1. Communicating and Interpreting Accounting Information
Chapter 5: Communicating and interpreting accounting information.
Chapter 5
McGraw-Hill/Irwin
© 2009 The McGraw-Hill Companies, Inc.

2. Players in the Accounting Communication Process
This graphic identifies the people involved in the accounting communication process. They include regulators, managers, directors, auditors, information intermediaries, and users. Each person or group plays a unique role in the process and is guided by legal and professional standards.

3. Players in the Accounting Communication Process
Management
Preparation
CEO, CFO, Accounting Staff
Guided by GAAP
Independent Auditors
Verification
Partners, Managers, Staff
Guided by GAAS
We will begin this chapter by looking at the players in the accounting communication process.
Management is responsible for the preparation of financial statements. The chief executive officer and chief financial officer bear ultimate responsibility for the content of the financial statements. They are guided by members of the accounting staff who followed generally accepted accounting principles. Independent auditors verify the fairness of presentation of the financial statements in accordance with generally accepted accounting standards. Independent auditors are guided by generally accepted auditing standards.
An unqualified opinion states that the financial statements are fair presentations in all material respects in conformity with GAAP.

4. Players in the Accounting Communication Process
Management
Preparation
CEO, CFO, Accounting Staff
Guided by GAAP
Independent Auditors
Verification
Partners, Managers, Staff
Guided by GAAS
Information Intermediaries
Analysis and Advice
Financial analysis, Information services
Information intermediaries such as financial analysts make predictions concerning the company’s future earnings and stock prices as a result of past financial information.
Financial analysts make predictions concerning companies’ future earnings and stock prices.

5. Players in the Accounting Communication Process
Management
Preparation
CEO, CFO, Accounting Staff
Guided by GAAP
Independent Auditors
Verification
Partners, Managers, Staff
Guided by GAAS
Information Intermediaries
Analysis and Advice
Financial analysis, Information services
Here are some web sites that contain extensive financial information about publicly listed companies.
Web Info Services:

6. Guiding Principles for Communicating Useful Information
Primary Objective of External Financial Reporting
To provide economic information to external users for decision making.
Primary Qualitative Characteristics
Relevance: Timely and Predictive Feedback Value
Reliability: Accurate, Unbiased, and Verifiable
The primary objective of external financial reporting is to provide economic information to external users that will assist them in the decision-making process. The primary qualitative characteristics of useful information include relevance and reliability. The secondary qualitative characteristics of useful information include comparability and consistency.
Secondary Qualitative Characteristics
Comparability: Across businesses
Consistency: Over time

7. Guiding Principles for Communicating Useful Information
Primary Objective of External Financial Reporting
To provide economic information to external users for decision making.
The full-disclosure principle requires . . .
A complete set of financial statements,
and
Notes to the financial statements
Primary Qualitative Characteristics
Relevance: Timely and Predictive and Feedback Value
Reliability: Accurate, Unbiased, and Verifiable
To meet the full disclosure principle, companies are required to publish a complete set of financial statements and all of the relevant notes to those financial statements.
Secondary Qualitative Characteristics
Comparability: Across businesses
Consistency: Over time

8. Notes to Financial Statements
Descriptions of the key accounting rules that apply to the company’s statements.
Additional detail supporting reported numbers.
The notes to financial statements provide the reader with descriptions of key accounting rules applied to the company’s financial statements. Detailed supporting schedules are used to report additional information to the reader, and information that is relevant to the reader but is not included in the financial statements may be disclosed in the notes to the financial statements.
Relevant financial information not disclosed on the statements.

9. Annual Reports
For privately held companies, annual reports are simple documents that include:
Four basic financial statements.
Related notes (footnotes).
Report of independent accountants (auditor’s opinion) if the statements are audited.
Privately held companies whose reports are not distributed to the general public are required to issue the four basic financial statements, related notes to financial statements, and if the statements are audited, the auditor’s report. The annual reports of public companies are significantly more elaborate, both because of additional SEC reporting requirements and because many companies use their annual reports as public relations tools.

10. Annual Reports
For public companies, annual reports are elaborate due to SEC reporting requirements:
Nonfinancial Section
Includes a letter to the stockholders, a description of management’s philosophy, products, successes, etc.
Financial Section
SEC sets minimum disclosure standards for the financial section for public companies.
Due to elaborate reporting requirements of the Securities and Exchange Commission, publicly held companies issue an annual report that can be divided into two major sections. The first section deals with nonfinancial matters and the second section deals with the financials. The nonfinancial section contains a letter to the stockholders, usually from the CEO, a description of management’s philosophy, products produced and sold, and any major successes or failures the company has experienced in the past year. Beautiful photographs of products, facilities, and personnel are often included. The financial section includes the core of the report. The SEC sets minimum disclosure standards for the financial section of the annual report for public companies.

