2ObjectivesDevelop the ability to read, analyze and interpret financial statementsUnderstand how financial accounting statements are constructedProvide you with tools for economic decision makingWhere to find informationHow the information got there
3TextbookFinancial & Management Accounting, an Introduction by Pauline Weetman, 5th edition, available in two forms:SoftcoverE-bookRegister on Prentice Hall website for additional materials! (Process to be announced in class, next time.)
4Rules of the GameRead the assigned material, do the assigned problems before the lectureCome to class on timeDo the assignments on a timely basisTurn off cell phones and other communication devicesAsk questions and participate in class
5Course Website & e-mail I will use the schools e-learning portal to post information.Make sure you log in at:
6GRADING SCHEMEFinal grades will be determined by the following scheme:Assignments 10%Midterm 40%Final: %
8Today’s ClassOverview of “Accounting” in general and “Financial Accounting” in particularDiscussion of Accounting terminologyMandatory Financial Reporting (including the Financial Statements)
9Financial AccountingFinancial accounting is the language that translates economic events into uniform and comprehensive information, understandable by OUTSIDE observers.Unfortunately, this language has become extremely complex and heterogeneous…This is naturally a bad thing for the outside observers.
10In an ideal world…“In an ideal world, the user of financial statements could focus only on the bottom lines of financial reporting. If financial statements were comparable among companies, consistent over time, and always fully reflecting the economic positions of the firms, financial statement analysis would be simple.”Adapted CFA Preparation Readings
11Other Types of Accounting (not covered in this course)Tax Preparation and Compliance is pretty self-explanatoryInternal Information Systems and Reporting provides firm managers useful, real-time performance information to help with decision makingAlso referred to as Management Information Systems and/or Managerial AccountingKey element here is that information is for internal use onlyTherefore, there are typically few rules to govern how this “should be” done.Information systems are designed specifically to cater to a single firm’s managers’ needs, hence there is little standardizationGeneral business performance consulting has attracted many accountants since accountants are typically familiar with many facets of firm operations
12Who cares? “Information Useful in Investment and Credit Decisions Financial reporting should provide information that is useful to present and potential investors and creditors and other users in making rational investment, credit and similar decisions. The information should be comprehensible to those who have a reasonable understanding of business and economic activities and are willing to study the information with reasonable diligence.”SFAC 1, paragraph 34.
13Credit and equity investors Or, in other words: Who cares?Credit and equity investorsOr, in other words:Agents in Capital Markets!
14Types of Firm Ownership and Information Demand There are generally three types of firms in two major categories of ownershipPrivately Held Firms:1. Proprietorship—typically a small firm with one specific owner2. Partnership—typically medium-sized firms with shared ownershipPublicly Held (or Traded) Firms:3. Corporation—typically large firms with diverse ownershipOwnership rights can be bought or sold on an open marketWe will talk primarily about corporations throughout this course since virtually all corporations must create and file financial reports
15Why do publicly-traded Corporations have to file financial reports Why do publicly-traded Corporations have to file financial reports? MonitoringSeparation of ownership (shareholders) and control (hired managers) presents a classic principal-agent problem (agency theory)Agency theory suggests that, without proper monitoring and incentives, agents will extract perquisites (Jensen and Meckling, 1976)Financial reports are one mechanism to help monitor managers’ actions
16Why do publicly-traded Corporations have to file financial reports Why do publicly-traded Corporations have to file financial reports? InvestingIt is true that accounting information relates to past economic events. Whereas capital market investors are worried with future value.Financial analysis is therefore mostly a way to anticipate future economic events from information about past ones.Statistical techniques provide the tools for this.Financial analysis doesn’t tell what will happen, but it tells you what can happen. There is a chance of things going wrong. This chance defines risk and it can be measured.
17Risk vs Return Equity vs Credit Investors If you want to share more risk and become a partner of the firm, then you want to know the potential growth of the firm and basically you want to know all the info you can get: you want to be an equity investor!If you want to limit your risk and you are a creditor, then your concern will be the potential ability of the borrower to pay.In between there is a rich palette of different flavors of investors, concerned with accurate information for their investments.
18Financial Reporting (Key Players) Managers Ultimately responsible for the information disclosedFinancial information reflects the economic outcome of their decisionsMay have their compensation linked to some financial numbersDo possess some discretion power as to some of the decisions conditioning the financial informationShareholdersCan hire or fire managersUse financial information to evaluate the performance of the managersUse financial information to make investment decisions
19Financial Reporting (Key Players) Financial Accountant Hired by a firm to help prepare the firm’s financial reportsUsually works beneath the senior supervision of the Chief Financial OfficerHead Financial Accountant is usually called the ControllerAuditorIndependent Agent hired by the firm to regularly assess and attest to the financial reporting quality of the firmMaintains an on-going relationship with the firm (the audit client) to allow for regular inspection of financial processes and internal controls over financial processesTypically works for a “CPA Firm”
20Financial Reporting (Key Players) Auditor (continued) Few major national “CPA Firms” exist, due to mergers and EnronMany of these firms also offer internal control compliance consulting services
21Other potential users of the informations Authorities: government, regulatory bodies, and tax authoritiesThey want the information to monitor whether their policies are been executed.General public and special interest groups: labor unions, environmentalist, consumer groups.They want specific information that help them protect their interests.Competitors:They want information to gain competitive edge.
