Chapter 3 Financial Statements

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Chapter 3 Outline3.1 Accounting

Principles• Generally accepted

accounting principles• Auditors• Accounting conventions• Measuring costs and value• Recognition principles• Managing financial

statements• The effect of recent

accounting scandals

3.2 Financial Statements

• The balance sheet• The income statement• The statement of cash

flows

3.3 The Tax System

• Interest and dividends received

• Depreciation• Capital gains• Tax rates

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Accounting is simply an organized method of summarizing all of a company’s transactions and presenting them in such a way that external users can understand the company’s affairs.

Clearly, problems arise when the company tries to present its accounting statements in a way that does not fairly represent its situation, either to creditors, like the bank, or to the common shareholders.

Consequently, external users of the company’s financial statements must become skilled in analyzing the statements and spotting signs that things may not be quite as management presents them.

3.1 Accounting principles

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Generally Accepted Accounting Principles It is important to realize that management prepares the

company’s financial statements, not the company’s auditors. Auditors, such as Deloitte & Touche LLP (Deloitte), attest to

whether or not the financial statements fairly represent the company’s financial position according to generally accepted accounting principles (GAAP).

Companies reporting in the U.S. follow the principles promulgated by the Financial Accounting Standards Board (FASB), whereas members of the European Economic Community, and other countries, follow the principles promulgated by the International Accounting Standards Board (IASB).

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Independent auditorsIndependent auditors review the financial statements prepared by a company’s management and provide a report, addressed to the company’s board of directors and shareholders, that generally consists of the following:1. A statement that the financial statements are the

responsibility of the company, and that the auditor is providing an opinion on the financial statements, not the accounting records themselves.

2. A description of the scope of the audit, and that it was conducted according to generally accepted auditing standards,

3. The auditor’s opinion, which is one of four types.

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Auditor’s opinionAn auditor’s opinion is one of four types:

Unqualified opinion - the auditor finds that the financial statements are presented fairly in accordance with generally accepted accounting principles.

Qualified opinion - the auditor finds that the financial statements are presented fairly in accordance with generally accepted accounting principles except for a matter of qualification.

Adverse opinion - the auditor concludes that the financial statements are not presented fairly according to GAAP.

Disclaimer of opinion - the auditor’s examination is severely restricted or the auditor finds some condition is present that prevents the application of generally accepted auditing standards.

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The purpose of financial statements is to provide information, at least annually, to a wide range of external users, including investors, employees, lenders, governments, and the general public.

The underlying assumptions in the financial statements are that transactions are recorded on the accrual basis, and that the entity is a going concern, and hence will continue indefinitely.

Accounting conventions: basic principles

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Financial statements should possess the qualitative characteristics of understandability, relevancy, reliability, and comparability. The relevancy of financial statements includes

consideration of the materiality of the information, the reliability of the information and related estimates, and prudence.

Accounting conventions: basic principles

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Business entities measure and report monetary amounts for the various elements in its financial statements.

The basis for measuring costs differs among accounts, and may differ among entities for the same accounts.

Measuring costs and value

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Historical cost

• What it cost the entity when it purchased the asset or took on the obligation.

Current cost • What it would cost to replace the asset or settle the liability.

Net realizable value

• What the company would reasonably get for the asset if it had to dispose of it in an orderly sale, or the settlement value for a liability.

Present value• The sum of the discounted expected future

cash flows arising from the asset or expected to be paid in the case of a liability.

Fair value• The amount reasonably expected to be

received for an asset or settled in the case of a liability, between knowledgeable, willing parties to the transaction.

Measuring costs and value

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Type When Recognized Example

Asset Likely that the future economic benefit will flow to the entity and that the value can be measured reliably

Purchase of equipment

Liability

Likely that the outflow of resources will result and that the amount of the obligation can be measured reliably

Borrowing by issuing a debt obligation

Income Increase in future economic benefit from an increase in an asset or a decrease in a liability can be measured reliably

Sale of goods or services, or waiver of a debt obligation

Expense

Decrease in future economic benefit from a decrease in an asset or an increase in a liability

Depreciation of equipment or accrual of wages to employees

Recognition principles

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Net income appears in the income statement;

Other comprehensive income is the adjustment to net income.

