Financial Statements I by Jimmy Gentry


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Jimmy Gentry presents "Financial Statements I" during the annual 2012 Reynolds Business Journalism Seminars, hosted by the Donald W. Reynolds National Center for Business Journalism. For more information about free training for business journalists, please visit

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  • The Supreme Court held that the Sarbanes-Oxley Act's provisions making PCAOB Board members removable by the Securities and Exchange Commission (SEC) only for good cause were inconsistent with the Constitution's separation of powers. Created by SOX to oversee accounting
  • Financial Statements I by Jimmy Gentry

    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. 3, 2012 </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>Began operating in 2003 </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>In 2008, Supreme Court upheld PCAOB but said SEC couldn’t remove board members </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. 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
    68. 68. 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
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