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  • Chapter 5: Communicating and Interpreting Accounting Information.
  • This graphic identifies the people involved in the accounting communication process. They include regulators, managers, directors, auditors, information intermediaries, and users. Each person or group plays a unique role in the process and is guided by legal and professional standards.
  • The mission of the U.S. Securities and Exchange Commission (SEC) is to protect investors and maintain the integrity of the securities markets. As part of this mission, the SEC oversees the work of the Financial Accounting Standards Board (FASB) that sets generally accepted accounting principles (GAAP), the Public Company Accounting Oversight Board (PCAOB) that sets auditing standards for independent auditors (CPAs) of public companies, and the stock exchanges (e.g., New York Stock Exchange), that, along with state governments, set overall corporate governance standards.
  • The primary responsibility for the information in the financial statements and disclosures lies with management, specifically, the highest officer in the company often called the chairman and chief executive officer (CEO), and the highest officer associated with the financial and accounting side of the business, often called the chief financial officer (CFO). The members of the accounting staff actually prepare the details of the information. At Callaway and all public companies, the CEO and CFO must personally certify that: Each report filed with the Securities and Exchange Commission does not contain any untrue material statement or omit a material fact and fairly presents in all material respects the financial condition, results of operations, and cash flows of the company. There are no significant deficiencies and material weaknesses in the internal controls over financial reporting. They have disclosed to the auditors and audit committee of the board any weaknesses in internal controls or any fraud involving management or other employees who have a significant role in financial reporting’ Executives who knowingly certify false financial reports are subject to a fine of $5 million and a 20-year prison term. The accounting staff also bear professional responsibility for the accuracy of this information , although their legal responsibility is smaller.
  • The board of directors (elected by the stockholders) is responsible for ensuring that processes are in place for maintaining the integrity of the company’s accounting, financial statement preparation, and financial reporting. The audit committee of the board, which must be composed of non-management (independent) directors with financial knowledge, is responsible for hiring the company’s independent auditors. They also meet separately with the auditors to discuss management’s compliance with their financial reporting responsibilities.
  • The SEC requires publicly traded companies to have their statements and their control systems over the financial reporting process audited by an independent registered public accounting firm (independent auditor) following auditing standards established by the PCAOB. Many privately owned companies also have their statements audited. By signing an unqualified (or clean) audit opinion, a CPA firm assumes part of the financial responsibility for the fairness of the financial statements and related presentations. This opinion, which adds credibility to the statements, is also often required by agreements with lenders and private investors. Subjecting the company’s statements to independent verification reduces the risk that the company’s financial condition is misrepresented in the statements. As a result, rational investors and lenders should lower the rate of return (interest) they charge for providing capital.
  • Financial analysts receive accounting reports and other information about the company from electronic information services. They also gather information through conversations with company executives and visits to company facilities and competitors. The results of their analyses are combined into analysts’ reports. Analysts’ reports normally include forecasts of future quarterly and annual earnings per share and share price; a buy, hold, or sell recommendation for the company’s shares; and explanations for these judgments. In making their earnings forecasts, the analysts rely heavily on their knowledge of the way the accounting system translates business events into the numbers on a company’s financial statements, which is the subject matter of this text. Individual analysts often specialize in particular industries (such as sporting goods or energy companies). Analysts are regularly evaluated based on the accuracy of their forecasts, as well as the profitability of their stock picks.
  • Institutional investors include pension funds (associated with unions, companies, or government agencies); mutual funds; and endowment, charitable foundation, and trust funds (such as the endowment of your college or university). These institutional stockholders usually employ their own analysts who also rely on the information intermediaries just discussed. Institutional shareholders control the majority of publicly traded shares of U.S. companies. Private investors include large individual investors such as Ely Callaway and his friends who originally invested directly in Callaway Golf, as well as small retail investors who buy shares of publicly traded companies through brokers such as Charles Schwab. Retail investors normally lack the expertise to understand financial statements and the resources to gather data efficiently. Lending officers and financial analysts in these organizations use the same public sources of information. They also use additional financial information (e.g., monthly statements) that companies often agree to provide as part of the lending contract. Lenders are the primary external user group for financial statements of private companies. Institutional and private investors also become creditors when they buy a company’s publicly traded bonds.
