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introduction to the corporate annual report: A Business Application with IFRS Content Brian B. Stanko, Ph.D., CPA & Thomas L. Zeller Ph.D., CPA [not for resale] 3rd edition project instructions This page is to be completed by the student and submitted with the final annual report project according to your instructor’s requirements. Complete the following before you submit your assignment. This step is required to validate your compliance with sections 107 or 108 of the 1976 United States Copyright Act. 1. Remove the front cover of the workbook and identify: Your Name: __________________________________________ School Term: __________________________________________ Company Selected: __________________________________________ Instructor: __________________________________________ 2. Print out your completed electronic template. 3. Attach the following: • Thisfrontcover(completed) • Electronicsolutiontemplate • Printedreportsasspecifiedbytheinstructionsthat immediately follow Chapter 1: Select a Company and Gather Documents – Question 1 authors Brian B. Stanko Professor of Accounting Chair: Department of Accounting and Business Law Loyola University Chicago and Thomas L. Zeller Professor of Accounting Loyola University Chicago Professors Stanko and Zeller are accounting professors at Loyola University Chicago. Eachhasover20yearsofexperienceteachingaccountingandrelatedtopicstoexecu- tives, graduate and undergraduate students. Their research, published in scholarly and practitioner journals, addresses accounting tools and techniques that link theory to practice. introduction to the corporate annual report: A Business Application with IFRS Content 3rd edition Dedications Brian B. Stanko Julie and family Thomas L. Zeller Mary and family Copyright 2012 by Applied Accounting Analytics. All rights reserved. Reproduction or translation of this book beyond that permitted by the applicable copyright law without Applied Accounting Analytics’ permission is prohibited. Requests for permission to reprint or for further information should be directed to [email protected] or [email protected] ISBN:978-0-9841839-2-0 Applied Accounting Analytics table of contents Preface ......................................................................................................................... 2 To The Faculty Member ............................................................................................. 2 To The Student ........................................................................................................... 3 CHAPTE.

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introduction to the corporate annual report: A Business Application with IFRS Content Brian B. Stanko, Ph.D., CPA & Thomas L. Zeller Ph.D., CPA [not for resale] 3rd edition project instructions This page is to be completed by the student and submitted with the final annual report project according to your instructor’s requirements. Complete the following before you submit your assignment. This step is required to validate your compliance with sections 107 or 108 of the 1976 United States Copyright Act. 1. Remove the front cover of the workbook and identify: Your Name: __________________________________________ School Term:
__________________________________________ Company Selected: __________________________________________ Instructor: __________________________________________ 2. Print out your completed electronic template. 3. Attach the following: • Thisfrontcover(completed) • Electronicsolutiontemplate • Printedreportsasspecifiedbytheinstructionsthat immediately follow Chapter 1: Select a Company and Gather Documents – Question 1 authors Brian B. Stanko Professor of Accounting Chair: Department of Accounting and Business Law Loyola University Chicago and Thomas L. Zeller Professor of Accounting
Loyola University Chicago Professors Stanko and Zeller are accounting professors at Loyola University Chicago. Eachhasover20yearsofexperienceteachingaccountingandrelatedt opicstoexecu- tives, graduate and undergraduate students. Their research, published in scholarly and practitioner journals, addresses accounting tools and techniques that link theory to practice. introduction to the corporate annual report: A Business Application with IFRS Content 3rd edition Dedications Brian B. Stanko Julie and family Thomas L. Zeller Mary and family Copyright 2012 by Applied Accounting Analytics. All rights reserved. Reproduction or translation of this book beyond that permitted by the applicable copyright
law without Applied Accounting Analytics’ permission is prohibited. Requests for permission to reprint or for further information should be directed to [email protected] or [email protected] ISBN:978-0-9841839-2-0 Applied Accounting Analytics table of contents Preface ............................................................................................... .......................... 2 To The Faculty Member ............................................................................................. 2 To The Student ............................................................................................... ............ 3 CHAPTER 1 - INTRODUCTION .................................................................................... 4 Select a Company and Gather Documents ....................................................................4 With a printed copy of the respective company information and an electronic copy of the annual report and/or SEC Form 10-K saved on a disk, you are set to begin your analysis. ...............................................................................................
........9 Identify Why You Selected This Company .....................................................................9 Company and Annual Report Essentials ........................................................................... 10 Company Strategy and Business Environment ..................................................................12 Wrap-up ............................................................................................... ...........................16 CHAPTER 2 - ANNUAL REPORT STRUCTURE ..............................................................17 Financial Highlights ............................................................................................... .........17 General Company and Marketing Information ................................................................18 Management’s Discussion and Analysis ...........................................................................19 Reports by Management ........................................................................................... .... ...20 Independent Auditors’ Report ........................................................................................... 21
Financial Statements and the Related Notes ....................................................................22 Five- or Ten-Year Summary of Operating Results .............................................................22 Shareholder Information ............................................................................................... ...24 Wrap-up ............................................................................................... ...........................24 CHAPTER 3 - FINANCIAL STATEMENTS ........................................................................25 The Balance Sheet ............................................................................................... ............25 The Income Statement or Statement of Earnings..............................................................39 Statement of Cash Flows (SCF)...................................................................................... .47 The Statement of Stockholders’ Equity (SSE) ...................................................................50 Notes to the Financial Statements ................................................................................... 51 Wrap-up ...............................................................................................
........................... 61 CHAPTER 4 - FINANCIAL ANALYSIS ...................................................................................62 CHAPTER 5 - DECISION-MAKING PROCESS ...............................................................67 1 preface This workbook makes the study of accounting and financial analysis an enjoyable andrewardinglearningexperience.Studentslearnaccountingandfin ancialanalysisby systematically gathering financial and nonfinancial information to answer questions and make business decisions. The corporate annual report is the primary document used to drive the learning process. Students can select their own company or the instructor can direct the study and assign the same company for the entire class. Accounting terms and concepts are definedandillustratedasneededtosupportthestudent’sdecision- makingneedsthroughout the workbook. The work is active and driven by the student’s need to answer questions as they relate to his or her inquiry. Upon completing this project a student understands how to use widely available accounting and related information to systematically answer business questions. Illustrative questions are: • WouldIliketoworkforthiscompany?
• ShouldIusethiscompanyasasupplier? • Isthiscompanyasolidinvestment,preliminaryanalysis? This project is suitable for undergraduate and graduate students in accounting and finance courses.Thelearningactivitiesstimulateacross- functional,integratedapplicationofbusi- nesstools.Workbooktasksillustratewhyandhowaccountingisthelan guageofbusinessand must be integrated with nonfinancial information to make a business decision. Students are requiredtoaccessandusethecorporateannualreport,SecuritiesandE xchangeCommission (SEC)Form- 10Kandwebsiteanalyticaltoolsintheevaluationoftheirselectedcom pany. Thelearningexperienceisactiveandstudentdriven.Accessingandint erpretinginfor- mation to arrive at a sound business decision drives the accounting and financial analysis learningprocess.Wehavetakenconsiderablecaretoremoveallroadbl ocksfromthe learning process. to the faculty member The challenge to link theory, practice and technology is ongoing. This workbook places you in position to meet this challenge in an easily managed format. The workbook instruc- tionsareself- directingandcomplete.Studentsassumethevastmajorityoftherespo nsibility
of the learning process in completing this workbook. As the instructor, you essentially take on a learning management role. You may have to respond to student questions when a company includesanatypicaldisclosureorfailstoprovideareasonabledisclosu re.Wesuggestyouuse these student questions to demonstrate to the class that annual reports are not all the same. This workbook has very distinct features that we want to highlight: 1. The workbook is designed for introductory and advanced students. Some studentsmayhavetoreferenceanaccountingtexttorefreshtheirmem ory regarding certain accounting topics. The following questions are considered the most difficult: Chapter3:NotestotheFinancialStatements-Questions4-14. 2. A completed workbook for The Home Depot Company is available to instructors upon request. 2 3. InternationalFinancialReportingStandardsareweavedintothework bookto inform the students about the changes presently underway in financial reporting.
4. Gradingthestudent’sworkbookisstraightforward.Studentsarerequi redto answerquestionsthroughouttheworkbook.Ourexperiencesuggests agood evaluation of a student’s project can be measured by selectively grading questions. 5. This workbook project is easy adapted to a presentation class requirement. Studentscanbeaskedtopresentandexplainsectionsoftheannualrepo rt orspecificelementsofthefinancialstatements.Thisrequirementcan beaccom- plishedasateamorindividualassignment.Ourexperienceshowsthats tudents are confident and happy to present information about their selected company. This edition of the workbook builds upon the success of the 2nd edition, with two additions.First,companiesarechangingthewaytheyprovideannualr eportinformation. Thereisadistincttrendawayfromthetraditional- AnnualReporttotheShareholders.Now companies provide most of this information on their website, and satisfy financial reporting requirementswithSecuritiesandExchangeCommission(SEC)Form 10-K.The3rdedition of the workbook accommodates these changes, as well as retains the same structure as the
2nd edition for those companies that continue to provide the traditional paper copy of the annual report to the shareholders. Second,InternationalFinancialReportingStandards(IFRS)continu etoinfluencefinancial reporting measures and disclosures. This edition retains the skill development around general- lyacceptedaccountingprinciple(GAAP),yetcallsattentiontopresen tInternationalFinancial ReportingStandards.Thiscontent:a)bringstolifeIFRS’sinfluenceo verfinancialreporting andb)providesaleveloflearningaboutIFRSthatcandistinguishabusi nessschoolgraduate inthemarketplace.AddingIFRStothiseditionconvenientlyweavesa ninternational perspective into the curriculum. The 3rd edition of the workbook requires NO additional work by the faculty member. You will find we modified the workbook to improve its readability and help the student achieve a higher level of learning. to the student The annual report is the most widely distributed company report provided to sharehold- ers and the general public. Company leadership uses this report to communicate nonfinancial and financial information about its company. By completing this workbook you learn how to systematically evaluate a company’s annual report and gather the information needed for making a business decision.
Your work begins by answering why you are investigating the annual report of a particularcompany.Forinstance,isthiscompanyapotentialemploye rorisitapotential customer?Next,youlearnhowacompanyusestheannualreportasama rketingtool and as a means to communicate its corporate strategy. Then you become more acquainted withtheannualreport’sstructure.Following,youlearnhowtousefina ncialstatements and widely available data in a systematic framework to make business decisions. In completingthisprojectyoubuildapowerfulskill- setthatshouldserveyouwellthrough- out your career. 3 CHAPTER 1: introduction elcome to the annual report project. You are beginning the process of learning a great deal about accounting, the language of business and financialanalysis.WesuggestyoureadthePreface and the To the Student section before moving forward. These sections recap the learning process. Completing this workbook will open your eyes to the business world in ways you may have never imagined. You will develop the skill and confidence to systematically study a company using the corporate annual report and related databases. You will build a solid foundation
andframeworkforbusinessdecision-making.ENJOY! Select a Company and Gather Documents Your instructor may identify the company or you may be allowed to select your own company in completing this workbook. The company must be publicly traded. A publicly tradedcompanyisonethathasitssharestraded(boughtandsold)onthe NewYorkStock Exchange(NYSE),AmericanStockExchange(ASE)orNationalAss ociationofSecurities DealersAutomatedQuotationStockExchange(NASDAQ). You will find two types of company annual reports. Both are suitable for this workbook. First,publiclytradedcompaniesmustcomplywithSecuritiesandExc hangeCommission (SEC)andfinancialreportingregulations.TheSECrequiresallcompa niestofileannual reportsinSECForm10- K.Theannualreportrecapstheoperatingenvironmentandbusiness conditionsofthecompanyandincludesauditedfinancialstatements. TheSECusesthisinfor- mationtomonitorcompanyperformance.AnexampleofTheHomeDe pot’s2008SECForm 10- Kcanbefoundat:http://www.homedepotar.com/.(SelectDOWNLO ADANNUAL REPORT(pdf)todownloadaPDFcopyofTheHomeDepot’sSECFor m10-K.) SECForm10-Krequiresspecificnon- financialandfinancialcompanyreporting. • Goto-http://www.sec.gov/answers/form10k.htmforageneral descriptionaboutSECForm10-Krequirements.
• Goto-http://www.sec.gov/about/forms/form10- k.pdfforadetailed descriptionaboutSECForm10-K. TheSECrequiresthefollowingcompanyinformation: • Item1:Business— generaldiscussionofthecompany’sbusinessenvironment. • Item1A:RiskFactors • Item2:Properties • Item3:LegalProceedings • Item4:SubmissionofMatterstoaVoteofSecurityHolders • Item5:MarketforRegistrant’sCommonEquityandRelatedStockhol derMatters • Item6:SelectedFinancialData; • Item7:Management’sDiscussionandAnalysisofFinancialConditio n and Results of Operations • Item7A:QuantitativeandQualitativeDisclosuresAboutMarketRisk • Item8:FinancialStatementsandSupplementaryData 4 W • Item9:ChangesinandDisagreementsWithAccountantsonAccounti ng andFinancialDisclosure
• Item9A:ControlsandProcedures • Item10:DirectorsandExecutiveOfficersoftheRegistrant, • Item11:ExecutiveCompensation, • Item12:SecurityOwnershipofCertainBeneficialOwnersandManag ement,and • Item13:CertainRelationshipsandRelatedTransactions;and(n) • Item14:PrincipalAccountantFeesandServices. Second, companies must provide an “annual report to shareholders” when they hold anannualmeetingtoelectdirectors.Goto- http://www.sec.gov/answers/annrep.htmfora general description about the annual report to the shareholders. This annual report, typically, serves as a marketing and reporting tool. The report opens with a letter from the Chief ExecutiveOfficer,followedbyselectivefinancialdata,productinfor mation,employeesuccess stories, market segment information and more. The company annual report, typically, is print- ed on quality paper, filled with colorful pictures, with suggestive words like “great,” “growth,” “powerful,” spread throughout. Often, these sections of the annual report are designed to positivelyinfluencethereader’sopinionaboutthecompany,longbef orefinancialanalysis begins. The audited financial statements and related notes follow in the report, neatly formatted. Developing, printing and distributing the annual report to shareholders is
anexpensive,timeconsumingprocessforacompany. You are likely to find one or a combination of reporting structures when searching for a company to use with this workbook. Some companies meet the annual report to the shareholdersrequirementbyincludingSECForm10- KwithaletterfromtheChiefExecutive Officer.Othersincludetheletterwithamixofselectivefinancialdata, picturesand/orproduct information.(TheHomeDepot2008annualreportservesasanexampl eofhowcompanies useSECForm10- Kasacomponenttheannualreporttotheshareholders.Goto:The http://www.homedepotar.com/.)Yet,somecompaniessimplyprovi deSECForm10-K andpublishtheChiefExecutiveOfficerletterandotherinformationon thecompany website in compliance with the annual report to the shareholders requirement. Wedesignedthisworkbooktoaccommodateyourcompany’sreportin gstructure,regard- less of how it satisfies annual report requirements. You simply need to search the annual report records provided by your company. The workbook’s questions point you to the documents that provide the information you need to develop a meaningful response. SELECT COMPANY Introductory accounting and finance students should avoid banks, insurance compa- nies, public utilities, and other regulated industry companies, as well as large conglomerates.
Regulated industries are often affected by unique accounting rules and practices. The financial statementsmaycontainelementsthatareconfusing,eventotheexperi encedprofessional. Largeconglomerates,ontheotherhand,oftenparticipateincomplexr eportingpractices, andthereforemaybedifficulttoanalyze.Wesuggestchoosingacompa nythatisinteresting to you and of a reasonable size. There are two ways to locate a publicly traded company that provides a separate annual report. 5 Method 1: Use this method to locate the appropriate information for a specific company. First,identifythecompany.Second,gotothecompanywebsiteandsea rchforlinkstoits annualreport(generallythroughthe“investorrelations”link).When youlocatetheannual report, follow the instructions to open or print the document. If no link is found to the annual report, it is unlikely that it is a publicly traded company. Method 2: Use this method to explore the many different companies and industries in
selecting a company. WesuggestworkingthroughtheNewYorkStockExchange(NYSE)E uronextWebsite toselectacompany.TheNYSEisthelargestequitiesmarketplaceinth eworld.The exchangeliststheworld’stoplargeandmediumsizedcompanies. TheNYSEEuronextwebsitedirectionsarelogicalandintuitive.Thef ollowing procedure will help you use the site to locate a company. • Goto:http://www.nyse.com/home.html, • Select–Listings(locatedonupperleftsideofpage),-select- ListingsDirectory, • Select–NYSEor, • Type:http://www.nyse.com/about/listed/lc_all_name.htmltogodi rectly totheNYSE. Using this guide you can select a company by searching by name, region, or industry. Themenuoptionsguideyoutotherespectivecompany’swebsite.Fore xample,ifyouselect an industry from the menu tab, four search options appear: Industry, Supersector, Sector or Subsector.Feelfreetoexploreandselectacompanythatyouwanttostu dy. GATHER DOCUMENTS
Now gather the necessary documents. You will find most company documents download inaPDFformat.Wesuggestyousavethedocumentsinanelectronicfor mat.Thisstepmakes it easier for you to find and print the information to respond to workbook questions. Down- load and save the following: • SECForm10-K • AnnualReporttoShareholders:Manytimesacompanysimplylabelst heannual report to shareholders as the Annual Report. As discussed above, some companies meettheannualreporttotheshareholdersrequirementbyprovidingS ECForm 10- Ktoitsshareholders.Ifthisisthecaseyouwillnotneedtodownload separatelySECForm10-K. • Next,completeChapter1:SelectaCompanyandGatherDocuments– Question1 below to begin your company analysis. Immediately following Question 1 is an exampleofQuestion1completedforTheHomeDepot2008AnnualRe port.The exampleshowsthespecifictypesofmaterialyouneedtocompletethec ompany analysis.
6 7 Chapter 1: Select a Company and Gather Documents—Question 1 Identify with an “X” the primary source of data for this project. Annual report to shareholders SEC Form 10-K and the company website. Fill in the page numbers from the annual report where the following are located. Required information for this workbook project. Financial Highlights • Notabsolutelynecessary,but very common in annual report to shareholders. • NotinSECForm10-K.Maybe postedoncompanywebsite. Ifso,putWEBinPageNo.box. • Ifnotavailable,putN/AinPage No.box. Management’sDiscussion andAnalysis(MD&A)
StatementofCashFlows IncomeStatement MaybelabeledStatementofEarnings BalanceSheet MaybelabeledStatement ofFinancialPosition StatementofChangein Stockholder’sEquity ChiefExecutiveOfficerLetter • MaybelabeledPresident’sCEO orothertopofficial’smessageor LettertotheShareholders. • NotinSECForm10-K.Likelyposted oncompanywebsiteifSECForm10-K used to satisfy the annual report to shareholdersreportingrequirements. Ifso,putWEBinPageNo.box. NotestoFinancialStatement Putrangeofpages,forexample,47-58. InvestorandCompany InformationorShareholder Information Report of Independent AccountantsorIndependent
Auditors’Report Five-orTen-YearSummary ofOperatingResults Item6inSECForm10-K Management’sReport (Responsibility)onInternal ControloverFinancial Reporting Item9A.ControlandProceduresin SEC10-K Required information for this workbook project. Page No. Page No. Annual report to shareholders with letter from Chief Executive Officer and SEC Form 10-K as part of the annual report to shareholders. The annual report may include additional general company information. (TheHomeDepot2008annualreportservesasanexampleofhowcomp aniesuse SECForm10- Kasacomponenttheannualreporttotheshareholders.Goto: Thehttp://www.homedepotar.com/andopenthepdffile.)
• Printtherespectivepage(s)whereyoufindtheaboveinformation.Tur n-inprintouts with your annual report analysis. It is helpful to have both a hard copy and an electronic copy to complete workbook questions. 8 Chapter 1: Select a Company and Gather Documents—Question 1 Identify with an “X” the primary source of data for this project. ExampleforTheHomeDepot2008AnnualReport: http://www.homedepotar.com/ Annual report to shareholders SEC Form 10-K and the company website. Fill in the page numbers from the annual report where the following are located. Required information for this workbook project. Financial Highlights Management’sDiscussion andAnalysis(MD&A) StatementofCashFlows IncomeStatement
BalanceSheet StatementofChangein Stockholder’sEquity ChiefExecutiveOfficerLetter NotestoFinancialStatement InvestorandCompany InformationorShareholder Information Report of Independent AccountantsorIndependent Auditors’Report Five-orTen-YearSummary ofOperatingResults Management’sReport (Responsibility)onInternal ControloverFinancial Reporting Required information for this workbook project. Page No. Page No. Annual report to shareholders with letter from Chief Executive Officer and
SEC Form 10-K as part of the annual report to shareholders.X F-1 F-2 15-24 28 27 32 29 50 30 25 31 51 and2nd to last pg. ofAR Nopage numbers, 1st3 pages ofAR Withaprintedcopyoftherespectivecompanyinformationandanelect ronic copyoftheannualreportand/orSECForm10- Ksavedonadisk,youaresettobegin your analysis.
Identify Why You Selected This Company There are numerous reasons why you would select a particular company. The typical reason is to make a decision regarding whether to purchase or sell its stock. This is, in fact, averynarrowview.Forexample,youmayhaveaparticularinterestina companybecause of a hobby or you may be looking at a company as a possible employment opportunity or both.Forthissituationyouwouldbemostinterestedinlearningmorea bouttheindustry andthecompany’slong- termprofitpotential.Anotherreasonmightbethatthecompanyis a major contributor to the economic success of your community. Or it could be that you are acustomerofthiscompanyandareinterestedinitspotentialforlong- termsuccess.Recognize that there are numerous reasons why you would select and study a company’s annual report. Answering why you selected a particular company helps build a solid focus to the learning process of accounting and financial analysis. 9 Chapter 1: Identify Why You Selected This Company— Question 1 A) Whatis/areyourmotivation(s)orinterest(s)inselectingthiscompany ? [Seeaboveforexamples] B) Whatquestion(s)areyouseekingtoanswer?
[Forexample,isthecompanyprofitable?Canthecompanychangeand developnewproducts andservicestobecompetitive?WouldIinvestinthiscompany?Willth ecompanyprovide rewardingcareeropportunities?Inchapter5youwillhavepulledtoget herthefinancialand nonfinancialinformationtoanswerthesequestion(s).] A) B) Company and Annual Report Essentials This section of the workbook asks you to identify specific information about your company. You will typically find the answers to most questions on the first few pages or on the back inside pages of the annual report. 10 Chapter 1: Company and Annual Report Essentials—Question 1 Whatisthecompany’scompletename? Chapter 1: Company and Annual Report Essentials—Question 5 Whichstockexchangelistsyourcompany? Chapter 1: Company and Annual Report Essentials—Question 2
Whatistheaddressofyourcompany’scorporateheadquarters? Chapter 1: Company and Annual Report Essentials—Question 3 Identifythecompany’swebsiteaddress. Chapter 1: Company and Annual Report Essentials—Question 4 Identifythetelephone#ande- mailaddressofyourcompany’sInvestorRelationsDept. Telephonenumber: E-mailaddress: 11 Chapter 1: Company and Annual Report Essentials—Question 6 Whatisyourcompany’sstockexchangetradingsymbol? Chapter 1: Company and Annual Report Essentials—Question 7 Whatisyourcompany’sStandardIndustrialClassification(SIC)ands ector?Runa searchon“StandardIndustrialClassification,”andtheclassification andcodewillbe identified.YourcompanymaylistmorethanoneSICcodenumber.The firstlistedis consideredtheprimarySICforthecompany.
