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

2. Financial Statements An Overview
Map or
Maze
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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
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4. Map:
Helps 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. Our Objective:
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:
Would an investment generate attractive returns?
What is the degree of risk inherent in the investment?
Should existing investing holdings be liquidated?
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12. Questions one might ask (cont.)
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. Questions one might ask (cont.)
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. Volume of Information The Annual Report (cont.)
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
Prepared according to generally accepted accounting principles (GAAP)
Present financial information that is understandable by users AND
relevant and reliable for decision
making
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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 (cont.) Requires regular filing of Annual reports (10-K)
Quarterly reports (10-Q); and
Other reports dependent upon particular circumstances (filed as 8-K reports)
Change in auditor
Bankruptcy
Financial restatements
Other important events
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20. SEC (cont.)
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 (SFASs) 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
Issuance of a discussion
memorandum
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23. The FASB Deliberation Process (cont.)
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 (cont.)
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 accounting policy
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26. The SEC and FASB (cont.)
Recent history of corporate failures and accounting scandals have focused attention and criticism on regulatory authorities
The two organizations continue to examine potential rule changes or new rules in a variety of areas
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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 Stockholders’ Equity
Statement of Cash Flows
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29. Financial Statement Notes
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 (cont.)
Contain some supplementary information required by SEC and FASB
Examples include:
Information on foreign currency translations for firms operating in foreign countries
Information by segment for firms with several lines of business
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31. Auditor’s Report Unqualified Qualified Adverse opinion
Disclaimer of opinion
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32. Auditor’s Report (cont.)
Unqualified (what you want!)
Statements present information in conformity with GAAP
Qualified
Reports other than an unqualified opinion due to various circumstances
Typically use word “except for”
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33. Auditor’s Report (cont.)
Adverse opinion (not what you want!)
Financial statements have not been presented fairly in accordance with
GAAP
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34. Auditor’s Report (cont.)
Disclaimer of opinion is issued when
auditor can’t evaluate the fairness of the statements and expresses no opinion
there is material scope limitation of the audit
there is lack of independence by the auditor
remember, the auditor is hired by the firm being audited, so there is always the possibility of conflict of interest
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35. Auditor’s Report (cont.)
Unqualified opinion with explanatory language is warranted when there is
a consistency departure due to a change in accounting principle
uncertainty caused by future events such as contract disputes and lawsuits
an event (or events) that the auditor wishes to describe because they may present business risk and/or going-concern problems
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36. Sarbanes-Oxley Act of 2002
Passed by Congress in hopes of ending future accounting scandals
and renewing investor confidence in the marketplace
Act established the Public Company Accounting Oversight Board (PCAOB)
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37. Public Company Accounting Oversight Board (PCAOB)
Has authority to register, inspect, and discipline auditors of all publicly owned companies
Prohibits audit firms from providing certain non-audit services when conducting an external audit
Requires chief executive officer (CEO) and chief financial officer (CFO) of a publicly owned company to certify the accuracy of the financial statements
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38. Sarbanes-Oxley Act of 2002 Example of actual Section 404 compliance statement on internal controls from a 10K*
Management report on internal control over financial reporting
“….. Management assessed our internal control over financial reporting as of December 31, ….., the end of our fiscal year. Management based its assessment on criteria established in Internal Control —Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.….”
*Data from SEC website,
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39. Sarbanes-Oxley Act of 2002 Example of actual Section 404 compliance statement on internal controls from a 10K*
Management report on internal control over financial reporting (cont.)
“……Based on the material weaknesses described….., management has concluded that our internal control over financial reporting were not effective as of the end of the fiscal year. We reviewed the results of management’s assessment with the Audit Committee of our Board of Directors……”
*Data from SEC website,
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40. Management Discussion and Analysis (MD&A)
Sometimes labeled “Financial Review”
Contains information that cannot be found in the financial data
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41. MD&A (cont.) Includes discussion of:
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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42. MD&A (cont.)
4. Anticipated changes in mix and cost of financing resources
5. Unusual/infrequent transactions that affect income from continuing operations
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43. MD&A (cont.)
6. Events causing material changes in cost/revenue relationships (e.g. future price increase)
7. Breakdown of sales increases into price & volume components
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44. Very few provide accurate forecasts
MD&A (cont.)
