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Understanding Financial Statements EIGHTH EDITION. Lyn M. Fraser Aileen Ormiston. Financial Statements An Overview. Map. or. Maze. Financial Statements An Overview. Map. or. Maze. Auditor’s Report. MD&A. Notes. Statement of Cash Flows. Income Statement.

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Understanding Financial Statements EIGHTH EDITION

Lyn M. Fraser

Aileen Ormiston


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Financial StatementsAn Overview

Map

or

Maze

(C) 2007 Prentice Hall, Inc.


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Financial StatementsAn Overview

Map

or

Maze

Auditor’s Report

MD&A

Notes

Statement of Cash Flows

Income Statement

Statement of Shareholders’ Equity

Balance Sheet

(C) 2007 Prentice Hall, Inc.


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Map:

Helps its user reach a desired destination through clarity of representation

(C) 2007 Prentice Hall, Inc.


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Maze:

Attempts to confuse its user by purposefully introducing conflicting elements and complexities that prevent reaching the desired goal

On the other hand. . .

(C) 2007 Prentice Hall, Inc.


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Map or Maze

Financial statements are potentially

both MAP and MAZE

(C) 2007 Prentice Hall, Inc.


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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

(C) 2007 Prentice Hall, Inc.


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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

(C) 2007 Prentice Hall, Inc.


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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

(C) 2007 Prentice Hall, Inc.


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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

(C) 2007 Prentice Hall, Inc.


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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?

(C) 2007 Prentice Hall, Inc.


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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?

(C) 2007 Prentice Hall, Inc.


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Questions one might ask (cont.)

  • How well does this company compete in its operating environment?

  • Is this firm a good prospect as a customer?

(C) 2007 Prentice Hall, Inc.


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Volume of Information:The Annual Report

Financial statements

Notes to the financial statements

The auditor’s report

Five-year summary of key financial data

(C) 2007 Prentice Hall, Inc.


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Volume of InformationThe Annual Report (cont.)

High and low stock prices

Management’s discussion and analysis of operations

Material included at the imagination

and discretion of management

(C) 2007 Prentice Hall, Inc.


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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

(C) 2007 Prentice Hall, Inc.


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GAAP

Two authorities primarily responsible for establishing GAAP in the United States are the SEC and the FASB

(C) 2007 Prentice Hall, Inc.


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SEC

Securities and Exchange Commission

Regulates US companies that issue securities to the public

Stands for

(C) 2007 Prentice Hall, Inc.


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SEC (cont.)

  • 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

Requires regular filing of

(C) 2007 Prentice Hall, Inc.


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SEC (cont.)

Has Congressional authority to set accounting policies, but usually delegates accounting rule-making to the FASB

(C) 2007 Prentice Hall, Inc.


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FASB

  • Financial Accounting Standards Board

  • Comprised of 7 full-time paid members

  • Issues Statements of Financial Accounting Standards (SFASs) and Interpretations

  • Lengthy deliberation process

Stands for

(C) 2007 Prentice Hall, Inc.


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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

(C) 2007 Prentice Hall, Inc.


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The FASB Deliberation Process(cont.)

4. Public hearings

5. Board analysis and evaluation

6. Issuance of an exposure draft

7. Period of public comment

(C) 2007 Prentice Hall, Inc.


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The FASB Deliberation Process (cont.)

8. Review of public response, revision

9. Issuance of SFAS

10. Amendments and Interpretations, as needed

(C) 2007 Prentice Hall, Inc.


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The SEC and FASB

Have worked closely together in the development of accounting policy

(C) 2007 Prentice Hall, Inc.


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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

(C) 2007 Prentice Hall, Inc.


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Where to Find a Company’s Financial Statements:

  • Form 10-K

  • Annual report

  • Website

(C) 2007 Prentice Hall, Inc.


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The Four Basic Financial Statements

  • Balance Sheet

  • Income Statement or Earnings Statement

  • Statement of Stockholders’ Equity

  • Statement of Cash Flows

(C) 2007 Prentice Hall, Inc.


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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.)

(C) 2007 Prentice Hall, Inc.


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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

(C) 2007 Prentice Hall, Inc.


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Auditor’s Report

Unqualified

Qualified

Adverse opinion

Disclaimer of opinion

(C) 2007 Prentice Hall, Inc.


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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”

(C) 2007 Prentice Hall, Inc.


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Auditor’s Report (cont.)

  • Adverse opinion (not what you want!)

    • Financial statements have not been presented fairly in accordance with

      GAAP

(C) 2007 Prentice Hall, Inc.


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Auditor’s Report (cont.)

  • Disclaimer of opinion isissued 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

(C) 2007 Prentice Hall, Inc.


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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 wishesto describe because they maypresent business risk and/or going-concernproblems

(C) 2007 Prentice Hall, Inc.


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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)

(C) 2007 Prentice Hall, Inc.


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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

(C) 2007 Prentice Hall, Inc.


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Sarbanes-Oxley Act of 2002Example 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, www.sec.gov

(C) 2007 Prentice Hall, Inc.


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Sarbanes-Oxley Act of 2002Example 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, www.sec.gov

(C) 2007 Prentice Hall, Inc.


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Management Discussion and Analysis (MD&A)

  • Sometimes labeled “Financial Review”

  • Contains information that cannot be found in the financial data

(C) 2007 Prentice Hall, Inc.


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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

(C) 2007 Prentice Hall, Inc.


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MD&A (cont.)