Forexample,search—TheHomeDepotSIC— bringupalistingofsources. InvestorWordsisonewebsitelocationoption: http://www.investorwords.com/cgi- bin/stocksymbol.cgi?ticker=HD. Movedownthepageandyouwillfind: SICCode:5211 Sector: BasicMaterials,Construction,Retain Industry:Lumberandotherbuildingmaterial Chapter 1: Company and Annual Report Essentials—Question 8 LocatetheBoardofDirectorslisting.Howmanyboardmembersdoesy ourcompanyhave? Chapter 1: Company and Annual Report Essentials—Question 9 Howmanyofthedirectorsarecompanyemployees,labeledinsidedire ctors?Andhow manyarenon- companydirectors,labeledoutsidedirectors?Whydoesacompanywa nt andneedoutsidedirectors? (Insideandoutsidedirectorsaretypicallyidentifiedassuchbytheirtit leandcompany.) The previous series of questions provides basic company
information. All are building blocks of a complete study of a company through the annual report. Company Strategy and Business Environment Evaluatingacompanyforaspecificreason(s)andseekinganswerstoq uestions is a systematic process. You are now starting that process. Begin by learning about the company’s corporate strategy and business environment. A company is likely to communicate a growth, stability, or retrenchment corporate strategy.Mostpopularisacorporategrowthstrategy.Ausercanidenti fyacorporategrowth strategywhenmanagementannouncesadecisiontoincreasesalesand capitalexpenditures. Growth occurs when leadership strategically directs corporate financial resources in one way or in a combination of ways: • Horizontal growth— Walgreensopensnewstoresonbusyintersections. • Vertical growth—Wal- Martcontrolsdistributiontostoresandretailing. • Concentric growth— TheHomeDepotsellstocontractorsandthegeneralpublic. • Conglomerate growth— GeneralElectricisinmedicalequipment,financial services, lighting, jet engines, and many more industries. A
stabilitystrategyisonewherechangeisslowand/orproblemsloomont hehorizon. Twotypesofstabilitystrategiesarepracticed:(1)pauseandproceedw ithcautionor(2)no change. You can identify this strategy when management talks about challenging economic times on the horizon or hints of waiting for market opportunities to become clear. A retrenchmentstrategyisexactlywhatlogictellsusitis.Thecompanyr equiresanew business model that can bring it back to life. Drastic action is necessary or business failure is imminent. A user can identify a corporate retrenchment strategy when numerous product lines are eliminated, plant layoffs are announced, or there is talk of general business closure. Chiefexecutivesusethechairman’smessagetocommunicatethecom pany’sstrategy. A reader will learn about events that have unfolded throughout the year. Attention is often directed to revenue growth, capital improvements, dividend strategy, impact of new account- ingpronouncements,newproductinformationand/ormarketdynami cs.Overall,thechief executiveattemptstomakethecompanyappeartobeinpositiontotake advantageof 12 Chapter 1: Company and Annual Report Essentials—Question 10
Leadershipaddressesthestockholders,typically,onceayearatthean nualstockholders’ meeting.Identifywhereandwhenthisoccurred,asreportedinyouran nualreport. 13 Chapter 1: Company Strategy and Business Environment— Question 1 Reviewthechairman’smessageofyourcompany’sannualreport.Doe sitappeartobe upliftingorsomewhatapologetic?Identifyphrasesthatsupportyourp osition. Chapter 1: Company Strategy and Business Environment— Question 2 Checkbelowtheoneprimarycompanystrategyidentifiedinthechair man’smessage. Supportyouranswerwithphrasesfoundinthechairman’smessagetha tpointedyou totheidentifiedcorporatestrategy. GROWTH:Vertical____Horizontal____Concentric____Conglom erate____ Stability____Retrenchment____ Phrasestosupportyourconclusion:
marketopportunitiesandgeneratewealthfortheshareholders.Empha sisisoftenplaced onword(s),suchas,growth,expansion,improvementinproductsands ervicesandmarket opportunities. As a user, always read the chairman’s message with full knowledge that it is designed to bias your thinking. The message is designed to communicate a robust and successful business and minimize the challenges faced by the company. Consume this letter as a starting point for your critical analysis. Question whether or not the company has ahistoryofsuccessasemphasizedthechiefexecutiveofficer.Doesthe companyhave thefinancialresourcestomoveasthechiefexecutiveofficermaybesu ggesting? The last step in learning more about your company is to complete a brief overview of eventstakingplaceinsociety.Allbusinessdecisionsmustbemadeint hecontextofbroad social,political,economic,andtechnologicalconcerns.Forexample, allbusinessesareinflu- enced by technological advance. Ask yourself what technology advances are on the horizon and if they may alter the corporate strategy of your company. The music industry, as an example,failedtoanticipatetheimpactoftechnologyinregardtofiles haringanddown- loading music.
Asocial- politicalconcern,forexample,isahumanrightsviolation.Currently,t heUnited States is working to widen trade channels throughout the world. If, however, human rights violations surface in a specific region, then trade may be restricted. This situation may impact your company if suppliers or customers are located in a region of government imposed restricted trade. Identifyingexternalissuesthatmayaffectyourcompanyisnotaoneti mestudy.Business professionals must read journals and business publications that address social, political, economic, international topics and more. Schools and local libraries hold a wealth of databases to support this information need. You will use these resources to learn more about companiesandindustriesthroughoutyourcareer.Knowinghowtouse thesesourcesis a skill you can sell to potential employers. Thefollowingservesasarepresentativeexampleofdatabasesthathol davastamountof company and industry specific information. These databases can help you address business questionsand/orissuesthroughoutyourcareer. • ABI/Inform(FirstSearch)–electronicdatabase • Business&Industry(FirstSearch)–electronicdatabase You can effectively and efficiently learn more about a company’s corporate strategy and
businessenvironmentbyreadingselectivedocuments.SECForm10- K,Item1requiressub- stantial disclosure about a company’s industry, business model, competitors, market segment, and product offerings. 14 Chapter 1: Company Strategy and Business Environment— Question 3 Brieflysummarizethecompany’sdiscussionfoundinItem1ofSECFo rm10-K. Typeofbusiness: Majorbusinesssegments: Primarycustomers: Other: Primaryproductsand/orservices: 15 Chapter 1: Company Strategy and Business Environment— Question 4 Identifybroad- basedsocial,political,economic,andtechnologicalconcernsthatma y affectyourcompany.PutN/Aifoneofthecategoriesdoesnotapply.
Social: Technological: Political: Other: Economic: • BusinessSourceElite(EBSCO)–electronicdatabase • Factiva/DowJones–electronicdatabase • LexisNexisAcademic–electronicdatabase • HooversHandbookofAmericanBusiness–hardcopybook • Web:www.money.msn.com • Standard&Poor’sIndustrySurveys–hardcopybook • U.S.Industry&TradeOutlook–hardcopybook The table below lists several industry and business issues to watch for: To complete the following question, you need to simply watch the news and read the press with eyes and ears open to broad social, political, economic, and technological concerns that may impact your company. Supplierrelationships Customerrelationships Politicalenvironment Competitiveenvironment Environmentalconcerns Socialresponsibility Employeeandlaborunions Specialinterestgroups Tradeassociations Infrastructure
Wrap-up You have now completed the information gathering stage of the annual report project. The learning activities provided a structured process to gaining a balanced perspective about yourcompanyandtheindustry(s)inwhichitoperates.Financialanaly sisisonlymeaningful when the corporate strategy is known and key business environment issues are clear. This foundation of knowledge will enable you to efficiently and effectively draw insight from the annual report. That is, you will be a more critical consumer of annual report data as you gather more facts in support of your business decisions. Another way to look at it is that you will now be on a steep level of learning as you go through the financial and nonfinancial sections of the annual report, building support for your decisions. You are now in position to specifically identify the company’s corporate strategy, beyond simply relying on the chairman’s message. 16 Chapter 1: Wrap-up—Question 1 Afterfurtherreviewofadditionalinformationyoushouldnowbeconfi dentinidentifying theoneprimarycompanystrategy,beyondtheinsightprovidedbythec
hairman’s message? Checkbelowtheoneprimarycompanystrategyidentifiedinthechair man’smessage andallothersupportingdocuments.Supportyouranswerwithphrases . GROWTH:Vertical____Horizontal____Concentric____Conglom erate____ Stability____Retrenchment____ Phrasestosupportyourconclusionfrominformationgatheredfromth echairman’smessage. Item1oftheSECForm10- KandotherinsightgainedfromcompletingChapter1. 17 CHAPTER 2: annual report structure sers of financial information may notice that most corporate annual reports have similar reporting structures. There are two main reasons for thislikeness.First,consistencyinthereportingstructureallowsaseas oned ornoviceusertoeasilylocateinformation.Knowingwheretolookimp roves the usefulness and value of the information. Second,
disclosure rules require specific types of information to be included in the annual report. This assures investors and others that companies will address similar topics, as well as provide supplemental disclosure where necessary. Youreadandinterpretthekeysectionsintheannualreportatthistime. Knowingwhat to look for and where to find specific information in the annual report is a skill all business professionals should possess. Financial Highlights Frequently,theannualreporttotheshareholdersopenswithapresenta tionoffinancial highlights or selected statistical data. This typically includes performance measures such as comparativesales,netearnings,per- shareinformation,andpossiblysomekeyfinancialratios or other company statistics over time. Bar and pie charts visually enhance the presentation of selected highlights. A company’s financial highlights represent a subset of more detailed information that follows in later sections of the annual report. Financialhighlightsarepresentedearlyinthereportinaneffortbyman agementtomake thecompanylookasgoodaspossible.Themessagemayormaynotbean accuratereflection of the company. Therefore, do not rely on this information alone to make a decision about thecompany.Viewthisinformationasabiasedintroductorysummary
. U Chapter 2: Financial Highlights—Question 1 Reviewthefinancialhighlightsofyourcompany’sannualreporttothe shareholders. Identifynetsalesorrevenues,netincome,basicearningspershare(BE PS),andtotal assetsforthecurrentandprecedingyears.Thesearethemostcommonv aluesincluded infinancialhighlights.Ifyourcompanyreportssomethingdifferent,s implycrossoutan itemhereandrecapwhatisreported.SECForm10- Kdoesnotprovidefinancialhighlights. Youmayfindthisinformationonthecompanywebsite.Ifnotavailable putN/Ainthefirst rowofboxes. Categories Current Year One Year Prior Two Years Prior Netincome Netsalesorrevenues BasicEPS TotalAssets
General Company and Marketing Information Managementusestheannualreporttotheshareholderstomarkettheco mpany’sproducts and services, and enhance its image. You will find information throughout the annual report to shareholders about company volunteer activities, employee relation programs, and research anddevelopmentsuccess,forexample.Thesevoluntarydisclosuresa reintendedtoimprove the company’s image. You are likely to find that colorful pictures and fancy charts and graphs are used to communicate a variety of messages. If this information is not available in the annual report, then search the company website and respond accordingly. 18 Basedonyourpreliminaryreview,isyourcompanyperformingbettert han,equalto,orless favorablythanintheprioryear?Brieflyexplain. Chapter 2: General Company and Marketing Information— Question 1 Lookforpicturesofproductandpeoplethatarecolorfulandsendaposit ivecompany signal to the reader. Category Message Example:Volunteer Activities
Ongoingandcontributingtothesuccessofthecommunity Whatisthebroadermessagefromthisinformation? 19 Chapter 2: Management’s Discussion and Analysis—Question 1 ResultsofOperations: Identifytheprimarydrivers/issuesthatexplaincurrentandfutureresu ltsofoperations discussedintheMD&A.Forexample,thegrossprofitpercentageincre asedbecauseof improvedbuyer/supplierrelationsresultingingreateroveralloperati ngperformance. Oranincreaseinoperatingexpensesbecauseofincreasedfuelcostsre ducedprofits. Listthesixmajordrivers/issuesofperformanceyoufindintheMD&A sectionofthe annual report. Management’s Discussion and Analysis The management’s discussion and analysis of results of operations and financial condition (MD&A)reportisconsideredbymanytobeoneofthemostimportantc omponentsofthe annual report. As a result, we have seen a significant increase in
the length of this section, a trend that is likely to continue under the current climate of financial reporting. TheSECrequiresmanagementtodiscussthecompany’spriorandcurr entperformanceso that readers can gain insight into what management perceives the direction of the company to be.Thisisimportanttotheuserfortworeasons.First,itmakesexplicith owsuccessfulleader- ship has been at achieving the corporate strategy and points to the company’s future strategic focus. Second, this information helps the user of the annual report compare and contrast the company’s corporate strategy to its available resources. WiththeMD&Areportmanagementisexpectedtoaddressthreeimpor tantareas:results of operations, capital resources, and liquidity. Typically the report begins with an analysis of prior,currentandfutureresultsfromoperations,i.e.performance.Ne xt,intheMD&A,isa disclosureaboutcashavailability.Ashort- termcashperspectiveisdiscussedwithdisclosures onliquidity.Along- termcashperspectiveisdiscussedwithdisclosuresoncapitalresource s. 1) 2) 3)
4) 5) 6) Reports by Management Managementnowfilesadditionalreportsintheannualreporttobeinco mpliancewith reportingrequirementsmandatedbytheSarbanes- Oxley(SOX)Actof2002.Thereports aredesignedtomakeexplicitthatmanagementisresponsibleforinter nalcontrolsand the financial statements. The reports are also intended to help the user recognize that the independent accountant is not responsible for internal controls and the financial statements. 20 Liquidity: Recapwhatyoufindaboutyourcompany’sliquidityintheMD&Asect ionoftheannualreport. Lookforinformationabouttheabilityofthecompanytosatisfyshort- termcashneedsandthe abilitytogenerateoperatingcashflows,forexample. CapitalResources: Recapwhatyoufindaboutyourcompany’scapitalresourcesintheMD &Asectionofthe annualreport.Lookforinformationaboutcashreservesandcreditavai lability.Forexample, yourcompany’sMD&Asectionmayhaveadisclosureaboutanestabli
shedlinedofcreditto fund future growth. Chapter 2: Reports by Management—Question 1 ReviewtheManagement’sReport(Responsibility)onInternalContr oloverFinancial Reportinginyourcompany’sannualreport.Answerthefollowingque stions. Whoisresponsibleformaintainingthe internal controls designed to provide reasonableassurancethatthebooks andrecordsreflectthetransactionsof thecompany? 21 Independent Auditors’ Report An outside accounting firm issues the independent auditors’ report to the shareholders and board of directors of the client corporation. It must be signed and dated by the account- ing firm that conducted the audit. This report provides important information and should be read before one interprets the financial statements. All material reporting deficiencies are disclosed in the report and should be taken into account before an analysis of the financial information.Mostauditreportsaredividedintothreeparagraphs,eac haddressingan important audit issue.
Recordthestatementthatidentifies management’sconclusionabout internal controls. Whoauditedmanagement’sassessment oftheeffectivenessofyourcompany’s internalcontroloverfinancialreporting? Chapter 2: Independent Auditors’ Report—Question 1 ReviewtheIndependentAuditors’Reportofyourcompany’sannualr eportandanswer thefollowingquestions. Whowasthecompany’s auditor and where is it located? Whoisresponsibleforthe preparation of and information withinthecompany’sfinancial statement? Whatistheresponsibility oftheauditor? Theauditwasconducted inaccordancewithwhat? Whatwastheopinionof theauditor?
