1. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1 Understanding Financial Statements NINTH EDITION Lyn M. Fraser Aileen Ormiston

2. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-2 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.

3. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-3 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.

4. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-4 Map or Maze A map helps its user reach a desired destination through clarity of representation.

5. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-5 Map or Maze A maze attempts to confuse its user by purposefully introducing conflicting elements and complexities that prevent reaching the desired goal.

6. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-6 Auditor’s Report Statement of Cash Flows MD&A Statement of Shareholders’ Equity Balance Sheet Notes Income Statement Map or Maze A maze of information

7. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-7 Map or Maze Business financial statements have the potential for being map and maze.

8. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-8 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

9. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-9 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

10. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-10 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

11. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-11 Usefulness Financial position of the company Financial position of the company Success of operations Success of operations Policies and strategies of management Policies and strategies of management Insight into future performance Insight into future performance Financial statements and accompanying notes contain a wealth of information.

12. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-12 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).

13. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-13 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?

14. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-14 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?

15. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-15 Volume of Information Annual Reports Financial statements Financial statements Notes to the financial statements Notes to the financial statements Auditor’s report Auditor’s report Five-year summary of key financial data Five-year summary of key financial data Annual reports contain a great quantity of information.

16. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-16 Volume of Information Annual Reports High and low stock prices High and low stock prices Management’s discussion and analysis of operations Management’s discussion and analysis of operations Material included at the imagination and discretion of management Material included at the imagination and discretion of management

17. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-17 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

18. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-18 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 Securities and Exchange Commission (SEC), a public-sector organization Financial Accounting Standards Board (FASB), a private-sector organization Financial Accounting Standards Board (FASB), a private-sector organization

19. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-19 Volume of Information Securities and Exchange Commission Regulates US companies that issue securities to the public Requires regular filing of Annual reports (10-K) Annual reports (10-K) Quarterly reports (10-Q) Quarterly reports (10-Q) 8-K reports in particular circumstances 8-K reports in particular circumstances

20. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-20 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.

21. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-21 Volume of Information Financial Accounting Standards Board Issues Statements of Financial Accounting Standards (SFASs) and interpretations

22. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-22 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.

23. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-23 Volume of Information The SEC and the FASB

24. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-24 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).

25. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-25 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.

26. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-26 Where to Find a Company’s Financial Statements Form 10-K Filed annually with the SEC Filed annually with the SEC Contains uniform content Contains uniform content Same order for all filing companies Same order for all filing companies Can be accessed through the Electronic Data Gathering, Analysis, and Retrieval (EDGAR) database at www.sec.gov Can be accessed through the Electronic Data Gathering, Analysis, and Retrieval (EDGAR) database at www.sec.gov

27. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-27 Where to Find a Company’s Financial Statements Annual report Financial statements Financial statements Other public relations material Other public relations material Sent to shareholders and prospective investors Sent to shareholders and prospective investors Corporate Web site

28. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-28 The Financial Statements Balance Sheet Balance Sheet Income Statement or Earnings Statement Income Statement or Earnings Statement Statement of Stockholders’ Equity Statement of Stockholders’ Equity Statement of Cash Flows Statement of Cash Flows Annual reports contain four basic financial statements.

29. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-29 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 Assets Liabilities Liabilities Stockholders’ equity Stockholders’ equity

30. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-30 The Financial Statements The Income Statement Also called the earnings statement Presents the results of operations for the accounting period Revenues Revenues Expenses Expenses Net profit or loss Net profit or loss Net profit or loss per share Net profit or loss per share

31. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-31 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.

32. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-32 The Financial Statements The Statement of Cash Flows Provides information about the cash inflows and outflows during an accounting period Operating activities Operating activities Financing activities Financing activities Investing activities Investing activities

33. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-33 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

34. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-34 Notes to the Financial Statements Present detail about particular accounts Inventory Inventory Property, plant, and equipment Property, plant, and equipment Investments Investments Long-term debt Long-term debt Equity accounts Equity accounts

35. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-35 Notes to the Financial Statements Include other information Major acquisitions or divestitures Major acquisitions or divestitures Officer and employee retirement, pension, and stock option plans Officer and employee retirement, pension, and stock option plans Leasing arrangements Leasing arrangements Term, cost, and maturity of debt Term, cost, and maturity of debt

36. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-36 Notes to the Financial Statements Include other information Pending legal proceedings Pending legal proceedings Income taxes Income taxes Contingencies and commitments Contingencies and commitments Quarterly results of operations Quarterly results of operations Operating segments Operating segments

37. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-37 Notes to the Financial Statements Supplementary information required by SEC and FASB Reserves for companies operating in extractive industries Reserves for companies operating in extractive industries Effect of foreign currency translations Effect of foreign currency translations Financial information for each reportable segment of a firm with several lines of business Financial information for each reportable segment of a firm with several lines of business

38. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-38 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 Internal control report Management’s assessment of internal control structures Management’s assessment of internal control structures

39. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-39 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

40. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-40 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…”

41. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-41 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.

42. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-42 Auditor’s Report Unqualified opinion with explanatory language Additional explanatory paragraphs Occurs under many circumstances Change in accounting principle Change in accounting principle Uncertainty caused by future events Uncertainty caused by future events Events that may present business risk and/or going-concern problems Events that may present business risk and/or going-concern problems

43. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-43 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)

44. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-44 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.

45. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-45 Sarbanes-Oxley Act of 2002 Title II Prohibits nonaudit services during an external audit Bookkeeping Bookkeeping Design and implementation of financial information systems Design and implementation of financial information systems Valuation, appraisal, actuarial, internal audit, broker, dealer, or investment banking services Valuation, appraisal, actuarial, internal audit, broker, dealer, or investment banking services Management or human resources functions Management or human resources functions

46. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-46 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.

47. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-47 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

48. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-48 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

49. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-49 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 MD&A Elements of discussion

50. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-50 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. MD&A Usefulness

51. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-51 Five-Year Summary of Selected Financial Data and Market Data Net sales or operating revenues Net sales or operating revenues Income or loss from continuing operations per common share Income or loss from continuing operations per common share Total assets Total assets Long-term obligations and redeemable preferred stock Long-term obligations and redeemable preferred stock Cash dividends per common share Cash dividends per common share Two years of high and low common stock prices by quarter Two years of high and low common stock prices by quarter

52. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-52 Pandora (A.K.A. “PR Fluff”) Colored photographs Colored photographs Charts Charts Shareholders’ letter from the CEO Shareholders’ letter from the CEO Other items to make the report attractive Other items to make the report attractive Getting to what is needed through the “PR fluff” can be a challenge.

53. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-53 Proxy Statement Used to solicit shareholder votes Important in assessing who manages the firm, how management is paid, and potential conflict-of-interest issues

54. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-54 Proxy Statement Contents Voting procedures and information Voting procedures and information Background of nominated directors Background of nominated directors Director and executive compensation Director and executive compensation Proposed changes in compensation plans Proposed changes in compensation plans Audit committee report Audit committee report Breakdown of audit and non-audit fees Breakdown of audit and non-audit fees

55. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-55 Missing and Hard-to-Find Information Employee relations with management Employee relations with management Morale and efficiency of employees Morale and efficiency of employees Reputation of the firm Reputation of the firm Firm’s prestige in the community Firm’s prestige in the community Effectiveness of management Effectiveness of management Provisions for management succession Provisions for management succession Potential exposure to regulation changes Potential exposure to regulation changes

56. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-56 Missing and Hard-to-Find Information These qualities impact the firm’s operating success both directly and indirectly but are difficult to quantify.

57. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-57 Missing and Hard-to-Find Information Affects public perception of firm Affects public perception of firm Can impact financial performance Can impact financial performance Publicity in the Media Breakdown of financial data is found in notes to financial statements Breakdown of financial data is found in notes to financial statements Companies Operating in Several Lines of Unrelated Business

58. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-58 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

59. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-59 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.

60. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-60 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.

61. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-61 The Future of Financial Statements Proposal for statements to show subtotals for five general categories Business Business Discontinued operations Discontinued operations Financing Financing Income taxes Income taxes Equity Equity

62. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-62 Quality of Financial Reporting Financial statements should reflect an accurate picture of a company’s financial condition and performance reflect an accurate picture of a company’s financial condition and performance be useful to assess the past and predict the future 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.

63. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-63 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. The Matching Principle

64. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-64 Quality of Financial Reporting Discretionary Items Budget level and timing of expenditures Budget level and timing of expenditures Marketing and advertising Marketing and advertising Research and development Research and development Capital expansion Capital expansion Replacement of plant assets Replacement of plant assets Development of new product lines Development of new product lines Disposal of an operating division Disposal of an operating division

65. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-65 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.

66. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall1-66 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