  • The primary objective of external financial reporting is to provide economic information to external users that will assist them in the decision-making process. The primary qualitative characteristics of useful information include relevance and reliability. The secondary qualitative characteristics of useful information include comparability and consistency.
  • Financial accounting standards and disclosure requirements are adopted by national regulatory agencies. Many countries, including the members of the European Union, have adopted international financial reporting standards (IFRS) issued by the International Accounting Standards Board (IASB). IFRS are similar to U.S. GAAP, but there are several important differences. Here is a chart showing some of the key similarity and differences between U. S. GAAP and IFRS rules.
  • Privately held companies whose reports are not distributed to the general public are required to issue the four basic financial statements, related notes to financial statements, and if the statements are audited, the auditor’s report. The annual reports of public companies are significantly more elaborate, both because of additional SEC reporting requirements and because many companies use their annual reports as public relations tools.
  • Due to elaborate reporting requirements of the Securities and Exchange Commission, publicly held companies issue an annual report that can be divided into two major sections. The first section deals with nonfinancial matters and the second section deals with the financials. The nonfinancial section contains a letter to the stockholders, usually from the CEO, a description of management’s philosophy, products produced and sold, and any major successes or failures the company has experienced in the past year. Beautiful photographs of products, facilities, and personnel are often included. The financial section includes the core of the report. The SEC sets minimum disclosure standards for the financial section of the annual report for public companies.
  • Here is a list of the major categories of information that you will find in the typical annual report of a publicly held company. Towards the end of the report there is a summary of financial data for five or ten years. Management is required to communicate to the reader certain financial and nonfinancial information. This is referred to as management discussion and analysis. All annual reports contain the four basic financial statements and related notes to those financial statements, and the report of the independent accountant, and the management certification. In addition, many annual reports contain information about the recent stock price for each quarter of the year. Also, we may find summaries of unaudited quarterly financial information, a listing of the company’s directors and officers, and relevant addresses and telephone numbers for contacting the company.
  • Publicly held companies usually produce quarterly reports. The typical quarterly report frequently begins with a short letter to the stockholders from either the CEO or the CFO. The quarterly report contains a condensed unaudited income statement and balance sheet for the quarter. In some quarterly reports, we can expect to find a statement of cash flows and the statement of stockholders’ equity, but these are often omitted. Additionally, some notes to the financial statements may be omitted.
  • Companies are required to prepare reports for the Securities and Exchange Commission. One of the most common reports is known as form 10-K, or the annual report. The form is due within 90 days of the end of the company’s fiscal year and it must contain audited financial statements. The form 10-Q is a quarterly report. It is due within 45 days of the end of each quarter and contains financial statements that are usually unaudited. Form 8-K is a current events report. It is due within 15 days of the occurrence of a major reportable event. Any financial statements that are included in the form can be unaudited.
  • Here is the consolidated balance sheet of Callaway Golf Company for the years ended December 31, 2008 and 2007. Notice that the assets are divided among current assets, property plant and equipment, net of accumulated depreciation, intangible assets, net of amortization, and other assets. The total assets at December 31, 2008 are $855,338. Remember that all values on the balance sheet are reported in thousands of dollars. So the actual total assets for Callaway Golf Company at December 31, 2008 are $855,338,000. Liabilities are divided into those that will be settled within one years, the current liabilities, and those that will be settled beyond one year, long-term liabilities. Notice the line for Commitments and contingencies (Note 15) that shows no dollar amount. We wish to call the reader’s attention to the fact that there may be significant commitments and contingencies that exist but cannot be reported on the balance sheet. Rather, these items are disclosed in the notes to the financial statements. Shareholders’ equity is divided into contributed capital from stockholders and earnings reinvested in the business, retained earnings. Current assets are those assets that will be converted into cash or expire, that is, be used up, within the longer of one year or the company’s normal operating cycle. Remember, we discussed the company’s operating cycle earlier. Property, plant and equipment includes assets with useful lives of more than one year that will be used by the business to generate revenue. The amount is always reported net of accumulated depreciation. Intangible assets have no physical existence and usually have a long useful life, therefore they present difficult accounting problems. Intangible assets include items such as patents, copyrights, trademarks, goodwill and franchises. Intangible assets are reported net of related amortization.