Financial Statements and the Related Notes A significant component of the annual report is devoted to a presentation of the company’s financial statements, which normally includes a consolidated statement of income, a consolidated balance sheet, a consolidated statement of cash flows, and a consolidated statement of change in stockholders’ equity.(Consolidatedstatementsincludetheresultsoftheparentand allsubsidiaries.)Thepurposeofeachfinancialstatementisaddressed asfollows: • Statement of income. Reports a company’s financial performance over a period of time. • Balance sheet. Reports a company’s financial position on a particular day. • Statement of cash flows.Reportsacompany’scashinflowsandoutflows over a period of time. • Statement of change in stockholders’ equity. Reports changes to stockholders’ equity accounts over a period of time. EachofthesefinancialstatementswillbeaddressedinChapter3,aswel lasthenotes to the financial statements. Notes to the financial statements are just as important as the state- mentsthemselvesbecausetheyprovideamoredetailedexplanationof thenumbers. Five- or Ten-Year Summary of Operating Results
TheSECrequiresacompanytoincludeafive- yearsummaryofselectedfinancialand nonfinancial information in the annual report. Summary information gives the investor and other users the opportunity to identify emerging trends and better understand where the companyhasbeenandwhereitisgoing,inoneconvenientlocation.Ma nyanalystsusethis reporttoidentifypendingweaknessesorstrengths.Often,companies extendthefive-year comparative to include ten years of information. Analystsandotherusersshouldexercisecautionwhentheyreviewthe sestatistical summaries. This report is not covered by the auditor’s opinion. In addition, management selects the information included in this report. Information presented in the summary may beextensiveforsomecompaniesandlimitedinothers.Thefive-orten- yearsummarytypi- cally includes comparative sales and earnings information as well as measures of financial position such as total assets, working capital, total debt, shareholders’ equity, and selective nonfinancial information. 22 23 Chapter 2: Five- or Ten-Year Summary of Operating Results— Question 1
Identifythemajorcomponentsprovidedinthefive-orten- yearsummary.Summarizethe insightprovidedbyeach.Lookforstable,increasingordecreasingtre nds.Consistent, slightlyimprovingperformancesignalsmanagementhascontrolofth ebusiness. Inconsistentperformancesignalsmanagementdoesnothavecontrolo fthebusiness. Component Example:TheHomeDepot StatementofEarningsData Summary of Insight Salesandearningshavegrownsignificantlyovertime. Operatingexpensesaregrowingatanincreasingrate. Shareholder Information Annual reports close with a section devoted to investor and company information (discussedinChapter1).Althoughthissectionisincludedatthebacko ftheannualreport, the placement should not diminish its importance. Wrap-up Observe that the annual report is a tool that frames past successes and failures and future activities within a company’s strategic focus. This section of the workbook stepped you
through the many components of the annual report. The vast majority of annual reports will havesimilarsections.Eachcompanywilldeliveritsinformationdiffe rently,however.Itis the consumer’s responsibility to apply this information in support of his or her individual decision- makingneeds.Criticalanalysisoccurswhenyoucomparethequalitati veinforma- tion gathered up to this point with the financial information you pull together in Chapters 3 and4.Thisiswhereasoundgraspofthelanguageofbusiness,accounti ng,servestheuser in decision making. Your distinct challenge is to determine if the company has the financial resources to move forwardwithitscorporatestrategy.Foryoutoevaluatethisissue,acom mandofthefinancial statements is essential. The following chapters build the tools to follow through with a sound, systematic framework for financial analysis. 24 25 CHAPTER 3: financial statements The Balance Sheet he balance sheet provides a snapshot of a company’s financial position at the closeofitsfiscalyear.TheHomeDepot’sbalancesheet,forexample,is
dated February1,2009,andprovidestwoyearsofcomparativeinformation, as requiredbytheSEC.Acompany,typically,selectsayear- endclosethatcoincides withsloworstablebusinessactivities.Forexample,mostretailerssele ctaJanuaryyear-end close because the holidays have passed and inventory holdings have been reduced. Classification of the Balance Sheet Balancesheetaccounts(orelements)aregenerallyclassifiedtofacilit atereadabilityand analysis. The three major classifications include assets(resources),liabilities(claimsagainst thoseresources),andshareholders’ equity(residualownershipintheassets).ButwhileUS GAAPrequiresaclassifiedorunclassifiedformatbasedonliquidity,I nternationalFinancial ReportingStandards(IFRS)allowflexibilityinreporting.Asanexam ple,anIFRSbased balancesheetmaylistnon- currentassetsfirst(asillustratedinUnilever’s2010Annual Reportfornoncurrentandcurrentassets)andthenfollowwithliabiliti es/equityorequity/ liabilities. Also note how Unilever references the specific note # that relates to each balance sheet element. T Chapter 3: Balance Sheet—Question 1
Identifythedateshownatthetopofyourselectedcompany’sbalances heet. Current Year Prior Year Doesthecompany’sfiscalyearfollowthecalendaryear?Yes____No_ ___ Ifnot,whydoyouthinkitisdifferent? Below,wediscussthestructureofaUSGAAP-basedbalancesheet. Assets CURRENT ASSETS Current assets represent a company’s resources that will ordinarily be consumed during the upcoming fiscal year. Often these include the following: Cash and Cash Equivalents: Cash in the balance sheet, and for the purpose of reporting cashinthestatementofcashflows,includescashonhand,cashinsavin gsandchecking accounts,andcashinvestedinhighlyliquidshort- terminstrumentswithoriginalmaturi- tiesofthreemonthsorless.Highlyliquidinstrumentsincludehigh- gradecommercialpaper, money market funds, or U.S. government agency securities, each with original maturities of 90 days or less. Short-term Investments including Current Maturities of Long- term Investments: The balancesheetaccountshort-
terminvestmentsincludesacompany’sinvestmentinthestocks andbondsofothercompaniesorinvestmentsincertificatesofdeposit( orthelike)with maturities beyond 90 days and less than one year. These are investment opportunities that appealtoacompanyfortheshort- termorinvestmentsthatwereonceclassifiedaslong-term but will mature in the upcoming year. 26 Unilever Group ConsolidatedBalanceSheetExcerptasat31December £ million £ million Goodwill9 Intangibleassets9 Property,plantandequipment10 Pensionassetforfundedschemesinsurplus19 Deferrredtaxassets17 Othernon-currentassets11 Total non-current assets Inventories12 Tradeandothercurrentreceivables13 Currenttaxassets Cashandcashequivalents14 Otherfinancialassets14 Non-currentassetsheldforsale27 Total current assets 2010
13,178 5,100 7,854 910 607 1,034 28,683 4,309 4,135 298 2,316 550 876 12,484 2009 12,464 4,583 6,644 759 738 1,017 26,205 3,578
3,429 173 2,642 972 17 10,811 27 Accounts Receivables, Net: Currentassets,inadditiontocashandshort-terminvestments, will generally include amounts due from other companies or individuals. These amounts are identified as accounts receivable in the balance sheet and correspond to the sale of merchan- dise or services on credit. The granting of credit is a business decision made by the company toenhancesalesrevenue.Withoutthispurchasealternative,manyindi vidualsorfirmswould shop elsewhere. Merchandise Inventories: A company’s inventory of goods is most likely the largest component of current assets but also the most illiquid. Inventories can be acquired from other manufacturers and then resold, as in the case of The Home Depot, or inventory can bemanufacturedandsoldbyasinglecompany.Whentheyaremanufac turedandsoldbythe same company the balance sheet may report three inventory accounts: raw materials, work
inprogress,andfinishedgoodsinventory.GeneralMotorsCorporatio nisanexampleofa company that would utilize three inventory accounts in its accounting system. NONCURRENT ASSETS Noncurrent assets represent a company’s resources that have value beyond the current year. Property and equipment (at cost): Generally these elements are the most significant noncurrent assets in terms of dollar value. They are the assets that companies commit millions of dollars to and when purchased, are often referred to in the business press as a company’s capital expenditure.Capitalexpendituresrepresentcompanycoststhatwillp rovidebenefits over more than one period. Propertyandequipmentorproperty(land),plant(buildings),andequi pment(PPE) are generally reported at cost less any accumulated depreciation. And since most companies usestraight- linedepreciationareadercangaininsightintotheapproximateaverag eremain- inglifeofPlantandEquipment(excludepropertybecauseitisnondepr eciable)witha simple computation. Chapter 3: Balance Sheet—Question 2
Reviewthecurrentassetsectionofyourselectedcompany’sbalances heet.Explainwhy theorderofindividualitemsbeginswithcash.Inyouropinion,wouldit bemoreorless appropriatetoordertheseitemsaccordingtodollarmagnitude?Explai n. If you recall from above, US GAAP requires that all depreciable assets be recorded at cost (lessaccumulateddepreciation).Thatbeingsaid,nosubsequentupwa rdrevaluationscanbe madeshouldanassetincreaseinvalueovertime.IFRS,however,allow scompaniestorevalue entire classes of assets. This means a class of assets can increase to fair market value, by essentiallyusingafairmarketvalueapproachtomeasurementunderI FRS. Long-term investments: Long- terminvestmentsarerecordedwhenacompanyinvestsin another company’s debt or equity. If management intends to hold these investments beyond one year, these investments must be categorized under the heading long-term investments. Occasionallymanagementreclassifieslong- terminvestmentsasmarketconditionschange fromoneperiodtothenext. Long-termstock investmentscanbeaccountedforusingfourapproaches:(1)cost,(2) fairvalue,(3)equity,or(4)consolidation.Theequitymethodofaccou nting(knownas
InvestmentinAssociatesunderIFRS)isusedwhenacompanyownsap proximately20-50% ofthevotingsharesofanothercompanyandissaidtohave“significanti nfluence”overthat company.Consolidationisusedwhenacompanyownsgreaterthan50 %ofthevotingshares ofanothercompany.Acarefulreviewoftheinvestmentsfootnote(foll owingthefinancial statements)mayidentifythetypesofinvestmentsandtheirrelatedval uation.Onoccasion, if the reported investment is minimal, the note will provide little assistance. 28 Chapter 3: Balance Sheet—Question 3 Reviewyourcompany’sbalancesheet(orSECForm10- K)andcompareaccumulated depreciationtothehistoricalcostofPlantandEquipment(PE)usingth efollowingratio. Istheinvestmentinfixedassets,onaverage,relativelyrecent?Ifnot,c anweassumethatthese assetswillbereplacedshortly? Computethefollowing: Accumulateddepreciation/ PlantandEquipment PercentageofAssetLifeRemaining: • Highpercentagemeansolderassets • Lowpercentagemeansnewerassets
29 Notes receivable: A note receivable is a written promise to pay a specific amount or amountsatsomepointforward.Mostnotesreceivableareloansbutcan alsoresultfrom aconventionalsalesarrangementthatallowsforextendedterms.Occa sionally,accounts receivablecanbeconvertedtoanotereceivabletoextendtheoriginalte rmsoftheagreement, generate a rate of return for the holder of the note, and legally strengthen the agreement between the parties. Intangible assets, including costs in excess of fair value of net assets acquired (Goodwill): Previous classifications included assets that were generally tangible in nature. Intangible assets, however, generally lack physical substance and possess a greater degree of uncertainty in regard to future benefits than do tangible assets. They represent rights, privileges, and competitive advantages, backed by a legal agreement. Nonetheless, intangible assets, when properly created or acquired, can enhance the profitability of the enterprise for years to come. Examplesofintangibleassetsincludepatents,copyrights,trademark s,organizationalcosts, and goodwill. Intangible assets with definite lives are amortized under both US GAAP and IFRS.Intangibleassetswithindefinitelivesarenotamortizedbutteste dforimpairmentif conditionswarrantunderGAAPandIFRS.Generally,note#1tothefin ancialstatements will provide clarification in regards to the types of intangible
assets that are present. Chapter 3: Balance Sheet—Question 4 Sinceproperty,plant,andequipment(PPE)andlong- terminvestmentsinstockrepresent acompany’sinvestment,whydowedistinguishbetweenthemintheba lancesheet? 30 Chapter 3: Balance Sheet—Question 5 Reviewthenoncurrentassetsectionofyourcompany’sbalancesheet. Areanyintangible assetslisted?Ifso,identifythetypesofintangibleassetsandthepercen toftotalassets thattheintangibleassetsrepresent. Ifthiscompanyweretobeacquiredbyanothercompany,wouldtheinta ngibleassetsinfluence thepurchaseprice?Explainyouranswer. IntangibleAsset1: IntangibleAsset2: IntangibleAsset3: TotalIntangibleAssets÷TotalAssets= Chapter 3: Balance Sheet—Question 6
Nowreviewyourcompany’stotalassetsforthemostrecentyear.What percentageof totalassetsiscurrent?Noncurrent? Current Noncurrent Shouldcompanieshaveagreaterinvestmentincurrentassetsornoncu rrentassets, ordoesitdependonthenatureoftheirbusiness?Explainyouranswer. 31 Liabilities CURRENT LIABILITIES Currentorshort- termliabilitiesareobligationsthatwillbesatisfiedintheupcomingye ar. Often these include the following: Accounts Payable: Accounts payable, also known as trade accounts payable, represent amounts owed to other companies as a result of goods, services, materials, supplies, and so on acquired throughout the year. Accrued Salaries and Related Expenses: The recognition of accrued salaries and related expensesresultsfromtheapplicationofaccrualbasisaccounting.Acc rualaccountingrequires revenuestoberecognizedwhenearnedandexpenseswhenincurred.T
heactualreceiptof orpaymentwithcashisnotessentialtotherecognitionofrevenuesand expensesinthe accounting records. Income Tax Payable: Incometaxespayablerepresentsanestimatedliabilitythatisgener- allysatisfiedwithperiodicpaymentsbythecorporationtoseveraltaxi ngauthorities.Income taxpaymentsarebasedonanestimateofcorporatepretaxincome.Ases timateschangewith the passage of time, so will the periodic installments paid by the firm. Any estimated liability should be reported at the close of the fiscal year. NONCURRENT LIABILITIES Noncurrent liabilities will be settled at some unspecified point or at points beyond one year. Long-term debt (excluding current installments): Long- termliabilitiesgenerallyrepresent the most significant obligation for the corporation. Although this obligation does not affect a firm’s current liquidity, ultimately it becomes payable. Thus, there is significant concern with regard to the payment of ongoing interest and the ability to retire the obligation when itbecomesdue.Long- termcapitalleases,mortgageobligations,pensionsandotherretireme nt benefitobligationsareexamplesoflong- termliabilities.Thenotestothefinancialstatements provideinsightintothenatureandtermsoflong-termdebt. Deferred income taxes:
Deferredincometaxliabilitiesandassetsrepresentfutureincome taxobligationsorfutureincometaxbenefitsasaresultofpastevents.T heyarisewhen generallyacceptedaccountingprinciples(GAAP)andtheInternalRe venueCodeconflict withregardtothetimingofrevenues,expenses,gains,andlosses.Ther esultingdifferences aretemporary(inmostcases),butnonethelesstheycreateareportingd ifferencebetweentax- ableincomeandfinancialincome.Timingdifferencesoccurwhenrev enues,gains,expenses, orlossesaffectfinancialreportedincomeinoneperiodbuttaxableinco meinanotherperiod. Notethatdeferredincometaxesarecalculatedusingonlyenactedtaxr atesunderUSGAAP butenactedorsubstantiallyenactedtaxratesunderIFRS.Thismeanst hatcompaniesthat followIFRSapplynewtaxratesandlawsearlierthanunderUSGAAP. 32 Chapter 3: Balance Sheet—Question 7 Reviewyourcompany’sbalancesheet.Doesitreportadeferredtaxass et?Adeferred taxliability?Ifso,arethedeferredtaxassetsand/orliabilitiesreported ascurrentor noncurrent? *Note:Ifyourcompanyreportsacurrentdeferredtaxasset(liability),i twillrealizeanincome taxbenefit(obligation)inthenextaccountingperiodbecauseofaprevi
ouslyreportedevent. If your company reports a noncurrentdeferredtaxasset(liability),itwillrealizean incometaxbenefit(obligation)infutureaccountingperiods(beyondt henext)because of a previously reported event. Deferredtaxasset?YesorNo CurrentorNoncurrent* Deferredtaxliability?YesorNo CurrentorNoncurrent* Shareholders’ Equity Equity represents the net assets of a corporation. This concept can be compared to own- ingahouse(asset)withanoutstandingmortgagenote(liability).Ifthe houseisvaluedat $150,000 and the payoff on the mortgage note is $90,000, then the equity in the house is $60,000. A company’s balance sheet is viewed in much the same way. It is composed of many assets,avarietyofliabilities,andaresidualinterest(equity)inthoseas sets.Therelationship betweenthethreeitemsdefinesthebalancesheetequation(assets=lia bilities+equity). Furthermore,aninverserelationshipexistsbetweenacompany’sdebt anditsequity. If equity increases relative to total assets, then debt decreases proportionally. The greater the equity component in a balance sheet, the less pressure there is on the organization tocoverrelatedinterestexpenseandgenerateaprofit.
Stockholders’ equity is generally divided into two categories: contributed capital and earned capital. Contributed capital is recognized when a company acquires assets through thesaleorexchangeofcommonstock.Whenthisoccurs,companiesre cognizeadditional contributedcapitalinthebalancesheetaswellasanassetorreductioni nanexistingliability. Mostoftentheassetreceivediscash,butoccasionallyabuildingorequ ipmentcanbereceived aswell.Companiesalsohavetheflexibilitytosettleexistingdebtoblig ationswiththe issuanceofcommonshares.Knowingthedefinitionofthefollowingfi vetermsisnecessary to understand contributed capital. • Authorizedshares • Issuedshares • Outstandingshares • Parvaluepershare • Treasuryshares 33 The authorized shares establish the ceiling on the total number of shares that may be issued by the company. The Articles of Incorporation identify this number, and it can be exceededonlyifthecorporatecharterisamended.Theissuednumbero fsharesrepresents
the shares sold over time. The number of shares outstanding can be less than or equal to the number of shares issued. If the number of shares outstanding is less than the number of shares issued, the company has reacquired some of its own common stock. Companies do this to enhance future earnings per share, reduce total future dividends paid, support executivecompensationprograms,orhelpfendoffhostiletakeovers. Whenacompany purchases its own stock it is known as treasury stock. Par value per share controls the legal capitalofthefirms.Reviewthisconceptinarecentaccountingtext. Thepaid-in- capitalaccountrepresentstheexcessofsellingpricepercommonshar e overparvaluepershare(IFRS’sidentifiesoverparamountsasasharep remium.).Because company stock is sold periodically, the selling price will often vary depending on market conditions.Thus,paid-in- capitalcanaccumulateindifferentamountswitheachpublic offering of the firm. The other component of shareholders’ equity is called earned capital or retained earnings.Earnedcapital(retainedearnings)representstheaccumulat edearningsofthat company since its inception, less any dividends paid to the company’s shareholders. Whenacompanybeginsoperations,earnedcapital(retainedearnings )iszero. Withthepassageoftime,earningsarereportedanddividendsaredistri
buted.Asaresult, retained earnings may be positive or negative. A positive measure indicates that the company hasattainedsomelevelofprofitability(netincome)andhasdistribute dlessthanthose earnings to shareholders. Negative retained earnings suggest that the company has sustained netlossesovertimeorpaidoutdividendsinexcessofprofitsachieved. Thereisnorelation- ship between retained earnings and a company’s cash position. Remember that retained earnings are a subset of equity, and equity supports all assets. Chapter 3: Balance Sheet—Question 8 Identifytheinformationthatrelatestothestockholders’equitysectio nofyourcompany’s balancesheet. Parvaluepershareofcommonstock? Numberofcommonsharesauthorized? Numberofcommonsharesissued? Numberofcommonsharesoutstanding? Numberoftreasurysharesheldbythecompany? 34 Chapter 3: Balance Sheet—Question 9
Answerthefollowingquestionsrelativetothestockholders’equityse ctionofthe balancesheet. *IfNo,thendividendswerepaid(ordeclared)byyourselectedcompan yorcertain eventstookplaceduringtheyearwheretheaccountingfortheeventsdi rectly affected the retained earnings account. Bywhatamountdidretainedearningsincrease ordecreasefromtheprioryear? Wastheincreaseordecreaseinretainedearnings YesorNo* equaltothecompany’scurrentyearnetincome ornetloss? Chapter 3: Balance Sheet—Question 10 List(write- in)eachfinancialstatementelementasshowninyourcompany’sbalan cesheet. Assets Liabilities Stockholders’ Equity Finally,shouldyouencountertheelementminority interest in stockholders’ equity, this is anindicationthatyourcompanyownslessthan100%ofanothercompa ny,knownasthe “investeecompany”.ASC810(SFASNo.160pre- codification)nowprohibitsminorityinterest from being classified as equity. As a result, it will be reported between liabilities and equity as astandaloneelement.IFRS,however,permitminorityinteresttobere
portedasacomponent of equity. Elements of the Balance Sheet Asyoureviewedthebalancesheetyousawthatspecificaccounts(label edfinancial state- ment elements), such as cash, receivables, building, equipment, accounts payable, and income taxespayable,haddollarvaluesassignedtothem.Theseamountsrepre senttheaccount’s carrying or book valueatthecloseofthefiscal(calendar)year. 35 * Note again that additional paid in capital is known as share premiuminIFRSbasedfinancialstatements. Chapter 3: Balance Sheet—Question 11 Identifythecombinedcarryingvalues(dollaramounts)ofthefollowi ngselectedaccount groupstakenfromyourcompany’sbalancesheet: Chapter 3: Balance Sheet—Question 12 Identifythethreemajorbalancesheetaccounts,forexampleaccountsr eceivable, accountspayable,inventory,etc.thatchangedthemostfromthepriory ear.Whatevents
mightexplainthesechanges?Workingtoexplainwhythesechangesoc curredcontributes toagreaterunderstandingaboutacompany. CurrentAssets NetFixedAssets IntangibleandOtherNoncurrentAssets CurrentLiabilities Long-TermLiabilities CommonStock AdditionalPaidinCapital* RetainedEarnings OtherEquityComponents Example: AccountReceivable Example: Anincreaseinaccountsreceivableshouldcoincide withanincreaseinsales,i.e.,a10%increaseinsaleswould explaina10%increaseinaccountsreceivable.Ifaccounts receivableareincreasingandsalesdecreasing,thesignal isunfavorable. Increase Current Prior or Decrease Account Groups Year Year (in dollars)
Account Explanation 36 Importance of the Balance Sheet Theactivityofpreparingacommon- sizedbalancesheetisthebeginningofthefinancial analysis phase of studying a company. The balance sheet serves as a data source for several importantmeasures.Measuresarewholedollaramounts.Measuresm ustbestandardized into ratios to help the user compare results and performance overtime and across companies. Toprepareacommon- sizedbalancesheet,allaccountsarestandardizedasapercentageof total assets. Therearetwodistincttake-a- waysfromtheprocessofpreparingacommon-sizedbalance sheet.Financialanalysisisbothanartandascience.Fortheartsidetoco meintoplaythe usermusthaveasenseaboutthedata.Preparingandreviewingtheoutp utofacommon-sized balance sheet builds this sense about the company’s financial position. Once the user has a sense about the company’s financial position, he or she is in a better position to critically reviewandinterpretdetailfinancialratios.Practiceandexperiencear ethebestteachersfor blending the art and science of financial analysis. Chapter 3: Balance Sheet—Question 13
Prepareacommon- sizedbalancesheet(expressedinpercentages)usingthefollowing accountgroupsshowninyourselectedcompany’sbalancesheet. CurrentAssets NetFixedAssets IntangibleandOtherNoncurrentAssets Total Assets CurrentLiabilities Long-TermLiabilities CommonStock AdditionalPaidinCapital RetainedEarnings OtherEquityComponents Total Liabilities and Stockholders’ Equity Increase or Decrease Current Prior (current year % Account Groups Year Year minus prior year %) 100% 100% 100% 100%
37 Chapter 3: Balance Sheet—Question 14 Identifythethreebalancesheetgroupsfromquestion13abovethatcha ngedmost significantly.Withineachofthesegroups,identifytheprimarybalanc esheetelementthat drovethischange.Whateventsmightexplainthesechanges? CurrentAssets (Example–salesincreasedby22%,thusaccountsreceiv- ableincreasedbyapproximately22%) Group Name Explanation The user turns to the balance sheet for two pieces of specific information. The balance sheet provides information concerning a firm’s liquidity and solvency on a particular day. Theseconceptsareintroducedinthischapterbutmorefullydeveloped inChapter4. Liquidityanalysisinvolvesacomparisonofacompany’sshort- termassetsandshort- termliabilities.Allcompaniesarerequiredtoaddressliquidityissuesi ntheManagement’s Discussion&Analysis(MD&A)sectionoftheannualreport.Liquidit ymeasuresindicate a company’s ability to meet its current maturing obligations, which must be satisfied in thenext12months.
