2. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Communicating and Interpreting Accounting Information Chapter 5

3. 5-2 Learning Objectives Recognize the people involved in the accounting communication process (regulators, managers, directors, auditors, information intermediaries and users), their role in the process and the guidance they receive from legal and professional standards.

4. 5-3 Players in the Accounting Communication Process An unqualified opinion states that the financial statements are fair presentations in all material respects in conformity with GAAP. Independent Auditors Verification Partners, Managers, Staff Guided by GAAS Independent Auditors Verification Partners, Managers, Staff Guided by GAAS ManagementPreparation CEO, CFO, Accounting Staff Guided by GAAP ManagementPreparation CEO, CFO, Accounting Staff Guided by GAAP

5. 5-4 Information Intermediaries Analysis and Advice Financial analysis, Information services Information Intermediaries Analysis and Advice Financial analysis, Information services Financial analysts make predictions concerning companies’ future earnings and stock prices. Independent Auditors Verification Partners, Managers, Staff Guided by GAAS Independent Auditors Verification Partners, Managers, Staff Guided by GAAS ManagementPreparation CFO, CEO, Accounting Staff Guided by GAAP ManagementPreparation CFO, CEO, Accounting Staff Guided by GAAP Players in the Accounting Communication Process

6. 5-5 Information Intermediaries Analysis and Advice Financial analysis, Information services Information Intermediaries Analysis and Advice Financial analysis, Information services Financial analysts make predictions concerning companies’ future earnings and stock prices. Independent Auditors Verification Partners, Managers, Staff Guided by GAAS Independent Auditors Verification Partners, Managers, Staff Guided by GAAS ManagementPreparation CFO, CEO, Accounting Staff Guided by GAAP ManagementPreparation CFO, CEO, Accounting Staff Guided by GAAP Web Info Services: www/sec/gov www.compustat.com www.djnr.com www.bloomberg.com www.firstcall.com www.hoover.com Players in the Accounting Communication Process

7. 5-6 Government Regulators Verification SEC Members Guided by SEC regs. Government Regulators Verification SEC Members Guided by SEC regs. Users Analysis and Decision Investors, Lenders, etc. Users Analysis and Decision Investors, Lenders, etc. Public companies only ManagementPreparation CFO, CEO, Accounting Staff Guided by GAAP ManagementPreparation CFO, CEO, Accounting Staff Guided by GAAP Information Intermediaries Analysis and Advice Financial analysis, Information services Information Intermediaries Analysis and Advice Financial analysis, Information services Independent Auditors Verification Partners, Managers, Staff Guided by GAAS Independent Auditors Verification Partners, Managers, Staff Guided by GAAS Players in the Accounting Communication Process

8. 5-7 Ensuring the Integrity of Financial Information Communication Process Regulators Standard Setting and Verification SEC Regulators Management Primary Responsibility CFO, CEO, Accounting Staff Management Primary Responsibility CFO, CEO, Accounting Staff Auditors (CPAs) Verification Partners, Managers, Staff Auditors (CPAs) Verification Partners, Managers, Staff DirectorsOversight Audit Committee (Independent directors) DirectorsOversight

9. 5-8 Using Financial Reports Management Primary Responsibility CFO, CEO, Accounting Staff Management Primary Responsibility CFO, CEO, Accounting Staff Information Intermediaries Analysis and Advice Financial analysts, Information services Information Intermediaries Analysis and Advice Financial analysts, Information services Users Analysis and Decision Institutional and private investors, Lenders, Suppliers, Customers, etc. Users Analysis and Decision Institutional and private investors, Lenders, Suppliers, Customers, etc.

