1. Chapter 3 Financial Statements

2. 3.1 Accounting Principles
Chapter 3 Outline
3.1 Accounting Principles
Generally accepted accounting principles
Auditors
Accounting conventions
Measuring costs and value
Recognition principles
Managing financial statements
The effect of recent accounting scandals
3.2 Financial Statements
The balance sheet
The income statement
The statement of cash flows
3.3 The Tax System
Interest and dividends received
Depreciation
Capital gains
Tax rates

3. 3.1 Accounting principles
Accounting is simply an organized method of summarizing all of a company’s transactions and presenting them in such a way that external users can understand the company’s affairs.
Clearly, problems arise when the company tries to present its accounting statements in a way that does not fairly represent its situation, either to creditors, like the bank, or to the common shareholders.
Consequently, external users of the company’s financial statements must become skilled in analyzing the statements and spotting signs that things may not be quite as management presents them.
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4. Generally Accepted Accounting Principles
It is important to realize that management prepares the company’s financial statements, not the company’s auditors.
Auditors, such as Deloitte & Touche LLP (Deloitte), attest to whether or not the financial statements fairly represent the company’s financial position according to generally accepted accounting principles (GAAP).
Companies reporting in the U.S. follow the principles promulgated by the Financial Accounting Standards Board (FASB), whereas members of the European Economic Community, and other countries, follow the principles promulgated by the International Accounting Standards Board (IASB).
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5. Independent auditors
Independent auditors review the financial statements prepared by a company’s management and provide a report, addressed to the company’s board of directors and shareholders, that generally consists of the following:
A statement that the financial statements are the responsibility of the company, and that the auditor is providing an opinion on the financial statements, not the accounting records themselves.
A description of the scope of the audit, and that it was conducted according to generally accepted auditing standards,
The auditor’s opinion, which is one of four types.

6. Auditor’s opinion An auditor’s opinion is one of four types:
Unqualified opinion - the auditor finds that the financial statements are presented fairly in accordance with generally accepted accounting principles.
Qualified opinion - the auditor finds that the financial statements are presented fairly in accordance with generally accepted accounting principles except for a matter of qualification.
Adverse opinion - the auditor concludes that the financial statements are not presented fairly according to GAAP.
Disclaimer of opinion - the auditor’s examination is severely restricted or the auditor finds some condition is present that prevents the application of generally accepted auditing standards.

7. Accounting conventions: basic principles
The purpose of financial statements is to provide information, at least annually, to a wide range of external users, including investors, employees, lenders, governments, and the general public.
The underlying assumptions in the financial statements are that transactions are recorded on the accrual basis, and that the entity is a going concern, and hence will continue indefinitely.
The objective of the financial statements is to provide information about an entity’s financial performance and changes in financial position, and the management of the entity has the primary responsibility for preparing and presenting the financial statements.
The accrual basis is the reporting convention in which revenues and expenses are recorded when a transaction occurs, regardless of when cash changes hands.
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8. Accounting conventions: basic principles
Financial statements should possess the qualitative characteristics of understandability, relevancy, reliability, and comparability.
The relevancy of financial statements includes consideration of the materiality of the information, the reliability of the information and related estimates, and prudence.

9. Measuring costs and value
Business entities measure and report monetary amounts for the various elements in its financial statements.
The basis for measuring costs differs among accounts, and may differ among entities for the same accounts.

10. Measuring costs and value
Historical cost
What it cost the entity when it purchased the asset or took on the obligation.
Current cost
What it would cost to replace the asset or settle the liability.
Net realizable value
What the company would reasonably get for the asset if it had to dispose of it in an orderly sale, or the settlement value for a liability.
Present value
The sum of the discounted expected future cash flows arising from the asset or expected to be paid in the case of a liability.
Fair value
The amount reasonably expected to be received for an asset or settled in the case of a liability, between knowledgeable, willing parties to the transaction.