Net income v. comprehensive income

Net incomeOther

comprehensive income

Comprehensive income

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Common stock at par+ Additional paid in capital

+ Preferred stock

+ Other comprehensive income

- Treasury stockShareholders’ equity

Shareholders’ equity

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Accounting principles offer some flexibility because it is simply not possible to design a one-size-fits-all set of principles. For example:

Mark-to-market - writing the value of an asset up or down, depending on its current market value

Available-for-sale - method of accounting for marketable securities in which unrealized gains or losses are reported as part of accumulated other comprehensive income

Trading securities - method of accounting for marketable securities that occurs when unrealized gains or losses are reported in net income

Held-to-maturity - method of accounting used when marketable debt securities are reported at cost

Managing financial statements

Enron’s History Enron was born in 1985 from the merger of Houston

Natural Gas and InterNorth. Enron incurred massive debt and no longer had

exclusive rights to its pipelines. Needed new and innovative business strategy Kenneth Lay, CEO, hired McKinsey & Company to

assist in developing business strategy. They assigned a Jeffrey Skilling to Enron. His background was in banking and asset and liability

management. His recommendation: that Enron create a “Gas Bank”—to

buy and sell gas

Enron’s History (cont’d)

Created Energy derivative. Lay created a new division in 1990 called Enron Finance Corp. and hired Skilling to run it

Enron soon had more contracts than any of its competitors and, with market dominance, could predict future prices with great accuracy, thereby guaranteeing superior profits. Fastow was a Kellogg MBA hired by Skilling in 1990—Became CFO in

1998 Started Enron Online Trading in late 90s

Created Performance Review Committee (PRC) that became known as the harshest employee ranking system in the country---based on earnings generated, creating fierce internal competition

The Motivation Enron delivered smoothly growing earnings (but not cash flows.)

Wall Street took Enron on its word but didn’t understand its financial statements.

It was all about the price of the stock. Enron was a trading company and Wall Street normally doesn’t reward volatile earnings of trading companies. (Goldman Sacks is a trading company. Its stock price was 20 times earnings while Enron’s was 70 times earnings.)

Enron reported 20 straight quarters of increasing income in its last 5 years.

Enron, that had once made its money from hard assets like pipelines, generated more than 80% of its earnings “wholesale energy operations and services.”

The Role of Stock Options Enron (and many other companies) avoided hundreds of

millions of dollars in taxes by its use of stock options. Corporate executives received large quantities of stock

options. When they exercised these options, the company claimed compensation expense on their tax returns.

Accounting rules let them omit that same expense from the earnings statement. The options only needed to be disclosed in a footnote.

Options allowed them to pay less taxes and report higher earnings while, at the same time, motivating them to manipulate earnings and stock price.

Enron’s Corporate Strategy Enron’s core business was losing money—shifted its focus from

bricks-and-mortar energy business to trading of derivatives (most derivatives profits were more imagined than real with many employees lying and misstating systematically their profits and losses in order to make their trading businesses appear less volatile than they were)

Enron’s top management gave its managers a blank order to “just do it”

Deals in unrelated areas such as weather derivatives, water services, metals trading, broadband supply and power plant were all justified.

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Confuse, confuse, confuse

Source: Bob Jenson, Trinity University

Aggressive nature of Enron Because Enron believed it was leading a revolution, it

pushed the rules. Competition was fierce among Enron traders, to the

extent that they were afraid to go to the bathroom and leave their computer screen unattended and available for perusal by other traders.

Enron’s use of special purpose entities (SPEs)

To: hide bad investments and poor-performing assets manage earnings—Blockbuster Video deal--$111 million

gain execute related-party transactions at desired prices report over $1 billion of false income hide debt manipulate cash flows, especially in 4th quarters book income just in time and in amounts needed, to

meet investor expectations

2001 - Notable EventsDate EventJuly 2001 Enron blamed for California’s energy

crisisAugust 14 Jeff Skilling left Enron; no reason givenMid-August Stock price fallingOctober 12 Discloses $638 billion loss in third quarterOctober 16 Former CEO returned (Kenneth Lay)November 8 Informed investors of restatement of

almost 5 years of earningsNovember 9 Dynergy offers buyout of EnronNovember 28 Dynergy cancels buyout agreementDecember 2 Filed bankruptcy