11. Annual Reports to Shareholders
Summarized financial data for 5- or 10-years.
Management Discussion and Analysis (MD&A).
The four basic financial statements.
Notes (footnotes).
Independent Accountant’s Report and the Management Certification.
Recent stock price information.
Summaries of the unaudited quarterly financial data.
Lists of directors and officers of the company and relevant addresses.
Here is a list of the major categories of information that you will find in the typical annual report of a publicly held company. Towards the end of the report there is a summary of financial data for five or ten years. Management is required to communicate to the reader certain financial and nonfinancial information. This is referred to as management discussion and analysis. All annual reports contain the four basic financial statements and related notes to those financial statements, and the report of the independent accountant, and the management certification. In addition, many annual reports contain information about the recent stock price for each quarter of the year. Also, we may find summaries of unaudited quarterly financial information, a listing of the company’s directors and officers, and relevant addresses and telephone numbers for contacting the company.

12. Quarterly Reports to Shareholders
Usually begin with short letter to stockholders
Condensed unaudited income statement and balance sheet for the quarter.
Often, cash flow statement and statement of stockholders’ equity are omitted. Some notes to the financial statements also may be omitted.
Publicly held companies usually produce quarterly reports. The typical quarterly report frequently begins with a short letter to the stockholders from either the CEO or the CFO. The quarterly report contains a condensed unaudited income statement and balance sheet for the quarter. In some quarterly reports, we can expect to find a statement of cash flows and the statement of stockholders’ equity, but these are often omitted. Additionally, some notes to the financial statements may be omitted.

13. SEC Reports – 10-K, 10-Q, 8-K Form 10-K Annual Report
Due within 90 days of the fiscal year-end.
Contains audited financial statements.
Form 10-Q Quarterly Report
Due within 45 days of the end of the quarter.
Financial statements can be unaudited.
Companies are required to prepare reports for the Securities and Exchange Commission.
One of the most common reports is known as form 10-K, or the annual report. The form is due within 90 days of the end of the company’s fiscal year and it must contain audited financial statements.
The form 10-Q is a quarterly report. It is due within 45 days of the end of each quarter and contains financial statements that are usually unaudited.
Form 8-K is a current events report. It is due within 15 days of the occurrence of a major reportable event. Any financial statements that are included in the form can be unaudited.
Form 8-K Current Report
Due within 4 days of the major event date.

14. Classified Balance Sheet
Assets used of turned into
cash within one year.
Assets used of turned into
cash beyond one year.
Here is the consolidated balance sheet of Callaway Golf Company for the years ended December 31, 2008 and Notice that the assets are divided among current assets, property plant and equipment, net of accumulated depreciation, intangible assets, net of amortization, and other assets. The total assets at December 31, 2008 are $855,338. Remember that all values on the balance sheet are reported in thousands of dollars. So the actual total assets for Callaway Golf Company at December 31, 2008 are $855,338,000.
Liabilities are divided into those that will be settled within one years, the current liabilities, and those that will be settled beyond one year, long-term liabilities. Notice the line for Commitments and contingencies (Note 15) that shows no dollar amount. We wish to call the reader’s attention to the fact that there may be significant commitments and contingencies that exist but cannot be reported on the balance sheet. Rather, these items are disclosed in the notes to the financial statements.
Shareholders’ equity is divided into contributed capital from stockholders and earnings reinvested in the business, retained earnings.
Current assets are those assets that will be converted into cash or expire, that is, be used up, within the longer of one year or the company’s normal operating cycle. Remember, we discussed the company’s operating cycle earlier.
Property, plant and equipment includes assets with useful lives of more than one year that will be used by the business to generate revenue. The amount is always reported net of accumulated depreciation.
Intangible assets have no physical existence and usually have a long useful life, therefore they present difficult accounting problems. Intangible assets include items such as patents, copyrights, trademarks, goodwill and franchises. Intangible assets are reported net of related amortization.
Obligations paid of
settled within one year.
Obligations paid of
settled after one year.
Contributed capital.
Reinvested earnings.

15. Classified Income Statement
Income Statements are prepared using the following basic structure.
Income statements have two major sections. The first presents the income statement as we have in prior chapters. The second presents net income on a per share basis or earnings per share.
Cost of goods sold is subtracted from net sales to arrive at gross profit. Cost of goods sold represents the inventory items that have been sold to customers.
One of the most important income measures that we will encounter is the income from operations. Financial analysts and others who exam our financial statements closely examine income from operations. It is a measure of how much profit or loss we incurred as a result of the normal operations of our business. Nonoperating revenues and expenses or gains and losses are not integral parts of the operations of our business, and are therefore separated out from income from operations.

