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    1. 1. Additional Aspects of Financial Reporting and Financial Analysis C hapter 5
    2. 2. <ul><li>1. Describe an auditor’s report. </li></ul><ul><li>2. Explain the disclosure in management’s discussions and analysis. </li></ul><ul><li>3. Understand the meaning of an operating segment. </li></ul><ul><li>4. Describe the disclosure in a segment report. </li></ul><ul><li>5. Explain interim reporting. </li></ul>Objectives
    3. 3. 6. Prepare an interim report. 7. Understand intracompany and intercompany comparisons. 8. Prepare horizontal and vertical percentage analysis. 9. Perform ratio analysis. Objectives
    4. 4. Market Efficiency The prices of securities traded in the capital market fully reflect all publicly available information. Evidence from research on an efficient market hypothesis tends to show-- These prices are adjusted almost immediately based on new information and in an unbiased manner.
    5. 5. Auditor’s Report (Opinion) <ul><li>The auditor is independent. </li></ul><ul><li>The audit was performed on specified financial statements. </li></ul><ul><li>The financial statements are the responsibility of the company’s management; the opinion is the responsibility of the auditors. </li></ul><ul><li>The audit was conducted according to generally accepted auditing standards. </li></ul>Continued An auditor’s standard report includes these statements...
    6. 6. Auditor’s Report (Opinion) <ul><li>The audit was planned and performed to obtain reasonable assurance about whether the financial statements are free of material misstatements. </li></ul><ul><li>The audit included examination, assessment, and evaluation stages. </li></ul><ul><li>The audit provides a reasonable basis for an opinion. </li></ul><ul><li>An opinion is expressed concerning the fair presentation. </li></ul>
    7. 7. Auditor’s Report (Opinion) The first ( introductory) paragraph lists the financial statements that were audited, declares that management is responsible for those statements, and asserts that the auditor is responsible for expressing an opinion on them. The second ( scope) paragraph describes what the auditor has done. The third ( opinion) paragraph gives the auditor’s opinion. An unqualified opinion contains three paragraphs.
    8. 8. <ul><li>An unqualified opinion is not a “clean bill of health.” </li></ul><ul><li>An unqualified opinion provides no assurance of the future success of the company. </li></ul><ul><li>An audit report does not provide an assurance that fraud has not been committed by a member, or members, of the company unless such fraud would cause a material misstatement in the financial statements. </li></ul>Auditor’s Report (Opinion) There are three things that the audit report does not say.
    9. 9. Management’s Discussion and Analysis (MD&A) The MD&A provides a narrative explanation of the financial statements so that investors can judge the “quality” of earnings and the likelihood that past performance is indicative of future performance in regard to cash flows. The MD&A provides information regarding liquidity, capital resources, and the results of operations, as well as other information necessary to understand its financial condition and changes in financial condition. Where knowledge of segment information is useful to understanding a company’s business, the discussion is to focus on each relevant, reportable operating segment, as well as on the whole company.
    10. 10. <ul><li>Liquidity </li></ul><ul><li>Capital Resources </li></ul><ul><li>Results of Operations </li></ul><ul><li>General Information </li></ul>Management’s Discussion and Analysis (MD&A) Major discussion issues that may involve intracompany and intercompany comparisons.
    11. 11. Segment Reporting <ul><li>that engages in business activities to earn revenues and incur expenses, </li></ul><ul><li>whose operating results are regularly reviewed by the company’s chief operating officer to make decisions about resources to be allocated to the segment and to assess its performance, and </li></ul><ul><li>for which financial information is available. </li></ul>An operating segment is a component of a company--
    12. 12. Segment Reporting An operating segment is considered significant and is a reportable segment if it satisfies at least one of the following tests: <ul><li>Revenue Test </li></ul><ul><li>Profit Test </li></ul><ul><li>Asset Test </li></ul>
    13. 13. TEAL COMPANY Operating Segment Financial Results for Year Ended December 31, 2000 Reportable Operating Segments All Other Total A B C Segments Results Segment revenues $ 300 $2,530 $ 370 $ 600 $ 3,800 Segment operating profit (pretax) $ 70 $ 495 $ 105 $ 140 $ 810 General corporate expenses (100) Corporate interest expense (80) Pretax income from cont’g operations $ 630 Segment assets at 12/31/2000 $1,800 $9,400 $2,000 $2,800 $16,000 Gen. corp. assets 3,000 Total assets 12/31/2000 $19,000
    14. 14. Interim Income Taxes Estimated Annual Income: First quarter $20,000 actual income Second quarter 26,000 actual income Third quarter 25,000 estimated income Fourth quarter 29,000 estimated income $100,000 estimated annual income Continued
    15. 15. Interim Income Taxes Estimated Effective Income Tax Rate: Continued $ 3, /4 3m 15% x $20,000 = $ 3,000 30% x ($100,000 - $20,000) = 24,000 Estimated total tax = $27,000 27% Effective tax rate = $27,000 Estimated income tax $100,000 Estimated Income
    16. 16. Interim Income Taxes Estimated Income Tax for First Six Months: $ 3, /4 3m $46,000 x 27% = $12,420 estimated income tax on first six months’ income Estimated Income Tax for Second Quarter: $ 3, /4 3m $12,420 estimated income tax on first six months of income (5,220 ) estimated income tax on first-quarter income $7,200 estimated income tax on second-quarter income
    17. 17. Preparation of Disclosure of Summarized Interim Financial Data When publicly held companies report interim summaries of financial information, the following data must be reported at a minimum.