22Other professions using the information ANALYSTS:They want the information to be vast!CONSULTANTS:They want the information to be exclusive.AUDITORS:They want clear information that easily signals wrongdoings.CORPORATE LAWYERS:They want normative (ambiguous) information…ACADEMICS:They want the information to be consistent with some rationality.
23Rules for everyone?Can the financial reporting system keep everyone happy?Obviously not! There are contradicting incentives surrounding accounting information.How does the system deal with this?By hearing as many people as possible.By aiming at simpler rules, that shift most of the responsibility to the preparers of information.What’s the implication for financial analysis?There is a lot of room for ambiguity and a lot of need for interpretation.
24Financial Reporting System Who decides what constitutes Generally Accepted Accounting Principles (GAAP)?SEC Securities and Exchange Commission“The mission of the U.S. Securities and Exchange Commission is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.”They do not set the accounting rules. They simply tell publicly traded firms what rules to follow and what information to disclose. (Regulation S-X)
25Financial Reporting System AICPA American Institute of Certified Public Accountants“Its mission is to provide members with the resources, information, and leadership that enable them to provide valuable services in the highest professional manner to benefit the public as well as employers and clients. ”It is a professional organization for American accountants.
26Financial Reporting System FASB Financial Accounting Standards Board“The mission of the Financial Accounting Standards Board is to establish and improve standards of financial accounting and reporting for the guidance and education of the public, including issuers, auditors, and users of financial information.”They are the ones setting the accounting rules!
27Financial Reporting System FASB has 4 major types of publications:Statements of Financial Accounting StandardsStatements of Financial Accounting ConceptsInterpretationsTechnical Bulletins
28Financial Reporting System Governmental Accounting Standards Board (GASB)Other influential organizations (e.g. American Accounting Association, Institute of Management Accountants, Financial Executives Institute)
29International Financial Reporting Standards IASB International Accounting Standards Board“Its principal objectives are:to develop a single set of high quality, understandable, enforceable and globally accepted international financial reporting standards (IFRSs);to promote the use and rigorous application of those standards;to take account of the financial reporting needs of emerging economies and small and medium-sized entities (SMEs); andto bring about convergence of national accounting standards and IFRSs to high quality solutions.”
30International Financial Reporting Standards IFRS in a broad sense comprise:Framework for the Preparation and Presentation of Financial Statements—stating basic principles and grounds of IFRSIAS—standards issued before 2001IFRS—standards issued after 2001SIC—interpretations of accounting standards, giving specific guidance on unclear issuesIFRIC—newer interpretations, issued after 2001
31Assets = Liabilities + Equity Balance SheetAssetsProbable future economic benefits obtained or controlled by a particular entity as a result of past transaction or eventsLiabilitiesProbable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or eventsEquityResidual interest in the net assets of an entity that remains after deducting its liabilities.FUNDAMENTAL EQUATION OF THE BALANCE SHEETAssets = Liabilities + Equity
32Income Statement Revenues Inflows from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing major or central operationsExpensesOutflows from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity’s ongoing major or central operationsGains (and losses)Increased (decreases) in equity (net assets) from peripheral or incidental transactions
33Statement of Cash Flows (SFAS 95) Operating Cash FlowsBreadwinner of the firm. Cash flow consequences of the revenue-producing activities of the firmReported directly, using major categories of gross cash receipts and paymentsReported indirectly as reconciliation of net income to net cash from operating activitiesInvesting Cash FlowsRelates to decisions to maintain the firm operating in longer terms. (Acquisitions or divestitures in PP&E or subsidiaries)Should be reported directed, as all investment/divestment related cash payments and receipts should be identifiable. (gross, rather than net)Financing Cash FlowsIn theory, this should be a residual category. What ever cash is left should either go to retire debt or to return to the stockholders, which ever money is lacking, should be raised from debt issuance or requested from stockholders.
34Statement of Stockholders’ Equity Categories inside the SE:Preferred sharesCommon sharesAdditional paid-in capitalRetained earningsTreasury sharesEmployee stock ownership plan adjustmentsAccumulated Other comprehensive income
35FootnotesMostly they serve the purpose of providing additional information to better interpret the numbers disclosed in the financial statements. They refer to:Accounting methods, assumptions, or estimates used by the prepares to determine the data in the fin. stat.
36ContingenciesFirms are required to disclose information related to added risk. Some losses may happen with an increased probability and such losses are called contingent losses.When it is probable that the assets have been impaired or a liability has been incurred (SFAS 5 suggests a probability of 50% or more)The expected value of the amount of the loss can be reasonably estimated.Things such as:Environmental remediation liabilities, litigation, expropriation, self/insurance, debt guarantees, repurchase agreements, take-or-pay contracts, and throughput arrangements.