  • Income statements have two major sections. The first presents the income statement as we have in prior chapters. The second presents net income on a per share basis or earnings per share. Cost of goods sold is subtracted from net sales to arrive at gross profit. Cost of goods sold represents the inventory items that have been sold to customers. One of the most important income measures that we will encounter is the income from operations. Financial analysts and others who exam our financial statements closely examine income from operations. It is a measure of how much profit or loss we incurred as a result of the normal operations of our business. Nonoperating revenues and expenses or gains and losses are not integral parts of the operations of our business, and are therefore separated out from income from operations.
  • Callaway Golf reports the subtotal Gross Profit (gross margin) which is the difference between net sales and cost of goods sold. Another subtotal— Income from Operations (also called operating income)—is computed by subtracting operating expenses from gross profit. Nonoperating (other) Items are income, expenses, gains, and losses that do not relate to the company’s primary operations. Examples include interest income, interest expense, and gains and losses on the sale of fixed assets and investments. These nonoperating items are added to or subtracted from income from operations to obtain Income before Income Taxes, also called Pretax Earnings.
  • A classified income statement may contain as many as three major sections. The first section, which we see on every classified income statement, is income from operations. Next, are two nonrecurring items that are related to events and transactions that do not recur often. These two items are discontinued operations and extraordinary items. When a major component of a business is sold or abandoned, income or loss from that component, as well as any gain or loss on disposal, are included as discontinued operations. Extraordinary Items are gains or losses incurred that are both unusual and infrequent in occurrence. The final section is related to earnings per share of common stock outstanding. All publicly owned companies are required to disclose earnings per share.
  • Basic earnings per share is calculated by dividing net income available to common shareholders by the weighted average number of shares outstanding during the reporting period. Net income available to common shareholders is equal to net income less dividends on preferred stock.
  • Here is Matrix International’s income statement for the one month ended January 31, 2009. Notice that besides expressing the income in dollar amounts, we also show income in percentage amounts. This type of presentation is referred to as a common size income statement. We normally let total revenues equal 100%, and express all other amounts on the income statement as a percent of total revenues. For example, we can see the cost of sales is 51.58% of total revenue. Income tax expense is 5.59% of total revenue. The common size income statement provides us with another way to analyze financial information. Notice for the one month ended January 31, 2009, Matrix International’s reported earnings per share of 40 cents.
  • Recall that the statement of cash flows is divided into three major sections. The first section is cash flows from operating activities, followed by cash flows from investing activities, and completed with cash flows from financing activities. In addition, we reconcile the beginning and ending cash balance.
  • This is Calloway’s statement of cash flows for the years ended December 31, 2008, 2007, and 2006. The statement is prepared on what’s called the indirect method. When we use the indirect method, we start with net income reported on the income statement and adjust it for reconciling items until we are able to calculate net cash provided from operating activities. Depreciation and amortization and similar non-cash charges to income appear on the income statement as expenses, but they have no cash flow impact. As a result, we add these items back to net income when we calculate cash provided from operating activities. In the second major section of the statement of cash flows we show the net cash used in investing activities. Investing activities include the purchase and sale of productive assets, like equipment, for cash, and the purchase or sale of long-term investments the company has made. In the third and final major section of the statement we show net cash generated or used in financing activities. Financing activities include the issuance and repurchase of stock, the issuance or retirement of long-term obligations and cash dividends paid. As a result of the amounts in the three categories on the statement of cash flows, the cash account decreased by $11,538 in 2008, and increased by $3,513 in 2007. At the beginning of 2008, the company had a total of $49,875 in cash. We combine this with the net decrease in cash for the period and get a cash balance at the end of 2008, of $38,337. This is the ending cash balance that will appear on the balance sheet of Callaway Golf Company. You can go back a few screen and see the balance on the Consolidated Balance Sheet for Callaway.
