Chapter 14Chapter 14

Understanding Financial Understanding Financial StatementsStatements

McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved.

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Information in Annual Reports Information in Annual Reports

Primary financial statements: Balance Sheet, Primary financial statements: Balance Sheet, Income Statement, Statement of Cash Flows.Income Statement, Statement of Cash Flows.

Auditor’s opinion.Auditor’s opinion. Notes to financial statements.Notes to financial statements. Management discussion and analysis.Management discussion and analysis. Operating segment info.Operating segment info. Comparative data.Comparative data. Optional info on products, personnel, facilities….Optional info on products, personnel, facilities….

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AuditorsAuditors

Certified public accountants.Certified public accountants.

Meet prescribed professional standards.Meet prescribed professional standards.

Licensed by state.Licensed by state.

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Auditors’ OpinionAuditors’ Opinion

Results of auditors examination.Results of auditors examination.

Relates to financial statements and notes, Relates to financial statements and notes, not other parts of annual report.not other parts of annual report.

Format of auditors’ report determined by Format of auditors’ report determined by American Institute of Certified Public American Institute of Certified Public Accountants (AICPA).Accountants (AICPA).

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Responsibility of AuditorsResponsibility of Auditors

Express opinion on fairness of financial Express opinion on fairness of financial statements.statements.

Provide reasonable assurance that financial Provide reasonable assurance that financial statements do not contain any material statements do not contain any material misstatements.misstatements.

Select and perform audit procedures such as: Select and perform audit procedures such as: Test checks of accounting system, verify existence of Test checks of accounting system, verify existence of

assets, confirm accounts receivable with customers.assets, confirm accounts receivable with customers. Management, not auditors, primarily responsible Management, not auditors, primarily responsible

for financial statement.for financial statement.

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Types of OpinionsTypes of Opinions

Clean opinion: Financial statements materially Clean opinion: Financial statements materially conform with GAAP.conform with GAAP.

Qualified opinions because of:Qualified opinions because of: Lack of consistency.Lack of consistency. Existence of a major uncertainty.Existence of a major uncertainty. Doubt as to the entity’s ability to continue as a going Doubt as to the entity’s ability to continue as a going

concern.concern.

Disclaimer: Unable to express an opinion.Disclaimer: Unable to express an opinion. Adverse opinion: Material departure from GAAP.Adverse opinion: Material departure from GAAP.

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Notes to Financial StatementsNotes to Financial Statements

Integral part of financial statements.Integral part of financial statements. First note summarizes accounting policies.First note summarizes accounting policies.

Basis of consolidation, depreciation and Basis of consolidation, depreciation and inventory methods,….inventory methods,….

Other notes:Other notes: Details of long-term debt.Details of long-term debt. Composition of inventory.Composition of inventory. Reconciliation of book to federal tax rate.Reconciliation of book to federal tax rate. Details of deferred taxes.Details of deferred taxes.

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Segment ReportingSegment Reporting

Required by GAAP.Required by GAAP. Supplements overall financial statements.Supplements overall financial statements. Operating segment: components of Operating segment: components of

corporation that are evaluated separately.corporation that are evaluated separately. Info required by segment:Info required by segment:

Revenues.Revenues. Operating profit.Operating profit. Interest expense.Interest expense. Identifiable assets.Identifiable assets.

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Full DisclosureFull Disclosure

Fundamental principle of financial statements.Fundamental principle of financial statements. What constitutes full disclosure:What constitutes full disclosure:

Economic info that would cause informed investors to Economic info that would cause informed investors to appraise company differently.appraise company differently.

Includes info that comes to light after fiscal year-Includes info that comes to light after fiscal year-end.end. E.g., plant fire after year-end.E.g., plant fire after year-end.

Differences of opinion on what should be Differences of opinion on what should be disclosed.disclosed.

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Comparative StatementsComparative Statements

Required in addition to current year’s:Required in addition to current year’s: Previous year’s balance sheet.Previous year’s balance sheet. Previous two years’ income and cash flow Previous two years’ income and cash flow

statements.statements. Most companies include summaries of Most companies include summaries of

important financial info for past five or ten important financial info for past five or ten years.years. Only restated for specified changes in Only restated for specified changes in

accounting principles.accounting principles.