Chapter 3: Balance Sheet—Question 15 Didyourcompanybecomemoreorlessliquidwhencomparingthisyea rtolastyear? Current Year Prior Year CurrentAssetsminusCurrentLiabilities= Explainwhy? CurrentAssetsminusCurrentLiabilities= 38 Measuresofsolvencyrefertoacompany’sabilitytomeetfutureprinci palandinter- estpaymentsonitslong- termdebt.Thegreatertheamountofdebt(financialleverage), thegreaterthefixedcost(interestexpense)associatedwiththedebt.M anycompanieshave shownanuncannyabilityovertimetomanagethisfixedcost.Successi nthisareacan be advantageous to the shareholder. A large amount of debt is necessary and typical in rapidly growing companies. A large debt load, however, also signals the company may have difficulty surviving turbulent periods. Chapter 3: Balance Sheet—Question 16
Didyourcompanyincreaseordecreaseitsfinancialleveragewhenco mparingtotaldebt tototalstockholders’equityfromthisyeartolast? Current Year Prior Year Totaldebt÷Totalstockholders’equity= Explainwhy? Totaldebt÷Totalstockholders’equity= 39 Interestingly,IFRSonlyrequiretwoyearsofcomparativefinancialre portingacrossall financial statements. Format of the Income Statement The income statement is generally divided into two sections: operating and nonoperating. The operatingsectionoftheincomestatementincludesrevenuesandexpe nsesthatcorre- spondtotheprincipleoperationsofthecompany(i.e.,day-to- dayoperations).Thecombina- tionofoperatingrevenueandoperatingexpensesleadstoareportedme asureofoperating income or operating loss. 1ColleenCunningham,“WillRevampedFinancialStatementBenefit Valuation?”ComplianceWeek,February24,2009
The Income Statement or Statement of Earnings The income statement, also labeled the statement of earnings, measures a company’s performanceoveraspecifiedperiodoftime.Forthisreason,thestatem entistitledfora periodoftime— forexample,theyearendingFebruary1,2009.Thestatementisdiffere nt from the balance sheet because it is a cumulative record of activity for a month, quarter, multiple quarters, or one year. Creditors, investors, and many others use the income statement as a measuring stick of how a company has performed, where it appears to be heading, and whatitsfuturecashflowswillbe.USGAAPrequiresthattheincomesta tementbepresented usingasingle-stepormultiple- stepformat.IFRS,however,donotrequireaparticularformat. Further,expensescanbegroupedaccordingtofunctionornaturerathe rthansimplyfunction under US GAAP. Function refers to the primary activities, such as selling goods, providing ser- vices, manufacturing, marketing, business development, and administration. Nature refers to the economic characteristics, such as separating total revenue into wholesale revenues and re- tail revenues, or disaggregating cost of sales into materials, labor, transport, and energy costs.1 Chapter 3: Income Statement—Question 1 Reviewtheheadingofyourcompany’sincomestatement.Doesthe company’sincomestatementprovidetwoorthreeyearsofcomparativ e _____ years
information?(Insertnumbertotheright.) WhydoyouthinktheSECrequiresthatbalancesheetsprovidetwoyear sofcomparative financialinformationandincomestatementsprovidethreeyearsofco mparativefinancial information? 40 The nonoperatingsectionoftheincomestatementincludesincome/expen seitemsand gain/lossitemsthatareroutinetomostanytypeofbusinessentitybutth atareperipheral today-to- daybusinessoperations.Examplesincludeinterestearnedoninvestm ents,interest incurredonborrowings,andgainsand/orlossesassociatedwiththedis posalofassetsand/or eliminationofliabilities.Anexampleofaperipheralactivitywouldbe thesaleofapieceof equipment. If the equipment has a book value of $20,000 and is sold for $15,000, there is a realizedlossof$5,000.Whilethelossisreportedontheincomestateme nt,itisrecognizedin the nonoperating section under other expenses and losses.Thislossisexcludedfromoperating income because it is related to a support of business activity rather than to an operating business activity. Thesumofoperatingincome(loss)andnonoperatingincome(loss)iss
implyincome (loss) before income tax expense.Onceincometaxexpenseorbenefitisconsidered,netincome (loss)istheresidual.Thelevelofdetaildisclosedbetweenoperatingin comeandnetincome variesamongcompanies.Whenevaluatingacompanyastudyofoperat ingincomefromone yeartothenextismuchmoremeaningfulthanastudyofnetincomefrom oneyearto thenext. Elements of the Income Statement As mentioned before, the income statement is often divided into two sections: operating and nonoperating. The operating section includes sales revenues, cost of goods sold, andotheroperatingexpenses. OPERATING SECTION Net Sales: Operating sections begin with net sales of goods and services. Net sales result when a company deducts from gross sales: Chapter 3: Income Statement—Question 2 Reviewthemiddlesectionofyourcompany’sincomestatement.Dido peratingincome (loss)increaseordecreasefromtheprioryearandbyhowmuch?Youm ayhaveto computeoperatingincome(loss). Chapter 3: Income Statement—Question 3
Doesthemiddlesectionofyourcompany’sincomestatementshowano noperating income(loss)increaseordecreasefromtheprioryearandbyhowmuch ?Youmayhave tocomputenonoperatingincome(loss). Increasedby$ ____________________ Increasedby$ ____________________ Decreasedby$____________________ Decreasedby$____________________ 41 • Costofgoodsreturnedbycustomers • Cashdiscountsawardedwhencustomers,clients,etc.paywithinthedi scountperiod • Allowancesgrantedtocustomerswhengoodsorservicesaredefective These items generally are not disclosed in the annual report but are tracked for internal reporting purposes. Cost of Merchandise Sold: Generallythemostsignificantexpensereportedinthe
income statement is the cost of goods. Cost of goods sold is recognized only when a sale of merchandise or services has taken place. Cost of goods sold as a percentage of net sales is an important measure of a firm’s performance. The percentage can be compared from year to year as well as across firms within an industry. Gross Profit: The difference between net sales and cost of goods sold is a company’s gross profit,orgrossmargin.Areportedgrossprofitisessentialtocoveroper atingexpensesthat acompanyincursduringtheoperatingyear.Management’seffectivec ontroloverinventory acquisition cost can lead to an improved or at least stable gross profit measure from one year tothenext. Companies that report lower operating profits often have been quoted as saying, “Product price increases could not be passed along to the consumer in a timely manner.” Circumstances like these create a squeeze on gross margins that ultimately filters down to a company’s operat- ingincome(loss),thatis,thebottomline.Manytimespriceincreasesc annotbepassedalong becauseofexistingmarketconditionssuchasaneconomicdownturn. Raisingpriceswould simply create less product demand. Selling Expenses: Sellingexpensesdirectlyrelatetothesellingofgoodsandservices. Examplesareadvertisingandthesalesforce’ssalary. General and Administrative Expenses:Generalandadministrativeexpensesofteninclude
avarietyofcoststhatrelatetooperationsotherthansales.Forexample, thedepreciation ofacompany’scorporateheadquartersconstitutesageneralandadmi nistrativeexpense. Managementsalaries,utilitycosts,andpropertytaxesarefurtherexa mples ofgeneralandadministrativeexpenses. Operating Income:Thedifferencebetweenoperatingrevenuesandoperatingex pensesis operating income. Operating income is essentially the most useful measure of a company’s performancefromoneyeartothenext.Thereasonforthis,asmentione dbefore,isthatit excludesnonoperatinggainsandlossesthatcandistortmeasuresofper formance. NONOPERATING SECTION Interest and Investment Income: Interest and investment income is earned and reported when a company invests in certificates of deposits, treasury bills or notes, or in the stocks and bonds of other companies. The success of these investments will be measured in the form of dividend, interest, or investment income. These returns will ultimately be reported on the company’sincomestatementundernonoperatingincome(expenses). As an aside, institutions that report interest and investment income as a part of operations include banks and other financial institutions. Their business purpose is to attract capital at a predetermined cost, invest the acquired capital, and achieve a higher rate of return. Therefore,
a financial institution’s gross profit is controlled by the percentage difference. 42 Interest Expense: Interest is a payment that companies make for using another company’s money and is directly related to the passage of time. Interest is associated with a company’s notes, mortgages, and bonds or is embedded as part of a lease obligation or pension obliga- tion.Inmostcases,acompany’slong-termliabilities(andsomeshort- termliabilitiesaswell) willhavesomerelatedinterestexpense.Onceagain,however,interest expense(andrevenue) falls outside operating income. Income Taxes: Mostcorporationsareresponsibleforavarietyoftaxes.Thesecanincl ude federal,state,andforeignincome- taxobligations.Becausemanyofthesetaxesarebased onrevenue,theymustbeaccruedforandpaidinatimelymanner.Incom etaxexpense,the number reported in the income statement, is essentially the federal statutory rate multiplied byacompany’sincomebeforetax.Thisratevaries,dependingontaxab leincomeand politicalagenda.Thenumberisfurtheradjustedtoincludeanystateorf oreignincometax obligation(orincometaxbenefits).Oncealloftheseeffectsareconsid ered,incometax expenseisreported.Therefore,incometaxexpense,asafunctionofinc omebeforetaxes,
can vary from year to year. Net Earnings:Netearnings(orincome)areoftenreferredtoasacompany’s bottom line. Net earnings, as we have seen, remain after a company deducts operating and nonoperating expensesfromoperatingandnonoperatingrevenues.Acompany’snet profitmarginisoften compared across years or across firms within the industry. Irregular Items Two items of special importance are also included in the conventional income statement butarereportedbeyondtheoperatingandnon- operatingsections:discontinuedoperations andextraordinaryevents.Athirdirregularitem,changesinaccountin gprinciples,isnow accounted for with a direct adjustment to the balance sheet. Accounting professionals view these events as irregular items and generally prefer that their effects be removed from the main body of the income statement. DISCONTINUED OPERATIONS Oneofthemostoftenoccurringirregularitemsisthegain/lossassociat edwiththe disposalofabusinesssegment.Justasmanycompanieshaverecentlye xpandedoperations through business acquisitions, many of these same companies have disposed of other Chapter 3: Income Statement—Question 4
Inreferencetowhyyouarestudyingthiscompany,isitimportanttokno wthedifferent sourcesofincome—operatingornonoperating? 43 operatingsegmentsalongtheway.Foradisposaltoqualifyasadiscont inuedoperation,the assets, results of operations, and activities of a business segment must be clearly distinguish- able,physicallyandoperationally,fromthebalanceoftheenterprise. Thefollowingexcerpt from Sara Lee’s 2009 annual report illustrates the note disclosure that would help clarify a recognizedgain/lossonthedisposalofabusinesssegment. “Note4– DiscontinuedOperations:Therewerenofinancialresultsattribut- able to discontinued operations in 2009. In 2008, the corporation disposed of itsMexicanMeatsoperation.In2007,thecorporationdisposedofitsE uropean MeatsandBrandedApparelAmericas/Asiabusinesses.Theresultsof these businesses have been reported as discontinued operations.” EXTRAORDINARY ITEMS A second irregular item that gets special accounting consideration under US GAAP but not underIFRSisanextraordinaryevent.Anextraordinaryitemisatransa ctionoreventthatis
both unusual and is infrequent in occurrence, taking into account the environment in which thecompanyoperates.Forexample,assumetwocompaniessustainsig nificantfloodlossdam- age.Onecompanymightclassifythelossasextraordinary,yettheothe rmightnot.Floodloss sustainedbyanenterpriselocatedinafloodplainwouldnotconstitutea nunusualoccurrence andwouldnotwarrantextraordinaryclassification.Norwouldaneart hquakelossfora companylocatedinCaliforniabereportedasextraordinary. Another item, known as a corporate restructuring charge, may appear to be unusual or infrequentbutisstillreportedasacomponentofcontinuingoperations .TheFASBconsiders organizational restructuring a part of today’s normal business environment. However, restruc- turing charges, if material, can be shown as a separate line item. Shown below is Sara Lee’s 2009 annualreportnotedisclosureforrestructuringactionstakenduringfis calyears2007-2009. Note 5—Exit, Disposal and Restructuring Activities Thefollowingisasummaryoftheincome(expense)associatedwithne wandongoingactions…. CostofSales TransformationCharges—IT Selling,Generaland AdministrativeExpenses TransformationCharges—IT Transformation/AccelerateCharges NetChargesfor(incomefrom) ExitActivities AssetandBusinessDispositions
Reduction in income from continuing operationsbeforetaxes Incometaxbenefit Reduction in income from continuing operations $ 5 21 18 114 --- $ 158 $ (43) $ 115 $ 8 40 3 39 (1) $ 89 $ (31) $ 58 $ 10 42 67
106 (12) $ 213 $ (77) $ 136 2009 2008 2007 44 CHANGE OF ACCOUNTING PRINCIPLE A third irregular event that requires special accounting treatment but no longer affects the income statement(ASC250-SFASNo.154pre- codification)isanaccounting principle change. A change in accounting principle results when a company voluntarily switches from onegenerallyacceptedaccountingprincipletoanotherorwhentheFA SBissuesanewac- counting pronouncement. A change in an accounting principle often requires an adjustment tospecificassetorliabilityaccounts,aswellasanadjustmenttoretaine dearnings(prior yearchangeswherenecessary).Whenretainedearningsareadjusteda ndprioryearsfinancial statements are restated, the firm is applying “retrospective application.” In the past, many of these accounting changes were accounted for under the “current approach” and the cumula- tive effects were reported as a component of net income.
Importance of the Income Statement Creditors, employees, suppliers, investors, and others use the income statement. The re- port serves as a measuring stick of how a company has performed, where it appears to beheading,andwhatfuturecashflowsarelikelytobe.Thefirstquestio nmostuserswant answerediswhatisnetincome?Next,theywanttoknowhowthatfigure comparestothe prior years. Chapter 3: Income Statement—Question 5 Ifanyoftheirregulareventsareshownonyourcompany’sincomestate ment,describethe natureandtheamount.Selectthemostcurrentyearaffectedbytheeven tifmultipleyears are affected. Restructuringcharge? Discontinuedoperation? Extraordinaryevent? Irregular Event Amount Nature of the Change Chapter 3: Income Statement—Question 6 Reviewthelowersectionofyourselectedcompany’sincomestatemen t.Didnetincome
(loss)increaseordecreasefromtheprioryearandbyhowmuch? Increasedby$ ____________________ Decreasedby$____________________ 45 Similartothebalancesheet,acommon- sizedincomestatementprovidesabasicstructure foraskingwhyandwhynotvaluesincreasedordecreased.Thecommo n-sizedincomestate- ment is standardized by net sales. Basic and Diluted Earnings per Share (BEPS and DEPS) Earningspercommonsharemustbecomputedandreportedbyallpubli clytraded companiesintheircorporateannualreportandSECForm10- K.Thereasonforthisisthat it measures performance on a per share basis and helps standardize earnings. Standardized earnings allow investors to compare two companies side by side without being unduly influencedbythemagnitudeofearnings.Forexample,ifCompanyAa chieves$5billion in net earnings while Company B achieves half that amount, Company A would appear to be more attractive as a shareholder investment. If, however, Company B had only half as manysharesofstockoutstanding(heldbyshareholders),CompanyB’ searningspershare would be equal to Company A’s.
Chapter 3: Income Statement—Question 7 Prepareacommon-sizedincomestatementforthecategoriesbelow. NetSales(revenues) CostofGoods/Services(ifapplicable) GrossProfit OperatingExpenses OperatingIncome(Loss) NonoperatingIncome(Loss) IncomeTaxExpense NetIncome Increase Current Prior or Decrease Account/Category Year Year (current yr.% - prior yr. %) Chapter 3: Income Statment—Question 8 Identifythethreeincomestatementaccounts/categoriesthatchanged themostin Question7.Whateventsmightexplainthesechanges? (Hint–theMD&Asectionwillprovidegood informationtoanswerthisquestion.) Account or Category Explanation
100% 100% 46 Becauseofavarietyofequity- relatedinstrumentsthatexistwithinacompany’scapital structure, companies are often required to report two measures of earnings per share. Examplesofequity- relatedinstrumentsthatmayleadtocommonstockinclude: • Convertiblebondsornotes • Convertiblepreferredstock • Stockoptions,stockwarrants,stockunits… Eachoftheseinstruments,ifconvertedintocommonstockbytheirhol ders,couldlower a company’s earnings per common share because the number of shares outstanding will increase. Therefore, accounting rules and the conservatism principle require companies to report two measures of per share performance: basic earnings per share and diluted earnings per share. The computation of diluted earnings per share considers the effect of converting all dilutive securities into common shares. Chapter 3: Income Statment—Question 9 Identifyyourcompany’sBasicandDilutedEPSamounts.PlaceaN/Ai nDilutedEPSif not reported.
Currentyear Precedingyear1 Precedingyear2 WhyisdilutedEPSalwaysequaltoorlessthanbasicEPS? Basic EPS Diluted EPS 47 Statement of Cash Flows (SCF) Format of the SCF Thestatementofcashflowsisdesignedtomeasurehowcashflowedint oandoutofthe businessforaperiodoftime.Cashflowsinsupportofdailyoperatingac tivitiesarelabeled operatingcashflows.Cashflowsassociatedwithpurchasesofinvestm entsandsaleofinvest- mentsarelabeledinvestingcashflows.Cashflowsassociatedwithfin ancingthebusiness throughstocksandbondsarelabeledfinancingcashflows. Chapter 3: SCF—Question 1 IstheSCFdatedinthetitleforaperiodoftimesimilartotheincomestate mentorfora pointintimesimilartothebalancesheet?Why?
Chapter 3: SCF—Question 2 IdentifythefollowingsectionsoftheSCFandrecordtheamounts.Che ckthemathby summing to the cash balance at end of year.Verifythattheendingcashbalancereported ontheSCFisthesameasreportedonthebalancesheet. Netoperatingcashflows Netinvestingcashflows Netfinancingcashflows Netincrease(decrease)incashflows Cashbalanceatbeginningofyear Cashbalanceatendofyear Doesthetotalmatchbalancesheetcash? Yes/No Yes/No Current Prior Second Section Year Year Prior Year 48 Importance of the SCF Twomethodsofreportingoperatingcashflowsareallowedbygenerall yacceptedaccount- ingprinciples.Thedirectmethodcomputesoperatingcashflowssimil
artohowtheincome statementcomputesearnings.Theindirectmethodcomputesoperatin gcashflowsbyadd- ingtoorsubtractingfromnetincome,thecashflowsassociatedwithda ilyactivities.Each areacceptableunderUSGAAPandIFRSreportingrules.Theindirect methodisfollowedby mostcompanieswhenpreparingtheSCF.Regardlessofthemethodem ployed,thefollowing questionsapply.AsyoureviewtheSCF,notethatinterestreceivedand dividendsreceivedare reportedasoperatingcashflowsunderUSGAAPbutcanbereportedas operatingorinvest- ingcashflowsunderIFRS.Interestpaidisalsoconsideredanoperating cashflowunderUS GAAPbutcanbereportedasanoperatingorfinancingcashflowunderI FRS. Chapter 3: SCF—Question 3 Recordnetsales,netincomeandnetoperatingcashflowsbelow.Allthr eeshouldbe trendinginapproximatelythesamedirection.Ifso,thisisasignofawel l-runbusiness. Ifoneormorearegoinginadifferentdirection,orrandom,thenyoumus tkeepaneye openforanexplanationwhy. NetSales NetIncome NetOperatingCashFlows
Explainwhynetsales,netincomeandnetoperatingcashflowsaretren dingtogetheror differently.(Hint:Lookatdepreciationexpenseandsubstantialchan gesininventory,accounts receivableandaccountspayablebalances.Explainingwhyisakeylear ningpoint.) Item Current Year Prior Year Second Prior Year 49 Chapter 3: SCF—Question 4 Identifytheprimarycashoutflowsandinflowsfrominvestingactiviti es. Chapter 3: SCF—Question 5 Identifytheprimarycashinflowandoutflowfromfinancingactivities . Cashoutflow: Cashinflow: Considerthreekeyissuesatthispoint.Isthecompanyaddingassets?T hisisasignofgrowth. Isthecompanyreplacingassets?Thisisasignofgrowthandstability.I sthecompanyonly sellingassets?Thisisasignofretrenchment. Cashinflow:
Cashoutflow:(Note:cashdividendspaidarereportedhere.) Considertwokeyissuesatthispoint.Howisthecompanybeingfinance d,throughdebtor equity?Canyoudeterminewhichisgrowingfasterandwhy?Asoundc orporatestrategyis tofinanceacompanywithdebtduringstabletimes,becausethisdeman dsregularpayment ofprincipalandinterest,andtofinanceacompanywithequityduringu nstabletimes,because leadership can elect to pay or not pay dividends. Description of Activity Amount Description of Activity Amount 50 The Statement of Stockholders’ Equity (SSE) Thestatementofstockholders’equity(orstatementofchangeinstock holders’equity) identifiesthechangesinallbalancesheetequityaccountsoveraspecif iedperiod.Forthis reason,thestatementistitled,forexample,“fiscalyearended,Februar y1,2009”Threepoints arenoteworthyaboutthestatementofstockholders’equity.First,asin thestatementofcash flows,threeyearsofinformationarepresentedinthereport.Second,tu ckedwithinthestate- ment of stockholders’ equity is a reconciliation of retained earnings from beginning balance to ending balance for the period. This reconciliation is a required disclosure and is identified
asthefourthrequiredfinancialstatement.Third,theFASBrequiresth atsignificantchanges in the equity accounts must be disclosed to include comprehensive income. The statement of stockholders’ equity fulfills this requirement. Importance of the Statement of Stockholders’ Equity Creditors and investors use this report to better understand the changes in a company’s equitypositionoveraspecificperiodoftime.Keepinmindthatthiscat egory—stockholders’ equity— presentsthenetassetsofacompany(excessofassetsoverliabilities). Asthemakeup ofassetsandliabilitieschangesfromoneperiodtothenext,sowillstoc kholders’equity.The statement of stockholders’ equity, therefore, helps the user focus on the changes that occur. Ingeneral,asacompanybecomesmorefinanciallycomplex,astateme ntofstockholders’ equitybecomesanecessityforexternalreporting.Intheirinfancy,co mpanieshavefewevents outsideofearningsanddividendsthataffectequity.Whenthisisthepat tern,astand-alone statementofretainedearningsisacceptableforexternalreporting.Ast hefinancialstructure becomesmorecomplexstatementsofstockholders’equityareinclude dasaseparatesched- ule, along with the three other financial statements in the corporate annual report. Occasion- ally, the statement will be separately included in the notes to the financial statements.
Chapter 3: SSE—Question 1 Identifytheelementsthatcomprisethestatementofstockholders’equ itysectionofyour company.Hint:Theseitemsaregenerallyillustratedacrossthetopoft hepageusinga columnarformat.(Example.Commonstock– sharesanddollaramount.) 51 Limitations The statement of stockholders’ equity has few limitations, simply because it is a summary financialstatementusedtoexplainequitychanges.Becauseofthis,the statementofstock- holders’equityisnotwellsuitedforfinancialanalysis.Mostrelevante quityinformation can be drawn specifically from the balance sheet stockholders’ equity section and the income statement.Oneexceptionisacompany’sdividendpayments.Dividen ddistributionsarenot reportedinthebalancesheet;theyfalloutsidetheincomestatement.H owever,cashdividend paymentscanbelocatedwithinthefinancingsectionofthestatemento fcashflows. Notes to the Financial Statements Theaccountingprofessionhasadoptedthefull- disclosureprinciple,whichemphasizes
thereportingofanyinformationthatwouldinfluencethejudgmentofa ninformedreader. Althoughthebalancesheet,statementofoperations,andstatementofc ashflowsprovide significant economic substance, additional clarification and amplification provided in the notes can improve the understanding of the financial statement information. Companies that provideextensivenotepresentationaresimplycomplyingwithgener allyacceptedaccount- ingprinciples(GAAP),andincertaincases,withregulationsissuedby theSEC.Notesare essentially the means of clarifying what is being presented in the financial statements and are audited along with the general financial statements. In compliance with GAAP, you will find your company sporadically identifies the related note to the financial statements in the body ofthebalancesheetand/orincomestatement.IFRS,however,requiret hattheelements Chapter 3: SSE—Question 2 Identify the cash dividends per share. Determinethedividendpayoutpercentage.Acompany’s dividendpayoutpercentageiscomputedbydividingdividend percommonsharebynet income or earnings per common share. (Hint:Ifyourcompanyreportedanetlossfortheyear,theanswer lacksmeaning.) Computedividendyield.Acompany’sdividendyieldiscomputed bydividingdividendpercommonsharebymarketpriceper commonshare.(Hint:Usethecurrentpersharepriceforyour selectedcompany.)
Isyourcompany’sdividendyieldareasonablereturngivencurrentma rketconditions? 52 of the financial statements be shown with their related note number specifically, as illustrated in a section of the Heineken 2008 Annual Report income statement shown below. The broadest and most generally read note is the first, “Summary of Significant Accounting Policies”. Accounting policies are the accounting principles and methods used bythereportingentity.Forthatreason,usersoffinancialinformationc anlooktothisnote to gain a general understanding of the business and related accounting applications and establish a framework for comparing two or more companies. The following questions are based upon information generally included in Note #1 Summary of Significant Accounting Policies and a selection of notes that are most common. Cashisoneofthemostimportantelementswithinthecorporatebalanc esheet.Without cash, a company is unable to meet its operational demands. Chapter 3: Note to the Financial Statements—Question 1 Howdoesyourcompanydefine“cashandcashequivalents”?
