1. Understanding Financial Statements Seventh EDITION
Lyn M. Fraser
Aileen Ormiston

2. Financial Statements An Overview
Map or
Maze
Chapter 1
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3. Financial Statements An Overview
Map or
Maze
Auditor’s Report
MD&A
Notes
Statement of Cash Flows
Income Statement
Statement of Shareholders’ Equity
Balance Sheet
Chapter 1
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4. Map:
To help its user reach a desired destination through clarity of representation
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5. Maze:
On the other hand. . .
Attempts to confuse its user by purposefully introducing conflicting elements and complexities that prevent reaching the desired goal
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6. Financial statements are potentially
Map or Maze
Financial statements are potentially
both MAP and MAZE
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7. Financial Statements--MAP
Form basis for understanding the financial position of a firm
Allow users to assess historical and prospective financial performance
Present picture of firm’s financial health, leading to informed business decisions
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8. Financial Statements--MAZE
Contain large amounts of information
Accounting policies and reporting requirements are complex and constantly changing
Allow management considerable discretion
Hide or omit key information
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9. To ensure that financial statements serve as a map, not a maze
Our Goal:
To ensure that financial statements serve as a map, not a maze
The better one can read and understand the financial statements, the more useful they are as a MAP to intelligent decision-making
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10. Why use financial statements?
Savvy use of financial statements
allows user to assess:
Financial position of the company
Success of its operations
Policies and strategies of management
Insight into future performance
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11. Questions one might ask:
What is the degree of risk inherent in the investment?
Would an investment generate attractive returns?
Should existing investing holdings be liquidated?
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12. More questions one might ask
Will cash flows be sufficient to service interest and principal payments on debt?
Does company provide a good opportunity for employment?
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13. More questions one might ask Con’t
How well does this company compete in its operating environment?
Is this firm a good prospect as a customer?
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14. Volume of Information The Annual Report Financial statements
Notes to the financial statements
The auditor’s report
Five-year summary of key financial data
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15. The Annual Report Continued
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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16. Financial Statements
Are prepared according to generally accepted accounting principles (GAAP)
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17. GAAP
Two authorities primarily responsible for establishing GAAP in the United States are the SEC and the FASB
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18. SEC Stands for Securities and Exchange Commission
Regulates US companies that issue securities to the public
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19. SEC Continued Requires Regular filing of annual reports (10-K)
Quarterly reports (10-Q); and
Other reports dependent upon particular circumstances
Change in auditor
Bankruptcy
Other important events
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20. SEC Continued
Has Congressional authority to set accounting policies, but usually delegates accounting rule-making to the FASB
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21. FASB Stands for Financial Accounting Standards Board
Comprised of 7 full-time paid members
Issues Statements of Financial Accounting Standards (SFAS) and Interpretations
Lengthy deliberation process
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22. The FASB Deliberation Process
1. Introduction of topic or project on the FASB agenda
2. Research and analysis of the problem
3. Issuance of a discussion memorandum
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23. The FASB Deliberation Process Con’t.
4. Public hearings
5. Board analysis and evaluation
6. Issuance of an exposure draft
7. Period of public comment
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24. The FASB Deliberation Process Con’t.
8. Review of public response, revision
9. Issuance of SFAS
10. Amendments and Interpretations, as needed
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25. The SEC and FASB
Have worked closely together in the development of account policy
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26. The SEC and FASB Continued
Recent history of corporate failures and accounting scandals have focused attention and criticism on regulatory authorities
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27. Where to Find a Company’s Financial Statements:
Form 10-K
Annual report
Website
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28. The Four Basic Financial Statements
Balance Sheet
Income Statement or Earnings Statement
Statement of Shareholders’ Equity
Statement of Cash Flows
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29. Financial Statement Notes:
Are an INTEGRAL part of the statements
Provide summary of accounting policies
Present detail about particular accounts (e.g. inventory, investments, etc.)
Include other information (e.g. leasing arrangements, pending legal proceedings, income taxes, etc.)
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30. Financial Statement Notes: Continued
Contain some supplementary information required by SEC and FASB
Examples include:
Information on foreign currency translations for firms doing business in/with foreign countries
Information by segment for firms with several lines of business
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31. Auditor’s Report Unqualified Qualified Adverse opinion
Scope limitation
Disclaimer of opinion
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32. Auditor’s Report Continued
Unqualified (what you want!)-- statements present information in conformity with GAAP
Qualified (not what you want)—are reports other than an unqualified opinion
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33. Auditor’s Report Continued
Adverse opinion states that the financial statements have not been presented fairly in accordance with GAAP
Scope limitation means that the extent of the audit work has been limited
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34. Auditor’s Report Continued
Disclaimer of opinion:
Keep in mind that auditor is hired by the firm being audited--always the possibility of conflict of interest
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35. Management Discussion and Analysis (MD&A)
Sometimes labeled “Financial Review”
Contains information that cannot be found in the financial data
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36. (MD&A) Continued 1. Internal/external sources of liquidity
2. Any material deficiencies in liquidity and how they will be remedied
3. Commitments for capital expenditures/sources of funding
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37. (MD&A) Continued
4. Anticipated changes in mix and cost of financing resources
5. Unusual/infrequent transactions which affect income from continuing operations
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38. (MD&A) Continued
6. Events causing material changes in cost/revenue relationships (e.g. future price increase)
7. Breakdown of sales increases in price & volume components
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39. (MD&A) Continued
Alas, there are problems as well with the usefulness of the MD&A section
Companies do a good job of describing historical events but. . .
