Financial Statements I - Reynolds Week 2011


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Jimmy Gentry on 'Financial Statements I" at Reynolds Business Journalism Week, Feb. 4-7, 2011.

Reynolds Center for Business Journalism,, Arizona State University's Walter Cronkite School of Journalism.

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Financial Statements I - Reynolds Week 2011

  1. 1. Accounting I: Financial Statements <ul><ul><ul><ul><ul><li>Strictly Financials </li></ul></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>Jan. 5, 2011 </li></ul></ul></ul></ul></ul>
  2. 2. <ul><li>Donald W. Reynolds National Center </li></ul><ul><li>For Business Journalism </li></ul><ul><li>At Arizona State University </li></ul>Strictly Financials
  3. 3. <ul><li>James K. Gentry, Ph.D. </li></ul><ul><li>Clyde M. Reed Teaching Professor </li></ul><ul><li>School of Journalism and Mass Communications </li></ul><ul><li>University of Kansas </li></ul><ul><li>[email_address] </li></ul>Strictly Financials
  4. 4. Types of Companies <ul><li>Public </li></ul><ul><li>Private </li></ul><ul><ul><li>Financial statements conforming to public company statements </li></ul></ul><ul><li>Non-profits </li></ul>Strictly Financials
  5. 5. Important Terms <ul><li>Unaudited </li></ul><ul><li>Audited </li></ul><ul><li>Accountants </li></ul><ul><li>Certified Public Accountants (CPAs) </li></ul><ul><li>GAAP, FASB, AICPA, PCAOB </li></ul>Strictly Financials
  6. 6. Assessing a Company <ul><li>Context </li></ul><ul><li>Trends </li></ul><ul><li>Rules </li></ul><ul><li>Outsiders </li></ul><ul><li>Insiders </li></ul>Strictly Financials
  7. 7. Annual Report (or 10-K) <ul><li>Auditor’s report: Clean, qualified? </li></ul><ul><li>MD&A or Management’s Discussion and Analysis </li></ul><ul><li>Financial statements and footnotes </li></ul><ul><li>Management’s letter if annual report </li></ul>Strictly Financials
  8. 8. MD&A <ul><li>Must read it </li></ul><ul><li>Often a source of good information and insights </li></ul><ul><li>Densely written </li></ul><ul><li>Explains financial information </li></ul><ul><li>SEC says it wants greater transparency </li></ul>Strictly Financials
  9. 9. Auditor’s Report <ul><li>Independent auditor’s opinion on whether financial statements are presented fairly in all material respects, in accordance with GAAP: </li></ul><ul><ul><li>We looked at these statements </li></ul></ul><ul><ul><li>They’re management’s responsibility; we’re just here to express our opinion </li></ul></ul><ul><ul><li>We followed the rules in our audits and here’s what an audit involves </li></ul></ul><ul><ul><li>In our opinion, the statements fairly present the company’s position </li></ul></ul>Strictly Financials
  10. 10. Auditor’s Report by Category <ul><li>Clean or Unqualified </li></ul><ul><li>Qualified </li></ul><ul><li>Disclaimer </li></ul><ul><li>Adverse </li></ul>Strictly Financials
  11. 11. New Auditor’s Report <ul><li>Combines traditional report with “internal controls” requirement of Sarbanes-Oxley Act </li></ul>Strictly Financials
  12. 12. Goal of Accounting <ul><li>Record, classify and report financial transactions. To provide managers across the organization with information that facilitates: </li></ul><ul><ul><li>Control of activities and expenditure </li></ul></ul><ul><ul><li>Refinement of operational plans </li></ul></ul><ul><ul><li>Accountability </li></ul></ul><ul><ul><li>Reporting on project outcomes </li></ul></ul><ul><ul><li>Writing of bids for new funds </li></ul></ul>Strictly Financials
  13. 13. Goal of Finance <ul><li>Maximize shareholder wealth as reflected in market price of the stock </li></ul><ul><li>Achieving this goal requires financial manager to focus on economic profit, not accounting profit </li></ul>Strictly Financials
  14. 14. Financial Decisions <ul><li>Long-term investment decisions </li></ul><ul><ul><li>Capital budgeting </li></ul></ul><ul><li>Long-term financing decisions </li></ul><ul><ul><li>Capital structure </li></ul></ul><ul><li>Working capital management decisions </li></ul><ul><ul><li>Net working capital </li></ul></ul>Strictly Financials
  15. 15. Financial Decisions <ul><li>Investing decisions: Types of assets firm wants to hold. </li></ul><ul><li>Financing decisions: Acquisition of funds needed to support long-term investments. </li></ul>Strictly Financials
