Understanding Financial Statements EIGHTH EDITION

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

2. Financial StatementsAn Overview Map or Maze (C) 2007 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 (C) 2007 Prentice Hall, Inc.

4. Map: Helps its user reach a desired destination through clarity of representation (C) 2007 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) 2007 Prentice Hall, Inc.

6. Map or Maze Financial statements are potentially both MAP and MAZE (C) 2007 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) 2007 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) 2007 Prentice Hall, Inc.

9. 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.

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) 2007 Prentice Hall, Inc.

11. 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.

12. 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.

13. 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.

14. 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.

15. 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.

16. 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.

17. GAAP Two authorities primarily responsible for establishing GAAP in the United States are the SEC and the FASB (C) 2007 Prentice Hall, Inc.

18. SEC Securities and Exchange Commission Regulates US companies that issue securities to the public Stands for (C) 2007 Prentice Hall, Inc.

19. 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.

20. SEC (cont.) Has Congressional authority to set accounting policies, but usually delegates accounting rule-making to the FASB (C) 2007 Prentice Hall, Inc.

21. 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.

22. 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.

23. 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.

24. 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.

25. The SEC and FASB Have worked closely together in the development of accounting policy (C) 2007 Prentice Hall, Inc.

26. 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.

27. Where to Find a Company’s Financial Statements: • Form 10-K • Annual report • Website (C) 2007 Prentice Hall, Inc.

28. 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.

29. 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.

30. 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.

31. Auditor’s Report Unqualified Qualified Adverse opinion Disclaimer of opinion (C) 2007 Prentice Hall, Inc.

32. 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.

33. 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.

34. 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.

35. 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.

36. 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.

37. 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.

38. 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.

39. 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.

40. 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.

41. 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.

42. 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.

43. 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.

44. 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.

45. 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.

46. 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.

47. 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.

48. Five-Year Summary (cont.) • Total assets • Long-term obligations and redeemable preferred stock • Cash dividends per common share (C) 2007 Prentice Hall, Inc.

49. 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.

50. 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.