10. 5-9 Guiding Principles for Communicating Useful Information Primary Objective of External Financial Reporting To provide economic information to external users for decision making. Primary Objective of External Financial Reporting To provide economic information to external users for decision making. Primary Qualitative Characteristics Relevance: Timely and Predictive Feedback Value Reliability: Accurate, Unbiased, and Verifiable Primary Qualitative Characteristics Relevance: Timely and Predictive Feedback Value Reliability: Accurate, Unbiased, and Verifiable Secondary Qualitative Characteristics Comparability: Across businesses Consistency: Over time Secondary Qualitative Characteristics Comparability: Across businesses Consistency: Over time

11. 5-10 Guiding Principles for Communicating Useful Information Primary Objective of External Financial Reporting To provide economic information to external users for decision making. Primary Objective of External Financial Reporting To provide economic information to external users for decision making. Primary Qualitative Characteristics Relevance: Timely and Predictive and Feedback Value Reliability: Accurate, Unbiased, and Verifiable Primary Qualitative Characteristics Relevance: Timely and Predictive and Feedback Value Reliability: Accurate, Unbiased, and Verifiable Secondary Qualitative Characteristics Comparability: Across businesses Consistency: Over time Secondary Qualitative Characteristics Comparability: Across businesses Consistency: Over time The full-disclosure principles require... 1.A complete set of financial statements, and 2.Notes to the financial statements The full-disclosure principles require... 1.A complete set of financial statements, and 2.Notes to the financial statements

12. 5-11 International Accounting Standards Board and Global Differences in Accounting International Financial Reporting Standards

13. 5-12 Learning Objectives Identify the steps in the accounting communication process, including the issuance of press releases, annual reports, quarterly reports and SEC filings as well as the role of electronic information services in this process.

14. 5-13 The Disclosure Process Press Releases are used to announce quarterly and annual earnings as soon as the verified figures are available. Earnings Press Release Excerpt for Callaway Golf Callaway® Golf CARLSBAD, Calif. -- Jan. 22, 2004-- Callaway Golf Company (NYSE:ELY) today reported record sales for the full year ended December 31, 2003, announcing net sales of $814 million compared with $793 million for the prior year. Net income for the full year was $46 million versus.... Earnings Press Release Excerpt for Callaway Golf Callaway® Golf CARLSBAD, Calif. -- Jan. 22, 2004-- Callaway Golf Company (NYSE:ELY) today reported record sales for the full year ended December 31, 2003, announcing net sales of $814 million compared with $793 million for the prior year. Net income for the full year was $46 million versus....

15. 5-14 Annual Reports For privately held companies, annual reports are simple documents that include: For privately held companies, annual reports are simple documents that include: 1. Four basic financial statements. 2. Related notes (footnotes). 3. Report of independent accountants (auditor’s opinion) if the statements are audited. For privately held companies, annual reports are simple documents that include: For privately held companies, annual reports are simple documents that include: 1. Four basic financial statements. 2. Related notes (footnotes). 3. Report of independent accountants (auditor’s opinion) if the statements are audited.

16. 5-15 Annual Reports For public companies, annual reports are elaborate due to SEC reporting requirements: For public companies, annual reports are elaborate due to SEC reporting requirements: 1.A Nonfinancial Section A letter to the stockholders, a description of management’s philosophy, products, successes, etc. A letter to the stockholders, a description of management’s philosophy, products, successes, etc. 2.A Financial Section See next slide for a detailed listing... See next slide for a detailed listing... For public companies, annual reports are elaborate due to SEC reporting requirements: For public companies, annual reports are elaborate due to SEC reporting requirements: 1.A Nonfinancial Section A letter to the stockholders, a description of management’s philosophy, products, successes, etc. A letter to the stockholders, a description of management’s philosophy, products, successes, etc. 2.A Financial Section See next slide for a detailed listing... See next slide for a detailed listing...

17. 5-16 Annual Reports - Financial Section 1.Summarized financial data for 5- or 10-years. 2.Management Discussion and Analysis (MD&A). 3.The four basic financial statements. 4.Notes (footnotes). 5.Independent Accountant’s Report and the Management Certification. 1.Summarized financial data for 5- or 10-years. 2.Management Discussion and Analysis (MD&A). 3.The four basic financial statements. 4.Notes (footnotes). 5.Independent Accountant’s Report and the Management Certification. 6.Recent stock price information. 7.Summaries of the unaudited quarterly financial data. 8.Lists of directors and officers of the company and relevant addresses. 6.Recent stock price information. 7.Summaries of the unaudited quarterly financial data. 8.Lists of directors and officers of the company and relevant addresses.