11. Recognition principles
Type
When Recognized
Example
Asset
Likely that the future economic benefit will flow to the entity and that the value can be measured reliably
Purchase of equipment
Liability
Likely that the outflow of resources will result and that the amount of the obligation can be measured reliably
Borrowing by issuing a debt obligation
Income
Increase in future economic benefit from an increase in an asset or a decrease in a liability can be measured reliably
Sale of goods or services, or waiver of a debt obligation
Expense
Decrease in future economic benefit from a decrease in an asset or an increase in a liability
Depreciation of equipment or accrual of wages to employees

12. Net income v. comprehensive income
Net income appears in the income statement;
Other comprehensive income is the adjustment to net income.
Net income
Other comprehensive income
Comprehensive income

13. Shareholders’ equity + - Common stock at par
Additional paid in capital
Preferred stock
Other comprehensive income -
Treasury stock
Shareholders’ equity

14. Managing financial statements
Accounting principles offer some flexibility because it is simply not possible to design a one-size-fits-all set of principles. For example:
Mark-to-market - writing the value of an asset up or down, depending on its current market value
Available-for-sale - method of accounting for marketable securities in which unrealized gains or losses are reported as part of accumulated other comprehensive income
Trading securities - method of accounting for marketable securities that occurs when unrealized gains or losses are reported in net income
Held-to-maturity - method of accounting used when marketable debt securities are reported at cost
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15. Enron’s History
Enron was born in 1985 from the merger of Houston Natural Gas and InterNorth.
Enron incurred massive debt and no longer had exclusive rights to its pipelines.
Needed new and innovative business strategy
Kenneth Lay, CEO, hired McKinsey & Company to assist in developing business strategy. They assigned a Jeffrey Skilling to Enron.
His background was in banking and asset and liability management.
His recommendation: that Enron create a “Gas Bank”—to buy and sell gas

16. Enron’s History (cont’d)
Created Energy derivative. Lay created a new division in 1990 called Enron Finance Corp. and hired Skilling to run it
Enron soon had more contracts than any of its competitors and, with market dominance, could predict future prices with great accuracy, thereby guaranteeing superior profits.
Fastow was a Kellogg MBA hired by Skilling in 1990—Became CFO in 1998
Started Enron Online Trading in late 90s
Created Performance Review Committee (PRC) that became known as the harshest employee ranking system in the country---based on earnings generated, creating fierce internal competition

17. The Motivation
Enron delivered smoothly growing earnings (but not cash flows.) Wall Street took Enron on its word but didn’t understand its financial statements.
It was all about the price of the stock. Enron was a trading company and Wall Street normally doesn’t reward volatile earnings of trading companies. (Goldman Sacks is a trading company. Its stock price was 20 times earnings while Enron’s was 70 times earnings.)
Enron reported 20 straight quarters of increasing income in its last 5 years.
Enron, that had once made its money from hard assets like pipelines, generated more than 80% of its earnings “wholesale energy operations and services.”

18. The Role of Stock Options
Enron (and many other companies) avoided hundreds of millions of dollars in taxes by its use of stock options.
Corporate executives received large quantities of stock options. When they exercised these options, the company claimed compensation expense on their tax returns.
Accounting rules let them omit that same expense from the earnings statement. The options only needed to be disclosed in a footnote.
Options allowed them to pay less taxes and report higher earnings while, at the same time, motivating them to manipulate earnings and stock price.

19. Enron’s Corporate Strategy
Enron’s core business was losing money—shifted its focus from bricks-and-mortar energy business to trading of derivatives (most derivatives profits were more imagined than real with many employees lying and misstating systematically their profits and losses in order to make their trading businesses appear less volatile than they were)
Enron’s top management gave its managers a blank order to “just do it”
Deals in unrelated areas such as weather derivatives, water services, metals trading, broadband supply and power plant were all justified.

20. Confuse, confuse, confuse
Source: Bob Jenson, Trinity University

21. Aggressive nature of Enron
Because Enron believed it was leading a revolution, it pushed the rules.
Competition was fierce among Enron traders, to the extent that they were afraid to go to the bathroom and leave their computer screen unattended and available for perusal by other traders.