  16. 16. Generally Accepted Accounting Principles <ul><li>Guidelines based on theory and practice </li></ul><ul><li>Evolved over time </li></ul><ul><li>Procedures, concepts and standards </li></ul>Strictly Financials
  17. 17. GAAP: Assumptions <ul><li>Periodicity </li></ul><ul><li>Going concern </li></ul><ul><li>Economic entity </li></ul><ul><li>Monetary unit </li></ul>Strictly Financials
  18. 18. GAAP: Principles <ul><li>Full disclosure </li></ul><ul><li>Matching </li></ul><ul><li>Historical cost </li></ul><ul><li>Revenue realization </li></ul><ul><li>Consistency </li></ul>Strictly Financials
  19. 19. GAAP: Underlying Considerations <ul><li>Materiality </li></ul><ul><li>Industry practices </li></ul><ul><li>Conservatism </li></ul>Strictly Financials
  20. 20. Specialized Industry GAAP <ul><li>Banking and thrift industries </li></ul><ul><li>Benefit plans, including pension funds </li></ul><ul><li>Broadcasting industry </li></ul><ul><li>Cable television industry </li></ul><ul><li>Computer software </li></ul><ul><li>Finance companies </li></ul><ul><li>Investment companies </li></ul>Strictly Financials
  21. 21. Cash or Operating Cycle <ul><li>Cash </li></ul><ul><li>Purchase inventory </li></ul><ul><li>Produce product </li></ul><ul><li>Sell product </li></ul><ul><li>Cash </li></ul>Strictly Financials
  22. 22. Cash or Operating Cycle (cont.) <ul><li>“ Cash” </li></ul><ul><ul><li>Cash </li></ul></ul><ul><ul><li>Receivables </li></ul></ul><ul><ul><li>Debt </li></ul></ul><ul><li>Inventory </li></ul><ul><ul><li>Raw materials </li></ul></ul><ul><ul><li>Work in progress </li></ul></ul><ul><ul><li>Finished goods </li></ul></ul>Strictly Financials
  23. 23. Cash or Operating Cycle (cont.) <ul><li>Sell product </li></ul><ul><ul><li>Accounts receivable </li></ul></ul><ul><ul><li>Cash </li></ul></ul><ul><li>Cash </li></ul><ul><ul><li>Collect receivables as cash </li></ul></ul><ul><li>Pay off payables </li></ul><ul><li>Start over </li></ul>Strictly Financials
  24. 24. Accrual Method <ul><li>Records revenues as soon as the “sale” occurs </li></ul><ul><li>Records expenses as soon as the bill is received </li></ul><ul><li>IE, transactions enter the financial records when they occur, not when cash changes hands </li></ul><ul><li>Accrual method, therefore, shows “scores,” not real spendable dollars </li></ul>Strictly Financials
  25. 25. About These Numbers: They’re Squishy <ul><li>Goods will not necessarily be paid for </li></ul><ul><li>Goods are not necessarily going to be kept </li></ul><ul><li>Inventory might be out of date, obsolete or unsellable </li></ul><ul><li>Status of some inventory may be uncertain </li></ul><ul><li>Intangible assets are estimates </li></ul>Strictly Financials
  26. 26. About These Numbers: They’re Squishy (cont.) <ul><li>Machinery or other fixed assets might be obsolete or falling apart long before the so-called useful life is up </li></ul><ul><li>Goodwill </li></ul><ul><li>Accounting conventions </li></ul><ul><li>Timing issues </li></ul><ul><li>Bottom line: In many ways, statements are a collection of estimates. </li></ul>Strictly Financials
  27. 27. Because They’re Squishy <ul><li>You need to know the rules and assumptions used to create the numbers </li></ul>Strictly Financials
  28. 28. Income Statement or ... <ul><li>Statement of earnings </li></ul><ul><li>Statement of operations </li></ul><ul><li>Statement of income and comprehensive income </li></ul>Strictly Financials
  29. 29. Income Statement <ul><li>Covers a period of time, typically a year or quarter </li></ul><ul><li>Reports income from ongoing activities </li></ul><ul><li>Reports income from activities beyond management’s control (comprehensive income) </li></ul><ul><li>Involves estimates </li></ul>Strictly Financials
  30. 30. Basic Income Statement <ul><li>Sales or revenues </li></ul><ul><li>Expenses </li></ul><ul><li>Taxes </li></ul><ul><li>Net income or profit </li></ul>Strictly Financials
  31. 31. Income Statement <ul><li>Sales or revenues </li></ul><ul><li>Cost of goods sold </li></ul><ul><li>Gross profit </li></ul><ul><li>Operating expenses </li></ul><ul><ul><li>Sales, general and administrative </li></ul></ul><ul><ul><li>Depreciation, amortization </li></ul></ul><ul><li>Operating profit </li></ul><ul><li>Other income/expenses </li></ul><ul><li>Interest </li></ul><ul><li>Income taxes </li></ul><ul><li>Net income or profit </li></ul>Strictly Financials
