The presentation covers the basics of financial statements, namely how to read financial statements and how to interpret them

1. 1-1
Chapter 1
Financial Statements: An Overview

2. 1-2
Map or Maze
• A map helps its user reach a desired
destination through clarity of
representation.
• A maze attempts to confuse its user by
purposefully introducing conflicting
elements and complexities that prevent
reaching the desired goal.
• Financial statements have the potential for
being both map and maze.
1-2

3. 1-3
Financial Statements as a Map
• Form the basis for understanding the
financial position of a firm
• Allow users to assess historical and
prospective financial performance
• Present clear representations of a
firm’s financial health
1-3

4. 1-4
Financial Statements as a Maze
• Overwhelming amount of information
• Unreliable auditing
• Complex policies and reporting
requirements
• Considerable discretion given to
management
• Key information hidden or omitted
1-4

5. 1-5
Map or Maze
The main objectives of this course are to
• ensure that financial statements serve as a map,
not a maze,
• demonstrate how to read and evaluate financial
statements,
• provide the tools and techniques needed to
complete a comprehensive financial statement
analysis, and
• encourage intelligent decision making.
1-5

6. 1-6
Map or Maze
Financial statements and their
accompanying notes contain a wealth of
useful information regarding:
• Financial position of a company
• Success of operations
• Policies and strategies of management
• Insight into future performance
1-6

7. 1-7
Map or Maze
• The user of a firm’s annual report can expect to
encounter a great quantity of information that
encompasses:
 Financial statements
 Notes to the financial statements
 Auditor’s report
 Five-year summary of key financial data
 High and low stock prices
 Management’s discussion and analysis of
operations
 Other material
1-7

8. 1-8
Map or Maze
• Financial statements are currently
prepared according to Generally Accepted
Accounting Principles (GAAP).
• The Securities Exchange Commission
(SEC) and the Financial Accounting
Standards Board (FASB) are the two
authorities primarily responsible for
establishing GAAP in the U.S.
1-8

9. 1-9
Map or Maze
• The SEC regulates U.S. companies that issue
securities to the public and requires the
issuance of a prospectus for any new security
offerings.
• The SEC also requires regular filing of:
 Annual reports (10-K)
 Quarterly reports (10-Q)
 Other reports dependent on particular
circumstances, such as a change in auditor,
bankruptcy, financial restatements, or other
important events (all filed as 8-K).
1-9

10. 1-10
Map or Maze
Figure 1.1 FASB/SEC Relationship
FIGURE 1.1 FASB/SEC
Relationship
1-10

11. 1-11
Map or Maze
• The globalization of business activity has
resulted in the need for a uniform set of
accounting rules in all countries.
• To address this need, the IASB (International
Accounting Standards Board) was formed in
1973.
• However, there’s a lack of SEC
recommendation to adopt IFRS standards in
the U.S.
• The course focuses on U.S. GAAP, however
the analysis process illustrated can be applied
to reports based on IFRS.
1-11

12. 1-12
Where to Find a Company’s
Financial Statements
• Corporate financial statements are
available from several sources:
 From the Form 10-K filed annually with the
SEC.
 From corporations’ websites
1-12

13. 1-13
Where to Find a Company’s
Financial Statements
• Form 10-K
 Filed annually with the SEC
 Same order for all filing companies
 Accessed through the Electronic Data
Gathering, Analysis, and Retrieval (EDGAR)
database.
1-13

14. 1-14
Where to Find a Company’s
Financial Statements
• Annual reports:
 Contain financial statements and public
relations material
 Are sent to shareholders and prospective
investors
 Are available on corporate websites.
1-14

15. 1-15
The Financial Statements
• A corporate annual report contains four
basic financial statements:
 Balance sheet (or statement of financial
position)
 Income statement (or earnings statement)
 Statement of stockholders’ equity
 Statement of cash flows
1-15

16. 1-16
Notes to the Financial Statements
• The notes
 are an integral part of the financial statements
and must be read in order to understand the
presentation of the face of each financial
statement.
 Provide a summary of the firm’s accounting
policies
 Present details about particular accounts
 Contain a section showing supplementary
information
1-16

17. 1-17
Auditor’s Report
• The auditor’s report from an external
auditor:
 Attests to the fairness of the presentation of
financial statements
 Must include an internal control report.
1-17

18. 1-18
Auditor’s Report
• Types of reports
 Unqualified reports
 Qualified reports
 Adverse opinion
 Disclaimer of opinion
 Unqualified opinion with explanatory
language
1-18

19. 1-19
Auditor’s Report
• An unqualified report states that the financial
statements present fairly, in all material respects,
the financial position, the results of operations,
and the cash flows for the accounting period in
conformity with GAAP.
1-19

20. 1-20
Auditor’s Report
• Some circumstances warrant reports other than
unqualified opinion and are called qualified
reports.
• A departure from GAAP will result in a qualified
opinion and the use of the following language in
the opinion sentence: ‘in our opinion, except for
the (nature of the departure explained), the
financial statements present fairly …’
1-20

21. 1-21
Auditor’s Report
• If the departure from GAAP affects numerous
accounts and financial statement relationships,
then an adverse opinion is rendered, which
states that the financial statements have not been
presented fairly in accordance with GAAP.
• A disclaimer of opinion means that the auditor
cannot evaluate the fairness of the statements
and therefore expresses no opinion on them.
Lack of independence by the auditor will also
result in a disclaimer of opinion.
1-21