16. Consolidated Income Statement
Operating activities – the focus of the business.
Callaway Golf reports the subtotal Gross Profit (gross margin) which is the difference between net sales and cost of goods sold. Another subtotal— Income from Operations (also called operating income)—is computed by subtracting operating expenses from gross profit.
Nonoperating (other) Items are income, expenses, gains, and losses that do not relate to the company’s primary operations. Examples include interest income, interest expense, and gains and losses on the sale of fixed assets and investments. These nonoperating items are added to or subtracted from income from operations to obtain Income before Income Taxes, also called Pretax Earnings.
Net Income ÷ Average Number of Shares Outstanding

17. Nonrecurring Items
In addition, companies may have nonrecurring items. These nonrecurring items may include:
1. Discontinued operations 2. Extraordinary items
These items are reported separately because they are not useful in predicting future income of the company.
Chapter Supplement: Nonrecurring Items
Recall our basic classified income statement format. If the company had incurred nonrecurring items such as discontinued operations or an extraordinary item, they would be reported (net of tax) after the other income and expense category and provision for income taxes. These two items are not likely to occur on a regular basis, and are therefore reported separately.

18. Discontinued Operations
Sale or abandonment of a segment of a business.
Income or loss on segment’s operation for the period.
Gain or loss on
disposal of the
segment.
Discontinued operations result from the sale or abandonment of a segment of our business operations. We divide discontinued operations into two categories. The first is the income or loss of the segment reported during the period. The second category is the gain or loss on disposal of the segment’s assets and liabilities. Each of these two categories are reported net of applicable taxes.
Show net of applicable taxes.

19. Show net of applicable taxes.
Extraordinary Items
Unusual
Infrequent
Extraordinary items are gains or losses that are considered both unusual in nature and infrequent in occurrence. Examples include losses suffered from natural disasters such as floods and hurricanes in geographic areas where such disasters are rare. These items must be reported separately on the income statement net of income tax effects. Separate reporting again informs decision makers that these items are not likely to recur, and so are not predictive of the company’s future. Note disclosure is needed to explain the nature of the extraordinary item. Companies report such items very rarely.
Show net of applicable taxes.

20. Reporting Extraordinary Items and Discontinued Operations
Here is an example where Verizon Communications, Inc. reported both income from discontinued operations and a loss from an extraordinary item for the year ended December 31, There are very few companies that report both of these items in a single year. Most extraordinary gains result from mergers and acquisitions.

21. Return on Assets (ROA) Analysis=
Net Income*
Average Total Assets1
ROA measures how much the firm earned for each dollar of investment.
In its broadest measure, return on assets is calculated by dividing net income by average total assets. Remember that average total assets is the beginning asset balance plus the ending asset balance divided by two.
ROA measures how much the firm earned for each dollar of investment. It is the broadest measure of profitability and management effectiveness, independent of financing strategy. Firms with higher ROA are doing a better job of selecting and managing investments, all other things equal. Since it is independent of the source of financing (debt vs. equity), it can be used to evaluate performance at any level within the organization. It is often computed on a division-by-division or product line basis and used to evaluate division or product line managers’ relative performance.
Like all ratios, the key to interpreting change is to dig deeper to understand the reason for each change. Inspection of the income statement reveals that the only reason for the increase in ROA between 2007 and 2008 was an increase in “Other income” from investing activities which cannot be repeated in future periods. Unless consumer discretionary spending increases, it will be very difficult for Callaway to continue to improve its ROA.
*(In complex calculations, interest expense (net of tax) and minority interest are added back to net income.
1(beginning total assets + ending total assets) ÷ 2

22. ROA Profit Driver Analysis
Net Profit Margin
Asset Turnover = ×
Net Income
Average Total Assets
Net Sales × =
1. Net profit margin is Net Income divided by Net Sales. It measures how much of every sales dollar is profit. It can be increased by
a. Increasing sales volume.
b. Increasing sales price.
c. Decreasing cost of goods sold and operating expenses.
2. Asset turnover is Net Sales divided by Average Total Assets. It measures how many sales dollars the company generates with each dollar of assets. It can be increased by
a. Collecting accounts receivable more quickly.
b. Centralizing distribution to reduce inventory kept on hand.
c. Consolidating production facilities in fewer factories to reduce the amount of assets necessary to generate each dollar of sales.

23. End of Chapter 5
End of chapter 5.