Very few provide accurate forecasts
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40. (MD&A) Continued
More helpful has been the addition to the MD&A of explanations about why changes have occurred in profitability and liquidity
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41. Five-Year Summary of Selected Financial Data and Market Data
Required by SEC
Offers a quick look at some overall trends
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42. Five-Year Summary Continued
Includes:
Net sales or operating revenues
Income or loss from continuing operations
Income or loss from continuing operations per common share
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43. Five-Year Summary Continued
Total assets
Long-term obligations and redeemable preferred stock
Cash dividends per common share
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44. Pandora (A.K.A. “PR Fluff”)
Getting what is needed can be a challenge
Colored photographs
Charts
Shareholders’ letter from the CEO
Website
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45. Used to solicit shareholder votes
Proxy Statement
Used to solicit shareholder votes
Required by the SEC
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46. Proxy Statement Continued
Contains
Voting procedures and information
Background information about the company’s nominated directors
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47. Proxy Statement Continued
Director compensation
Executive compensation
Any proposed changes in compensation plans
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48. Proxy Statement Continued
Audit committee report
Breakdown of audit and nonaudit fees paid to the auditing firm
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49. Missing and Hard-to-Find Information
Not available in the financial statements:
Employee relations with management
Morale/efficiency of employees
Reputation/public perceptions of firm
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50. Missing and Hard-to-Find Information Continued
Effectiveness of management team/provisions for succession
Potential exposure to regulatory changes
IMPACT OPERATING SUCCESS BUT ARE DIFFICULT TO QUANTIFY
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51. Missing and Hard-to-Find Information Continued
Publicity in the Media
Affects public perception of firm and can impact financial performance
Proven correlation between financial returns and reputation
A recent example of adverse publicity is Bridgestone/Firestone for denying and covering up the deaths allegedly caused by their tires
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52. Missing and Hard-to-Find Information Continued
Facts are available, but may be difficult for an average user to find
Many items must be extracted from notes, supplementary schedules, MD&A section in order to interpret financial statement numbers--the facts are there, but they are not self-evident!
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53. Complexities A Global Marketplace
International Accounting Standards Committee (IASC) formed in 1973 with goal of determining international GAAP
US presently has not accepted the current international accounting standards
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54. Complexities continued
Mythical Mountain
GAAP provide some measure but they allow considerable discretion
Accounting choices and estimates affect amounts on financial statements
Depreciation of fixed assets is a good example (choice of method, different “good faith” estimates possible)
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55. Complexities continued
Other Discretionary Issues
Although the firm’s life is continuous, financial data is presented for arbitrary time periods--year, quarter and the like
Leads to need for more adjustments and estimates
Statements are prepared on “accrual” basis
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56. More Complications Goodwill and Other Intangible Assets
Consolidation of parent and subsidiaries
Reporting leases
Reporting pensions
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57. More Complications Continued
Translation of foreign operations
Off-balance sheet financing
Accounting for derivatives
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58. More Complications Continued
“Comprehensive” income reporting
Two sets of books (yes, it’s legal!!) - financial vs. tax reporting
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59. Quality of Financial Reporting
Management has considerable discretion within GAAP
Potential exists to “manipulate” the profit/loss reported
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60. Quality of Financial Reporting Continued
Ideally, financial statements should:
Reflect an accurate picture of a company’s financial condition and performance
Information should be useful both to assess the past and predict the future
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61. Quality of Financial Reporting Continued
The sharper and clearer the picture presented through the financial data and the closer that picture is to financial reality. . .
The higher is the quality of the financial statements and reported earnings
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62. Quality of Financial Reporting Continued
Examples of opportunities for
management to affect the quality
of financial statements
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63. Quality of Financial Reporting Continued
Accounting Policies, Estimates—Choices and Changes
Timing of Revenue and Expense Recognition
Discretionary Items
Nonrecurring and Nonoperating Items
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64. Accounting Policies, Estimates—Choices and Changes
Management makes choices with respect to accounting policies
Management makes estimations in the applications of those policies
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65. Accounting Policies, Estimates—Choices and Changes Continued
Policy or estimate may be changed
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66. Timing of Revenue and Expense Recognition
The Matching Principle:
Expenses are matched with the generation of revenues in order to determine net income for an accounting period
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67. Timing of Revenue and Expense Recognition Continued
Matching process involves management judgments regarding the timing of expense and revenue recognition
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68. Timing of Revenue and Expense Recognition Continued
Usually the more conservative the approach (least favorable to management) the higher the quality of earnings
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69. Discretionary Items Budget level and timing of expenditures
for many items are discretionary, e.g.
Advertising/marketing
Repairs/maintenance
Research and development
Capital expansion
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70. Nonrecurring and Nonoperating Items
Are not part of normal ongoing business
Earnings figure should reflect future operating potential
Should be reviewed and possibly eliminated from earnings
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71. Nonrecurring and Nonoperating Items Continued
Other transactions to consider
Write-downs for the impairment of assets
Accounting changes
Extraordinary items
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72. The Journey Through the Maze Continues
Ch. 2: The Balance Sheet
Ch. 3: The Income Statement and Statement of Stockholders’ Equity
Ch. 4: Statement of Cash Flows
Ch. 5: The Analysis of Financial Statements
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