Heineken N.V., ConsolidatedIncomeStatementExcerpt Fortheyearended31December2008 Revenue Otherincome Rawmaterials,consumablesandservices Personnelexpenses Amortization,depreciationandimpairments Total expenses Results from operating activities Interest income Interestexpenses Othernetfinanceexpenses Netfinanceexpenses 5 8 9 10 11 12 12 12 14,319 32 9,548 2,415 1,206 13,169
1,182 91 (469) (107) (485) 11,245 28 7,320 1,951 638 9,909 1,364 64 NoteIn millions of EUR 2008 2007 (155) (4) (95) 53 Inventory consumes a substantial amount of company resources. How a company values inventoryaffectsfinancialperformanceandthecomparabilityofonec ompanytothenext. USGAAPallowsmultiplecostflowassumptionsforinventoryvaluati onpurposes.These includeLIFO,FIFO,weighted/movingaverageandspecificidentific ation.IFRS,however, donotpermittheuseoftheLIFOcostflowassumptionbutallowinvent orytobewritten
up even if it were to be written down as a result of impairment. US GAAP does not permit asubsequentwrite-up. Investmentsinequityanddebtsecurities(alsoreferredtoasmarketabl esecuritiesinmany companynotes)canberecordedatcost,atfair-marketvalue(ASC820- SFASNo.157pre- codification, defines fair value, establishes a framework for measuring fair value in generally acceptedaccountingprinciples,andexpandsdisclosuresaboutfairva luemeasurements),or at amortized cost. The appropriate investment valuation model is based on its classification. Investments are generally categorized as trading investments, available-for-sale investments, or held-to-maturity investments. Forexample,equity(othercompanies’stock)investmentsarecarried atcostifmarketval- ueisnotreadilydeterminable.Alternatively,theycanbecarriedatfair -marketvalue,andclas- sified as trading or available for sale,ifthereexistsareadymarketforliquidation.Thedistinc- tion between classes determines whether unrealized gains and losses will affect the income statement(nonoperatingincome)inagivenperiodorwhetherthegain sandlosseswillbe excludedfromnonoperatingincomebutincludedintheorganization’ sstockholders’equity. Bondinvestments,bycontrast,canbecarriedatcostorfair- marketvalue,dependingon the investment’s classification. If management intends on
holding the investment until the bondsreachmaturity(held-to- maturityclassification),costoramortizedcostisusedasthe basisforvaluation.Essentially,thisrequirestheorganizationtocarry theinvestmentatcost throughmaturityandnotadjusttofair- marketvaluefromonereportingperiodtothenext. If the debt investment is classified as trading or available for sale, the valuation model is similartothatofaninvestmentinequitysecurities.ASC825(SFASNo .159pre-codification) permits entities to choose to measure many financial instruments and certain other items at fair value. The objective is to improve financial reporting by providing entities with the op- portunity to mitigate volatility in reported earnings caused by measuring related assets and liabilitiesdifferentlywithouthavingtoapplycomplexhedgeaccounti ngprovisions. Chapter 3: Note to the Financial Statements—Question 2 Howdoesyourcompanyvalueits“inventories”?Explainthemeaning oftheinventory valuationmethod.Aredomesticandinternationalinventoriesvaluedt hesame? Service companies will typically not have inventory. 54 TheHomeDepot’sinvestments,consistingprimarilyofhigh- gradedebtsecurities,
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
introduction to thecorporate annual reportA Business Ap.docx
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introduction to thecorporate annual reportA Business Ap.docx

  • 1. introduction to the corporate annual report: A Business Application with IFRS Content Brian B. Stanko, Ph.D., CPA & Thomas L. Zeller Ph.D., CPA [not for resale] 3rd edition project instructions This page is to be completed by the student and submitted with the final annual report project according to your instructor’s requirements. Complete the following before you submit your assignment. This step is required to validate your compliance with sections 107 or 108 of the 1976 United States Copyright Act. 1. Remove the front cover of the workbook and identify: Your Name: __________________________________________ School Term:
  • 2. __________________________________________ Company Selected: __________________________________________ Instructor: __________________________________________ 2. Print out your completed electronic template. 3. Attach the following: • Thisfrontcover(completed) • Electronicsolutiontemplate • Printedreportsasspecifiedbytheinstructionsthat immediately follow Chapter 1: Select a Company and Gather Documents – Question 1 authors Brian B. Stanko Professor of Accounting Chair: Department of Accounting and Business Law Loyola University Chicago and Thomas L. Zeller Professor of Accounting
  • 3. Loyola University Chicago Professors Stanko and Zeller are accounting professors at Loyola University Chicago. Eachhasover20yearsofexperienceteachingaccountingandrelatedt opicstoexecu- tives, graduate and undergraduate students. Their research, published in scholarly and practitioner journals, addresses accounting tools and techniques that link theory to practice. introduction to the corporate annual report: A Business Application with IFRS Content 3rd edition Dedications Brian B. Stanko Julie and family Thomas L. Zeller Mary and family Copyright 2012 by Applied Accounting Analytics. All rights reserved. Reproduction or translation of this book beyond that permitted by the applicable copyright
  • 4. law without Applied Accounting Analytics’ permission is prohibited. Requests for permission to reprint or for further information should be directed to [email protected] or [email protected] ISBN:978-0-9841839-2-0 Applied Accounting Analytics table of contents Preface ............................................................................................... .......................... 2 To The Faculty Member ............................................................................................. 2 To The Student ............................................................................................... ............ 3 CHAPTER 1 - INTRODUCTION .................................................................................... 4 Select a Company and Gather Documents ....................................................................4 With a printed copy of the respective company information and an electronic copy of the annual report and/or SEC Form 10-K saved on a disk, you are set to begin your analysis. ...............................................................................................
  • 5. ........9 Identify Why You Selected This Company .....................................................................9 Company and Annual Report Essentials ........................................................................... 10 Company Strategy and Business Environment ..................................................................12 Wrap-up ............................................................................................... ...........................16 CHAPTER 2 - ANNUAL REPORT STRUCTURE ..............................................................17 Financial Highlights ............................................................................................... .........17 General Company and Marketing Information ................................................................18 Management’s Discussion and Analysis ...........................................................................19 Reports by Management ........................................................................................... .... ...20 Independent Auditors’ Report ........................................................................................... 21
  • 6. Financial Statements and the Related Notes ....................................................................22 Five- or Ten-Year Summary of Operating Results .............................................................22 Shareholder Information ............................................................................................... ...24 Wrap-up ............................................................................................... ...........................24 CHAPTER 3 - FINANCIAL STATEMENTS ........................................................................25 The Balance Sheet ............................................................................................... ............25 The Income Statement or Statement of Earnings..............................................................39 Statement of Cash Flows (SCF)...................................................................................... .47 The Statement of Stockholders’ Equity (SSE) ...................................................................50 Notes to the Financial Statements ................................................................................... 51 Wrap-up ...............................................................................................
  • 7. ........................... 61 CHAPTER 4 - FINANCIAL ANALYSIS ...................................................................................62 CHAPTER 5 - DECISION-MAKING PROCESS ...............................................................67 1 preface This workbook makes the study of accounting and financial analysis an enjoyable andrewardinglearningexperience.Studentslearnaccountingandfin ancialanalysisby systematically gathering financial and nonfinancial information to answer questions and make business decisions. The corporate annual report is the primary document used to drive the learning process. Students can select their own company or the instructor can direct the study and assign the same company for the entire class. Accounting terms and concepts are definedandillustratedasneededtosupportthestudent’sdecision- makingneedsthroughout the workbook. The work is active and driven by the student’s need to answer questions as they relate to his or her inquiry. Upon completing this project a student understands how to use widely available accounting and related information to systematically answer business questions. Illustrative questions are: • WouldIliketoworkforthiscompany?
  • 8. • ShouldIusethiscompanyasasupplier? • Isthiscompanyasolidinvestment,preliminaryanalysis? This project is suitable for undergraduate and graduate students in accounting and finance courses.Thelearningactivitiesstimulateacross- functional,integratedapplicationofbusi- nesstools.Workbooktasksillustratewhyandhowaccountingisthelan guageofbusinessand must be integrated with nonfinancial information to make a business decision. Students are requiredtoaccessandusethecorporateannualreport,SecuritiesandE xchangeCommission (SEC)Form- 10Kandwebsiteanalyticaltoolsintheevaluationoftheirselectedcom pany. Thelearningexperienceisactiveandstudentdriven.Accessingandint erpretinginfor- mation to arrive at a sound business decision drives the accounting and financial analysis learningprocess.Wehavetakenconsiderablecaretoremoveallroadbl ocksfromthe learning process. to the faculty member The challenge to link theory, practice and technology is ongoing. This workbook places you in position to meet this challenge in an easily managed format. The workbook instruc- tionsareself- directingandcomplete.Studentsassumethevastmajorityoftherespo nsibility
  • 9. of the learning process in completing this workbook. As the instructor, you essentially take on a learning management role. You may have to respond to student questions when a company includesanatypicaldisclosureorfailstoprovideareasonabledisclosu re.Wesuggestyouuse these student questions to demonstrate to the class that annual reports are not all the same. This workbook has very distinct features that we want to highlight: 1. The workbook is designed for introductory and advanced students. Some studentsmayhavetoreferenceanaccountingtexttorefreshtheirmem ory regarding certain accounting topics. The following questions are considered the most difficult: Chapter3:NotestotheFinancialStatements-Questions4-14. 2. A completed workbook for The Home Depot Company is available to instructors upon request. 2 3. InternationalFinancialReportingStandardsareweavedintothework bookto inform the students about the changes presently underway in financial reporting.
  • 10. 4. Gradingthestudent’sworkbookisstraightforward.Studentsarerequi redto answerquestionsthroughouttheworkbook.Ourexperiencesuggests agood evaluation of a student’s project can be measured by selectively grading questions. 5. This workbook project is easy adapted to a presentation class requirement. Studentscanbeaskedtopresentandexplainsectionsoftheannualrepo rt orspecificelementsofthefinancialstatements.Thisrequirementcan beaccom- plishedasateamorindividualassignment.Ourexperienceshowsthats tudents are confident and happy to present information about their selected company. This edition of the workbook builds upon the success of the 2nd edition, with two additions.First,companiesarechangingthewaytheyprovideannualr eportinformation. Thereisadistincttrendawayfromthetraditional- AnnualReporttotheShareholders.Now companies provide most of this information on their website, and satisfy financial reporting requirementswithSecuritiesandExchangeCommission(SEC)Form 10-K.The3rdedition of the workbook accommodates these changes, as well as retains the same structure as the
  • 11. 2nd edition for those companies that continue to provide the traditional paper copy of the annual report to the shareholders. Second,InternationalFinancialReportingStandards(IFRS)continu etoinfluencefinancial reporting measures and disclosures. This edition retains the skill development around general- lyacceptedaccountingprinciple(GAAP),yetcallsattentiontopresen tInternationalFinancial ReportingStandards.Thiscontent:a)bringstolifeIFRS’sinfluenceo verfinancialreporting andb)providesaleveloflearningaboutIFRSthatcandistinguishabusi nessschoolgraduate inthemarketplace.AddingIFRStothiseditionconvenientlyweavesa ninternational perspective into the curriculum. The 3rd edition of the workbook requires NO additional work by the faculty member. You will find we modified the workbook to improve its readability and help the student achieve a higher level of learning. to the student The annual report is the most widely distributed company report provided to sharehold- ers and the general public. Company leadership uses this report to communicate nonfinancial and financial information about its company. By completing this workbook you learn how to systematically evaluate a company’s annual report and gather the information needed for making a business decision.
  • 12. Your work begins by answering why you are investigating the annual report of a particularcompany.Forinstance,isthiscompanyapotentialemploye rorisitapotential customer?Next,youlearnhowacompanyusestheannualreportasama rketingtool and as a means to communicate its corporate strategy. Then you become more acquainted withtheannualreport’sstructure.Following,youlearnhowtousefina ncialstatements and widely available data in a systematic framework to make business decisions. In completingthisprojectyoubuildapowerfulskill- setthatshouldserveyouwellthrough- out your career. 3 CHAPTER 1: introduction elcome to the annual report project. You are beginning the process of learning a great deal about accounting, the language of business and financialanalysis.WesuggestyoureadthePreface and the To the Student section before moving forward. These sections recap the learning process. Completing this workbook will open your eyes to the business world in ways you may have never imagined. You will develop the skill and confidence to systematically study a company using the corporate annual report and related databases. You will build a solid foundation
  • 13. andframeworkforbusinessdecision-making.ENJOY! Select a Company and Gather Documents Your instructor may identify the company or you may be allowed to select your own company in completing this workbook. The company must be publicly traded. A publicly tradedcompanyisonethathasitssharestraded(boughtandsold)onthe NewYorkStock Exchange(NYSE),AmericanStockExchange(ASE)orNationalAss ociationofSecurities DealersAutomatedQuotationStockExchange(NASDAQ). You will find two types of company annual reports. Both are suitable for this workbook. First,publiclytradedcompaniesmustcomplywithSecuritiesandExc hangeCommission (SEC)andfinancialreportingregulations.TheSECrequiresallcompa niestofileannual reportsinSECForm10- K.Theannualreportrecapstheoperatingenvironmentandbusiness conditionsofthecompanyandincludesauditedfinancialstatements. TheSECusesthisinfor- mationtomonitorcompanyperformance.AnexampleofTheHomeDe pot’s2008SECForm 10- Kcanbefoundat:http://www.homedepotar.com/.(SelectDOWNLO ADANNUAL REPORT(pdf)todownloadaPDFcopyofTheHomeDepot’sSECFor m10-K.) SECForm10-Krequiresspecificnon- financialandfinancialcompanyreporting. • Goto-http://www.sec.gov/answers/form10k.htmforageneral descriptionaboutSECForm10-Krequirements.
  • 14. • Goto-http://www.sec.gov/about/forms/form10- k.pdfforadetailed descriptionaboutSECForm10-K. TheSECrequiresthefollowingcompanyinformation: • Item1:Business— generaldiscussionofthecompany’sbusinessenvironment. • Item1A:RiskFactors • Item2:Properties • Item3:LegalProceedings • Item4:SubmissionofMatterstoaVoteofSecurityHolders • Item5:MarketforRegistrant’sCommonEquityandRelatedStockhol derMatters • Item6:SelectedFinancialData; • Item7:Management’sDiscussionandAnalysisofFinancialConditio n and Results of Operations • Item7A:QuantitativeandQualitativeDisclosuresAboutMarketRisk • Item8:FinancialStatementsandSupplementaryData 4 W • Item9:ChangesinandDisagreementsWithAccountantsonAccounti ng andFinancialDisclosure
  • 15. • Item9A:ControlsandProcedures • Item10:DirectorsandExecutiveOfficersoftheRegistrant, • Item11:ExecutiveCompensation, • Item12:SecurityOwnershipofCertainBeneficialOwnersandManag ement,and • Item13:CertainRelationshipsandRelatedTransactions;and(n) • Item14:PrincipalAccountantFeesandServices. Second, companies must provide an “annual report to shareholders” when they hold anannualmeetingtoelectdirectors.Goto- http://www.sec.gov/answers/annrep.htmfora general description about the annual report to the shareholders. This annual report, typically, serves as a marketing and reporting tool. The report opens with a letter from the Chief ExecutiveOfficer,followedbyselectivefinancialdata,productinfor mation,employeesuccess stories, market segment information and more. The company annual report, typically, is print- ed on quality paper, filled with colorful pictures, with suggestive words like “great,” “growth,” “powerful,” spread throughout. Often, these sections of the annual report are designed to positivelyinfluencethereader’sopinionaboutthecompany,longbef orefinancialanalysis begins. The audited financial statements and related notes follow in the report, neatly formatted. Developing, printing and distributing the annual report to shareholders is
  • 16. anexpensive,timeconsumingprocessforacompany. You are likely to find one or a combination of reporting structures when searching for a company to use with this workbook. Some companies meet the annual report to the shareholdersrequirementbyincludingSECForm10- KwithaletterfromtheChiefExecutive Officer.Othersincludetheletterwithamixofselectivefinancialdata, picturesand/orproduct information.(TheHomeDepot2008annualreportservesasanexampl eofhowcompanies useSECForm10- Kasacomponenttheannualreporttotheshareholders.Goto:The http://www.homedepotar.com/.)Yet,somecompaniessimplyprovi deSECForm10-K andpublishtheChiefExecutiveOfficerletterandotherinformationon thecompany website in compliance with the annual report to the shareholders requirement. Wedesignedthisworkbooktoaccommodateyourcompany’sreportin gstructure,regard- less of how it satisfies annual report requirements. You simply need to search the annual report records provided by your company. The workbook’s questions point you to the documents that provide the information you need to develop a meaningful response. SELECT COMPANY Introductory accounting and finance students should avoid banks, insurance compa- nies, public utilities, and other regulated industry companies, as well as large conglomerates.
  • 17. Regulated industries are often affected by unique accounting rules and practices. The financial statementsmaycontainelementsthatareconfusing,eventotheexperi encedprofessional. Largeconglomerates,ontheotherhand,oftenparticipateincomplexr eportingpractices, andthereforemaybedifficulttoanalyze.Wesuggestchoosingacompa nythatisinteresting to you and of a reasonable size. There are two ways to locate a publicly traded company that provides a separate annual report. 5 Method 1: Use this method to locate the appropriate information for a specific company. First,identifythecompany.Second,gotothecompanywebsiteandsea rchforlinkstoits annualreport(generallythroughthe“investorrelations”link).When youlocatetheannual report, follow the instructions to open or print the document. If no link is found to the annual report, it is unlikely that it is a publicly traded company. Method 2: Use this method to explore the many different companies and industries in
  • 18. selecting a company. WesuggestworkingthroughtheNewYorkStockExchange(NYSE)E uronextWebsite toselectacompany.TheNYSEisthelargestequitiesmarketplaceinth eworld.The exchangeliststheworld’stoplargeandmediumsizedcompanies. TheNYSEEuronextwebsitedirectionsarelogicalandintuitive.Thef ollowing procedure will help you use the site to locate a company. • Goto:http://www.nyse.com/home.html, • Select–Listings(locatedonupperleftsideofpage),-select- ListingsDirectory, • Select–NYSEor, • Type:http://www.nyse.com/about/listed/lc_all_name.htmltogodi rectly totheNYSE. Using this guide you can select a company by searching by name, region, or industry. Themenuoptionsguideyoutotherespectivecompany’swebsite.Fore xample,ifyouselect an industry from the menu tab, four search options appear: Industry, Supersector, Sector or Subsector.Feelfreetoexploreandselectacompanythatyouwanttostu dy. GATHER DOCUMENTS
  • 19. Now gather the necessary documents. You will find most company documents download inaPDFformat.Wesuggestyousavethedocumentsinanelectronicfor mat.Thisstepmakes it easier for you to find and print the information to respond to workbook questions. Down- load and save the following: • SECForm10-K • AnnualReporttoShareholders:Manytimesacompanysimplylabelst heannual report to shareholders as the Annual Report. As discussed above, some companies meettheannualreporttotheshareholdersrequirementbyprovidingS ECForm 10- Ktoitsshareholders.Ifthisisthecaseyouwillnotneedtodownload separatelySECForm10-K. • Next,completeChapter1:SelectaCompanyandGatherDocuments– Question1 below to begin your company analysis. Immediately following Question 1 is an exampleofQuestion1completedforTheHomeDepot2008AnnualRe port.The exampleshowsthespecifictypesofmaterialyouneedtocompletethec ompany analysis.
  • 20. 6 7 Chapter 1: Select a Company and Gather Documents—Question 1 Identify with an “X” the primary source of data for this project. Annual report to shareholders SEC Form 10-K and the company website. Fill in the page numbers from the annual report where the following are located. Required information for this workbook project. Financial Highlights • Notabsolutelynecessary,but very common in annual report to shareholders. • NotinSECForm10-K.Maybe postedoncompanywebsite. Ifso,putWEBinPageNo.box. • Ifnotavailable,putN/AinPage No.box. Management’sDiscussion andAnalysis(MD&A)
  • 21. StatementofCashFlows IncomeStatement MaybelabeledStatementofEarnings BalanceSheet MaybelabeledStatement ofFinancialPosition StatementofChangein Stockholder’sEquity ChiefExecutiveOfficerLetter • MaybelabeledPresident’sCEO orothertopofficial’smessageor LettertotheShareholders. • NotinSECForm10-K.Likelyposted oncompanywebsiteifSECForm10-K used to satisfy the annual report to shareholdersreportingrequirements. Ifso,putWEBinPageNo.box. NotestoFinancialStatement Putrangeofpages,forexample,47-58. InvestorandCompany InformationorShareholder Information Report of Independent AccountantsorIndependent
  • 22. Auditors’Report Five-orTen-YearSummary ofOperatingResults Item6inSECForm10-K Management’sReport (Responsibility)onInternal ControloverFinancial Reporting Item9A.ControlandProceduresin SEC10-K Required information for this workbook project. Page No. Page No. Annual report to shareholders with letter from Chief Executive Officer and SEC Form 10-K as part of the annual report to shareholders. The annual report may include additional general company information. (TheHomeDepot2008annualreportservesasanexampleofhowcomp aniesuse SECForm10- Kasacomponenttheannualreporttotheshareholders.Goto: Thehttp://www.homedepotar.com/andopenthepdffile.)
  • 23. • Printtherespectivepage(s)whereyoufindtheaboveinformation.Tur n-inprintouts with your annual report analysis. It is helpful to have both a hard copy and an electronic copy to complete workbook questions. 8 Chapter 1: Select a Company and Gather Documents—Question 1 Identify with an “X” the primary source of data for this project. ExampleforTheHomeDepot2008AnnualReport: http://www.homedepotar.com/ Annual report to shareholders SEC Form 10-K and the company website. Fill in the page numbers from the annual report where the following are located. Required information for this workbook project. Financial Highlights Management’sDiscussion andAnalysis(MD&A) StatementofCashFlows IncomeStatement
  • 25. SEC Form 10-K as part of the annual report to shareholders.X F-1 F-2 15-24 28 27 32 29 50 30 25 31 51 and2nd to last pg. ofAR Nopage numbers, 1st3 pages ofAR Withaprintedcopyoftherespectivecompanyinformationandanelect ronic copyoftheannualreportand/orSECForm10- Ksavedonadisk,youaresettobegin your analysis.
  • 26. Identify Why You Selected This Company There are numerous reasons why you would select a particular company. The typical reason is to make a decision regarding whether to purchase or sell its stock. This is, in fact, averynarrowview.Forexample,youmayhaveaparticularinterestina companybecause of a hobby or you may be looking at a company as a possible employment opportunity or both.Forthissituationyouwouldbemostinterestedinlearningmorea bouttheindustry andthecompany’slong- termprofitpotential.Anotherreasonmightbethatthecompanyis a major contributor to the economic success of your community. Or it could be that you are acustomerofthiscompanyandareinterestedinitspotentialforlong- termsuccess.Recognize that there are numerous reasons why you would select and study a company’s annual report. Answering why you selected a particular company helps build a solid focus to the learning process of accounting and financial analysis. 9 Chapter 1: Identify Why You Selected This Company— Question 1 A) Whatis/areyourmotivation(s)orinterest(s)inselectingthiscompany ? [Seeaboveforexamples] B) Whatquestion(s)areyouseekingtoanswer?
  • 27. [Forexample,isthecompanyprofitable?Canthecompanychangeand developnewproducts andservicestobecompetitive?WouldIinvestinthiscompany?Willth ecompanyprovide rewardingcareeropportunities?Inchapter5youwillhavepulledtoget herthefinancialand nonfinancialinformationtoanswerthesequestion(s).] A) B) Company and Annual Report Essentials This section of the workbook asks you to identify specific information about your company. You will typically find the answers to most questions on the first few pages or on the back inside pages of the annual report. 10 Chapter 1: Company and Annual Report Essentials—Question 1 Whatisthecompany’scompletename? Chapter 1: Company and Annual Report Essentials—Question 5 Whichstockexchangelistsyourcompany? Chapter 1: Company and Annual Report Essentials—Question 2
  • 28. Whatistheaddressofyourcompany’scorporateheadquarters? Chapter 1: Company and Annual Report Essentials—Question 3 Identifythecompany’swebsiteaddress. Chapter 1: Company and Annual Report Essentials—Question 4 Identifythetelephone#ande- mailaddressofyourcompany’sInvestorRelationsDept. Telephonenumber: E-mailaddress: 11 Chapter 1: Company and Annual Report Essentials—Question 6 Whatisyourcompany’sstockexchangetradingsymbol? Chapter 1: Company and Annual Report Essentials—Question 7 Whatisyourcompany’sStandardIndustrialClassification(SIC)ands ector?Runa searchon“StandardIndustrialClassification,”andtheclassification andcodewillbe identified.YourcompanymaylistmorethanoneSICcodenumber.The firstlistedis consideredtheprimarySICforthecompany.
