Framework For Financial Statement Analysis

1. Framework For Financial Statement Analysis 1 Chapter

2. Chapter Objectives • Explain why Financial Statement Analysis is needed. • Discuss the General Principles of the Financial reporting system • Review the elements of the FASB’s conceptual framework. • Briefly describe the principal financial statement: Balance Sheet, Income Statement, Statement of Comprehensive Income, Statement of Cash Flows & Statement of Stockholder’s Equity. • Discuss the usefulness of Financial Statement footnotes & supplementary data. • Describe the usefulness of the Management Discussion and Analysis & other sources of financial information.

3. Need For Financial Statement Analysis • In an ideal world, the user of financial statements could focus only on the bottom lines of financial reporting: net income and stockholders equity. • The financial reporting system is not perfect. Economic events & accounting entries do not correspond precisely; they diverge across the dimensions of timing, recognition & measurement. • Economic events and accounting recognition of those events frequently take place at different times. • Example- the recognition of capital gain and losses only upon sale in most cases. • Long - lived assets are written down, most of the time, in the Fiscal Period of management’s choice.

4. Need For Financial Statement Analysis, cont.. • Many Economic events do not receive accounting recognition at all. Some contracts such as leases and hedging activities. • Generally Accepted Accounting Principles (GAAP) permit economic events that do receive accounting recognition to be recognized in different ways by different financial statement prepares. • Financial reports often contain supplementary data that, although not included in the statements themselves, help the financial statement users to interpret the statements or to adjust measures of corporate performance to make them more comparable. • Information from outside the financial reporting process can be used to make financial data more useful.

5. Classes of Users External users of financial information encompasses a wide range of interests but can be classified into three general groups: • Credit and equity investors; • Government (executive and legislative branches), regulatory bodies & tax authorities. • The general public and special interest groups, labor unions and consumer groups.

6. The Financial Reporting System The Accounting process or financial reporting system, which generates financial information for external users, encompasses five principal financial statements: • Balance sheet ( statement of financial position) • Income statement ( statement of earnings) • Statement of comprehensive income • Statement of cash flows • Statement of stockholders’ equity

7. General Principles & Measurement Rules Financial statement provide information about the assets (resources), liabilities (obligations), income & cash flows, and stockholders’ equity of the firm. The effects of transactions and other events are recorded in the appropriate financial statements. • The income statement reports revenues, expenses, and gains & losses. • The balance sheet shows assets, liabilities, & stockholders equity; the statement of stockholders’ equity reports capital transaction with owners. • The statement of comprehensive income reports changes in certain balance sheet accounts that bypass the income statement. • The statement of cash flows includes operating investing, and financial inflows and outflows. Many transactions are reflected in more than one statement so that the entire set is required to evaluate the firm.

8. Qualitative Characteristics of Accounting Information Relevance: Defined as “the capacity of information to make a difference in a decision ..” In practice, of course the relevance of information depends on the decision maker. Timeliness: Is an important aspect of relevance. Information loses value rapidly in the financial world. Market prices are predicted on estimates of the future; data on the past are helpful in making projections. But, if future becomes the present, past data become irrelevant.

9. Qualitative Characteristics of Accounting Information, cont.. Reliability: Encompasses verifiability, representational faithfulness and neutrality. The first two elements (verifiability & representational faithfulness) are concerned with whether financial data have been measured accurately and whether they are what they purport to be. Neutrality: Is Concerned with whether financial statement data are biased. The principle of neutrality states that the board should consider only the relevance and reliability of the data, not any possible economic impact.

10. Qualitative Characteristics of Accounting Information, cont.. Consistency & Comparability: Are also key Characteristics of accounting information from the analyst perspective. Consistency refers to use of the same accounting principles over time. A broader term, comparability, refers to comparison among companies. Materiality: Is paradoxically the most elusive accounting quality and arguably the most important. We define information to be material when it would make a difference in the valuation of the firm.

11. International Accounting Standards Growing international trade, multinational industrial and financial enterprises, and increasingly global capital markets have significantly expanded investment opportunities. Creditors and equity investors need to analyze both domestic and foreign companies. Yet differences in accounting and reporting standards make it difficult to compare domestic companies with those in other countries. Furthermore, as accounting standards are established separately in each country, it is difficult to generalize about those differences. International Accounting Standard Board: The IASB was established in 1973 to harmonize (conform) the accounting standards of different nations.