22. Enron’s use of special purpose entities (SPEs)
To:
hide bad investments and poor-performing assets
manage earnings—Blockbuster Video deal--$111 million gain
execute related-party transactions at desired prices
report over $1 billion of false income
hide debt
manipulate cash flows, especially in 4th quarters
book income just in time and in amounts needed, to meet investor expectations

23. 2001 - Notable Events Date Event July 2001
Enron blamed for California’s energy crisis
August 14
Jeff Skilling left Enron; no reason given
Mid-August
Stock price falling
October 12
Discloses $638 billion loss in third quarter
October 16
Former CEO returned (Kenneth Lay)
November 8
Informed investors of restatement of almost 5 years of earnings
November 9
Dynergy offers buyout of Enron
November 28
Dynergy cancels buyout agreement
December 2
Filed bankruptcy

24. Enron’s revenues and income
Fiscal year
Net income
Operating cash flow
Revenues
1987
-$29
$184
$5,916
1988
$109
$82
$5,708
1989
$226
$194
$9,836
1990
$202
$1,107
$13,165
1991
$242
$791
$5,563
1992
$306
$293
$6,325
1993
$333
$468
$7,972
1994
$453
$504
$8,984
1995
$520
-$15
$9,189
1996
$584
$1,040
$13,289
1997
$105
$501
$20,273
1998
$703
$1,640
$31,260
1999
$893
$1,228
$40,112
2000
$979
$4,779
$100,789
Source of data: Standard & Poor’s Compustat
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25. Enron’s stock price
Blackout period for retirement sales: October 19 – November 13, 2001
Source of data: Center for Research in Security Prices
Booth Cleary Drake

26. Executives and board members got out of the stock (1999 – mid-2001)
NAME
POSITION AT ENRON
SHARES SOLD
GROSS PROCEEDS
PRICE PER SHARE
Norman Blake
Member of Board of Directors
21,200
$1,705,328
$80.44
Steve Kean
Executive Vice President, Chief of Staff
64,932
$5,166,414
$79.57
Cindy Olson
Executive Vice President
83,183
$6,505,870
$78.21
Michael McConnell
32,960
$2,506,311
$76.04
Rick Buy
Chief Risk Officer
140,234
$10,656,595
$75.99
Ken Harrison
1,011,436
$75,416,636
$74.56
Joe Hirko
CEO, Enron Communications
473,837
$35,168,721
$74.22
Mark Koenig
129,153
$9,110,466
$70.54
Jeff McMahon
Treasurer
39,630
$2,739,226
$69.12
Lou Pai
CEO, Enron Energy Services
3,912,205
$270,276,065
$69.09
Rick Causey
Chief Accounting Officer
208,940
$13,386,896
$64.07
Robert Jaedicke
13,360
$841,438
$62.98
Ken Rice
CEO, Enron Broadband Services
1,234,009
$76,825,145
$62.26
Joe Sutton
Vice-Chairman
688,996
$42,231,283
$61.29
John Duncan
35,000
$2,009,700
$57.42
Stan Horton
CEO, Enron Transportation
830,444
$47,371,361
$57.04
J. Clifford Baxter
619,898
$34,734,854
$56.03
Mark Frevert
Chief Executive Office, Enron Europe
986,898
$54,831,220
$55.56
James Derrick
General Counsel
230,660
$12,563,928
$54.47
Robert Belfer
2,065,137
$111,941,200
$54.21
Jeffrey Skilling
Chief Executive Officer, Enron Corp.
1,307,678
$70,687,199
$54.06
Andy Fastow
Chief Financial Officer
687,445
$33,675,004
$48.99

27. The effect of recent accounting scandals
As a consequence of accounting scandals, particularly that of Enron, the U.S. Congress passed the Sarbanes-Oxley Act (SOX) in The main provisions are as follows:
The establishment of a Public Company Accounting Oversight Board to register and inspect public accounting firms and establish audit standards.
The separation of audit functions from other services, such as consulting, provided by the big accounting firms, with the auditors rotating every 5 years so that they do not get too close to the companies they are auditing.

28. SOX, continued
The implementation of much stricter governance standards, including internal controls
Auditors report to the company’s audit committee, which is to be composed of independent members of the board of directors with the power to engage independent consultants.
The requirement that the company’s annual report contain an internal control report that indicates the state of the company’s internal controls and assesses their effectiveness.
The requirement that both the chief executive officer (CEO) and the chief financial officer (CFO) “certify” that the company’s financial statements “fairly present, in all material respects, the operations and financial condition of the issuer.”
Booth Cleary Drake

29. Up next … Financial statements

30. Question 1 The independent accountants attest that: There is no fraud.
Statements are prepared according to GAAP.
They are independent.

31. Question 2
Which opinion is best?
Adverse
Qualified
Unqualified