  32. 32. Cost of Goods Sold <ul><li>Expenses incurred in the cost of manufacturing or creating or acquiring the product the company sells. </li></ul>Strictly Financials
  33. 33. Cost of Goods Sold <ul><li>Manufacturer: What the company pays for inventory, i.e. raw materials and supplies used to make its product(s). Includes price of raw materials plus cost of turning it into a product, and transportation costs, i.e. direct factory labor, overhead costs, energy costs. Inventory is largest percent of CGS for manufacturer. </li></ul>Strictly Financials
  34. 34. Cost of Goods Sold <ul><li>Retailer: What the company pays suppliers for the products it sells on its shelves. Only the cost of merchandise purchased for resale, not the cost of providing the service to customers. </li></ul><ul><li>Service business: Since it doesn’t make or sell a product per se, typically find a modest CGS. </li></ul>Strictly Financials
  35. 35. SGA <ul><li>Includes office expenses, accounting, shipping department, advertising, R&D, depreciation and other expenses that can’t be directly attributed to particular items for sale. </li></ul><ul><li>Often includes depreciation and amortization. </li></ul>Strictly Financials
  36. 36. Other Income/Expenses <ul><li>Discontinued items </li></ul><ul><li>Unusual/extraordinary items </li></ul><ul><li>Changes in accounting principle </li></ul><ul><li>Impairment charge </li></ul><ul><li>Sale of investment </li></ul><ul><li>Minority interest </li></ul>Strictly Financials
  37. 37. Thinking Inside the Box <ul><li>Revenues </li></ul><ul><li>Minus cost of goods sold </li></ul><ul><li>Equals gross profit </li></ul><ul><li>Minus operating expenses </li></ul><ul><li>Equals operating profit </li></ul><ul><li>Minus or plus other expenses/income </li></ul><ul><li>Minus or plus interest expenses/income </li></ul><ul><li>Minus income taxes </li></ul><ul><li>Net income </li></ul>Strictly Financials
  38. 38. Inside the Box Earnings <ul><li>Sales or revenues </li></ul><ul><li>Cost of goods sold </li></ul><ul><li>Gross profit </li></ul><ul><li>Operating expenses </li></ul><ul><ul><li>Sales, general and administrative </li></ul></ul><ul><ul><li>Depreciation, amortization </li></ul></ul><ul><li>Operating profit </li></ul>Strictly Financials
  39. 39. ‘ One-Time’ Gains That Reoccur <ul><li>Don’t be fooled by extraordinary items that make the net income look better than it really is </li></ul><ul><li>Extraordinary items should be both unusual in nature and infrequent in occurrence </li></ul><ul><li>Examples: Writedowns, restructurings, etc. </li></ul>Strictly Financials
  40. 40. Earnings Per Share <ul><li>Basic earnings per share (Bloomberg) </li></ul><ul><li>Diluted earnings per share (Wall Street Journal, fully diluted) </li></ul>Strictly Financials
  41. 41. Calculating EPS <ul><li>Basic: Net income for period divided by weighted average number shares outstanding. </li></ul><ul><li>Diluted: Net income for period divided by weighted average number shares outstanding for period, plus assumption of exercise of all potentially dilutive instruments. </li></ul>Strictly Financials
  42. 42. Pro Forma Results <ul><li>Expenses against earnings are not standardized across an industry </li></ul><ul><li>Selectively defined earnings </li></ul><ul><li>SEC’s Regulation G (1/03) states that non-GAAP numbers used in an earnings release must be accompanied by, and reconciled with, the “most directly comparable GAAP number” </li></ul>Strictly Financials
  43. 43. Pro Forma Results <ul><li>Recommendation: GAAP results should precede pro forma results in earnings releases </li></ul><ul><li>Headlines should show GAAP earnings </li></ul><ul><li>Pro forma has value for many companies </li></ul><ul><li>Common pro forma: EBITDA </li></ul><ul><li>“ As a matter of form” </li></ul>Strictly Financials
  44. 44. Balance Sheet <ul><li>It balances </li></ul><ul><li>Assets = Liabilities + Shareholders’ Equity </li></ul>Strictly Financials
  45. 45. Assets <ul><li>Current assets </li></ul><ul><ul><li>Cash and cash equivalents </li></ul></ul><ul><ul><li>Accounts receivable </li></ul></ul><ul><ul><li>Inventories </li></ul></ul><ul><ul><li>Prepaids </li></ul></ul><ul><li>Investments and other assets </li></ul>Strictly Financials
