supplementary information required by SEC and FASB
Reserves for companies operating in extractive industries
Effect of foreign currency translations
Financial information for each reportable segment of a firm with several lines of business
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38. 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
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39. Auditor’s Report Impact of SOX on Internal Auditing
Need for internal auditors to assess effectiveness of internal controls and to disclose weaknesses in a firm’s internal controls system
Strengthened internal controls
Enhanced value of internal audit function
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40. 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…”
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41. Auditor’s Report 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.
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42. 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
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43. Sarbanes-Oxley Act of 2002
Passed by Congress in hopes of ending future accounting scandals and renewing investor confidence in the marketplace
Established the Public Company Accounting Oversight Board (PCAOB)
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44. Sarbanes-Oxley Act of 2002 The PCAOB
Private, non-profit organization
Registers, inspects, and disciplines auditors
Writes auditing rules
Sets quality control and ethics standards
SEC has oversight of the board.
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45. Sarbanes-Oxley Act of 2002 Title II
Prohibits nonaudit services during an external audit
Bookkeeping
Design and implementation of financial information systems
Valuation, appraisal, actuarial, internal audit, broker, dealer, or investment banking services
Management or human resources functions
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46. Sarbanes-Oxley Act of 2002 Titles III, IV, and IX
Corporate responsibility
Harsher penalties for violations
CEO and CFO must certify accuracy of financial statements.
Officers who certify inaccurate reports could face up to $1,000,000 in fines and/or a jail sentence of up to 10 years.
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47. 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
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48. 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
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49. MD&A Elements of discussion
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
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50. 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.
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51. 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
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52. Pandora (A.K.A. “PR Fluff”)
Colored photographs
Charts
Shareholders’ letter from the CEO
Other items to make the report attractive
Getting to what is needed through the “PR fluff” can be a challenge.
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53. Proxy Statement Used to solicit shareholder votes
Important in assessing who manages the firm, how management is paid, and potential conflict-of-interest issues
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54. Proxy Statement Contents
Voting procedures and information
Background of nominated directors
Director and executive compensation
Proposed changes in compensation plans
Audit committee report
Breakdown of audit and non-audit fees
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55. Missing and Hard-to-Find Information
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
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56. Missing and Hard-to-Find Information
These qualities impact the firm’s operating success both directly and indirectly but are difficult to quantify.
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57. Missing and Hard-to-Find Information
Publicity in the Media
Affects public perception of firm
Can impact financial performance
Companies Operating in Several Lines of Unrelated Business
Breakdown of financial data is found in notes to financial statements
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58. Complexities GAAP Provide some measure of uniformity
Allow management considerable discretion in applying regulations
Use of the accrual rather than the cash basis of accounting
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59. Complexities Accounting Choices
Accounting choices and estimates impact financial statement numbers.
Quality of financial reporting is impacted if accounting choice does not reflect economic reality.
Financial data must be appropriated to particular time periods even though a firm’s life is continuous.
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60. 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.
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61. The Future of Financial Statements
Proposal for statements to show subtotals for five general categories
Business
Discontinued operations
Financing
Income taxes
Equity
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62. Quality of Financial Reporting
Financial statements should
reflect an accurate picture of a company’s financial condition and performance
be useful to assess the past and predict the future
The closer the picture to financial reality, the higher the quality of the financial statements.
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63. Quality of Financial Reporting Timing of Revenue and Expense Recognition
The Matching Principle
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.
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64. Quality of Financial Reporting Discretionary Items
Budget level and timing of expenditures
Marketing and advertising
Research and development
Capital expansion
Replacement of plant assets
Development of new product lines
Disposal of an operating division
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65. Quality of Financial Reporting Discretionary Items
The financial analyst should carefully scrutinize management’s policies with respect to discretionary items.
Such analysis can provide insight into strengths and weaknesses of a company and contribute to an assessment of its ability to perform successfully in the future.
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66. The Journey Through the Maze Continues
Ch. 2: The Balance Sheet
Ch. 3: Income Statement and Statement of Stockholders’ Equity
Ch. 4: Statement of Cash Flows
Ch. 5: A Guide to Earnings and Financial Reporting Quality
Ch. 6: The Analysis of Financial Statements
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