  • 29. Forexample,search—TheHomeDepotSIC— bringupalistingofsources. InvestorWordsisonewebsitelocationoption: http://www.investorwords.com/cgi- bin/stocksymbol.cgi?ticker=HD. Movedownthepageandyouwillfind: SICCode:5211 Sector: BasicMaterials,Construction,Retain Industry:Lumberandotherbuildingmaterial Chapter 1: Company and Annual Report Essentials—Question 8 LocatetheBoardofDirectorslisting.Howmanyboardmembersdoesy ourcompanyhave? Chapter 1: Company and Annual Report Essentials—Question 9 Howmanyofthedirectorsarecompanyemployees,labeledinsidedire ctors?Andhow manyarenon- companydirectors,labeledoutsidedirectors?Whydoesacompanywa nt andneedoutsidedirectors? (Insideandoutsidedirectorsaretypicallyidentifiedassuchbytheirtit leandcompany.) The previous series of questions provides basic company
  • 30. information. All are building blocks of a complete study of a company through the annual report. Company Strategy and Business Environment Evaluatingacompanyforaspecificreason(s)andseekinganswerstoq uestions is a systematic process. You are now starting that process. Begin by learning about the company’s corporate strategy and business environment. A company is likely to communicate a growth, stability, or retrenchment corporate strategy.Mostpopularisacorporategrowthstrategy.Ausercanidenti fyacorporategrowth strategywhenmanagementannouncesadecisiontoincreasesalesand capitalexpenditures. Growth occurs when leadership strategically directs corporate financial resources in one way or in a combination of ways: • Horizontal growth— Walgreensopensnewstoresonbusyintersections. • Vertical growth—Wal- Martcontrolsdistributiontostoresandretailing. • Concentric growth— TheHomeDepotsellstocontractorsandthegeneralpublic. • Conglomerate growth— GeneralElectricisinmedicalequipment,financial services, lighting, jet engines, and many more industries. A
  • 31. stabilitystrategyisonewherechangeisslowand/orproblemsloomont hehorizon. Twotypesofstabilitystrategiesarepracticed:(1)pauseandproceedw ithcautionor(2)no change. You can identify this strategy when management talks about challenging economic times on the horizon or hints of waiting for market opportunities to become clear. A retrenchmentstrategyisexactlywhatlogictellsusitis.Thecompanyr equiresanew business model that can bring it back to life. Drastic action is necessary or business failure is imminent. A user can identify a corporate retrenchment strategy when numerous product lines are eliminated, plant layoffs are announced, or there is talk of general business closure. Chiefexecutivesusethechairman’smessagetocommunicatethecom pany’sstrategy. A reader will learn about events that have unfolded throughout the year. Attention is often directed to revenue growth, capital improvements, dividend strategy, impact of new account- ingpronouncements,newproductinformationand/ormarketdynami cs.Overall,thechief executiveattemptstomakethecompanyappeartobeinpositiontotake advantageof 12 Chapter 1: Company and Annual Report Essentials—Question 10
  • 32. Leadershipaddressesthestockholders,typically,onceayearatthean nualstockholders’ meeting.Identifywhereandwhenthisoccurred,asreportedinyouran nualreport. 13 Chapter 1: Company Strategy and Business Environment— Question 1 Reviewthechairman’smessageofyourcompany’sannualreport.Doe sitappeartobe upliftingorsomewhatapologetic?Identifyphrasesthatsupportyourp osition. Chapter 1: Company Strategy and Business Environment— Question 2 Checkbelowtheoneprimarycompanystrategyidentifiedinthechair man’smessage. Supportyouranswerwithphrasesfoundinthechairman’smessagetha tpointedyou totheidentifiedcorporatestrategy. GROWTH:Vertical____Horizontal____Concentric____Conglom erate____ Stability____Retrenchment____ Phrasestosupportyourconclusion:
  • 33. marketopportunitiesandgeneratewealthfortheshareholders.Empha sisisoftenplaced onword(s),suchas,growth,expansion,improvementinproductsands ervicesandmarket opportunities. As a user, always read the chairman’s message with full knowledge that it is designed to bias your thinking. The message is designed to communicate a robust and successful business and minimize the challenges faced by the company. Consume this letter as a starting point for your critical analysis. Question whether or not the company has ahistoryofsuccessasemphasizedthechiefexecutiveofficer.Doesthe companyhave thefinancialresourcestomoveasthechiefexecutiveofficermaybesu ggesting? The last step in learning more about your company is to complete a brief overview of eventstakingplaceinsociety.Allbusinessdecisionsmustbemadeint hecontextofbroad social,political,economic,andtechnologicalconcerns.Forexample, allbusinessesareinflu- enced by technological advance. Ask yourself what technology advances are on the horizon and if they may alter the corporate strategy of your company. The music industry, as an example,failedtoanticipatetheimpactoftechnologyinregardtofiles haringanddown- loading music.
  • 34. Asocial- politicalconcern,forexample,isahumanrightsviolation.Currently,t heUnited States is working to widen trade channels throughout the world. If, however, human rights violations surface in a specific region, then trade may be restricted. This situation may impact your company if suppliers or customers are located in a region of government imposed restricted trade. Identifyingexternalissuesthatmayaffectyourcompanyisnotaoneti mestudy.Business professionals must read journals and business publications that address social, political, economic, international topics and more. Schools and local libraries hold a wealth of databases to support this information need. You will use these resources to learn more about companiesandindustriesthroughoutyourcareer.Knowinghowtouse thesesourcesis a skill you can sell to potential employers. Thefollowingservesasarepresentativeexampleofdatabasesthathol davastamountof company and industry specific information. These databases can help you address business questionsand/orissuesthroughoutyourcareer. • ABI/Inform(FirstSearch)–electronicdatabase • Business&Industry(FirstSearch)–electronicdatabase You can effectively and efficiently learn more about a company’s corporate strategy and
  • 35. businessenvironmentbyreadingselectivedocuments.SECForm10- K,Item1requiressub- stantial disclosure about a company’s industry, business model, competitors, market segment, and product offerings. 14 Chapter 1: Company Strategy and Business Environment— Question 3 Brieflysummarizethecompany’sdiscussionfoundinItem1ofSECFo rm10-K. Typeofbusiness: Majorbusinesssegments: Primarycustomers: Other: Primaryproductsand/orservices: 15 Chapter 1: Company Strategy and Business Environment— Question 4 Identifybroad- basedsocial,political,economic,andtechnologicalconcernsthatma y affectyourcompany.PutN/Aifoneofthecategoriesdoesnotapply.
  • 36. Social: Technological: Political: Other: Economic: • BusinessSourceElite(EBSCO)–electronicdatabase • Factiva/DowJones–electronicdatabase • LexisNexisAcademic–electronicdatabase • HooversHandbookofAmericanBusiness–hardcopybook • Web:www.money.msn.com • Standard&Poor’sIndustrySurveys–hardcopybook • U.S.Industry&TradeOutlook–hardcopybook The table below lists several industry and business issues to watch for: To complete the following question, you need to simply watch the news and read the press with eyes and ears open to broad social, political, economic, and technological concerns that may impact your company. Supplierrelationships Customerrelationships Politicalenvironment Competitiveenvironment Environmentalconcerns Socialresponsibility Employeeandlaborunions Specialinterestgroups Tradeassociations Infrastructure
  • 37. Wrap-up You have now completed the information gathering stage of the annual report project. The learning activities provided a structured process to gaining a balanced perspective about yourcompanyandtheindustry(s)inwhichitoperates.Financialanaly sisisonlymeaningful when the corporate strategy is known and key business environment issues are clear. This foundation of knowledge will enable you to efficiently and effectively draw insight from the annual report. That is, you will be a more critical consumer of annual report data as you gather more facts in support of your business decisions. Another way to look at it is that you will now be on a steep level of learning as you go through the financial and nonfinancial sections of the annual report, building support for your decisions. You are now in position to specifically identify the company’s corporate strategy, beyond simply relying on the chairman’s message. 16 Chapter 1: Wrap-up—Question 1 Afterfurtherreviewofadditionalinformationyoushouldnowbeconfi dentinidentifying theoneprimarycompanystrategy,beyondtheinsightprovidedbythec
  • 38. hairman’s message? Checkbelowtheoneprimarycompanystrategyidentifiedinthechair man’smessage andallothersupportingdocuments.Supportyouranswerwithphrases . GROWTH:Vertical____Horizontal____Concentric____Conglom erate____ Stability____Retrenchment____ Phrasestosupportyourconclusionfrominformationgatheredfromth echairman’smessage. Item1oftheSECForm10- KandotherinsightgainedfromcompletingChapter1. 17 CHAPTER 2: annual report structure sers of financial information may notice that most corporate annual reports have similar reporting structures. There are two main reasons for thislikeness.First,consistencyinthereportingstructureallowsaseas oned ornoviceusertoeasilylocateinformation.Knowingwheretolookimp roves the usefulness and value of the information. Second,
  • 39. disclosure rules require specific types of information to be included in the annual report. This assures investors and others that companies will address similar topics, as well as provide supplemental disclosure where necessary. Youreadandinterpretthekeysectionsintheannualreportatthistime. Knowingwhat to look for and where to find specific information in the annual report is a skill all business professionals should possess. Financial Highlights Frequently,theannualreporttotheshareholdersopenswithapresenta tionoffinancial highlights or selected statistical data. This typically includes performance measures such as comparativesales,netearnings,per- shareinformation,andpossiblysomekeyfinancialratios or other company statistics over time. Bar and pie charts visually enhance the presentation of selected highlights. A company’s financial highlights represent a subset of more detailed information that follows in later sections of the annual report. Financialhighlightsarepresentedearlyinthereportinaneffortbyman agementtomake thecompanylookasgoodaspossible.Themessagemayormaynotbean accuratereflection of the company. Therefore, do not rely on this information alone to make a decision about thecompany.Viewthisinformationasabiasedintroductorysummary
  • 40. . U Chapter 2: Financial Highlights—Question 1 Reviewthefinancialhighlightsofyourcompany’sannualreporttothe shareholders. Identifynetsalesorrevenues,netincome,basicearningspershare(BE PS),andtotal assetsforthecurrentandprecedingyears.Thesearethemostcommonv aluesincluded infinancialhighlights.Ifyourcompanyreportssomethingdifferent,s implycrossoutan itemhereandrecapwhatisreported.SECForm10- Kdoesnotprovidefinancialhighlights. Youmayfindthisinformationonthecompanywebsite.Ifnotavailable putN/Ainthefirst rowofboxes. Categories Current Year One Year Prior Two Years Prior Netincome Netsalesorrevenues BasicEPS TotalAssets
  • 41. General Company and Marketing Information Managementusestheannualreporttotheshareholderstomarkettheco mpany’sproducts and services, and enhance its image. You will find information throughout the annual report to shareholders about company volunteer activities, employee relation programs, and research anddevelopmentsuccess,forexample.Thesevoluntarydisclosuresa reintendedtoimprove the company’s image. You are likely to find that colorful pictures and fancy charts and graphs are used to communicate a variety of messages. If this information is not available in the annual report, then search the company website and respond accordingly. 18 Basedonyourpreliminaryreview,isyourcompanyperformingbettert han,equalto,orless favorablythanintheprioryear?Brieflyexplain. Chapter 2: General Company and Marketing Information— Question 1 Lookforpicturesofproductandpeoplethatarecolorfulandsendaposit ivecompany signal to the reader. Category Message Example:Volunteer Activities
  • 42. Ongoingandcontributingtothesuccessofthecommunity Whatisthebroadermessagefromthisinformation? 19 Chapter 2: Management’s Discussion and Analysis—Question 1 ResultsofOperations: Identifytheprimarydrivers/issuesthatexplaincurrentandfutureresu ltsofoperations discussedintheMD&A.Forexample,thegrossprofitpercentageincre asedbecauseof improvedbuyer/supplierrelationsresultingingreateroveralloperati ngperformance. Oranincreaseinoperatingexpensesbecauseofincreasedfuelcostsre ducedprofits. Listthesixmajordrivers/issuesofperformanceyoufindintheMD&A sectionofthe annual report. Management’s Discussion and Analysis The management’s discussion and analysis of results of operations and financial condition (MD&A)reportisconsideredbymanytobeoneofthemostimportantc omponentsofthe annual report. As a result, we have seen a significant increase in
  • 43. the length of this section, a trend that is likely to continue under the current climate of financial reporting. TheSECrequiresmanagementtodiscussthecompany’spriorandcurr entperformanceso that readers can gain insight into what management perceives the direction of the company to be.Thisisimportanttotheuserfortworeasons.First,itmakesexplicith owsuccessfulleader- ship has been at achieving the corporate strategy and points to the company’s future strategic focus. Second, this information helps the user of the annual report compare and contrast the company’s corporate strategy to its available resources. WiththeMD&Areportmanagementisexpectedtoaddressthreeimpor tantareas:results of operations, capital resources, and liquidity. Typically the report begins with an analysis of prior,currentandfutureresultsfromoperations,i.e.performance.Ne xt,intheMD&A,isa disclosureaboutcashavailability.Ashort- termcashperspectiveisdiscussedwithdisclosures onliquidity.Along- termcashperspectiveisdiscussedwithdisclosuresoncapitalresource s. 1) 2) 3)
  • 44. 4) 5) 6) Reports by Management Managementnowfilesadditionalreportsintheannualreporttobeinco mpliancewith reportingrequirementsmandatedbytheSarbanes- Oxley(SOX)Actof2002.Thereports aredesignedtomakeexplicitthatmanagementisresponsibleforinter nalcontrolsand the financial statements. The reports are also intended to help the user recognize that the independent accountant is not responsible for internal controls and the financial statements. 20 Liquidity: Recapwhatyoufindaboutyourcompany’sliquidityintheMD&Asect ionoftheannualreport. Lookforinformationabouttheabilityofthecompanytosatisfyshort- termcashneedsandthe abilitytogenerateoperatingcashflows,forexample. CapitalResources: Recapwhatyoufindaboutyourcompany’scapitalresourcesintheMD &Asectionofthe annualreport.Lookforinformationaboutcashreservesandcreditavai lability.Forexample, yourcompany’sMD&Asectionmayhaveadisclosureaboutanestabli
  • 45. shedlinedofcreditto fund future growth. Chapter 2: Reports by Management—Question 1 ReviewtheManagement’sReport(Responsibility)onInternalContr oloverFinancial Reportinginyourcompany’sannualreport.Answerthefollowingque stions. Whoisresponsibleformaintainingthe internal controls designed to provide reasonableassurancethatthebooks andrecordsreflectthetransactionsof thecompany? 21 Independent Auditors’ Report An outside accounting firm issues the independent auditors’ report to the shareholders and board of directors of the client corporation. It must be signed and dated by the account- ing firm that conducted the audit. This report provides important information and should be read before one interprets the financial statements. All material reporting deficiencies are disclosed in the report and should be taken into account before an analysis of the financial information.Mostauditreportsaredividedintothreeparagraphs,eac haddressingan important audit issue.
  • 46. Recordthestatementthatidentifies management’sconclusionabout internal controls. Whoauditedmanagement’sassessment oftheeffectivenessofyourcompany’s internalcontroloverfinancialreporting? Chapter 2: Independent Auditors’ Report—Question 1 ReviewtheIndependentAuditors’Reportofyourcompany’sannualr eportandanswer thefollowingquestions. Whowasthecompany’s auditor and where is it located? Whoisresponsibleforthe preparation of and information withinthecompany’sfinancial statement? Whatistheresponsibility oftheauditor? Theauditwasconducted inaccordancewithwhat? Whatwastheopinionof theauditor?
  • 47. Financial Statements and the Related Notes A significant component of the annual report is devoted to a presentation of the company’s financial statements, which normally includes a consolidated statement of income, a consolidated balance sheet, a consolidated statement of cash flows, and a consolidated statement of change in stockholders’ equity.(Consolidatedstatementsincludetheresultsoftheparentand allsubsidiaries.)Thepurposeofeachfinancialstatementisaddressed asfollows: • Statement of income. Reports a company’s financial performance over a period of time. • Balance sheet. Reports a company’s financial position on a particular day. • Statement of cash flows.Reportsacompany’scashinflowsandoutflows over a period of time. • Statement of change in stockholders’ equity. Reports changes to stockholders’ equity accounts over a period of time. EachofthesefinancialstatementswillbeaddressedinChapter3,aswel lasthenotes to the financial statements. Notes to the financial statements are just as important as the state- mentsthemselvesbecausetheyprovideamoredetailedexplanationof thenumbers. Five- or Ten-Year Summary of Operating Results
  • 48. TheSECrequiresacompanytoincludeafive- yearsummaryofselectedfinancialand nonfinancial information in the annual report. Summary information gives the investor and other users the opportunity to identify emerging trends and better understand where the companyhasbeenandwhereitisgoing,inoneconvenientlocation.Ma nyanalystsusethis reporttoidentifypendingweaknessesorstrengths.Often,companies extendthefive-year comparative to include ten years of information. Analystsandotherusersshouldexercisecautionwhentheyreviewthe sestatistical summaries. This report is not covered by the auditor’s opinion. In addition, management selects the information included in this report. Information presented in the summary may beextensiveforsomecompaniesandlimitedinothers.Thefive-orten- yearsummarytypi- cally includes comparative sales and earnings information as well as measures of financial position such as total assets, working capital, total debt, shareholders’ equity, and selective nonfinancial information. 22 23 Chapter 2: Five- or Ten-Year Summary of Operating Results— Question 1
  • 49. Identifythemajorcomponentsprovidedinthefive-orten- yearsummary.Summarizethe insightprovidedbyeach.Lookforstable,increasingordecreasingtre nds.Consistent, slightlyimprovingperformancesignalsmanagementhascontrolofth ebusiness. Inconsistentperformancesignalsmanagementdoesnothavecontrolo fthebusiness. Component Example:TheHomeDepot StatementofEarningsData Summary of Insight Salesandearningshavegrownsignificantlyovertime. Operatingexpensesaregrowingatanincreasingrate. Shareholder Information Annual reports close with a section devoted to investor and company information (discussedinChapter1).Althoughthissectionisincludedatthebacko ftheannualreport, the placement should not diminish its importance. Wrap-up Observe that the annual report is a tool that frames past successes and failures and future activities within a company’s strategic focus. This section of the workbook stepped you
  • 50. through the many components of the annual report. The vast majority of annual reports will havesimilarsections.Eachcompanywilldeliveritsinformationdiffe rently,however.Itis the consumer’s responsibility to apply this information in support of his or her individual decision- makingneeds.Criticalanalysisoccurswhenyoucomparethequalitati veinforma- tion gathered up to this point with the financial information you pull together in Chapters 3 and4.Thisiswhereasoundgraspofthelanguageofbusiness,accounti ng,servestheuser in decision making. Your distinct challenge is to determine if the company has the financial resources to move forwardwithitscorporatestrategy.Foryoutoevaluatethisissue,acom mandofthefinancial statements is essential. The following chapters build the tools to follow through with a sound, systematic framework for financial analysis. 24 25 CHAPTER 3: financial statements The Balance Sheet he balance sheet provides a snapshot of a company’s financial position at the closeofitsfiscalyear.TheHomeDepot’sbalancesheet,forexample,is