    18. 18. Preparation of Disclosure of Summarized Interim Financial Data Sales or gross revenues, income taxes, extraordinary items (net of tax), the cumulative effect of a change in accounting principle, and net income. Earnings per share for each period presented. Seasonal revenues, costs, and expenses. Significant changes in estimates of income taxes. Contingent items. Changes in accounting principles or estimates. Significant changes in financial position.
    19. 19. SEC Reports Form 10-K Form 10-Q Two SEC forms that are important to accountants are--
    20. 20. SEC Reports Form 10-K is the most common SEC annual report form and is required to be filed with the SEC within 90 days of a company’s fiscal year-end.
    21. 21. SEC Reports Form 10-Q is used to report a company’s quarterly financial information to the SEC and is required to be filed within 45 days of the end of the company’s first three fiscal quarters.
    22. 22. Financial Analysis Comparison Financial Analysis Comparisons Intracompany Intercompany Percentage Analyses Horizontal Vertical Ratio
    23. 23. Horizontal Analysis In horizontal analysis, changes in a company’s operating results and financial position over time are shown in percentages as well as in dollars.
    24. 24. Horizontal Analysis = 6.2%  from 12/31/00 to 12/31/01 Base Year % = Sales $138,000 $130,000 12/31/01 12/31/00 $8,000 $8,000 $130,000 % = Now, using the data from Exhibit 5-5, let’s try gross profit from December 31, 1999 to December 31, 2001.
    25. 25. Horizontal Analysis Gross profit $55,900 $42,000 12/31/01 12/31/ 99 = 33.1%  from 12/31/99 to 12/31/01 Base Year % = $13,900 $13,900 $42,000 % =
    26. 26. Vertical Analysis (Income Statement) In vertical analysis, the monetary relationships between items on the financial statements are shown in percentages as well as in dollars.
    27. 27. Sales, net $130,000 100.0 106.2 106.2 Vertical Analysis (Income Statement) 2001 Amount Percent Sales $138,000 Sales returns (8,000 ) Sales, net $130,000 Cost of goods sold (74,100 ) Gross profit $ 55,900 Sales, $138,000 Sales, net, $130,000 =
    28. 28. Sales, net $130,000 100.0 (6.2)% 106.2 Vertical Analysis (Income Statement) 2001 Amount Percent Sales $138,000 Sales returns (8,000 ) Sales, net $130,000 Cost of goods sold (74,100 ) Gross profit $ 55,900 Sales returns, ($8,000) Sales, net , $130,000 = (6.2)
    29. 29. Sales, net $130,000 100.0 (57.0)% 106.2 (57.0) Vertical Analysis (Income Statement) 2001 Amount Percent Sales $138,000 Sales returns (8,000 ) Sales, net $130,000 Cost of goods sold (74,100 ) Gross profit $ 55,900 Cost of goods sold, ($74,100) Sales, net , $130,000 = (6.2)
    30. 30. Sales, net $130,000 100.0 43.0% 106.2 (57.0) 43.0 Vertical Analysis (Income Statement) 2001 Amount Percent Sales $138,000 Sales returns (8,000 ) Sales, net $130,000 Cost of goods sold (74,100 ) Gross profit $ 55,900 Gross profit, $55,900 Sales, net , $130,000 = (6.2)
    31. 31. Vertical Analysis (Balance Sheet) 3.2% 3.0 Total Assets $129,200 100.0 2001 Amount Percent Cash $ 3,900 Receivables (net) 7,600 Inventories 8,900 Prepaid Items 1,000 Total current assets $ 21,400 Noncurrent assets (net) 107,800 Total Assets $129,200 Cash, $3,900 Total Assets, $129,200 =
    32. 32. Vertical Analysis (Balance Sheet) 3.0 Total Assets $129,200 100.0 5.9% 5.9 2001 Amount Percent Cash $ 3,900 Receivables (net) 7,600 Inventories 8,900 Prepaid Items 1,000 Total current assets $ 21,400 Noncurrent assets (net) 107,800 Total Assets $129,200 Receivables (net), $7,600 Total Assets, $129,200 =
    33. 33. Vertical Analysis (Balance Sheet) Using this approach on the rest of the assets, this section can be completed.