18. 5-17 Quarterly Reports Usually begin with short letter to stockholders Condensed unaudited income statement and balance sheet for the quarter. Condensed unaudited income statement and balance sheet for the quarter. Often, cash flow statement and statement of stockholders’ equity are omitted. Some notes to the financial statements also may be omitted. Often, cash flow statement and statement of stockholders’ equity are omitted. Some notes to the financial statements also may be omitted. Usually begin with short letter to stockholders Condensed unaudited income statement and balance sheet for the quarter. Condensed unaudited income statement and balance sheet for the quarter. Often, cash flow statement and statement of stockholders’ equity are omitted. Some notes to the financial statements also may be omitted. Often, cash flow statement and statement of stockholders’ equity are omitted. Some notes to the financial statements also may be omitted.

19. 5-18 SEC Reports Form 10-K Annual Report Due within 90 days of the fiscal year-end.Due within 90 days of the fiscal year-end. Contains audited financial statements.Contains audited financial statements. Form 10-K Annual Report Due within 90 days of the fiscal year-end.Due within 90 days of the fiscal year-end. Contains audited financial statements.Contains audited financial statements. Form 10-Q Quarterly Report Due within 45 days of the end of the quarter.Due within 45 days of the end of the quarter. Financial statements can be unaudited.Financial statements can be unaudited. Form 10-Q Quarterly Report Due within 45 days of the end of the quarter.Due within 45 days of the end of the quarter. Financial statements can be unaudited.Financial statements can be unaudited. Form 8-K Current Report Due within 15 days of the major event date.Due within 15 days of the major event date. Financial statements can be unaudited.Financial statements can be unaudited. Form 8-K Current Report Due within 15 days of the major event date.Due within 15 days of the major event date. Financial statements can be unaudited.Financial statements can be unaudited.

20. 5-19 Learning Objectives Recognize and apply the different financial statement and disclosure formats used by companies in practice.

21. 5-20 Financial Statement Formats Let’s take a closer look at the asset section of the balance sheet!

22. 5-21

23. 5-22 Current assets are assets that will be turned into cash or expire (be used up) within the longer of one year or the operating cycle.

24. 5-23 Property, plant and equipment includes assets with useful lives of more than one year acquired for use in the business rather than for resale. The amount is reported net of accumulated depreciation.

25. 5-24 Intangible assets have no physical existence and a long life. They include patents, copyrights, trademarks, etc.

26. 5-25 Let’s now look at the liability section of a classified balance sheet.

27. 5-26

28. 5-27 Current liabilities are obligations that will be paid with current assets, normally within one year.

29. 5-28 Long-term liabilities are debts that have maturity dates extending beyond one year from the balance sheet date.

30. 5-29 Finally, we get to the stockholders’ equity section of a classified balance sheet.

31. 5-30 Contributed capital is often shown in two separate accounts 1.Common stock. 2.Additional paid-in capital. Contributed capital is often shown in two separate accounts 1.Common stock. 2.Additional paid-in capital.

32. 5-31 Retained earnings is the total earnings of the company less the total dividends declared since inception of operations.

33. 5-32 Balance Sheet Ratios and Debt Contracts When a company borrows money, it often agrees to certain restrictions on activity. Ratios typically part of the borrowing agreement include:

34. 5-33 Classified Income Statement Income statements may contain five sections: 1.Continuing operations 2.Discontinued operations 3.Extraordinary items 4.Cumulative effect of changes in accounting methods 5.Earnings per share Income statements may contain five sections: 1.Continuing operations 2.Discontinued operations 3.Extraordinary items 4.Cumulative effect of changes in accounting methods 5.Earnings per share

35. 5-34 Classified Income Statement General Format for the Classified Income Statement Gross sales minus any discounts, returns, and allowances during the period.

36. 5-35 General Format for the Classified Income Statement Classified Income Statement Cost of inventory sold.

37. 5-36 General Format for the Classified Income Statement Classified Income Statement Not related to the company’s primary operations. Usually includes interest income or expense and any gains or losses from the retirement of equipment.

38. 5-37 Common-Size Income Statement Total revenue is equal to 100%.