  • 51. dated February1,2009,andprovidestwoyearsofcomparativeinformation, as requiredbytheSEC.Acompany,typically,selectsayear- endclosethatcoincides withsloworstablebusinessactivities.Forexample,mostretailerssele ctaJanuaryyear-end close because the holidays have passed and inventory holdings have been reduced. Classification of the Balance Sheet Balancesheetaccounts(orelements)aregenerallyclassifiedtofacilit atereadabilityand analysis. The three major classifications include assets(resources),liabilities(claimsagainst thoseresources),andshareholders’ equity(residualownershipintheassets).ButwhileUS GAAPrequiresaclassifiedorunclassifiedformatbasedonliquidity,I nternationalFinancial ReportingStandards(IFRS)allowflexibilityinreporting.Asanexam ple,anIFRSbased balancesheetmaylistnon- currentassetsfirst(asillustratedinUnilever’s2010Annual Reportfornoncurrentandcurrentassets)andthenfollowwithliabiliti es/equityorequity/ liabilities. Also note how Unilever references the specific note # that relates to each balance sheet element. T Chapter 3: Balance Sheet—Question 1
  • 52. Identifythedateshownatthetopofyourselectedcompany’sbalances heet. Current Year Prior Year Doesthecompany’sfiscalyearfollowthecalendaryear?Yes____No_ ___ Ifnot,whydoyouthinkitisdifferent? Below,wediscussthestructureofaUSGAAP-basedbalancesheet. Assets CURRENT ASSETS Current assets represent a company’s resources that will ordinarily be consumed during the upcoming fiscal year. Often these include the following: Cash and Cash Equivalents: Cash in the balance sheet, and for the purpose of reporting cashinthestatementofcashflows,includescashonhand,cashinsavin gsandchecking accounts,andcashinvestedinhighlyliquidshort- terminstrumentswithoriginalmaturi- tiesofthreemonthsorless.Highlyliquidinstrumentsincludehigh- gradecommercialpaper, money market funds, or U.S. government agency securities, each with original maturities of 90 days or less. Short-term Investments including Current Maturities of Long- term Investments: The balancesheetaccountshort-
  • 53. terminvestmentsincludesacompany’sinvestmentinthestocks andbondsofothercompaniesorinvestmentsincertificatesofdeposit( orthelike)with maturities beyond 90 days and less than one year. These are investment opportunities that appealtoacompanyfortheshort- termorinvestmentsthatwereonceclassifiedaslong-term but will mature in the upcoming year. 26 Unilever Group ConsolidatedBalanceSheetExcerptasat31December £ million £ million Goodwill9 Intangibleassets9 Property,plantandequipment10 Pensionassetforfundedschemesinsurplus19 Deferrredtaxassets17 Othernon-currentassets11 Total non-current assets Inventories12 Tradeandothercurrentreceivables13 Currenttaxassets Cashandcashequivalents14 Otherfinancialassets14 Non-currentassetsheldforsale27 Total current assets 2010
  • 55. 3,429 173 2,642 972 17 10,811 27 Accounts Receivables, Net: Currentassets,inadditiontocashandshort-terminvestments, will generally include amounts due from other companies or individuals. These amounts are identified as accounts receivable in the balance sheet and correspond to the sale of merchan- dise or services on credit. The granting of credit is a business decision made by the company toenhancesalesrevenue.Withoutthispurchasealternative,manyindi vidualsorfirmswould shop elsewhere. Merchandise Inventories: A company’s inventory of goods is most likely the largest component of current assets but also the most illiquid. Inventories can be acquired from other manufacturers and then resold, as in the case of The Home Depot, or inventory can bemanufacturedandsoldbyasinglecompany.Whentheyaremanufac turedandsoldbythe same company the balance sheet may report three inventory accounts: raw materials, work
  • 56. inprogress,andfinishedgoodsinventory.GeneralMotorsCorporatio nisanexampleofa company that would utilize three inventory accounts in its accounting system. NONCURRENT ASSETS Noncurrent assets represent a company’s resources that have value beyond the current year. Property and equipment (at cost): Generally these elements are the most significant noncurrent assets in terms of dollar value. They are the assets that companies commit millions of dollars to and when purchased, are often referred to in the business press as a company’s capital expenditure.Capitalexpendituresrepresentcompanycoststhatwillp rovidebenefits over more than one period. Propertyandequipmentorproperty(land),plant(buildings),andequi pment(PPE) are generally reported at cost less any accumulated depreciation. And since most companies usestraight- linedepreciationareadercangaininsightintotheapproximateaverag eremain- inglifeofPlantandEquipment(excludepropertybecauseitisnondepr eciable)witha simple computation. Chapter 3: Balance Sheet—Question 2
  • 57. Reviewthecurrentassetsectionofyourselectedcompany’sbalances heet.Explainwhy theorderofindividualitemsbeginswithcash.Inyouropinion,wouldit bemoreorless appropriatetoordertheseitemsaccordingtodollarmagnitude?Explai n. If you recall from above, US GAAP requires that all depreciable assets be recorded at cost (lessaccumulateddepreciation).Thatbeingsaid,nosubsequentupwa rdrevaluationscanbe madeshouldanassetincreaseinvalueovertime.IFRS,however,allow scompaniestorevalue entire classes of assets. This means a class of assets can increase to fair market value, by essentiallyusingafairmarketvalueapproachtomeasurementunderI FRS. Long-term investments: Long- terminvestmentsarerecordedwhenacompanyinvestsin another company’s debt or equity. If management intends to hold these investments beyond one year, these investments must be categorized under the heading long-term investments. Occasionallymanagementreclassifieslong- terminvestmentsasmarketconditionschange fromoneperiodtothenext. Long-termstock investmentscanbeaccountedforusingfourapproaches:(1)cost,(2) fairvalue,(3)equity,or(4)consolidation.Theequitymethodofaccou nting(knownas
  • 58. InvestmentinAssociatesunderIFRS)isusedwhenacompanyownsap proximately20-50% ofthevotingsharesofanothercompanyandissaidtohave“significanti nfluence”overthat company.Consolidationisusedwhenacompanyownsgreaterthan50 %ofthevotingshares ofanothercompany.Acarefulreviewoftheinvestmentsfootnote(foll owingthefinancial statements)mayidentifythetypesofinvestmentsandtheirrelatedval uation.Onoccasion, if the reported investment is minimal, the note will provide little assistance. 28 Chapter 3: Balance Sheet—Question 3 Reviewyourcompany’sbalancesheet(orSECForm10- K)andcompareaccumulated depreciationtothehistoricalcostofPlantandEquipment(PE)usingth efollowingratio. Istheinvestmentinfixedassets,onaverage,relativelyrecent?Ifnot,c anweassumethatthese assetswillbereplacedshortly? Computethefollowing: Accumulateddepreciation/ PlantandEquipment PercentageofAssetLifeRemaining: • Highpercentagemeansolderassets • Lowpercentagemeansnewerassets
  • 59. 29 Notes receivable: A note receivable is a written promise to pay a specific amount or amountsatsomepointforward.Mostnotesreceivableareloansbutcan alsoresultfrom aconventionalsalesarrangementthatallowsforextendedterms.Occa sionally,accounts receivablecanbeconvertedtoanotereceivabletoextendtheoriginalte rmsoftheagreement, generate a rate of return for the holder of the note, and legally strengthen the agreement between the parties. Intangible assets, including costs in excess of fair value of net assets acquired (Goodwill): Previous classifications included assets that were generally tangible in nature. Intangible assets, however, generally lack physical substance and possess a greater degree of uncertainty in regard to future benefits than do tangible assets. They represent rights, privileges, and competitive advantages, backed by a legal agreement. Nonetheless, intangible assets, when properly created or acquired, can enhance the profitability of the enterprise for years to come. Examplesofintangibleassetsincludepatents,copyrights,trademark s,organizationalcosts, and goodwill. Intangible assets with definite lives are amortized under both US GAAP and IFRS.Intangibleassetswithindefinitelivesarenotamortizedbutteste dforimpairmentif conditionswarrantunderGAAPandIFRS.Generally,note#1tothefin ancialstatements will provide clarification in regards to the types of intangible
  • 60. assets that are present. Chapter 3: Balance Sheet—Question 4 Sinceproperty,plant,andequipment(PPE)andlong- terminvestmentsinstockrepresent acompany’sinvestment,whydowedistinguishbetweenthemintheba lancesheet? 30 Chapter 3: Balance Sheet—Question 5 Reviewthenoncurrentassetsectionofyourcompany’sbalancesheet. Areanyintangible assetslisted?Ifso,identifythetypesofintangibleassetsandthepercen toftotalassets thattheintangibleassetsrepresent. Ifthiscompanyweretobeacquiredbyanothercompany,wouldtheinta ngibleassetsinfluence thepurchaseprice?Explainyouranswer. IntangibleAsset1: IntangibleAsset2: IntangibleAsset3: TotalIntangibleAssets÷TotalAssets= Chapter 3: Balance Sheet—Question 6
  • 61. Nowreviewyourcompany’stotalassetsforthemostrecentyear.What percentageof totalassetsiscurrent?Noncurrent? Current Noncurrent Shouldcompanieshaveagreaterinvestmentincurrentassetsornoncu rrentassets, ordoesitdependonthenatureoftheirbusiness?Explainyouranswer. 31 Liabilities CURRENT LIABILITIES Currentorshort- termliabilitiesareobligationsthatwillbesatisfiedintheupcomingye ar. Often these include the following: Accounts Payable: Accounts payable, also known as trade accounts payable, represent amounts owed to other companies as a result of goods, services, materials, supplies, and so on acquired throughout the year. Accrued Salaries and Related Expenses: The recognition of accrued salaries and related expensesresultsfromtheapplicationofaccrualbasisaccounting.Acc rualaccountingrequires revenuestoberecognizedwhenearnedandexpenseswhenincurred.T
  • 62. heactualreceiptof orpaymentwithcashisnotessentialtotherecognitionofrevenuesand expensesinthe accounting records. Income Tax Payable: Incometaxespayablerepresentsanestimatedliabilitythatisgener- allysatisfiedwithperiodicpaymentsbythecorporationtoseveraltaxi ngauthorities.Income taxpaymentsarebasedonanestimateofcorporatepretaxincome.Ases timateschangewith the passage of time, so will the periodic installments paid by the firm. Any estimated liability should be reported at the close of the fiscal year. NONCURRENT LIABILITIES Noncurrent liabilities will be settled at some unspecified point or at points beyond one year. Long-term debt (excluding current installments): Long- termliabilitiesgenerallyrepresent the most significant obligation for the corporation. Although this obligation does not affect a firm’s current liquidity, ultimately it becomes payable. Thus, there is significant concern with regard to the payment of ongoing interest and the ability to retire the obligation when itbecomesdue.Long- termcapitalleases,mortgageobligations,pensionsandotherretireme nt benefitobligationsareexamplesoflong- termliabilities.Thenotestothefinancialstatements provideinsightintothenatureandtermsoflong-termdebt. Deferred income taxes:
  • 63. Deferredincometaxliabilitiesandassetsrepresentfutureincome taxobligationsorfutureincometaxbenefitsasaresultofpastevents.T heyarisewhen generallyacceptedaccountingprinciples(GAAP)andtheInternalRe venueCodeconflict withregardtothetimingofrevenues,expenses,gains,andlosses.Ther esultingdifferences aretemporary(inmostcases),butnonethelesstheycreateareportingd ifferencebetweentax- ableincomeandfinancialincome.Timingdifferencesoccurwhenrev enues,gains,expenses, orlossesaffectfinancialreportedincomeinoneperiodbuttaxableinco meinanotherperiod. Notethatdeferredincometaxesarecalculatedusingonlyenactedtaxr atesunderUSGAAP butenactedorsubstantiallyenactedtaxratesunderIFRS.Thismeanst hatcompaniesthat followIFRSapplynewtaxratesandlawsearlierthanunderUSGAAP. 32 Chapter 3: Balance Sheet—Question 7 Reviewyourcompany’sbalancesheet.Doesitreportadeferredtaxass et?Adeferred taxliability?Ifso,arethedeferredtaxassetsand/orliabilitiesreported ascurrentor noncurrent? *Note:Ifyourcompanyreportsacurrentdeferredtaxasset(liability),i twillrealizeanincome taxbenefit(obligation)inthenextaccountingperiodbecauseofaprevi
  • 64. ouslyreportedevent. If your company reports a noncurrentdeferredtaxasset(liability),itwillrealizean incometaxbenefit(obligation)infutureaccountingperiods(beyondt henext)because of a previously reported event. Deferredtaxasset?YesorNo CurrentorNoncurrent* Deferredtaxliability?YesorNo CurrentorNoncurrent* Shareholders’ Equity Equity represents the net assets of a corporation. This concept can be compared to own- ingahouse(asset)withanoutstandingmortgagenote(liability).Ifthe houseisvaluedat $150,000 and the payoff on the mortgage note is $90,000, then the equity in the house is $60,000. A company’s balance sheet is viewed in much the same way. It is composed of many assets,avarietyofliabilities,andaresidualinterest(equity)inthoseas sets.Therelationship betweenthethreeitemsdefinesthebalancesheetequation(assets=lia bilities+equity). Furthermore,aninverserelationshipexistsbetweenacompany’sdebt anditsequity. If equity increases relative to total assets, then debt decreases proportionally. The greater the equity component in a balance sheet, the less pressure there is on the organization tocoverrelatedinterestexpenseandgenerateaprofit.
  • 65. Stockholders’ equity is generally divided into two categories: contributed capital and earned capital. Contributed capital is recognized when a company acquires assets through thesaleorexchangeofcommonstock.Whenthisoccurs,companiesre cognizeadditional contributedcapitalinthebalancesheetaswellasanassetorreductioni nanexistingliability. Mostoftentheassetreceivediscash,butoccasionallyabuildingorequ ipmentcanbereceived aswell.Companiesalsohavetheflexibilitytosettleexistingdebtoblig ationswiththe issuanceofcommonshares.Knowingthedefinitionofthefollowingfi vetermsisnecessary to understand contributed capital. • Authorizedshares • Issuedshares • Outstandingshares • Parvaluepershare • Treasuryshares 33 The authorized shares establish the ceiling on the total number of shares that may be issued by the company. The Articles of Incorporation identify this number, and it can be exceededonlyifthecorporatecharterisamended.Theissuednumbero fsharesrepresents
  • 66. the shares sold over time. The number of shares outstanding can be less than or equal to the number of shares issued. If the number of shares outstanding is less than the number of shares issued, the company has reacquired some of its own common stock. Companies do this to enhance future earnings per share, reduce total future dividends paid, support executivecompensationprograms,orhelpfendoffhostiletakeovers. Whenacompany purchases its own stock it is known as treasury stock. Par value per share controls the legal capitalofthefirms.Reviewthisconceptinarecentaccountingtext. Thepaid-in- capitalaccountrepresentstheexcessofsellingpricepercommonshar e overparvaluepershare(IFRS’sidentifiesoverparamountsasasharep remium.).Because company stock is sold periodically, the selling price will often vary depending on market conditions.Thus,paid-in- capitalcanaccumulateindifferentamountswitheachpublic offering of the firm. The other component of shareholders’ equity is called earned capital or retained earnings.Earnedcapital(retainedearnings)representstheaccumulat edearningsofthat company since its inception, less any dividends paid to the company’s shareholders. Whenacompanybeginsoperations,earnedcapital(retainedearnings )iszero. Withthepassageoftime,earningsarereportedanddividendsaredistri
  • 67. buted.Asaresult, retained earnings may be positive or negative. A positive measure indicates that the company hasattainedsomelevelofprofitability(netincome)andhasdistribute dlessthanthose earnings to shareholders. Negative retained earnings suggest that the company has sustained netlossesovertimeorpaidoutdividendsinexcessofprofitsachieved. Thereisnorelation- ship between retained earnings and a company’s cash position. Remember that retained earnings are a subset of equity, and equity supports all assets. Chapter 3: Balance Sheet—Question 8 Identifytheinformationthatrelatestothestockholders’equitysectio nofyourcompany’s balancesheet. Parvaluepershareofcommonstock? Numberofcommonsharesauthorized? Numberofcommonsharesissued? Numberofcommonsharesoutstanding? Numberoftreasurysharesheldbythecompany? 34 Chapter 3: Balance Sheet—Question 9
  • 68. Answerthefollowingquestionsrelativetothestockholders’equityse ctionofthe balancesheet. *IfNo,thendividendswerepaid(ordeclared)byyourselectedcompan yorcertain eventstookplaceduringtheyearwheretheaccountingfortheeventsdi rectly affected the retained earnings account. Bywhatamountdidretainedearningsincrease ordecreasefromtheprioryear? Wastheincreaseordecreaseinretainedearnings YesorNo* equaltothecompany’scurrentyearnetincome ornetloss? Chapter 3: Balance Sheet—Question 10 List(write- in)eachfinancialstatementelementasshowninyourcompany’sbalan cesheet. Assets Liabilities Stockholders’ Equity Finally,shouldyouencountertheelementminority interest in stockholders’ equity, this is anindicationthatyourcompanyownslessthan100%ofanothercompa ny,knownasthe “investeecompany”.ASC810(SFASNo.160pre- codification)nowprohibitsminorityinterest from being classified as equity. As a result, it will be reported between liabilities and equity as astandaloneelement.IFRS,however,permitminorityinteresttobere
  • 69. portedasacomponent of equity. Elements of the Balance Sheet Asyoureviewedthebalancesheetyousawthatspecificaccounts(label edfinancial state- ment elements), such as cash, receivables, building, equipment, accounts payable, and income taxespayable,haddollarvaluesassignedtothem.Theseamountsrepre senttheaccount’s carrying or book valueatthecloseofthefiscal(calendar)year. 35 * Note again that additional paid in capital is known as share premiuminIFRSbasedfinancialstatements. Chapter 3: Balance Sheet—Question 11 Identifythecombinedcarryingvalues(dollaramounts)ofthefollowi ngselectedaccount groupstakenfromyourcompany’sbalancesheet: Chapter 3: Balance Sheet—Question 12 Identifythethreemajorbalancesheetaccounts,forexampleaccountsr eceivable, accountspayable,inventory,etc.thatchangedthemostfromthepriory ear.Whatevents
  • 71. Account Explanation 36 Importance of the Balance Sheet Theactivityofpreparingacommon- sizedbalancesheetisthebeginningofthefinancial analysis phase of studying a company. The balance sheet serves as a data source for several importantmeasures.Measuresarewholedollaramounts.Measuresm ustbestandardized into ratios to help the user compare results and performance overtime and across companies. Toprepareacommon- sizedbalancesheet,allaccountsarestandardizedasapercentageof total assets. Therearetwodistincttake-a- waysfromtheprocessofpreparingacommon-sizedbalance sheet.Financialanalysisisbothanartandascience.Fortheartsidetoco meintoplaythe usermusthaveasenseaboutthedata.Preparingandreviewingtheoutp utofacommon-sized balance sheet builds this sense about the company’s financial position. Once the user has a sense about the company’s financial position, he or she is in a better position to critically reviewandinterpretdetailfinancialratios.Practiceandexperiencear ethebestteachersfor blending the art and science of financial analysis. Chapter 3: Balance Sheet—Question 13
  • 73. 37 Chapter 3: Balance Sheet—Question 14 Identifythethreebalancesheetgroupsfromquestion13abovethatcha ngedmost significantly.Withineachofthesegroups,identifytheprimarybalanc esheetelementthat drovethischange.Whateventsmightexplainthesechanges? CurrentAssets (Example–salesincreasedby22%,thusaccountsreceiv- ableincreasedbyapproximately22%) Group Name Explanation The user turns to the balance sheet for two pieces of specific information. The balance sheet provides information concerning a firm’s liquidity and solvency on a particular day. Theseconceptsareintroducedinthischapterbutmorefullydeveloped inChapter4. Liquidityanalysisinvolvesacomparisonofacompany’sshort- termassetsandshort- termliabilities.Allcompaniesarerequiredtoaddressliquidityissuesi ntheManagement’s Discussion&Analysis(MD&A)sectionoftheannualreport.Liquidit ymeasuresindicate a company’s ability to meet its current maturing obligations, which must be satisfied in thenext12months.
