1. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing UNDERSTANDING FINANCIAL STATEMENTS AN OVERVIEW Chapter 1

2. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing 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

3. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing 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

4. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing Conclusion Financial statements are potentially both MAP and MAZE The better one can read and understand the financial statements, the more useful they are as a MAP to intelligent decision-making

5. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing 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 Financial statements are “ancient history,” BUT they can help project the future

6. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing 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? Is this firm a good prospect as a customer?

7. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing 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? How well does this company compete in its operating environment?

8. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing Financial Statement Analysis Can help find answers Can help wade through large quantities of information in the firm’s annual report

9. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing The Annual Report includes: financial statements notes to the financial statements auditor’s report 5-year summary of key financial data high and low stock selling prices management discussion & analysis of operations (“forward-looking” info)

10. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing Basic Financial Statements Balance Sheet Income Statement (Earnings Statement) Statement of Shareholders’ Equity (or Statement of Retained Earnings which is often incorporated as part of the Income Statement) Statement of Cash Flows

11. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing 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.)

12. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing Notes (more stuff included) 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

13. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing Auditor’s Report Unqualified (what you want!) -- states that statements present information in conformity with GAAP Sometimes qualified or adverse opinions are issued (not what you want!) Keep in mind that auditor is hired by the firm -- always the possibility of conflict of interest

14. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing Other Required Information Five-year summary of selected financial data Market data (high and low stock sale prices) for past two years MD&A -- source of FORWARD- LOOKING INFORMATION

15. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing MD&A (Financial Review) 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 4.Anticipated changes in mix and cost of financing resources

16. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing MD&A (continued) 5.Unusual/infrequent transactions which affect income from continuing operations 6.Events causing material changes in cost/revenue relationships (e.g. future price increase) 7.Breakdown of sales increases in price & volume components

17. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing “PR Fluff” Amount sometimes varies INVERSELY with performance... Can visit many corporate websites to view some interesting “creations”

18. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing Are there any RULES? YES! Accounting rules have been issued in order to insure that financial information is relevant, reliable and understandable by users Who makes the rules for the United States ???

19. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing SEC Stands for Securities and Exchange Commission Regulates US companies that issue securities to the public Has Congressional authority to set accounting policies, but Usually delegates accounting rule- making to……………………………….

20. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing 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

21. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing As for the rest of the world…. International Accounting Standards Committee (IASC) formed in 1973 with goal of determining international GAAP Good idea but a SLOW process Caution: If you are going to invest in foreign companies, take time to research their accounting standards! Now, back to the United States…….

22. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing Do rules = uniformity? 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)

23. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing Accounting Period Another complexity 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

24. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing Cash versus “Accrual” Financial statements are prepared on an “accrual” basis Attempt to MATCH expenses with revenue in a given accounting period Revenues reported when “earned” not when received in cash Expenses are “matched” with revenues in the same accounting period

25. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing More Sources of “Confusion” Earnings per share Consolidation of parent and subs Reporting leases Reporting pensions Translation of foreign operations Off-balance sheet financing Accounting for derivatives (continued…….)

26. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing Even MORE Confusion... “Comprehensive” income reporting Two sets of books (yes, it’s legal!!) - financial vs. tax reporting

27. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing Quality of Financial Reporting Management has considerable discretion within GAAP Potential exists to “manipulate” the profit/loss reported The closer the financial data presented represent financial reality, the higher the quality of the financial statements and reported earnings

28. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing Means to Affect Quality Accounting policies and estimates –choices and changes Timing of revenues and expenses Discretionary items Nonrecurring and nonoperating items ALL ARE WITHIN THE PURVIEW OF MANAGEMENT

29. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing Accounting Policies/Estimates Choices –Management may choose among acceptable accounting policies –Management has opportunity to make estimates when applying policies Changes –Policy or estimate may be changed

30. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing Timing of Revenues/Expenses Matching process involves judgments by management regarding recognition of revenues and/or expenses Usually the more conservative the approach (least favorable to management) the higher the quality of earnings

31. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing Discretionary Items Budget level and timing of expenditures for many items are discretionary, e.g. –advertising/marketing –repairs/maintenance –research and development –capital expansion

32. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing Nonrecurring and Nonoperating Items Nonrecurring and nonoperating items are not part of normal ongoing business Earnings figure should reflect future operating potential Therefore segregate such things as major asset sales, accounting changes, asset impairments, extraordinary items

33. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing What about Inflation??? Historical cost principle prevails in financial reporting Impact of inflation is uneven -- relevance vs. reliability tradeoff Produces both purchasing power gains and losses -- e.g. debt is good in inflationary situation

34. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing Missing Information Morale/efficiency of employees Reputation/public perceptions of firm Effectiveness of management team/provisions for succession Potential exposure to regulatory changes IMPACT OPERATING SUCCESS BUT ARE DIFFICULT TO QUANTIFY

35. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing What about publicity? Affects public perception of firm and can impact financial performance Proven correlation between financial returns and reputation Recent examples are adverse publicity for Coca Cola and Northwest Airlines -- countered by the respective companies to minimize impact

36. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing What Info is Hard 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! Coverage in Chapters 2-5 is geared to helping FIND and EFFECTIVELY USE information in financial statements and supplementary materials

37. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing MAP VS MAZE? The idea is that by the time readers finish this book, financial statements will be much more of a map than a maze...

38. Fraser/Ormiston: Understanding Financial Statements, 6th ed. (C) 2001 Prentice Hall Business Publishing Preview: Coming Attractions 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