4. Anticipated changes in mix and cost of financing resources

5. Unusual/infrequent transactions that affect income from continuing operations

(C) 2007 Prentice Hall, Inc.


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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

(C) 2007 Prentice Hall, Inc.


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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

(C) 2007 Prentice Hall, Inc.


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MD&A (cont.)

More helpful has been the addition to the MD&A of explanations about why changes have occurred in profitability and liquidity

(C) 2007 Prentice Hall, Inc.


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Five-Year Summary of Selected Financial Data and Market Data

  • Required by SEC

  • Offers a quick look at some overall trends

(C) 2007 Prentice Hall, Inc.


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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

(C) 2007 Prentice Hall, Inc.


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Five-Year Summary (cont.)

  • Total assets

  • Long-term obligations and redeemable preferred stock

  • Cash dividends per common share

(C) 2007 Prentice Hall, Inc.


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Pandora (A.K.A. “PR Fluff”)

Colored photographs

Charts

Shareholders’ letter from the CEO

Website

Getting what is needed can be a challenge

(C) 2007 Prentice Hall, Inc.


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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

(C) 2007 Prentice Hall, Inc.


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Proxy Statement (cont.)

  • Voting procedures and information

  • Background information about the company’s nominated directors

Contains

(C) 2007 Prentice Hall, Inc.


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Proxy Statement (cont.)

  • Director compensation

  • Executive compensation

  • Any proposed changes in compensation plans

(C) 2007 Prentice Hall, Inc.


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Proxy Statement (cont.)

  • Audit committee report

  • Breakdown of audit and non-audit fees paid to the auditing firm

(C) 2007 Prentice Hall, Inc.


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Missing and Hard-to-Find Information

  • Employee relations with management

  • Morale/efficiency of employees

  • Reputation/public perceptions of firm

Not available in the financial statements:

(C) 2007 Prentice Hall, Inc.


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Missing andHard-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

(C) 2007 Prentice Hall, Inc.


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Missing and Hard-to-Find Information (cont.)

  • 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

Publicity in the Media

(C) 2007 Prentice Hall, Inc.


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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!

(C) 2007 Prentice Hall, Inc.


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Complexities

International Accounting Standards Board (IASB) formed in 1973 with goal of establishing international

GAAP

US presently has not accepted the current international accounting standards

A global marketplace

(C) 2007 Prentice Hall, Inc.


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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 www.iasb.org and www.fasb.org

(C) 2007 Prentice Hall, Inc.


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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)

(C) 2007 Prentice Hall, Inc.


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Complexities (cont.)

  • 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.

Other Discretionary Issues

(C) 2007 Prentice Hall, Inc.


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More Complications

  • Goodwill and Other Intangible Assets

  • Consolidation of parent and subsidiaries

  • Accounting for leases and pensions

(C) 2007 Prentice Hall, Inc.


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More Complications (cont.)

  • Translation of foreign operations

  • Off-balance sheet financing

  • Accounting for derivatives

(C) 2007 Prentice Hall, Inc.


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More Complications (cont.)

  • “Comprehensive” income reporting

  • Two sets of books (yes, it’s legal!!) - financial vs. tax reporting

(C) 2007 Prentice Hall, Inc.


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Quality of Financial Reporting

Management has considerable discretion within GAAP

Potential exists to “manipulate” the profit/loss reported

(C) 2007 Prentice Hall, Inc.


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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

(C) 2007 Prentice Hall, Inc.


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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

(C) 2007 Prentice Hall, Inc.


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Quality of Financial Reporting(cont.)

Examples of opportunities for

management to affect the quality

of financial statements. . . .

(C) 2007 Prentice Hall, Inc.


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Quality of Financial Reporting(cont.)

  • Accounting Policies, Estimates—Choices and Changes

  • Timing of Revenue and Expense Recognition

  • Discretionary Items

  • Nonrecurring and Nonoperating Items

(C) 2007 Prentice Hall, Inc.


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Accounting Policies, Estimates—Choices and Changes

Choices

Management makes choices with respect to accounting policies

Management makes estimations in the applications of those policies

(C) 2007 Prentice Hall, Inc.


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Accounting Policies, Estimates—Choices and Changes (cont.)

Changes

Policy or estimate may be changed

(C) 2007 Prentice Hall, Inc.


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Timing of Revenue and Expense Recognition

Expenses are matched with the generation of revenues in order to determine net income for an accounting period

The Matching Principle:

(C) 2007 Prentice Hall, Inc.


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Timing of Revenue and Expense Recognition (cont.)

Matching process involves judgments by management regarding the timing of expense and revenue recognition

(C) 2007 Prentice Hall, Inc.


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Timing of Revenue and Expense Recognition (cont.)

Generally, the more conservative the approach (least favorable to the firm) the higher the quality of earnings

(C) 2007 Prentice Hall, Inc.


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Discretionary Items

Advertising/marketing

Repairs/maintenance

Research and development

Capital expansion

Budget level and timing of expenditures

for many items are discretionary, e.g.

(C) 2007 Prentice Hall, Inc.


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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

(C) 2007 Prentice Hall, Inc.


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Nonrecurring and Nonoperating Items (cont.)

  • Gains and losses on the sale of an asset or business segment

  • Write-downs for the impairment of assets

  • Accounting changes

  • Extraordinary items

Transactions include

(C) 2007 Prentice Hall, Inc.


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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

(C) 2007 Prentice Hall, Inc.


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