Financial Statements I by Jimmy Gentry

Accounting I: Financial Statements
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Jan. 3, 2012

Donald W. Reynolds National Center
For Business Journalism
At Arizona State University
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James K. Gentry, Ph.D.
Clyde M. Reed Teaching Professor
School of Journalism and Mass Communications
University of Kansas
[email_address]
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Types of Companies
Public
Private
Financial statements conforming to public company statements
Non-profits
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Important Terms
Unaudited
Audited
Accountants
Certified Public Accountants (CPAs)
GAAP, FASB, AICPA, PCAOB
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Assessing a Company
Context
Trends
Rules
Outsiders
Insiders
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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
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MD&A
Must read it
Often a source of good information and insights
Densely written
Explains financial information
SEC says it wants greater transparency
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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
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Auditor’s Report by Category
Clean or Unqualified
Qualified
Disclaimer
Adverse
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New Auditor’s Report
Combines traditional report with “internal controls” requirement of Sarbanes-Oxley Act
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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
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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
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Financial Decisions
Long-term investment decisions
Capital budgeting
Long-term financing decisions
Capital structure
Working capital management decisions
Net working capital
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Financial Decisions
Investing decisions: Types of assets firm wants to hold.
Financing decisions: Acquisition of funds needed to support long-term investments.
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Generally Accepted Accounting Principles
Guidelines based on theory and practice
Evolved over time
Procedures, concepts and standards
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GAAP: Assumptions
Periodicity
Going concern
Economic entity
Monetary unit
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GAAP: Principles
Full disclosure
Matching
Historical cost
Revenue realization
Consistency
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GAAP: Underlying Considerations
Materiality
Industry practices
Conservatism
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Specialized Industry GAAP
Banking and thrift industries
Benefit plans, including pension funds
Broadcasting industry
Cable television industry
Computer software
Finance companies
Investment companies
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Cash or Operating Cycle
Cash
Purchase inventory
Produce product
Sell product
Cash
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Cash or Operating Cycle (cont.)
“ Cash”
Cash
Receivables
Debt
Inventory
Raw materials
Work in progress
Finished goods
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Cash or Operating Cycle (cont.)
Sell product
Accounts receivable
Cash
Cash
Collect receivables as cash
Pay off payables
Start over
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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
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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
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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.
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Because They’re Squishy
You need to know the rules and assumptions used to create the numbers
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Income Statement or ...
Statement of earnings
Statement of operations
Statement of income and comprehensive income
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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
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Basic Income Statement
Sales or revenues
Expenses
Taxes
Net income or profit
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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
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Cost of Goods Sold
Expenses incurred in the cost of manufacturing or creating or acquiring the product the company sells.
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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.
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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.
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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.
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Other Income/Expenses
Discontinued items
Unusual/extraordinary items
Changes in accounting principle
Impairment charge
Sale of investment
Minority interest
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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
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Inside the Box Earnings
Sales or revenues
Cost of goods sold
Gross profit
Operating expenses
Sales, general and administrative
Depreciation, amortization
Operating profit
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‘ 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.
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Earnings Per Share
Basic earnings per share (Bloomberg)
Diluted earnings per share (Wall Street Journal, fully diluted)
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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.
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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”
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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”
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Balance Sheet
It balances
Assets = Liabilities + Shareholders’ Equity
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Assets
Current assets
Cash and cash equivalents
Accounts receivable
Inventories
Prepaids
Investments and other assets
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Assets
Property, plant and equipment, net
Land and improvement
Buildings and improvements
Equipment
Less accumulated depreciation
Goodwill and other intangibles
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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
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Impairment
Instead of writing off over time, now use “impairment testing”
The impairment is expensed on the income statement
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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
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Shareholders’ Equity
Capital stock
Preferred stock
Common stock
Additional paid-in capital
Retained earnings
Treasury stock
Total shareholders’ equity
Total L + OE
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Statement of Cash Flows
Record of cash provided by cash sources and of cash consumed by cash uses .
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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
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Cash Flows
From operations
From investing
From financing
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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.
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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.
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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
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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
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Free Cash Models
‘Gross’ method
American Standard method
VF method
Cash from operating minus cash from investing
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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.
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Techniques
Calculate percentage change
Trend analysis
Common size analysis
Ratio analysis
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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
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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
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Public Company Accounting Oversight Board
Created by SOX to oversee accounting
Began operating in 2003
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”
In 2008, Supreme Court upheld PCAOB but said SEC couldn’t remove board members
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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
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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
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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.
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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
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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”
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Financial Statements I by Jimmy Gentry

by Reynolds Center for Business Journalism on Jan 03, 2012

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Financial Statements I by Jimmy Gentry — Presentation Transcript