  • The impact of changes in current assets and current liabilities, other than cash, affect the calculation of net cash provided from operating activities. You can use the table at the top of your screen to analyze the impact of the change in specific current assets and current liabilities accounts. For example, accounts receivable is a current asset. If accounts receivable increases, we subtract the change in the account balance from net income to arrive at net cash provided from operating activities. We would complete a similar analysis for all other current assets and current liabilities other than cash.
  • The notes to financial statements provide the reader with descriptions of key accounting rules applied to the company’s financial statements. Detailed supporting schedules are used to report additional information to the reader, and information that is relevant to the reader but is not included in the financial statements may be disclosed in the notes to the financial statements.
  • As you will see in your study of subsequent chapters, generally accepted accounting principles (GAAP) permit companies to select from alternative methods for measuring the effects of transactions. The summary of significant accounting policies tells the user which accounting methods the company has adopted. Without an understanding of the various accounting methods used, it is impossible to analyze a company’s financial results effectively.
  • Among other information, these notes may show revenues broken out by geographic region or business segment, describe unusual transactions, and/or offer expanded detail on a specific classification. Note 17 shows the company’s sales revenue and long-lived assets in various parts of the world. Accounting rules provide specific guidance on how we should report segment information. You will study segment reporting if you take additional accounting courses.
  • In its broadest measure, return on assets is calculated by dividing net income by average total assets. Remember that average total assets is the beginning asset balance plus the ending asset balance divided by two. ROA measures how much the firm earned for each dollar of investment. It is the broadest measure of profitability and management effectiveness, independent of financing strategy. Firms with higher ROA are doing a better job of selecting and managing investments, all other things equal. Since it is independent of the source of financing (debt vs. equity), it can be used to evaluate performance at any level within the organization. It is often computed on a division-by-division or product line basis and used to evaluate division or product line managers’ relative performance. Like all ratios, the key to interpreting change is to dig deeper to understand the reason for each change. Inspection of the income statement reveals that the only reason for the increase in ROA between 2007 and 2008 was an increase in “Other income” from investing activities which cannot be repeated in future periods. Unless consumer discretionary spending increases, it will be very difficult for Callaway to continue to improve its ROA.
  • 1. Net profit margin is Net Income divided by Net Sales. It measures how much of every sales dollar is profit. It can be increased by a. Increasing sales volume. b. Increasing sales price. c. Decreasing cost of goods sold and operating expenses. 2. Asset turnover is Net Sales divided by Average Total Assets. It measures how many sales dollars the company generates with each dollar of assets. It can be increased by a. Collecting accounts receivable more quickly. b. Centralizing distribution to reduce inventory kept on hand. c. Consolidating production facilities in fewer factories to reduce the amount of assets necessary to generate each dollar of sales.
  • Some companies may develop a business strategy to promote a high value product or to differentiate their products from the competition. The company is usually required to spend a significant amount of money on research and development and to heavily promote the product so that customers believe it is superior to the competition. Other companies use a strategy to promote the low cost of their product. To produce a low-cost product, management must efficiently manage accounts receivable, inventory and other productive assets. Failure to control these assets will increase the cost of the product and decrease the company’s profit margin.
  • Chapter Supplement: Nonrecurring Items Recall our basic classified income statement format. If the company had incurred nonrecurring items such as discontinued operations or an extraordinary item, they would be reported (net of tax) after the other income and expense category and provision for income taxes. These two items are not likely to occur on a regular basis, and are therefore reported separately.
  • Discontinued operations result from the sale or abandonment of a segment of our business operations. We divide discontinued operations into two categories. The first is the income or loss of the segment reported during the period. The second category is the gain or loss on disposal of the segment’s assets and liabilities. Each of these two categories are reported net of applicable taxes.
