Understanding Financial Statements Seventh EDITION

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

2. Financial StatementsAn Overview Map or Maze Chapter 1 (C) 2004 Prentice Hall, Inc.

3. Financial StatementsAn Overview Map or Maze Auditor’s Report MD&A Notes Statement of Cash Flows Income Statement Statement of Shareholders’ Equity Balance Sheet Chapter 1 (C) 2004 Prentice Hall, Inc.

4. Map: To help its user reach a desired destination through clarity of representation (C) 2004 Prentice Hall, Inc.

5. Maze: Attempts to confuse its user by purposefully introducing conflicting elements and complexities that prevent reaching the desired goal On the other hand. . . (C) 2004 Prentice Hall, Inc.

6. Map or Maze Financial statements are potentially both MAP and MAZE (C) 2004 Prentice Hall, Inc.

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 (C) 2004 Prentice Hall, Inc.

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 (C) 2004 Prentice Hall, Inc.

9. 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 (C) 2004 Prentice Hall, Inc.

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 (C) 2004 Prentice Hall, Inc.

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? (C) 2004 Prentice Hall, Inc.

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? (C) 2004 Prentice Hall, Inc.

13. More questions one might askCon’t • How well does this company compete in its operating environment? • Is this firm a good prospect as a customer? (C) 2004 Prentice Hall, Inc.

14. Volume of Information Financial statements Notes to the financial statements The auditor’s report Five-year summary of key financial data The Annual Report (C) 2004 Prentice Hall, Inc.

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 (C) 2004 Prentice Hall, Inc.

16. Financial Statements Are prepared according to generally accepted accounting principles (GAAP) (C) 2004 Prentice Hall, Inc.

17. GAAP Two authorities primarily responsible for establishing GAAP in the United States are the SEC and the FASB (C) 2004 Prentice Hall, Inc.

18. SEC Securities and Exchange Commission Regulates US companies that issue securities to the public Stands for (C) 2004 Prentice Hall, Inc.

19. SEC Continued • 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 Requires (C) 2004 Prentice Hall, Inc.

20. SEC Continued Has Congressional authority to set accounting policies, but usually delegates accounting rule-making to the FASB (C) 2004 Prentice Hall, Inc.

21. FASB • Financial Accounting Standards Board • Comprised of 7 full-time paid members • Issues Statements of Financial Accounting Standards (SFAS) and Interpretations • Lengthy deliberation process Stands for (C) 2004 Prentice Hall, Inc.

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 (C) 2004 Prentice Hall, Inc.

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 (C) 2004 Prentice Hall, Inc.

24. The FASB Deliberation Process Con’t. 8. Review of public response, revision 9. Issuance of SFAS 10. Amendments and Interpretations, as needed (C) 2004 Prentice Hall, Inc.

25. The SEC and FASB Have worked closely together in the development of account policy (C) 2004 Prentice Hall, Inc.

26. The SEC and FASB Continued Recent history of corporate failures and accounting scandals have focused attention and criticism on regulatory authorities (C) 2004 Prentice Hall, Inc.

27. Where to Find a Company’s Financial Statements: • Form 10-K • Annual report • Website (C) 2004 Prentice Hall, Inc.

28. The Four Basic Financial Statements • Balance Sheet • Income Statement or Earnings Statement • Statement of Shareholders’ Equity • Statement of Cash Flows (C) 2004 Prentice Hall, Inc.

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.) (C) 2004 Prentice Hall, Inc.

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 (C) 2004 Prentice Hall, Inc.

31. Auditor’s Report Unqualified Qualified Adverse opinion Scope limitation Disclaimer of opinion (C) 2004 Prentice Hall, Inc.

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 (C) 2004 Prentice Hall, Inc.

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 (C) 2004 Prentice Hall, Inc.

34. Auditor’s Report Continued Keep in mind that auditor is hired by the firm being audited--always the possibility of conflict of interest Disclaimer of opinion: (C) 2004 Prentice Hall, Inc.

35. Management Discussion and Analysis (MD&A) • Sometimes labeled “Financial Review” • Contains information that cannot be found in the financial data (C) 2004 Prentice Hall, Inc.

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 (C) 2004 Prentice Hall, Inc.

37. (MD&A) Continued 4. Anticipated changes in mix and cost of financing resources 5. Unusual/infrequent transactions which affect income from continuing operations (C) 2004 Prentice Hall, Inc.

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 (C) 2004 Prentice Hall, Inc.

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 (C) 2004 Prentice Hall, Inc.

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 (C) 2004 Prentice Hall, Inc.

41. Five-Year Summary of Selected Financial Data and Market Data • Required by SEC • Offers a quick look at some overall trends (C) 2004 Prentice Hall, Inc.

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 (C) 2004 Prentice Hall, Inc.

43. Five-Year Summary Continued • Total assets • Long-term obligations and redeemable preferred stock • Cash dividends per common share (C) 2004 Prentice Hall, Inc.

44. Pandora (A.K.A. “PR Fluff”) Colored photographs Charts Shareholders’ letter from the CEO Website Getting what is needed can be a challenge (C) 2004 Prentice Hall, Inc.

45. Proxy Statement Used to solicit shareholder votes Required by the SEC (C) 2004 Prentice Hall, Inc.

46. Proxy Statement Continued • Voting procedures and information • Background information about the company’s nominated directors Contains (C) 2004 Prentice Hall, Inc.

47. Proxy Statement Continued • Director compensation • Executive compensation • Any proposed changes in compensation plans (C) 2004 Prentice Hall, Inc.

48. Proxy Statement Continued • Audit committee report • Breakdown of audit and nonaudit fees paid to the auditing firm (C) 2004 Prentice Hall, Inc.

49. 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) 2004 Prentice Hall, Inc.

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 (C) 2004 Prentice Hall, Inc.