    34. 34. Vertical Analysis (Balance Sheet) 3.0 Total Assets $129,200 100.0 5.9 6.9 .8 83.4 2001 Amount Percent Cash $ 3,900 Receivables (net) 7,600 Inventories 8,900 Prepaid Items 1,000 Total current assets $ 21,400 Noncurrent assets (net) 107,800 Total Assets $129,200 16.6
    35. 35. In calculating vertical analysis amounts for liabilities and stockholders’ equity, all items are divided by “total liabilities and stockholders’ equity.” Vertical Analysis (Balance Sheet) 3.9% Accounts Payable, $5,000 Total L& SE, $129,200 =
    36. 36. Ratio Analysis Stockholders’ Profitability Ratios Earnings per share is probably the most frequently cited ratio in a financial analysis. $11,000 $1,200 5,400 = $1.81 Net Income - Preferred Dividends Average Common Shares Outstanding
    37. 37. Ratio Analysis Stockholders’ Profitability Ratios Price/earnings is used by actual and potential stockholders to evaluate the attractiveness of an investment in the stock of a company. $14.25 $1.81 = 7.9 times Market Price per Common Share Earnings per Share
    38. 38. Ratio Analysis Stockholders’ Profitability Ratios Dividend yield provides the stockholders’ their individual rates of return based on the actual dividends received as compared with the ending market price of the stock. $1.00 $14.25 = 7.0% Dividends per Common Share Market Price per Common Share
    39. 39. Ratio Analysis Company Profitability Ratios Profit margin is used to evaluate a company’s efficiency in controlling costs and expenses in relation to sales. $11,000 $130,000 = 8.5% Net Income Net Sales
    40. 40. Ratio Analysis Return on total assets indicates how efficiently a company uses its economic resources. $11,000 + ($3,000 x 0.7) ($129,200 + $112,000)/2 = 10.9% Company Profitability Ratios Net Income + Interest Expense (net of tax) Average Total Assets
    41. 41. Ratio Analysis Return on stockholders’ equity shows the residual returns on the owners’ equity. Company Profitability Ratios $11,000 ($93,000 + $79,000)/2 = 12.8% Net Income Average Stockholders’ Equity
    42. 42. Ratio Analysis The c urrent ratio is used to evaluate a company’s short-run liquidity. Liquidity Ratios $21,400 $11,200 = 1.91 times Current Assets Current Liabilities
    43. 43. Ratio Analysis The acid-test ratio is a more severe test of a company’s short-term debt-paying abilities. Liquidity Ratios $11,500 $11,200 = 1.03 times Quick Assets Current Liabilities
    44. 44. Ratio Analysis Inventory turnover indicates the number of times the inventory is “turned over” or sold during that period. Activity Ratios $74,100 ($8,900 + $10,100)/2 = 7.8 times or 47 days Cost of Goods Sold Average Inventory 365 7.8
    45. 45. Ratio Analysis Receivables turnover indicates how many times receivables are “turned over” or collected each period. Activity Ratios $130,000 x 0.70 ($7,600 + $8,600)/2 = 11.2 times or 33 days Net Credit Sales Average Net Receivables 365 11.2
    46. 46. Ratio Analysis The payables turnover ratio measures the number of times accounts payable turns over during the year. Activity Ratios $74,100 ($5,000 + $6,600)/2 = 12.8 times or 29 days Cost of Goods Sold Average Accounts Payable 365 12.8
    47. 47. Ratio Analysis The debt ratio indicates the percentage of total assets contributed by creditors. Stability Ratios $36,200 $129,200 = 28% Total Liabilities Total Assets
    48. 48. Ratio Analysis Times interest earned is used to evaluate the ability of a company to cover its interest obligations through its annual earnings. Stability Ratios $15,700 + $3,000 $3,000 = 6.2 times Pretax Operating Income Interest Expense
    49. 49. Ratio Analysis Book value per common share shows the net assets per share of stock. Stability Ratios $93,000 - ($140 x 150) 5,400 = 13.33 per common share Common Stockholders’ Equity Outstanding Common Shares
    50. 50. Ratio Analysis Cash flow from operations to sales ratio is used to evaluate the cash generated from sales. Cash Flow Ratios Cash Flow From Operations Sales
    51. 51. Ratio Analysis Cash flow from operations to net income ratio enables users to understand how the earnings of net income relates to the cash flow from operations. Cash Flow Ratios Cash Flow From Operations Net Income
    52. 52. Ratio Analysis Cash flow from operations per share is expressly prohibited. However, users may wish to compute it for internal use. Cash Flow Ratios Cash Flow From Operations Average Shares of Common Stock Outstanding
    53. 53. Ratio Analysis Cash flow from operations divided by the amount of debt maturing next year ratio measures the ability of a company to make principal payments. Cash Flow Ratios Cash Flow From Operations Debt Maturing Next Year
    54. 54. C hapter 5 The End

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