39. 5-38 Earnings Per Share EPS = Net Income Available to Common Shareholders Weighted Average Number of Shares Outstanding During the Reporting Period Basic EPS

40. 5-39 Earnings Per Share EPS = Net Income Available to Common Shareholders Weighted Average Number of Shares Outstanding During the Reporting Period Diluted EPS Stock options, debt securities, equity securities are assumed to be converted into common stock at the beginning of the period.

41. 5-40 Statement of Cash Flows Recall that the Statement of Cash Flows is divided into three major sections. Recall that the Statement of Cash Flows is divided into three major sections. 1.Cash flows from operating activities. 2.Cash flows from investing activities. 3.Cash flows from financing activities. We will examine the indirect method of preparing the statement. This format begins with a reconciliation of accrual income to cash flows from operations. We will examine the indirect method of preparing the statement. This format begins with a reconciliation of accrual income to cash flows from operations. Recall that the Statement of Cash Flows is divided into three major sections. Recall that the Statement of Cash Flows is divided into three major sections. 1.Cash flows from operating activities. 2.Cash flows from investing activities. 3.Cash flows from financing activities. We will examine the indirect method of preparing the statement. This format begins with a reconciliation of accrual income to cash flows from operations. We will examine the indirect method of preparing the statement. This format begins with a reconciliation of accrual income to cash flows from operations.

42. 5-41 This is the operating activities section of Callaway using the indirect method. Begin with accounting net income and arrive at cash provided by operating activities.

43. 5-42 While these items are on the income statement, they have no current cash effect.

44. 5-43 This table provides guidance for adjustments related to changes in current assets and current liabilities.

45. 5-44 Here is the rest of Callaway’s Statement of Cash Flows showing the cash balance on the company’s balance sheet.

46. 5-45 Notes to Financial Statements Descriptions of the key accounting rules that apply to the company’s statements. Additional detail supporting reported numbers. Relevant financial information not disclosed on the statements.

47. 5-46 Learning Objectives Analyze a company’s performance based on return on equity and its components.

48. 5-47 Return on Equity (ROE) 1 (beginning equity + ending equity) ÷ 2 Return on Equity = Net Income Average Stockholders’ Equity 1 ROE measures how much the firm earned for each dollar of stockholders’ investment.

49. 5-48 ROE Profit Driver Analysis ROE Net Profit Margin Asset Turnover Financial Leverage =×× Net Income Average Stockholders’ Equity Net Income Average Stockholders’ Equity Net Income Net Sales Net Income Net Sales Average Total Assets Net Sales Average Total Assets Average Stockholders’ Equity Average Total Assets Average Stockholders’ Equity ×× =

50. 5-49 Profit Drivers and Business Strategy High-value or product-differentiation. Rely on R&D and product promotion to convince customers of the superiority of your product. Low-Cost. Rely on efficient management of accounts receivable, inventory and productive assets to produce high asset turnover.

51. 5-50 Other Items Reported on the Income Statement Chapter Supplement A

52. 5-51 General Format for the Classified Income Statement Classified Income Statement In addition, companies may have nonrecurring items. These nonrecurring items may include: 1. Discontinued operations, 2. Extraordinary items, 3. Cumulative effect of changes in accounting methods. These items are reported separately because they are not useful in predicting future income of the company. In addition, companies may have nonrecurring items. These nonrecurring items may include: 1. Discontinued operations, 2. Extraordinary items, 3. Cumulative effect of changes in accounting methods. These items are reported separately because they are not useful in predicting future income of the company.

53. 5-52 Discontinued Operations Income or loss on segment’s operation for the period. Gain or loss on disposal of the segment. Gain or loss on disposal of the segment. Sale or abandonment of a segment of a business. Show net of applicable taxes.

54. 5-53 Extraordinary Items UnusualInfrequent Show net of applicable taxes.

55. 5-54 Cumulative Effect of Changes in Accounting Methods The change must be to a preferable method and must be disclosed in notes to financial statements. GAAP Method Change to Alternative GAAP Method Show net of applicable taxes.

56. 5-55 End of Chapter 5