  46. 46. Assets <ul><li>Property, plant and equipment, net </li></ul><ul><ul><li>Land and improvement </li></ul></ul><ul><ul><li>Buildings and improvements </li></ul></ul><ul><ul><li>Equipment </li></ul></ul><ul><ul><li>Less accumulated depreciation </li></ul></ul><ul><li>Goodwill and other intangibles </li></ul>Strictly Financials
  47. 47. Goodwill <ul><li>Difference between what a firm pays to buy another company and the book value (total assets minus total liabilities) of that company. </li></ul><ul><li>Has been written off over time, typically 40 years </li></ul><ul><li>No longer amortize </li></ul><ul><li>Other intangible assets will continue to be amortized over useful lives </li></ul>Strictly Financials
  48. 48. Impairment <ul><li>Instead of writing off over time, now use “impairment testing” </li></ul><ul><li>The impairment is expensed on the income statement </li></ul>Strictly Financials
  49. 49. Liabilities <ul><li>Current liabilities </li></ul><ul><ul><li>Accounts payable </li></ul></ul><ul><ul><li>Accrued liabilities </li></ul></ul><ul><ul><li>Income taxes </li></ul></ul><ul><ul><li>Current maturity of long-term debt </li></ul></ul><ul><li>Noncurrent liabilities </li></ul><ul><ul><li>Long-term debt </li></ul></ul><ul><ul><li>Deferred income taxes </li></ul></ul><ul><li>Commitments and contingencies </li></ul>Strictly Financials
  50. 50. Shareholders’ Equity <ul><li>Capital stock </li></ul><ul><ul><li>Preferred stock </li></ul></ul><ul><ul><li>Common stock </li></ul></ul><ul><li>Additional paid-in capital </li></ul><ul><li>Retained earnings </li></ul><ul><li>Treasury stock </li></ul><ul><ul><li>Total shareholders’ equity </li></ul></ul><ul><ul><li>Total L + OE </li></ul></ul>Strictly Financials
  51. 51. Statement of Cash Flows <ul><li>Record of cash provided by cash sources and of cash consumed by cash uses . </li></ul>Strictly Financials
  52. 52. Cash Flows (cont.) <ul><li>Information about use of cash </li></ul><ul><li>Information about investing and financing </li></ul><ul><li>Ability to continue as a going concern </li></ul><ul><li>Ability to generate future positive cash flows </li></ul><ul><li>Ability to meet obligations and pay dividends </li></ul>Strictly Financials
  53. 53. Cash Flows <ul><li>From operations </li></ul><ul><li>From investing </li></ul><ul><li>From financing </li></ul>Strictly Financials
  54. 54. Flexibility <ul><li>Companies have some flexibility in categories for entries. </li></ul><ul><li>Total change in cash, however, will not change. </li></ul><ul><li>Overwhelming majority of all accounting standards deal with balance sheet and income statement, not cash flows statement. </li></ul>Strictly Financials
  55. 55. Free Cash Flow <ul><li>Powerful tool for making a company successful </li></ul><ul><li>Powerful indicator for investors </li></ul><ul><li>Cash that is left over after productive capacity is maintained or expanded </li></ul><ul><li>Permits expansion, paying down debt, buying back shares, etc. </li></ul>Strictly Financials
  56. 56. Free Cash Flow (cont.) <ul><li>Several ways to calculate it </li></ul><ul><li>Companies create their own models </li></ul><ul><li>Gross way to do it: </li></ul><ul><ul><li>Cash from operating activities </li></ul></ul><ul><ul><li>Minus capital expenditures </li></ul></ul><ul><ul><li>Equals free cash flow </li></ul></ul>Strictly Financials
  57. 57. American Standard Model <ul><li>Cash from operating activities </li></ul><ul><li>Minus capital expenditures </li></ul><ul><li>Plus proceeds from disposal of property </li></ul><ul><li>Plus proceeds from sale and leasebacks </li></ul><ul><li>Equals free cash flow </li></ul>Strictly Financials
  58. 58. Free Cash Models <ul><li>‘ Gross’ method </li></ul><ul><li>American Standard method </li></ul><ul><li>VF method </li></ul><ul><ul><li>Cash from operating minus cash from investing </li></ul></ul>Strictly Financials
  59. 59. Looking at the Numbers <ul><li>Note changes in amounts year to year, especially revenues and expenses </li></ul><ul><li>Note numbers that are significantly larger or smaller than the previous period </li></ul><ul><li>Look at trend line for sales/revenues, operating income and net income. Calculate percentage change for each. </li></ul><ul><li>Look at cash flow. </li></ul><ul><li>Look at free cash flow </li></ul><ul><li>Tie the numbers to the footnotes. </li></ul>Strictly Financials