  • 74. Chapter 3: Balance Sheet—Question 15 Didyourcompanybecomemoreorlessliquidwhencomparingthisyea rtolastyear? Current Year Prior Year CurrentAssetsminusCurrentLiabilities= Explainwhy? CurrentAssetsminusCurrentLiabilities= 38 Measuresofsolvencyrefertoacompany’sabilitytomeetfutureprinci palandinter- estpaymentsonitslong- termdebt.Thegreatertheamountofdebt(financialleverage), thegreaterthefixedcost(interestexpense)associatedwiththedebt.M anycompanieshave shownanuncannyabilityovertimetomanagethisfixedcost.Successi nthisareacan be advantageous to the shareholder. A large amount of debt is necessary and typical in rapidly growing companies. A large debt load, however, also signals the company may have difficulty surviving turbulent periods. Chapter 3: Balance Sheet—Question 16
  • 75. Didyourcompanyincreaseordecreaseitsfinancialleveragewhenco mparingtotaldebt tototalstockholders’equityfromthisyeartolast? Current Year Prior Year Totaldebt÷Totalstockholders’equity= Explainwhy? Totaldebt÷Totalstockholders’equity= 39 Interestingly,IFRSonlyrequiretwoyearsofcomparativefinancialre portingacrossall financial statements. Format of the Income Statement The income statement is generally divided into two sections: operating and nonoperating. The operatingsectionoftheincomestatementincludesrevenuesandexpe nsesthatcorre- spondtotheprincipleoperationsofthecompany(i.e.,day-to- dayoperations).Thecombina- tionofoperatingrevenueandoperatingexpensesleadstoareportedme asureofoperating income or operating loss. 1ColleenCunningham,“WillRevampedFinancialStatementBenefit Valuation?”ComplianceWeek,February24,2009
  • 76. The Income Statement or Statement of Earnings The income statement, also labeled the statement of earnings, measures a company’s performanceoveraspecifiedperiodoftime.Forthisreason,thestatem entistitledfora periodoftime— forexample,theyearendingFebruary1,2009.Thestatementisdiffere nt from the balance sheet because it is a cumulative record of activity for a month, quarter, multiple quarters, or one year. Creditors, investors, and many others use the income statement as a measuring stick of how a company has performed, where it appears to be heading, and whatitsfuturecashflowswillbe.USGAAPrequiresthattheincomesta tementbepresented usingasingle-stepormultiple- stepformat.IFRS,however,donotrequireaparticularformat. Further,expensescanbegroupedaccordingtofunctionornaturerathe rthansimplyfunction under US GAAP. Function refers to the primary activities, such as selling goods, providing ser- vices, manufacturing, marketing, business development, and administration. Nature refers to the economic characteristics, such as separating total revenue into wholesale revenues and re- tail revenues, or disaggregating cost of sales into materials, labor, transport, and energy costs.1 Chapter 3: Income Statement—Question 1 Reviewtheheadingofyourcompany’sincomestatement.Doesthe company’sincomestatementprovidetwoorthreeyearsofcomparativ e _____ years
  • 77. information?(Insertnumbertotheright.) WhydoyouthinktheSECrequiresthatbalancesheetsprovidetwoyear sofcomparative financialinformationandincomestatementsprovidethreeyearsofco mparativefinancial information? 40 The nonoperatingsectionoftheincomestatementincludesincome/expen seitemsand gain/lossitemsthatareroutinetomostanytypeofbusinessentitybutth atareperipheral today-to- daybusinessoperations.Examplesincludeinterestearnedoninvestm ents,interest incurredonborrowings,andgainsand/orlossesassociatedwiththedis posalofassetsand/or eliminationofliabilities.Anexampleofaperipheralactivitywouldbe thesaleofapieceof equipment. If the equipment has a book value of $20,000 and is sold for $15,000, there is a realizedlossof$5,000.Whilethelossisreportedontheincomestateme nt,itisrecognizedin the nonoperating section under other expenses and losses.Thislossisexcludedfromoperating income because it is related to a support of business activity rather than to an operating business activity. Thesumofoperatingincome(loss)andnonoperatingincome(loss)iss
  • 78. implyincome (loss) before income tax expense.Onceincometaxexpenseorbenefitisconsidered,netincome (loss)istheresidual.Thelevelofdetaildisclosedbetweenoperatingin comeandnetincome variesamongcompanies.Whenevaluatingacompanyastudyofoperat ingincomefromone yeartothenextismuchmoremeaningfulthanastudyofnetincomefrom oneyearto thenext. Elements of the Income Statement As mentioned before, the income statement is often divided into two sections: operating and nonoperating. The operating section includes sales revenues, cost of goods sold, andotheroperatingexpenses. OPERATING SECTION Net Sales: Operating sections begin with net sales of goods and services. Net sales result when a company deducts from gross sales: Chapter 3: Income Statement—Question 2 Reviewthemiddlesectionofyourcompany’sincomestatement.Dido peratingincome (loss)increaseordecreasefromtheprioryearandbyhowmuch?Youm ayhaveto computeoperatingincome(loss). Chapter 3: Income Statement—Question 3
  • 79. Doesthemiddlesectionofyourcompany’sincomestatementshowano noperating income(loss)increaseordecreasefromtheprioryearandbyhowmuch ?Youmayhave tocomputenonoperatingincome(loss). Increasedby$ ____________________ Increasedby$ ____________________ Decreasedby$____________________ Decreasedby$____________________ 41 • Costofgoodsreturnedbycustomers • Cashdiscountsawardedwhencustomers,clients,etc.paywithinthedi scountperiod • Allowancesgrantedtocustomerswhengoodsorservicesaredefective These items generally are not disclosed in the annual report but are tracked for internal reporting purposes. Cost of Merchandise Sold: Generallythemostsignificantexpensereportedinthe
  • 80. income statement is the cost of goods. Cost of goods sold is recognized only when a sale of merchandise or services has taken place. Cost of goods sold as a percentage of net sales is an important measure of a firm’s performance. The percentage can be compared from year to year as well as across firms within an industry. Gross Profit: The difference between net sales and cost of goods sold is a company’s gross profit,orgrossmargin.Areportedgrossprofitisessentialtocoveroper atingexpensesthat acompanyincursduringtheoperatingyear.Management’seffectivec ontroloverinventory acquisition cost can lead to an improved or at least stable gross profit measure from one year tothenext. Companies that report lower operating profits often have been quoted as saying, “Product price increases could not be passed along to the consumer in a timely manner.” Circumstances like these create a squeeze on gross margins that ultimately filters down to a company’s operat- ingincome(loss),thatis,thebottomline.Manytimespriceincreasesc annotbepassedalong becauseofexistingmarketconditionssuchasaneconomicdownturn. Raisingpriceswould simply create less product demand. Selling Expenses: Sellingexpensesdirectlyrelatetothesellingofgoodsandservices. Examplesareadvertisingandthesalesforce’ssalary. General and Administrative Expenses:Generalandadministrativeexpensesofteninclude
  • 81. avarietyofcoststhatrelatetooperationsotherthansales.Forexample, thedepreciation ofacompany’scorporateheadquartersconstitutesageneralandadmi nistrativeexpense. Managementsalaries,utilitycosts,andpropertytaxesarefurtherexa mples ofgeneralandadministrativeexpenses. Operating Income:Thedifferencebetweenoperatingrevenuesandoperatingex pensesis operating income. Operating income is essentially the most useful measure of a company’s performancefromoneyeartothenext.Thereasonforthis,asmentione dbefore,isthatit excludesnonoperatinggainsandlossesthatcandistortmeasuresofper formance. NONOPERATING SECTION Interest and Investment Income: Interest and investment income is earned and reported when a company invests in certificates of deposits, treasury bills or notes, or in the stocks and bonds of other companies. The success of these investments will be measured in the form of dividend, interest, or investment income. These returns will ultimately be reported on the company’sincomestatementundernonoperatingincome(expenses). As an aside, institutions that report interest and investment income as a part of operations include banks and other financial institutions. Their business purpose is to attract capital at a predetermined cost, invest the acquired capital, and achieve a higher rate of return. Therefore,
  • 82. a financial institution’s gross profit is controlled by the percentage difference. 42 Interest Expense: Interest is a payment that companies make for using another company’s money and is directly related to the passage of time. Interest is associated with a company’s notes, mortgages, and bonds or is embedded as part of a lease obligation or pension obliga- tion.Inmostcases,acompany’slong-termliabilities(andsomeshort- termliabilitiesaswell) willhavesomerelatedinterestexpense.Onceagain,however,interest expense(andrevenue) falls outside operating income. Income Taxes: Mostcorporationsareresponsibleforavarietyoftaxes.Thesecanincl ude federal,state,andforeignincome- taxobligations.Becausemanyofthesetaxesarebased onrevenue,theymustbeaccruedforandpaidinatimelymanner.Incom etaxexpense,the number reported in the income statement, is essentially the federal statutory rate multiplied byacompany’sincomebeforetax.Thisratevaries,dependingontaxab leincomeand politicalagenda.Thenumberisfurtheradjustedtoincludeanystateorf oreignincometax obligation(orincometaxbenefits).Oncealloftheseeffectsareconsid ered,incometax expenseisreported.Therefore,incometaxexpense,asafunctionofinc omebeforetaxes,
  • 83. can vary from year to year. Net Earnings:Netearnings(orincome)areoftenreferredtoasacompany’s bottom line. Net earnings, as we have seen, remain after a company deducts operating and nonoperating expensesfromoperatingandnonoperatingrevenues.Acompany’snet profitmarginisoften compared across years or across firms within the industry. Irregular Items Two items of special importance are also included in the conventional income statement butarereportedbeyondtheoperatingandnon- operatingsections:discontinuedoperations andextraordinaryevents.Athirdirregularitem,changesinaccountin gprinciples,isnow accounted for with a direct adjustment to the balance sheet. Accounting professionals view these events as irregular items and generally prefer that their effects be removed from the main body of the income statement. DISCONTINUED OPERATIONS Oneofthemostoftenoccurringirregularitemsisthegain/lossassociat edwiththe disposalofabusinesssegment.Justasmanycompanieshaverecentlye xpandedoperations through business acquisitions, many of these same companies have disposed of other Chapter 3: Income Statement—Question 4
  • 84. Inreferencetowhyyouarestudyingthiscompany,isitimportanttokno wthedifferent sourcesofincome—operatingornonoperating? 43 operatingsegmentsalongtheway.Foradisposaltoqualifyasadiscont inuedoperation,the assets, results of operations, and activities of a business segment must be clearly distinguish- able,physicallyandoperationally,fromthebalanceoftheenterprise. Thefollowingexcerpt from Sara Lee’s 2009 annual report illustrates the note disclosure that would help clarify a recognizedgain/lossonthedisposalofabusinesssegment. “Note4– DiscontinuedOperations:Therewerenofinancialresultsattribut- able to discontinued operations in 2009. In 2008, the corporation disposed of itsMexicanMeatsoperation.In2007,thecorporationdisposedofitsE uropean MeatsandBrandedApparelAmericas/Asiabusinesses.Theresultsof these businesses have been reported as discontinued operations.” EXTRAORDINARY ITEMS A second irregular item that gets special accounting consideration under US GAAP but not underIFRSisanextraordinaryevent.Anextraordinaryitemisatransa ctionoreventthatis
  • 85. both unusual and is infrequent in occurrence, taking into account the environment in which thecompanyoperates.Forexample,assumetwocompaniessustainsig nificantfloodlossdam- age.Onecompanymightclassifythelossasextraordinary,yettheothe rmightnot.Floodloss sustainedbyanenterpriselocatedinafloodplainwouldnotconstitutea nunusualoccurrence andwouldnotwarrantextraordinaryclassification.Norwouldaneart hquakelossfora companylocatedinCaliforniabereportedasextraordinary. Another item, known as a corporate restructuring charge, may appear to be unusual or infrequentbutisstillreportedasacomponentofcontinuingoperations .TheFASBconsiders organizational restructuring a part of today’s normal business environment. However, restruc- turing charges, if material, can be shown as a separate line item. Shown below is Sara Lee’s 2009 annualreportnotedisclosureforrestructuringactionstakenduringfis calyears2007-2009. Note 5—Exit, Disposal and Restructuring Activities Thefollowingisasummaryoftheincome(expense)associatedwithne wandongoingactions…. CostofSales TransformationCharges—IT Selling,Generaland AdministrativeExpenses TransformationCharges—IT Transformation/AccelerateCharges NetChargesfor(incomefrom) ExitActivities AssetandBusinessDispositions
  • 86. Reduction in income from continuing operationsbeforetaxes Incometaxbenefit Reduction in income from continuing operations $ 5 21 18 114 --- $ 158 $ (43) $ 115 $ 8 40 3 39 (1) $ 89 $ (31) $ 58 $ 10 42 67
  • 87. 106 (12) $ 213 $ (77) $ 136 2009 2008 2007 44 CHANGE OF ACCOUNTING PRINCIPLE A third irregular event that requires special accounting treatment but no longer affects the income statement(ASC250-SFASNo.154pre- codification)isanaccounting principle change. A change in accounting principle results when a company voluntarily switches from onegenerallyacceptedaccountingprincipletoanotherorwhentheFA SBissuesanewac- counting pronouncement. A change in an accounting principle often requires an adjustment tospecificassetorliabilityaccounts,aswellasanadjustmenttoretaine dearnings(prior yearchangeswherenecessary).Whenretainedearningsareadjusteda ndprioryearsfinancial statements are restated, the firm is applying “retrospective application.” In the past, many of these accounting changes were accounted for under the “current approach” and the cumula- tive effects were reported as a component of net income.
  • 88. Importance of the Income Statement Creditors, employees, suppliers, investors, and others use the income statement. The re- port serves as a measuring stick of how a company has performed, where it appears to beheading,andwhatfuturecashflowsarelikelytobe.Thefirstquestio nmostuserswant answerediswhatisnetincome?Next,theywanttoknowhowthatfigure comparestothe prior years. Chapter 3: Income Statement—Question 5 Ifanyoftheirregulareventsareshownonyourcompany’sincomestate ment,describethe natureandtheamount.Selectthemostcurrentyearaffectedbytheeven tifmultipleyears are affected. Restructuringcharge? Discontinuedoperation? Extraordinaryevent? Irregular Event Amount Nature of the Change Chapter 3: Income Statement—Question 6 Reviewthelowersectionofyourselectedcompany’sincomestatemen t.Didnetincome
  • 89. (loss)increaseordecreasefromtheprioryearandbyhowmuch? Increasedby$ ____________________ Decreasedby$____________________ 45 Similartothebalancesheet,acommon- sizedincomestatementprovidesabasicstructure foraskingwhyandwhynotvaluesincreasedordecreased.Thecommo n-sizedincomestate- ment is standardized by net sales. Basic and Diluted Earnings per Share (BEPS and DEPS) Earningspercommonsharemustbecomputedandreportedbyallpubli clytraded companiesintheircorporateannualreportandSECForm10- K.Thereasonforthisisthat it measures performance on a per share basis and helps standardize earnings. Standardized earnings allow investors to compare two companies side by side without being unduly influencedbythemagnitudeofearnings.Forexample,ifCompanyAa chieves$5billion in net earnings while Company B achieves half that amount, Company A would appear to be more attractive as a shareholder investment. If, however, Company B had only half as manysharesofstockoutstanding(heldbyshareholders),CompanyB’ searningspershare would be equal to Company A’s.
  • 90. Chapter 3: Income Statement—Question 7 Prepareacommon-sizedincomestatementforthecategoriesbelow. NetSales(revenues) CostofGoods/Services(ifapplicable) GrossProfit OperatingExpenses OperatingIncome(Loss) NonoperatingIncome(Loss) IncomeTaxExpense NetIncome Increase Current Prior or Decrease Account/Category Year Year (current yr.% - prior yr. %) Chapter 3: Income Statment—Question 8 Identifythethreeincomestatementaccounts/categoriesthatchanged themostin Question7.Whateventsmightexplainthesechanges? (Hint–theMD&Asectionwillprovidegood informationtoanswerthisquestion.) Account or Category Explanation
  • 91. 100% 100% 46 Becauseofavarietyofequity- relatedinstrumentsthatexistwithinacompany’scapital structure, companies are often required to report two measures of earnings per share. Examplesofequity- relatedinstrumentsthatmayleadtocommonstockinclude: • Convertiblebondsornotes • Convertiblepreferredstock • Stockoptions,stockwarrants,stockunits… Eachoftheseinstruments,ifconvertedintocommonstockbytheirhol ders,couldlower a company’s earnings per common share because the number of shares outstanding will increase. Therefore, accounting rules and the conservatism principle require companies to report two measures of per share performance: basic earnings per share and diluted earnings per share. The computation of diluted earnings per share considers the effect of converting all dilutive securities into common shares. Chapter 3: Income Statment—Question 9 Identifyyourcompany’sBasicandDilutedEPSamounts.PlaceaN/Ai nDilutedEPSif not reported.
  • 92. Currentyear Precedingyear1 Precedingyear2 WhyisdilutedEPSalwaysequaltoorlessthanbasicEPS? Basic EPS Diluted EPS 47 Statement of Cash Flows (SCF) Format of the SCF Thestatementofcashflowsisdesignedtomeasurehowcashflowedint oandoutofthe businessforaperiodoftime.Cashflowsinsupportofdailyoperatingac tivitiesarelabeled operatingcashflows.Cashflowsassociatedwithpurchasesofinvestm entsandsaleofinvest- mentsarelabeledinvestingcashflows.Cashflowsassociatedwithfin ancingthebusiness throughstocksandbondsarelabeledfinancingcashflows. Chapter 3: SCF—Question 1 IstheSCFdatedinthetitleforaperiodoftimesimilartotheincomestate mentorfora pointintimesimilartothebalancesheet?Why?
  • 93. Chapter 3: SCF—Question 2 IdentifythefollowingsectionsoftheSCFandrecordtheamounts.Che ckthemathby summing to the cash balance at end of year.Verifythattheendingcashbalancereported ontheSCFisthesameasreportedonthebalancesheet. Netoperatingcashflows Netinvestingcashflows Netfinancingcashflows Netincrease(decrease)incashflows Cashbalanceatbeginningofyear Cashbalanceatendofyear Doesthetotalmatchbalancesheetcash? Yes/No Yes/No Current Prior Second Section Year Year Prior Year 48 Importance of the SCF Twomethodsofreportingoperatingcashflowsareallowedbygenerall yacceptedaccount- ingprinciples.Thedirectmethodcomputesoperatingcashflowssimil
  • 94. artohowtheincome statementcomputesearnings.Theindirectmethodcomputesoperatin gcashflowsbyadd- ingtoorsubtractingfromnetincome,thecashflowsassociatedwithda ilyactivities.Each areacceptableunderUSGAAPandIFRSreportingrules.Theindirect methodisfollowedby mostcompanieswhenpreparingtheSCF.Regardlessofthemethodem ployed,thefollowing questionsapply.AsyoureviewtheSCF,notethatinterestreceivedand dividendsreceivedare reportedasoperatingcashflowsunderUSGAAPbutcanbereportedas operatingorinvest- ingcashflowsunderIFRS.Interestpaidisalsoconsideredanoperating cashflowunderUS GAAPbutcanbereportedasanoperatingorfinancingcashflowunderI FRS. Chapter 3: SCF—Question 3 Recordnetsales,netincomeandnetoperatingcashflowsbelow.Allthr eeshouldbe trendinginapproximatelythesamedirection.Ifso,thisisasignofawel l-runbusiness. Ifoneormorearegoinginadifferentdirection,orrandom,thenyoumus tkeepaneye openforanexplanationwhy. NetSales NetIncome NetOperatingCashFlows
  • 95. Explainwhynetsales,netincomeandnetoperatingcashflowsaretren dingtogetheror differently.(Hint:Lookatdepreciationexpenseandsubstantialchan gesininventory,accounts receivableandaccountspayablebalances.Explainingwhyisakeylear ningpoint.) Item Current Year Prior Year Second Prior Year 49 Chapter 3: SCF—Question 4 Identifytheprimarycashoutflowsandinflowsfrominvestingactiviti es. Chapter 3: SCF—Question 5 Identifytheprimarycashinflowandoutflowfromfinancingactivities . Cashoutflow: Cashinflow: Considerthreekeyissuesatthispoint.Isthecompanyaddingassets?T hisisasignofgrowth. Isthecompanyreplacingassets?Thisisasignofgrowthandstability.I sthecompanyonly sellingassets?Thisisasignofretrenchment. Cashinflow:
  • 96. Cashoutflow:(Note:cashdividendspaidarereportedhere.) Considertwokeyissuesatthispoint.Howisthecompanybeingfinance d,throughdebtor equity?Canyoudeterminewhichisgrowingfasterandwhy?Asoundc orporatestrategyis tofinanceacompanywithdebtduringstabletimes,becausethisdeman dsregularpayment ofprincipalandinterest,andtofinanceacompanywithequityduringu nstabletimes,because leadership can elect to pay or not pay dividends. Description of Activity Amount Description of Activity Amount 50 The Statement of Stockholders’ Equity (SSE) Thestatementofstockholders’equity(orstatementofchangeinstock holders’equity) identifiesthechangesinallbalancesheetequityaccountsoveraspecif iedperiod.Forthis reason,thestatementistitled,forexample,“fiscalyearended,Februar y1,2009”Threepoints arenoteworthyaboutthestatementofstockholders’equity.First,asin thestatementofcash flows,threeyearsofinformationarepresentedinthereport.Second,tu ckedwithinthestate- ment of stockholders’ equity is a reconciliation of retained earnings from beginning balance to ending balance for the period. This reconciliation is a required disclosure and is identified
  • 97. asthefourthrequiredfinancialstatement.Third,theFASBrequiresth atsignificantchanges in the equity accounts must be disclosed to include comprehensive income. The statement of stockholders’ equity fulfills this requirement. Importance of the Statement of Stockholders’ Equity Creditors and investors use this report to better understand the changes in a company’s equitypositionoveraspecificperiodoftime.Keepinmindthatthiscat egory—stockholders’ equity— presentsthenetassetsofacompany(excessofassetsoverliabilities). Asthemakeup ofassetsandliabilitieschangesfromoneperiodtothenext,sowillstoc kholders’equity.The statement of stockholders’ equity, therefore, helps the user focus on the changes that occur. Ingeneral,asacompanybecomesmorefinanciallycomplex,astateme ntofstockholders’ equitybecomesanecessityforexternalreporting.Intheirinfancy,co mpanieshavefewevents outsideofearningsanddividendsthataffectequity.Whenthisisthepat tern,astand-alone statementofretainedearningsisacceptableforexternalreporting.Ast hefinancialstructure becomesmorecomplexstatementsofstockholders’equityareinclude dasaseparatesched- ule, along with the three other financial statements in the corporate annual report. Occasion- ally, the statement will be separately included in the notes to the financial statements.
  • 98. Chapter 3: SSE—Question 1 Identifytheelementsthatcomprisethestatementofstockholders’equ itysectionofyour company.Hint:Theseitemsaregenerallyillustratedacrossthetopoft hepageusinga columnarformat.(Example.Commonstock– sharesanddollaramount.) 51 Limitations The statement of stockholders’ equity has few limitations, simply because it is a summary financialstatementusedtoexplainequitychanges.Becauseofthis,the statementofstock- holders’equityisnotwellsuitedforfinancialanalysis.Mostrelevante quityinformation can be drawn specifically from the balance sheet stockholders’ equity section and the income statement.Oneexceptionisacompany’sdividendpayments.Dividen ddistributionsarenot reportedinthebalancesheet;theyfalloutsidetheincomestatement.H owever,cashdividend paymentscanbelocatedwithinthefinancingsectionofthestatemento fcashflows. Notes to the Financial Statements Theaccountingprofessionhasadoptedthefull- disclosureprinciple,whichemphasizes
  • 99. thereportingofanyinformationthatwouldinfluencethejudgmentofa ninformedreader. Althoughthebalancesheet,statementofoperations,andstatementofc ashflowsprovide significant economic substance, additional clarification and amplification provided in the notes can improve the understanding of the financial statement information. Companies that provideextensivenotepresentationaresimplycomplyingwithgener allyacceptedaccount- ingprinciples(GAAP),andincertaincases,withregulationsissuedby theSEC.Notesare essentially the means of clarifying what is being presented in the financial statements and are audited along with the general financial statements. In compliance with GAAP, you will find your company sporadically identifies the related note to the financial statements in the body ofthebalancesheetand/orincomestatement.IFRS,however,requiret hattheelements Chapter 3: SSE—Question 2 Identify the cash dividends per share. Determinethedividendpayoutpercentage.Acompany’s dividendpayoutpercentageiscomputedbydividingdividend percommonsharebynet income or earnings per common share. (Hint:Ifyourcompanyreportedanetlossfortheyear,theanswer lacksmeaning.) Computedividendyield.Acompany’sdividendyieldiscomputed bydividingdividendpercommonsharebymarketpriceper commonshare.(Hint:Usethecurrentpersharepriceforyour selectedcompany.)
  • 100. Isyourcompany’sdividendyieldareasonablereturngivencurrentma rketconditions? 52 of the financial statements be shown with their related note number specifically, as illustrated in a section of the Heineken 2008 Annual Report income statement shown below. The broadest and most generally read note is the first, “Summary of Significant Accounting Policies”. Accounting policies are the accounting principles and methods used bythereportingentity.Forthatreason,usersoffinancialinformationc anlooktothisnote to gain a general understanding of the business and related accounting applications and establish a framework for comparing two or more companies. The following questions are based upon information generally included in Note #1 Summary of Significant Accounting Policies and a selection of notes that are most common. Cashisoneofthemostimportantelementswithinthecorporatebalanc esheet.Without cash, a company is unable to meet its operational demands. Chapter 3: Note to the Financial Statements—Question 1 Howdoesyourcompanydefine“cashandcashequivalents”?
  • 101. Heineken N.V., ConsolidatedIncomeStatementExcerpt Fortheyearended31December2008 Revenue Otherincome Rawmaterials,consumablesandservices Personnelexpenses Amortization,depreciationandimpairments Total expenses Results from operating activities Interest income Interestexpenses Othernetfinanceexpenses Netfinanceexpenses 5 8 9 10 11 12 12 12 14,319 32 9,548 2,415 1,206 13,169
  • 102. 1,182 91 (469) (107) (485) 11,245 28 7,320 1,951 638 9,909 1,364 64 NoteIn millions of EUR 2008 2007 (155) (4) (95) 53 Inventory consumes a substantial amount of company resources. How a company values inventoryaffectsfinancialperformanceandthecomparabilityofonec ompanytothenext. USGAAPallowsmultiplecostflowassumptionsforinventoryvaluati onpurposes.These includeLIFO,FIFO,weighted/movingaverageandspecificidentific ation.IFRS,however, donotpermittheuseoftheLIFOcostflowassumptionbutallowinvent orytobewritten
  • 103. up even if it were to be written down as a result of impairment. US GAAP does not permit asubsequentwrite-up. Investmentsinequityanddebtsecurities(alsoreferredtoasmarketabl esecuritiesinmany companynotes)canberecordedatcost,atfair-marketvalue(ASC820- SFASNo.157pre- codification, defines fair value, establishes a framework for measuring fair value in generally acceptedaccountingprinciples,andexpandsdisclosuresaboutfairva luemeasurements),or at amortized cost. The appropriate investment valuation model is based on its classification. Investments are generally categorized as trading investments, available-for-sale investments, or held-to-maturity investments. Forexample,equity(othercompanies’stock)investmentsarecarried atcostifmarketval- ueisnotreadilydeterminable.Alternatively,theycanbecarriedatfair -marketvalue,andclas- sified as trading or available for sale,ifthereexistsareadymarketforliquidation.Thedistinc- tion between classes determines whether unrealized gains and losses will affect the income statement(nonoperatingincome)inagivenperiodorwhetherthegain sandlosseswillbe excludedfromnonoperatingincomebutincludedintheorganization’ sstockholders’equity. Bondinvestments,bycontrast,canbecarriedatcostorfair- marketvalue,dependingon the investment’s classification. If management intends on
  • 104. holding the investment until the bondsreachmaturity(held-to- maturityclassification),costoramortizedcostisusedasthe basisforvaluation.Essentially,thisrequirestheorganizationtocarry theinvestmentatcost throughmaturityandnotadjusttofair- marketvaluefromonereportingperiodtothenext. If the debt investment is classified as trading or available for sale, the valuation model is similartothatofaninvestmentinequitysecurities.ASC825(SFASNo .159pre-codification) permits entities to choose to measure many financial instruments and certain other items at fair value. The objective is to improve financial reporting by providing entities with the op- portunity to mitigate volatility in reported earnings caused by measuring related assets and liabilitiesdifferentlywithouthavingtoapplycomplexhedgeaccounti ngprovisions. Chapter 3: Note to the Financial Statements—Question 2 Howdoesyourcompanyvalueits“inventories”?Explainthemeaning oftheinventory valuationmethod.Aredomesticandinternationalinventoriesvaluedt hesame? Service companies will typically not have inventory. 54 TheHomeDepot’sinvestments,consistingprimarilyofhigh- gradedebtsecurities,