22. 1-22
Auditor’s Report
• Many circumstances warrant an unqualified
opinion with explanatory language such as: a
consistent departure due to a change in
accounting principle, uncertainty caused by
future events such as contract disputes and
lawsuits, or events that the auditor wishes to
describe because they may present business risk
and going-concern problems.
1-22

23. 1-23
Financial Reporting Reforms
• Over time, a lack of independence and
conflicts of interest between companies
and their hired auditors led to a series of
accounting scandals that eroded
investors’ confidence in the capital
markets.
• The Sarbanes-Oxley Act (SOX) of 2002
was enacted in hopes of ending future
accounting scandals and renewing
investors’ confidence in the marketplace.
1-23

24. 1-24
Financial Reporting Reforms
• SOX Title I established the Public Company
Accounting Oversight Board (PCAOB)
• SOX Title II – prohibits non-audit services
during an external audit
• SOX Titles III and IV – corporate responsibility
• SOX Title IX – harsh penalties for violations
1-24

25. 1-25
Management Discussion and
Analysis (MD & A)
• Management discussion & analysis:
 Sometimes labeled “Financial Review”
 Contains information that cannot be found in
the financial data.
 Includes coverage of trends, events, and/or
uncertainties in liquidity, capital resources,
and results of operations.
1-25

26. 1-26
Five-Year Summary of Selected
Financial Data and Market Data
• Five-year Summary of Selected Financial
Data and Market Data required by the
SEC includes:
 Net sales or operating revenues
 Income or loss from continuing operations
 Total assets
 Long-term obligations and redeemable
preferred stock
 Cash dividends per common share
 Two years of high and low common stock
price by quarter 1-26

27. 1-27
Pandora (a.k.a ‘PR Fluff’)
• Pandora (a.k.a. “PR Fluff”) contains
 Colored photographs
 Charts
 Shareholders’ letter from the CEO
 Other items to make the report
attractive
• The ‘PR fluff’ is often informative but
sometimes misleading
1-27

28. 1-28
Proxy Statement
• Proxy Statement
 Used to solicit shareholder votes
 Important in assessing who manages the firm,
how management is paid, and conflict of
interest issues
 Provides information about the longevity and
compensation of top management as well as
corporate governance, audit-related matters,
etc.
1-28

29. 1-29
Missing and Hard-to-Find
Information
• Missing and Hard-to-Find Information includes:
 Employee relations with management
 Morale and efficiency of employees
 Reputation of the firm with customers
 Firm’s prestige in the community
 Effectiveness of management
 Provision for management succession
 Potential exposure to regulation changes
 Publicity in the media
 Companies operating in several lines of unrelated business.
1-29

30. 1-30
Characteristics, Assumptions,
Principles, and Basis of Accounting
• Investors, creditors, and analysts use a
firm’s financial statements to predict the
future value of a company and the ability
of that firm to repay debt.
• It is helpful to have a basic understanding
of the key accounting characteristics,
assumptions, and principles used to
predict this data.
1-30

31. 1-31
Characteristics, Assumptions,
Principles, and Basis of Accounting
• Materiality
• Comparability
• Consistency
• The Going Concern Assumption
• The Time Period Assumption
• The Monetary Unit Assumption
• The Revenue Recognition Principle
• The Matching Principle
• The Accrual Basis of Accounting
• The Cash Basis of Accounting
1-31

32. 1-32
Complexities and the Quality
of Financial Reporting
• Interpreting financial statements can be
challenging because of the complexities
inherent in the accounting rules that
underlie financial reporting.
• Ideally, financial statements should reflect
an accurate picture of a company’s
financial condition and performance.
1-32

33. 1-33
Complexities and the Quality
of Financial Reporting
• Many opportunities exist for management
to affect the quality of financial
statements. These include:
 Accounting choices
 Timing of revenue and expense recognition
 Discretionary items
1-33

34. 1-34
Complexities and the Quality
of Financial Reporting
• Accounting Choices
 Management discretion in application of
reporting regulations
 Differing accounting methods impact
comparability of companies
 Financial data appropriated to particular time
periods
1-34

35. 1-35
Complexities and the Quality
of Financial Reporting
• Timing of Revenue and Expense
Recognition
 Published financial statements are based
on the accrual basis of accounting, which
• Recognizes revenues when earned
• Recognizes expenses when incurred
• Recognizes revenues and expenses regardless
of when cash inflows and outflows occur.
• Involves judgments by management on timing
1-35

36. 1-36
Complexities and the Quality
of Financial Reporting
• Discretionary Items
 Equipment repair and maintenance
 Marketing and advertising
 Research and development
 Capital expansion
 Replacement of plant assets
 Development of new product lines
 Disposal of an operating division
1-36

37. 1-37
Complexities and the Quality
of Financial Reporting
• Discretionary Items
 Management choices have an immediate and
long-term impact on profitability (perhaps
not in the same direction).
 Financial analyst should scrutinize
management’s policies regarding
discretionary items.
1-37

38. 1-38
The Journey Through the Maze
Continues
Chapter 2 – The Balance Sheet
Chapter 3 – Income Statement and
Statement of Stockholders’ Equity
Chapter 4 – Statement of Cash Flows
Chapter 5 – The Analysis of Financial
Statements
1-38