  60. 60. Techniques <ul><li>Calculate percentage change </li></ul><ul><li>Trend analysis </li></ul><ul><li>Common size analysis </li></ul><ul><li>Ratio analysis </li></ul>Strictly Financials
  61. 61. Sarbanes-Oxley Act of 2002 <ul><li>Response to abuses with Enron and WorldCom as catalysts </li></ul><ul><li>New responsibilities and resources for SEC </li></ul><ul><li>Created PCAOB </li></ul><ul><li>Major emphasis on “internal controls” </li></ul><ul><li>More disclosure for public companies </li></ul>Strictly Financials
  62. 62. Sarbanes-Oxley Act <ul><li>Analysts must disclose potential conflicts of interest </li></ul><ul><li>Limited types of services accounting firms can provide to public company clients </li></ul><ul><li>CEO, CFO attest to accuracy, completeness, fairness of financial statements </li></ul><ul><li>Rigorous penalties for fraud, other misdeeds </li></ul>Strictly Financials
  63. 63. Public Company Accounting Oversight Board <ul><li>Created by SOX to oversee accounting </li></ul><ul><li>SEC appoints members to five-year terms </li></ul><ul><li>Five full-time members including a chairman </li></ul><ul><li>Two must be or have been CPAs </li></ul><ul><li>All members must be “financially literate” </li></ul><ul><li>Began operating May 2003 </li></ul>Strictly Financials
  64. 64. PCAOB’s Duties <ul><li>Set rules on “auditing, quality control, ethics, independence, and other standards…” </li></ul><ul><li>Conduct “inspections” of accounting firms </li></ul><ul><li>Conduct “investigations and disciplinary proceedings” </li></ul><ul><li>Enforce compliance with SOX </li></ul>Strictly Financials
  65. 65. Section 404: Internal Controls <ul><li>“ Management Assessment of Internal Controls” </li></ul><ul><li>Each 10-K must contain an “internal control report” that: </li></ul><ul><li>States management is responsible for internal control structure and procedures </li></ul><ul><li>Contains an assessment on effectiveness of internal control structure and procedures </li></ul>Strictly Financials
  66. 66. Management on the Spot <ul><li>Section 404 means that management must evaluate and test internal controls over financial reporting, including anti-fraud programs, annually. </li></ul><ul><li>Management certifies that it does (or doesn’t) have adequate internal controls in place. </li></ul><ul><li>Independent auditor attests to adequacy of controls. </li></ul><ul><li>Management will be forced to answer for fraudulent activities, misconduct, etc. </li></ul>Strictly Financials
  67. 67. Why A Private Company Files With SEC <ul><li>If a company sold bonds or notes as part of a contract sale and the buyer said the company must file with the SEC until the bonds are retired . Most common reason. </li></ul>Strictly Financials
  68. 68. Why A Private Company Files With SEC <ul><li>If a private company has any debt that trades on an exchange . Even if a public company is bought by a private equity group and taken private, the obligation to file with the SEC continues if the debt remains under previous conditions. </li></ul>Strictly Financials
  69. 69. Why A Private Company Files With SEC <ul><li>If the debt was issued on a registration statement and is held by more than 500 holders of record, even if it is not traded on an exchange. Obligation continues until the number of shareholders of record falls below 300. </li></ul>Strictly Financials
  70. 70. Private Company Impact <ul><li>Banks, insurers requiring companies to embrace SOX. </li></ul><ul><li>Now most private firms have audited financial statements </li></ul><ul><li>If private company owners want to sell to public company, must be in compliance </li></ul><ul><li>Private equity funds more willing to invest in companies in compliance </li></ul><ul><li>Best outside directors easier to attract </li></ul><ul><li>Adding ethics codes, independent directors </li></ul>Strictly Financials
  71. 71. Non-Profit Impact <ul><li>Audit committees, independent members </li></ul><ul><li>CEO, CFO attest to accuracy, completeness, fairness of financial statements </li></ul><ul><li>Financial statements more accessible </li></ul><ul><li>Codes of ethics </li></ul><ul><li>Rules governing transactions with “insiders” </li></ul>Strictly Financials