37Risks and Uncertainties Disclosure of Certain Significant Risks and Uncertainties require the following:Nature of operationsUse of estimatesCertain significant estimatesCurrent vulnerability due to certain concentrations
38Supplementary Schedules Special Cases for certain industries require these additional supplementsOil and gas companies are required to provide additional data on their exploration activities, including the NPV of some of their projectsImpact of changing pricesSegment disclosure of sales revenue, operating income, according to geographical or business segmentsFinancial instruments and hedging activities.
39Management Discussion and Analysis Mandated by the SEC, the MD&A is required to discuss:D&A of the management’s opinion on the current and prospective situation of the operations of the firm (trends in sales and expenses)Same for the cash flow situation. Where will the funding come from?
40Role of the AuditorIndependent CPA, their role is to certify the financial statements in conformity with GAAP.Must agree (or explain disagreement) with the management’s choices of accounting policies and estimates.Hired by the management, they are expected to be completely independent of it and do a thorough analysis of the firm’s accounts, by verifying the internal control system through their own separate control systems.
41Role of the AuditorAudit Opinion: Summary of the audit results regarding the financial reports and an assessment of internal controlsUnqualified: Financial statements appear to be presented fairly and in accordance with Generally Accepted Accounting Principles (GAAP); internal controls appear to be adequateQualified: Generally, financial statements appear to be presented fairly and in accordance with Generally Accepted Accounting Principles (GAAP), but there is some material issue that needs to be addressed; there is an issue that needs to be addressed regarding internal controlsAdverse: There is a high probability of material errors within the financial statements; there are material weaknesses in internal controls
42Role of the AuditorAuditors should be the main Agency Problem mitigators as they operate on behalf of the stockholders.Commonly ignored, their reports should always be checked by an analyst, specially if it raises doubts about the firm’s financials.Auditors are mandated to express not only their disagreements but also their doubts, mostly about:The going concern assumption;Uncertainties related to the value of some assets or liabilities;Some contingencies.
43Critical definitions of terms used throughout this course Assets: items owned by the firmLiabilities: items the firm owes to creditors(One source of funds available to purchase or create assets)Net Assets: Assets – Liabilities (the assets left over after paying off debt)Owners’ Equity: the owners’ claims to the assetsOwners’ Equity = Net Assets. Why?These are the fundamental concepts for the Balance SheetAssets(what is owned)=Liabilities(what is owed)Provide funds forOwners’ Equity(owners’ claims)
44Critical definitions of terms used throughout this course (contd.) Accounting Equation: Assets = Liabilities + Owners’ EquityCash + Other Assets(what is owned)=Liabilities(what is owed)Owners’ Equity(owners’ claims)Retained EarningsContributed Capital(cumulative profits kept withinthe firm)(Stock Issues)(note this is a second source of fundsfor purchasing or creating assets)Revenues(inflows of resources)Expenses(outflows of resources)
45Critical definitions of terms used throughout this course (contd.) Revenues: inflows to the firm (from providing services or sales)Expenses: outflows by the firm that are generated to help create revenuesGains: increases in value of firm assetsLosses: decreases in value of firm assetsNet Income: “profit” earned during the periodNote: the difference between these classifications is often subtle and confusingRevenues-ExpensesGenerally, “revenues” and “expenses” are associated with fundamental operational transactions+Gains-Losses=Net Income“Gains” and “losses” are associated with tangential transactionsThese are the fundamental concepts for theIncome StatementIn N’ Out Burger’s sales of hamburgers would generate “revenues”In N’ Out Burger’s sales of a delivery truck might generate a “gain” or a “loss”
46Critical definitions of terms used throughout this course (contd.)Income Statement: summary of revenues and expenses for the periodRevenuesOperations Section- Cost of Sales (Cost of Goods Sold)= Gross Margin- Selling and Administration Expenses= Income from Operations- Interest ExpenseNon operations Section- Other Expenses or Losses+ Other Revenues or Gains= Income before Taxes- Income Tax Expense= Income before Irregular Items-/+ Loss or Gain from Discontinued Operations (net of tax)Irregular Items Section-/+ Loss or Gain from Extraordinary Items (net of tax)-/+ Loss or Gain from Change in Accounting Principle (net of tax)= Net IncomeWe’ll cover this in more detail later…
48Critical definitions of terms used throughout this course (contd.) Dividend: periodic payment back to the owners; a distribution of profitsNow, let’s put this all together…
49The Big Picture Review Assets (what is owned) Liabilities The firm also borrows funds to purchase or create assetsAssets(what is owned)Liabilities(what is owed)Owners’ Equity(owners’ claims)Owners’ funds are used to purchase or create firm assetsInvestors (owners) contribute funds to create a firm
50The Big Picture Review Assets (what is owned) Liabilities (what is owed)Owners’ Equity(owners’ claims)Assets are used up (expenses)to generate revenueswhich nets to Net IncomeNet Income (Revenues – Expenses) is collected within the firm (as Retained Earnings)Retained EarningsBack to OwnersSome proportion of Retained Earnings is distributed to owners as a Dividend
51Next Class… Overview of the Financial Statements. More detailed discussion of the Balance Sheet.