  • Extraordinary items are gains or losses that are considered both unusual in nature and infrequent in occurrence. Examples include losses suffered from natural disasters such as floods and hurricanes in geographic areas where such disasters are rare. These items must be reported separately on the income statement net of income tax effects. Separate reporting again informs decision makers that these items are not likely to recur, and so are not predictive of the company’s future. Note disclosure is needed to explain the nature of the extraordinary item. Companies report such items very rarely.
  • Here is an example where Verizon Communications, Inc. reported both income from discontinued operations and a loss from an extraordinary item for the year ended December 31, 2007. There are very few companies that report both of these items in a single year. Most extraordinary gains result from mergers and acquisitions.
  • End of chapter 5.

Chap005 Chap005 Presentation Transcript

  • Communicating and Interpreting Accounting Information Chapter 05 McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
  • Players in the Accounting Communication Process
  • Regulators Securities and Exchange Commission Primary Responsibility Protect investors and maintain the integrity of the securities market. Stock Exchanges Primary Responsibility Along with state governments, set overall corporate governance standards. Financial Accounting Standards Board Primary Responsibility Set Generally Accepted Accounting Standards (GAAP). Public Company Accounting Oversight Board Primary Responsibility Sets auditing standards for independent auditors (CPAs) of public companies.
  • Managers
    • Management
    • Primary Responsibility
    • Responsible for the information in the financial statements and disclosures.
    • Chief Executive Officer (CEO) : highest officer of the company
    • Chief Financial Officer (CFO) : highest officer associated with the financial and accounting side of the business
    • Accounting Staff : prepare the details of the reports and bear professional responsibility for the accuracy of the information.
  • Board of Directors (Audit Committee) Board of Directors Primary Responsibility Responsible for ensuring that processes are in place for maintaining the integrity of the company’s accounting, financial statement preparation, and financial reporting. Board of Directors (Audit Committee) Primary Responsibility Is composed of non-management (independent) directors with financial knowledge and is responsible for hiring the company’s independent auditors. They also meet separately with the auditors to discuss management’s compliance with their financial reporting responsibilities.
  • Auditors Independent Auditors Primary Responsibility Follow established auditing standards to assess the fairness of the financial statements and related presentations An unqualified, or clean, opinion states that the financial statements are fair presentations in all material respects in conformity with GAAP. Unqualified Opinion
  • Information Intermediaries: Financial Analysts and Information Services
    • Information Intermediaries
    • Analysis and Advice
    • Receive accounting reports and other information about the company from electronic information services
    • Gather information through conversations with company executives and visits to company facilities and competitors
    • Results of their analyses are combined into analysts’ reports.
  • Users: Institutional and Private Investors, Creditors, and Other Institutional Investors Includes pension, mutual, endowment and other funds that invest on the behalf of others Private Investors Individuals who purchase shares in companies Lenders or Creditors Suppliers, banks, commercial credit companies, and other financial institutions that lend money to companies
  • Guiding Principles for Communicating Useful Information Primary Objective of External Financial Reporting To provide economic information to external users for decision making. Primary Qualitative Characteristics Relevance: Timely and Predictive Feedback Value Reliability: Accurate, Unbiased, and Verifiable Secondary Qualitative Characteristics Comparability: Across businesses Consistency: Over time
  • Differences in Accounting Methods
  • Annual Reports
    • For privately held companies, annual reports are simple documents that include:
      • Four basic financial statements.
      • Related notes (footnotes).
      • Report of independent accountants (auditor’s opinion) if the statements are audited.
  • Annual Reports
    • For public companies , annual reports are elaborate due to SEC reporting requirements:
      • Nonfinancial Section
        • Includes a letter to the stockholders, a description of management’s philosophy, products, successes, etc.
      • Financial Section
        • SEC sets minimum disclosure standards for the financial section for public companies.
  • Annual Reports
    • Summarized financial data for 5- or 10-years.
    • Management Discussion and Analysis (MD&A).
    • The four basic financial statements.
    • Notes (footnotes).
    • Independent Accountant’s Report and the Management Certification.