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Management’s Discussion and Management’s Discussion and AnalysisAnalysis

Discussion of:Discussion of: Operating results.Operating results. Liquidity.Liquidity. Solvency.Solvency. Important events.Important events.

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Securities and Exchange Securities and Exchange Commission (SEC) ReportsCommission (SEC) Reports

Form 10-K: financial data consistent with but Form 10-K: financial data consistent with but more detailed annual report.more detailed annual report. SEC Regulation S-X governs preparation.SEC Regulation S-X governs preparation.

• Generally consistent with FASB standards.Generally consistent with FASB standards.

Financial data required to be included in notice Financial data required to be included in notice of annual meeting to stockholders:of annual meeting to stockholders: Top executive compensation, common stock holdings Top executive compensation, common stock holdings

of top executives,….of top executives,…. Form 10-Q: quarterly interim statements.Form 10-Q: quarterly interim statements. Form 8-K: significant events such as earnings Form 8-K: significant events such as earnings

announcements, major investment,….announcements, major investment,….

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Review: Basic Accounting CriteriaReview: Basic Accounting Criteria

Relevant: Useful for investor decision Relevant: Useful for investor decision making.making.

Objective: UnbiasedObjective: Unbiased

Feasible: Its value should exceed cost of Feasible: Its value should exceed cost of providing it.providing it.

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Tradeoff: Relevance vs. Objectivity Tradeoff: Relevance vs. Objectivity and Feasibilityand Feasibility

Property, plant and equipment at current Property, plant and equipment at current or historical cost.or historical cost.

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Concepts 1 of 5Concepts 1 of 5

Money Measurement: Accounting records Money Measurement: Accounting records only records facts that can be expressed only records facts that can be expressed in monetary terms.in monetary terms.

Entity: Accounts are kept for entities, not Entity: Accounts are kept for entities, not persons who are associated with those persons who are associated with those entities.entities.

Going concern: An entity will continue Going concern: An entity will continue indefinitely and is not about to be indefinitely and is not about to be liquidated.liquidated.

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Concepts 2 of 5Concepts 2 of 5

Cost: An asset is generally recorded at the Cost: An asset is generally recorded at the amount paid to acquire it, and this cost amount paid to acquire it, and this cost rather than current market value is the rather than current market value is the basis for subsequent accounting.basis for subsequent accounting. Exceptions: Impaired value, monetary assets Exceptions: Impaired value, monetary assets

at fair value.at fair value. Dual aspect: Total amount of assets = Dual aspect: Total amount of assets =

total amount of liabilities plus owners’ total amount of liabilities plus owners’ equity.equity. Debits = credits.Debits = credits.

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Concepts 3 of 5Concepts 3 of 5

Accounting period: Accounting measures Accounting period: Accounting measures activity for a specified interval of time, activity for a specified interval of time, usually one year.usually one year.

Conservatism: Revenues are recognized Conservatism: Revenues are recognized when when reasonably certainreasonably certain, expenses are , expenses are recognized as soon as they are recognized as soon as they are reasonably possiblereasonably possible..

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Concepts 4 of 5Concepts 4 of 5

Realization: The amount recognized as revenue Realization: The amount recognized as revenue is the amount reasonably certain to be realized, is the amount reasonably certain to be realized, that is, paid by customers.that is, paid by customers.

Matching: When a given event affects both Matching: When a given event affects both revenues and expenses, the effect on each is revenues and expenses, the effect on each is recognized in the same accounting period.recognized in the same accounting period. Direct matching (cost of goods sold).Direct matching (cost of goods sold). Costs associated with the period itself (rent).Costs associated with the period itself (rent). Costs not associated with future revenue (asset Costs not associated with future revenue (asset

impairment).impairment).

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Concepts 5 of 5Concepts 5 of 5

Consistency: Once an accounting method Consistency: Once an accounting method is selected, the same method should be is selected, the same method should be used for all subsequent events of the used for all subsequent events of the same character unless there is a sound same character unless there is a sound reason to change.reason to change.

Materiality: Insignificant events may be Materiality: Insignificant events may be disregarded, full disclosure of all important disregarded, full disclosure of all important info.info.

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MisconceptionsMisconceptions

Cost concept: accounting reports Cost concept: accounting reports nonmonetary assets at cost not at their fair nonmonetary assets at cost not at their fair value or worth.value or worth.