12. Principal Financial Statements The Balance Sheet The balance sheet reports major classes and amounts of assets (resources owned or controlled by the firm), liabilities (external claims on those assets), and stockholders’ equity (owners’ capital contributions and other internally generated sources of capital) and their interrelationships at specific points of time. Elements of Balance Sheet: Assets: Are defined in SFAC 6 as – Probable future economic benefits obtained or enrolled by a particular entity as a result of past transaction or events. (Para - 25)

13. Principal Financial Statements, cont.. Liabilities: Are defined, similarly, as – Probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets provide services to other entities in the future as a result of past transactions or events. (Para – 35) Owners’ equity: As required by the fundamental accounting equation, stockholders’ equity is therefore – The residual interest in the net assets of an entity that remains after deducting its liabilities. (Para – 49)

14. Principal Financial Statements, cont.. The Income Statement: The income statement (statement of earnings) reports on the performance of the firm. The result of its operating activities. It explains some but not all of the changes in the assets, liabilities, and the equity of the firm between two consecutive balance sheet dates. Use of the accrual concept means that income and the balance sheet are interrelated. Elements of the Income Statement: Revenues: Are defined in SFAC 6 as – Inflows of an entity from delivering or producing goods, rendering services, or other activities that constitute the entities’ ongoing major or central operations. (Para -78)

15. Principal Financial Statements, cont.. Expenses: Are defined as – Outflows from delivering or producing goods, rendering services, or carrying out other activities that constitute the entities’ ongoing major or central operations. (Para -80) These definitions explicitly exclude gains (and losses) defined as – Increases (decreases) in equity (net assets) from peripheral or incidental transactions…(Para – 82)

16. Principal Financial Statements, cont.. Statement of Cash Flows: The statement of cash flows reports cash receipts and payments in the period of their occurrence, classified as to operating, investing and financing activities. It also provides supplementary disclosures about noncash investing and financing activities. Defining investing cash flows as those resulting from: • Acquisition or sale of property, plant an equipment • Acquisition or sale of a subsidiary or segment • Purchase or sale of investments in other firms.

17. Principal Financial Statements, cont.. Similarly, financing cash flows are those resulting from: • Issuance or retirement of debt and equity securities • Dividends paid to stockholders Cash from operations – This key performance measure includes the cash effects of all transactions that do not meet the definition of investing or financing.

18. Principal Financial Statements, cont.. Statement of Stockholders’ Equity: This statement reports the amounts and sources of changes in equity from capital transactions with owners and may include the following components: • Preferred shares • common Shares (at par of stated value) • Additional paid-in capital • Retained earnings • Treasury Shares (repurchase equity) • Employee Stock Ownership Plan (ESOP) adjustments

19. Footnotes Footnotes provide information about the accounting method, assumptions, and estimates used by management to develop the data reported in the financial statements. They are designed to allow users to improve assessments of the amounts, timing, and uncertainty of the estimates reported in the financial statements. Footnotes provide additional disclosure related to such areas as: • Fixed assets • Inventories • Income taxes • Pension and other postemployment benefit plans • Debt (interest rates, maturity schedules, and contractual terms) • Lawsuits and other loss contingencies

20. Footnotes, cont.. • Marketable securities and other investments • Hedging and other risk management activities • Business segments • Significant customers, sales to related parties and export sales. • In some cases, additional information about the assets and liabilities of a firm is provided within the financial statement footnotes, or as supplementary data outside the financial statements. Example include: • Oil and gas companies provide additional data on their exploration activities, quantities and types of reserves and the present value of cash flows expected from those reserves. • Disclosure of sales revenue, operating income, and other data for major business segments and by geographic areas (chap. 13 & 15). Firms also provide information about export sales.

21. Other Sources of Financial Information Management Discussion and Analysis Companies with publicly traded securities have been required since 1968 to provide a discussion of earnings in the MD & A sections. The MD & A is required to discuss: • Results of operations, including discussion of trends in sales and categories of expense • Capital resources and liquidity, including discussion of cash flow trends • Outlook based on known trends.

22. Other Data Sources Companies that issue securities to the public are required to publish a registration statement including a prospectus. Proxy statements, issued in connection with shareholder meetings, contain information about board members and management, executive compensation, stock options, and major stockholders. Many companies prepare periodic “fact books” containing additional financial and operational data. Corporate press releases also provide new information on a timely basis. In addition, many companies hold periodic meetings or conference telephone calls to keep the financial community appraised of recent developments regarding the company.