    • Recent stock price information.
    • Summaries of the unaudited quarterly financial data.
    • Lists of directors and officers of the company and relevant addresses.
  • Quarterly Reports
    • Usually begin with short letter to stockholders
    • Condensed unaudited income statement and balance sheet for the quarter.
    • Often, cash flow statement and statement of stockholders’ equity are omitted . Some notes to the financial statements also may be omitted.
  • SEC Reports – 10-K, 10-Q, 8-K
    • Form 10-K Annual Report
    • Due within 90 days of the fiscal year-end.
    • Contains audited financial statements.
    • Form 10-Q Quarterly Report
    • Due within 45 days of the end of the quarter.
    • Financial statements can be unaudited.
    • Form 8-K Current Report
    • Due within 15 days of the major event date.
    • Financial statements can be unaudited.
  • Classified Balance Sheet Assets used of turned into cash within one year. Assets used of turned into cash beyond one year. Obligations paid of settled within one year. Obligations paid of settled after one year. Contributed capital.. Reinvested earnings.
  • Classified Income Statement Income Statements are prepared using the following basic structure.
  • Consolidated Income Statement Operating activities – the focus of the business. Net Income ÷ Average Number of Shares Outstanding
  • Nonrecurring Items
    • Income statements may contain three sections:
      • Continuing operations
      • Nonrecurring Items
        • Discontinued operations
        • Extraordinary items
      • Earnings per share
  • Earnings Per Share EPS = Net Income * Average Number of Shares of Common Stock Outstanding During the Period Basic EPS * If there are preferred dividends, the amount is subtracted from the Net Income in the numerator.
  • Common-Size Income Statement Total revenue is equal to 100%. DELETE THIS SLIDE`
  • Statement of Cash Flows
    • Recall that the Statement of Cash Flows is divided into three major sections.
    • Cash flows from operating activities.
    • Cash flows from investing activities.
    • Cash flows from financing activities.
    We will examine the indirect method of preparing the statement. This format begins with a reconciliation of accrual income to cash flows from operations.
  • Cash flows associated with earning income. Cash flows related to purchase and sale of productive assets and investments. Cash flows related to borrowing and repaying loans and issue and repurchase of stock. Change in the cash account.
  •  
  • Notes to Financial Statements Descriptions of the key accounting rules that apply to the company’s statements. Additional detail supporting reported numbers. Relevant financial information not disclosed on the statements.
  • Accounting Rules Applied in the Company’s Statements One of the first notes to the financial statements is usually the statement of significant account policies. This particular note relates to the Callaway Golf’s policies regarding depreciation of Property, Plant, and Equipment.
  • Additional Detail Supporting Reported Numbers The second category of notes provides supplemental information concerning the data shown on the financial statements.
  • Relevant Financial Information Not Disclosed on the Statements The final category includes information that impacts the company financially but is not shown on the statements.
  • Return on Assets (ROA) Analysis 1 (beginning total assets + ending total assets) ÷ 2 ROA measures how much the firm earned for each dollar of investment. * (In complex calculations, interest expense (net of tax) and minority interest are added back to net income.
  • ROA Profit Driver Analysis = × Net Income Average Total Assets Net Income Net Sales Net Sales Average Total Assets × =
  • Profit Drivers and Business Strategy High-Value or Product-Differentiation Rely on R&D and product promotion to convince customers of the superiority of your product. Low-Cost Strategy Rely on efficient management of accounts receivable, inventory and productive assets to produce high asset turnover.
  • Chapter Supplement: Nonrecurring Items In addition, companies may have nonrecurring items. These nonrecurring items may include: 1. Discontinued operations 2. Extraordinary items These items are reported separately because they are not useful in predicting future income of the company.
  • Discontinued Operations Income or loss on segment’s operation for the period. Gain or loss on disposal of the segment. Sale or abandonment of a segment of a business. Show net of applicable taxes.
  • Extraordinary Items Unusual Infrequent Show net of applicable taxes.
  • Reporting Extraordinary Items and Discontinued Operations
  • End of Chapter 05