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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. …

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