Going concern concept: productive assets Going concern concept: productive assets are held for their future use therefore their are held for their future use therefore their current value is of limited importance.current value is of limited importance.

Matching concept: expenses occur when Matching concept: expenses occur when costs expire not when expenditures are costs expire not when expenditures are made.made.

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Accounting AlternativesAccounting Alternatives

Requirements of regulatory agencies in Requirements of regulatory agencies in certain industries.certain industries.

Choices within GAAP.Choices within GAAP.

Judgments and estimates throughout Judgments and estimates throughout accounting.accounting.

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Income Tax PrinciplesIncome Tax Principles

Basically similar to GAAP with important Basically similar to GAAP with important exceptions:exceptions: Depreciation expense.Depreciation expense. Depletion allowance.Depletion allowance. Ordinary income vs. capital gains.Ordinary income vs. capital gains. Cash based tax accounting.Cash based tax accounting.

Primarily changes timing of recognition not Primarily changes timing of recognition not amount.amount.

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Basis of Choice of Accounting Basis of Choice of Accounting MethodMethod

Maximize earnings (and stock price?).Maximize earnings (and stock price?). Conform to others in industry.Conform to others in industry. Loan agreements and bond indentures.Loan agreements and bond indentures. Managers’ bonuses.Managers’ bonuses. Belief that conservatism raises investor Belief that conservatism raises investor

confidence.confidence.

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Efficient Market Hypothesis (EMH)Efficient Market Hypothesis (EMH)

All information that is publicly known is All information that is publicly known is priced into share prices.priced into share prices.

Implies a change in a company’s Implies a change in a company’s accounting methods has no effect on price accounting methods has no effect on price of its stock.of its stock.

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SignalingSignaling

Accounting choices signal management’s Accounting choices signal management’s view of the future.view of the future.

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Implications of Accounting DiversityImplications of Accounting Diversity

Complexity of businesses.Complexity of businesses.

Overcome somewhat by:Overcome somewhat by: Consistency from year to year.Consistency from year to year. Required disclosure of changes in accounting Required disclosure of changes in accounting

principle.principle. Same methods tend to be used within an Same methods tend to be used within an

industry.industry.

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Inherent LimitationsInherent Limitations

Accounting reports are necessarily:Accounting reports are necessarily: Monetary.Monetary. Influenced by estimates of future events.Influenced by estimates of future events.

• Life of assets.Life of assets.• Collectibility of receivables.Collectibility of receivables.• Sales and pricing of inventory.Sales and pricing of inventory.• Wage agreements.Wage agreements.• Resolution of litigation.Resolution of litigation.

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Ethical ProblemsEthical Problems

Foreign Corrupt Practices Act: bribing Foreign Corrupt Practices Act: bribing government officials.government officials.

Booking revenues early.Booking revenues early. ““Big bath” phenomenon:Big bath” phenomenon:

Writing off substantial amounts in year new Writing off substantial amounts in year new management takes over.management takes over.

Consequences of challenging positions Consequences of challenging positions and judgments of top management.and judgments of top management.

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Meaning of Income StatementMeaning of Income Statement

Dominant financial statement.Dominant financial statement.

Measures changes in retained earnings Measures changes in retained earnings during period (except for dividends and during period (except for dividends and correction of errors).correction of errors).

Judgments influence recording of Judgments influence recording of revenues and expenses.revenues and expenses.

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CapitalizationCapitalization

Challenge to distinguish among capital Challenge to distinguish among capital costs, product costs, and expenses.costs, product costs, and expenses.

Judgment influences accounting.Judgment influences accounting.

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Meaning of Balance SheetMeaning of Balance Sheet

Collection of several types of items reported Collection of several types of items reported according to different concepts.according to different concepts.

Monetary items usually definite and at fair value.Monetary items usually definite and at fair value. Unexpired costs: original cost allocated over life.Unexpired costs: original cost allocated over life. Inventories: lower of cost or market.Inventories: lower of cost or market. Investments: accounted for according to type.Investments: accounted for according to type. Paid-in capital: amount from issuance of stock.Paid-in capital: amount from issuance of stock. Retained earnings: earnings not paid out in Retained earnings: earnings not paid out in

dividends.dividends.