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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45. MD&A (cont.)
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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46. 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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47. Five-Year Summary (cont.)
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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48. Five-Year Summary (cont.)
Total assets
Long-term obligations and redeemable preferred stock
Cash dividends per common share
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49. 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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50. Proxy Statement Used to solicit shareholder votes Required by the SEC
Important in assessing who manages the firm, how management is paid and potential conflict-of-interest issues
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51. Proxy Statement (cont.)
Contains
Voting procedures and information
Background information about the company’s nominated directors
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52. Proxy Statement (cont.)
Director compensation
Executive compensation
Any proposed changes in compensation plans
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53. Proxy Statement (cont.)
Audit committee report
Breakdown of audit and non-audit fees paid to the auditing firm
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54. 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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55. Missing and Hard-to-Find Information (cont.)
Effectiveness of management team/provisions for succession
Potential exposure to regulatory changes
QUALITIES THAT IMPACT OPERATING SUCCESS BUT ARE DIFFICULT TO QUANTIFY
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56. Missing and Hard-to-Find Information (cont.)
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 Enron for denying their involvement in any wrongdoing
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57. Missing and Hard-to-Find Information (cont.)
Facts are available, but may be difficult for an average user to find
Many items must be extracted from notes, supplementary schedules and the MD&A section in order to interpret financial statement numbers--the facts are there, but they are not self-evident!
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58. Complexities A global marketplace
International Accounting Standards Board (IASB) formed in 1973 with goal of establishing international
GAAP
US presently has not accepted the current international accounting standards
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59. Complexities: (cont.) Example of convergence of IASB and FASB accounting principles
Stock Options:
IASB – IFRS 2, Share-based Payment, addresses
the expensing of stock options and was
released 2/04*
FASB – SFAS 123(R), Share-based Payment,
addresses the expensing of stock options
and was released 12/04*
*Data from and
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60. Complexities (cont.) Mythical Mountain
GAAP provide some measure of uniformity 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 for asset life and
salvage value)
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61. Complexities (cont.) Other Discretionary Issues
Statements are prepared on “accrual” basis which involves considerable estimation and judgment to match expense and revenue to accounting periods
Although the firm’s life is continuous, financial data is presented for arbitrary time periods--year, quarter, month, etc.
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62. More Complications Goodwill and Other Intangible Assets
Consolidation of parent and subsidiaries
Accounting for leases and pensions
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63. More Complications (cont.)
Translation of foreign operations
Off-balance sheet financing
Accounting for derivatives
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64. More Complications (cont.)
“Comprehensive” income reporting
Two sets of books (yes, it’s legal!!) - financial vs. tax reporting
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65. Quality of Financial Reporting
Management has considerable discretion within GAAP
Potential exists to “manipulate” the profit/loss reported
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66. Quality of Financial Reporting (cont.)
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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67. Quality of Financial Reporting (cont.)
The sharper and clearer the picture presented through the financial data and the closer that picture is to financial reality. . .
The higher the quality of the financial statements and reported earnings
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68. Quality of Financial Reporting (cont.)
Examples of opportunities for
management to affect the quality
of financial statements
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69. Quality of Financial Reporting (cont.)
Accounting Policies, Estimates—Choices and Changes
Timing of Revenue and Expense Recognition
Discretionary Items
Nonrecurring and Nonoperating Items
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70. 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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71. Accounting Policies, Estimates—Choices and Changes (cont.)
Policy or estimate may be changed
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72. 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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73. Timing of Revenue and Expense Recognition (cont.)
Matching process involves judgments by management regarding the timing of expense and revenue recognition
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74. Timing of Revenue and Expense Recognition (cont.)
Generally, the more conservative the approach (least favorable to the firm) the higher the quality of earnings
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75. 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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76. Nonrecurring and Nonoperating Items
Are not part of normal ongoing business
Should be reviewed and possibly eliminated from earnings
Earnings figure should reflect future operating potential
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77. Nonrecurring and Nonoperating Items (cont.)
Transactions include
Gains and losses on the sale of an asset or business segment
Write-downs for the impairment of assets
Accounting changes
Extraordinary items
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78. 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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