Enron’s revenues and incomeFiscal year

Net income

Operating cash flow Revenues

1987 -$29 $184 $5,9161988 $109 $82 $5,7081989 $226 $194 $9,8361990 $202 $1,107 $13,1651991 $242 $791 $5,5631992 $306 $293 $6,3251993 $333 $468 $7,9721994 $453 $504 $8,9841995 $520 -$15 $9,1891996 $584 $1,040 $13,2891997 $105 $501 $20,2731998 $703 $1,640 $31,2601999 $893 $1,228 $40,1122000 $979 $4,779 $100,789

1987

1989

1991

1993

1995

1997

1999

-$20,000

$0

$20,000

$40,000

$60,000

$80,000

$100,000

$120,000

Enron’s cash flow and revenues

Operating cash flowRevenues

Source of data: Standard & Poor’s Compustat

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Enron’s stock price

Jan-85Dec-

85Nov

-86Oct-

87Se

p-88Aug

-89Jul

-90Jun

-91

May-92Apr-

93Mar-

94Fe

b-95Jan

-96Dec-

96Nov

-97Oct-

98Se

p-99Aug

-00Jul

-01$0

$10$20$30$40$50$60$70$80$90

$100

Month

Shar

e pr

ice

Blackout period for retirement sales: October 19 – November 13, 2001

Source of data: Center for Research in Security Prices

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NAME POSITION AT ENRON SHARES SOLD GROSS PROCEEDS PRICE PER

SHARENorman Blake Member of Board of Directors 21,200 $1,705,328 $80.44 Steve Kean Executive Vice President, Chief of Staff 64,932 $5,166,414 $79.57 Cindy Olson Executive Vice President 83,183 $6,505,870 $78.21 Michael McConnell Executive Vice President 32,960 $2,506,311 $76.04 Rick Buy Chief Risk Officer 140,234 $10,656,595 $75.99 Ken Harrison Member of Board of Directors 1,011,436 $75,416,636 $74.56 Joe Hirko CEO, Enron Communications 473,837 $35,168,721 $74.22 Mark Koenig Executive Vice President 129,153 $9,110,466 $70.54 Jeff McMahon Treasurer 39,630 $2,739,226 $69.12 Lou Pai CEO, Enron Energy Services 3,912,205 $270,276,065 $69.09 Rick Causey Chief Accounting Officer 208,940 $13,386,896 $64.07 Robert Jaedicke Member of Board of Directors 13,360 $841,438 $62.98 Ken Rice CEO, Enron Broadband Services 1,234,009 $76,825,145 $62.26 Joe Sutton Vice-Chairman 688,996 $42,231,283 $61.29 John Duncan Member of Board of Directors 35,000 $2,009,700 $57.42 Stan Horton CEO, Enron Transportation 830,444 $47,371,361 $57.04 J. Clifford Baxter Vice-Chairman 619,898 $34,734,854 $56.03 Mark Frevert Chief Executive Office, Enron Europe 986,898 $54,831,220 $55.56 James Derrick General Counsel 230,660 $12,563,928 $54.47 Robert Belfer Member of Board of Directors 2,065,137 $111,941,200 $54.21 Jeffrey Skilling Chief Executive Officer, Enron Corp. 1,307,678 $70,687,199 $54.06 Andy Fastow Chief Financial Officer 687,445 $33,675,004 $48.99

Executives and board members got out of the stock (1999 – mid-2001)

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As a consequence of accounting scandals, particularly that of Enron, the U.S. Congress passed the Sarbanes-Oxley Act (SOX) in 2002. The main provisions are as follows:

The establishment of a Public Company Accounting Oversight Board to register and inspect public accounting firms and establish audit standards.

The separation of audit functions from other services, such as consulting, provided by the big accounting firms, with the auditors rotating every 5 years so that they do not get too close to the companies they are auditing.

The effect of recent accounting scandals

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The implementation of much stricter governance standards, including internal controls

Auditors report to the company’s audit committee, which is to be composed of independent members of the board of directors with the power to engage independent consultants.

SOX, continued

Up next … Financial statements

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The independent accountants attest that:A. There is no fraud.B. Statements are prepared according to

GAAP.C. They are independent.

Question 1

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Which opinion is best?A. AdverseB. QualifiedC. Unqualified

Question 2